There will be no Weekly Commentary for the week of XXXXXX. Scott’s most recent commentary is available below.
Inflation-adjusted Gross Domestic Product rose at a 3.2% annual rate in the advance estimate for the first quarter. The headline figure was a little less than expected and a little disappointing, but the details are what matters. One shouldn’t become wedded to these estimates, they will be revised, and revised, and revised again. However, the story is unlikely to change much. That story reinforces what we already knew.
The details of the advance 1Q10 GDP report were mixed. Consumer spending rose at a 3.6% annual rate (vs. +1.6% in 4Q09) and business spending on equipment rose at 13.4% pace (vs. +19.0%). Some of the improvement in consumer spending came through a drop in the savings rate. Wages and salaries rose at a 3.9% annual rate, although disposable income rose just 1.5% – just enough to keep up with inflation. The savings rate is a poor measure (it’s calculated as a residual, not measured directly, and subject to very large revisions). However, the drop in the savings estimate suggests that there is considerably less fear in the household sector. Job losses are one thing, but those who did not lose their jobs also cut their spending during the downturn. These households appear to be spending somewhat more now, perhaps encouraged by the improvement in the stock market over the last year and by a firming in home prices. Ultimately, we will need to see strong and steady job growth to make spending growth more sustainable.
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Consumer spending and business fixed investment are the heart and lungs of the economy. The 1Q10 numbers were good, consistent with an improving economy. However, other GDP components reflected continued headwinds. Spending on business structures fell at a 14.0% annual rate (vs. -18.0% in 4Q10). Residential fixed investment (homebuilding) fell at a 10.9% annual rate (vs. +3.8%). More troublesome, state and local government fell at a 3.8% pace (vs. -2.2%). Remember, the fiscal stimulus package included aid to the states, but it wasn’t enough apparently. Most states and cities have balanced budget requirements. Revenues slow down during a recession, so they have to raise taxes or cut services – both contractionary for the overall economy. These strains may get worse as the fiscal stimulus ramps down. The Los Angeles Times reported recently that the city had to scale back murder investigations since it didn’t have enough money to pay the detectives overtime. These kinds of tough decisions are occurring in city after city and will remain a moderate drag on overall economic growth in the quarters ahead. At the federal level, the government doesn’t have the same constraints. However, while the federal government should not try to balance its budget in the near term, it does need to reduce the size of deficit over the long term. Officials need to come up with a credible plan.
Inventories rose at a $31.1 billion (in 2005 dollars) pace in 1Q10, vs. a $19.7 billion decline in 4Q09, a $139.2 billion decline in 3Q09, and a $160.2 billion decline in 2Q10. This shift has added considerably to GDP growth in the last few quarters. However, inventories are unlikely to add as much to GDP growth from here on. Inventories have trended lower as a percentage of final sales over the last few decades, reflecting improvements in inventory management and global trade (a tendency to hold inventories abroad).
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What does the GDP report tell us about growth in 2Q10 and beyond? Not much, although it’s reasonable to suspect that positive momentum will carry through consumer spending and business investment, and that headwinds in residential and commercial construction will continue. State and local budget strains are not going to go away anytime soon, but the improving economy has already begun to lift tax revenues.
The mixed 1Q10 GDP report allows one to make all sorts of arguments about growth, but one should focus on the positives.
Wide federal budget deficits and highly accommodative monetary policy have led to some worries about a weaker dollar. However, there are many forces at work behind exchange rates. Will the dollar weaken in the quarters ahead, hold its own, or possibly rally? Let’s take a look.
First, where have we been? After rallying in the early part of the last decade, the exchange rate of the dollar weakened heading into the financial crisis. The crisis led to a boost in the dollar as a safe haven (in addition, there was a bid for dollars to cover expected losses in dollar-denominated securities, including derivatives, held abroad). With global economic conditions having improved considerably over the last year, the dollar moved back toward its pre-recession level.
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The exchange rate of the dollar is a price, determined by supply and demand. Trade and capital flows in and out of the United States are huge. In the U.S., we have a net trade outflow and a net capital inflow – and these two theoretically balance (the dollar moves to equate the two).
The current account deficit (which is mostly the trade deficit in goods and services) has a significant long-term impact on the dollar. The rise in the current account deficit in the last decade meant that the U.S. had to attract more net capital inflows to keep the dollar stable. The current account deficit peaked at 6.5% of GDP in 4Q05. The softer dollar resulted in some increase in imported inflation, but also dampened imports and made U.S. exports more competitive. The current account deficit had been improving ahead of the global financial crisis, but that improvement accelerated sharply as the global economy weakened. As a consequence, the U.S. needs smaller net capital inflows than it did before the crisis to keep the dollar steady. The current account deficit is now widening again – a long-term negative for the dollar.
Over the intermediate term (less than two years) relative growth prospects matter a lot. The U.S economic recovery is expected to be stronger than that of the United Kingdom and Europe. The IMF expects 2.8% GDP growth (4Q-over-4Q) for the U.S. in 2010 and 2.4% in 2011. In contrast, the IMF expects 1.2% growth in the Euro Area in 2010 and 1.8% in 2011. Growth in the UK is expected at 2.3% in 2010 and 2.6% in 2011. However, the upcoming election (May 6) in the UK, further sovereign debt worries in Europe (Spain, Portugal), and fiscal policy uncertainty in the U.S. cloud the relative growth outlook.
What about the U.S. federal budget deficit? As mentioned in previous missives, the large U.S. deficit is a function of the recession and two large temporary spending programs. The deficit should decrease as tax revenues pick up. However, the decrease in the fiscal stimulus into 2011 will act as a drag on economic growth. The Bush tax cuts are set to sunset at the end of the year. Raising taxes is not a good idea in a fledging economic expansion. Postponing those tax increases would be a good idea, but that would require a bipartisan effort.
In the short term, central bank policies are a major factor in exchange rates. The U.S. Federal Reserve is on hold for an extended period. Foreign central banks may be itching to hike, but should be reluctant to move until inflation appears as a more credible threat. However, the Fed is more likely to raise later, perhaps putting some downward pressure on the dollar.
Worries about the UK and Europe will provide some support for the dollar in the near term. In the Great White North, the strong Canadian dollar poses a dilemma, for Canada’s economy depends on exports to the U.S. – and a weaker economy would push its currency down again. The Chinese appear likely to let the renminbi appreciate, but don’t expect much.
In short, there are a lot of uncertainties in the dollar outlook, but a large move in either direction seems unlikely for now.
The core CPI rose just 1.1% over the 12 months ending in March. That’s at the low end of the Fed’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 it’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 Bernanke’s first stint as a Fed governor. At the time, Bernanke led the charge at the Fed to insure that deflation “doesn’t happen here.” In a deflationary period, consumers postpone purchases (since prices will be lower next month) and businesses curtail capital expenditures (since they won’t receive a return on investment) – and economic weakness leads to even lower prices – 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 – yielding the misleading moniker “Helicopter Ben.” 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 – a small fraction of government debt.
It’s been suggested that the Fed could reduce the government’s debt burden by allowing inflation to increase – 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.
It’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. That’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 government’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). It’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, we’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 – 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, there’s little flow-through to the consumer level. Inflation is simply not going to be a problem for the foreseeable future.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – 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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