There will be no Weekly Commentary for the week of XXXXXX. Scottâ??s most recent commentary is available below.
The core CPI rose just 1.1% over the 12 months ending in March. Thatâ??s at the low end of the Fedâ??s comfort range and likely to lead to renewed talk of possible deflation. Deflation, a general decline in the overall price level, is still not likely and the Fed has the tools to defeat it. However, recent disinflation (a declining inflation rate) should raise some eyebrows at the Fed.
Several measures of core inflation have been trending lower in recent months. Weakness in rents has a lot to do with that, but itâ??s more than a housing story. Nearly half of the weight in the CPI has seen flat or lower prices over the last year.
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The last time core inflation was this low was during Ben Bernankeâ??s first stint as a Fed governor. At the time, Bernanke led the charge at the Fed to insure that deflation â??doesnâ??t happen here.â? In a deflationary period, consumers postpone purchases (since prices will be lower next month) and businesses curtail capital expenditures (since they wonâ??t receive a return on investment) â?? and economic weakness leads to even lower prices â?? a vicious downward spiral.
The Fed has the tools to fight deflation. Bernanke once joked that the central bank can always throw money from helicopters to generate inflation â?? yielding the misleading moniker â??Helicopter Ben.â? More accurately, the Fed could purchase Treasury securities outright. In fact, The Fed did buy Treasuries last year (the Fed purchased $300 billion in long-term Treasury securities between April and October). That move was justified due to the threat of deflation, which was a serious risk as the economy was tanking. Still, $300 billion was not a lot in the scheme of things â?? a small fraction of government debt.
Itâ??s been suggested that the Fed could reduce the governmentâ??s debt burden by allowing inflation to increase â?? effectively monetizing the debt. However, that makes no sense. Entitlement programs are tied to the CPI. So higher inflation would simply raise future obligations accordingly. In addition, higher inflation would raise borrowing costs, adding further to the deficit. Monetizing the debt is simply not an option.
Itâ??s also been suggested that the Fed target a higher level of inflation, say around 4%, to give policymakers more leeway to cut short-term interest rates during an economic downturn. Thatâ??s also inadvisable, for the same reasons.
Many worry that elevated budget deficits will lead to higher inflation, perhaps even hyper-inflation. Hyper-inflations are the result of the government taking control of monetary policy and simply printing money to pay the governmentâ??s debt. The basic difference between government policy and Fed policy is that the government has to borrow to spend and the Fed can simply create money out of thin air. That power is not something that the Fed takes lightly. It also emphasizes the critical importance of having an independent central bank.
Higher budget deficits are not inflationary. Much of the increase in the deficit has been due to the loss of tax revenue in the recession and to two big spending programs (the bank rescue and the fiscal stimulus). Itâ??s perfectly natural to run large deficits during a recession, but we started the recession already in a pretty big hole. After the economy recovers and temporary spending has faded, weâ??ll still be left with a structural deficit. Efforts to reduce the deficit will require tough choices on spending and taxes. However, lawmakers rarely win any points for doing something to benefit the country in the long term.
With moderate wage gains and strong productivity growth, there is no inflation pressure coming from the labor market â?? nor will there be for some time. Manufacturing is growing, but there is a huge amount of slack in production. Commodity price pressures are mixed, but generally higher. However, thereâ??s little flow-through to the consumer level. Inflation is simply not going to be a problem for the foreseeable future.
The economy is growing again. Recent data reports have been consistent with a gradual recovery. While the advance estimate of 1Q10 GDP growth wonâ??t be released until later this month (and most March data have yet to arrive), it appears likely that real GDP growth may have been close to a 4% annual rate. As with 4Q09 GDP growth, much of that is expected to be inventories (shifting from a moderate decline to a moderate increase). Underlying demand still appears relatively lackluster at this point in the recovery, but it is increasing.
Consumer spending, roughly 70% of Gross Domestic Product, was tracking at a little more than a 3% annual rate through February. Wage income fell during the recession, but the economyâ??s automatic stabilizers (taxes fall and transfer payments rise during recessions) helped disposable income advance. These stabilizers will fade away as job growth picks up, making the recovery more sustainable.
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Business sales (factory shipments plus wholesale and retail sales) have been improving since the middle of last year.
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The end of the inventory correction and a rebound in global trade have helped the manufacturing sector to recover. ISMâ??s monthly manufacturing survey showed broader strength in March. Corporate profits, a key driver of business fixed investment, have improved through the fourth quarter.
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A number of headwinds lie ahead in the second half of this year. The fiscal stimulus will start to ramp down. The Bush tax cuts will sunset at the end of the year. State and local government budgets remain under considerable strain. Residential housing problems will linger and commercial real estate is expected to be a problem for many small to medium-sized banks around the country. However, these forces are likely to only dampen growth, not send us into a double dip.
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The biggest risk of a double dip would come from a policy mistake (interest rates or taxes are raised too soon). However, the price of oil is always a wildcard in the economic outlook. A substantial rise in the price of oil would boost inflation in the short-term, but the more worrisome aspect would be the negative impact on economic growth.
High levels of government debt are a big concern for investors both here and abroad. Efforts must be made eventually to reduce deficits. However, acting too soon will weaken the economic recovery. Looking ahead, there are no easy solutions.
The U.S. federal budget deficit has soared during the recession, due largely to a drop in revenues (which happens in every economic downturn, this current one being a lot more severe) and two large, but temporary, spending programs (the bank rescue and the fiscal stimulus). Large deficits are (or should be) fully justifiable during a severe recession. The federal government cannot spend its way to a recovery. A sustainable expansion will depend on the private sector. However, large government deficits should buy some time, reducing the damage and allowing the private sector time to recover.
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The federal debt (the sum of past deficits and a few surpluses) is currently about $12.7 trillion, of which $4.5 trillion (35%) is debt that the government owes itself. Marketable debt totals about $8.2 trillion, or nearly 56% of Gross Domestic Product. Government debt is not like household debt. There is no reason that it has to be paid off. In fact, one wouldnâ??t want to. That doesnâ??t mean that the deficit shouldnâ??t be reduced as a percentage of GDP. That could be accomplished by reducing the annual budget deficit as the economy improves. Projections suggest that the deficit will decrease to around 3.5% of GDP in a few years as the economy recovers and temporary spending fades. The bigger worry is the longer-term outlook. A recent New York Times article pointed out that Social Security will have net outflows this year, much earlier than expected. Thatâ??s true, but itâ??s largely a consequence of the recession. The Times also suggested that the Social Security System is â??on a path toward insolvency.â? Thatâ??s nonsense. Benefits may have to be cut back or revenues increased, but the system cannot go bankrupt.
What about the cost of servicing the government debt? Currently, interest payments on the debt arenâ??t particularly onerous. Over the last 12 months, these payments totaled $202 billion, vs. $229 billion over the 12 months ending February 2000. However, interest rates may not stay low forever. As interest rates rise, interest payments will increase.
What about foreign ownership of U.S. government debt? Foreign purchases of U.S. debt are largely a function of the trade deficit. Theoretically, the current account deficit exactly matches the capital account surplus (in reality, there is statistical discrepancy) and the dollar moves to equate the two. A wider current account deficit implies larger net capital inflows.
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The current account deficit dropped significantly during the recession (and net capital inflows were correspondingly lower), but is increasing again. Itâ??s important that global imbalances do not return to previous levels (the current account deficit was 6.5% of GDP in 4Q05). Currency adjustments, particularly an appreciation of the Chinese currency, may be needed. Treasuryâ??s semiannual exchange rate report is due on April 15. There is pressure to officially label China a currency manipulator. To do so would set in motion trade restrictions (tariffs, quotas). Nobody wins in a trade war, but in this case, China probably has more to lose. After holding its currency steady against the greenback for the last two years, China may allow its currency to appreciate â?? and thatâ??s a good thing.
Meanwhile, there is growing public sentiment that the federal budget deficit be reduced. Having a credible plan to reduce the deficit over time is important, but the deficit is currently playing an important part in the recovery processes. To address the shortfall too soon, raising taxes or cutting spending, risks derailing the economic recovery. History is clear on this. State and local government budgets are also under strain, and some very tough choices on spending and taxes lie ahead.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report â?? to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy â?? please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
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