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August 2010
Nearly two years of zero percent interest rates, a $1.2 trillion expansion of the Federal Reserve's balance sheet, and a nearly $800 billion fiscal stimulus package in February 2009 have failed to produce sustainable growth. The newly released gross domestic product data, including first estimates of second-quarter growth and revisions of past data, carry two disappointing messages. First, growth of demand--final sales of goods and services, a necessary condition for sustainable employment growth--is very weak and set to weaken further. And second, demand growth over the past year has been overestimated.
The second-quarter growth rate was reported at a 2.4 percent annual rate. Excluding the substantial contributions of 1.1 percentage points from inventory accumulation (unsold goods) and 0.9 percentage points from government spending (set to slow down sharply during the coming quarters), second-quarter growth was just 0.4 percent.[1] Meanwhile, 2009 final sales growth, originally reported as a tepid 1.4 percent, was cut to just 0.9 percent.
The second-quarter data would have been even weaker--close to zero--were it not for the temporary boost to residential investment from the homebuyer tax credit that expired at the end of April. Homebuilding added another 0.6 percentage points to second-quarter growth, essentially negative at minus 0.2 percent. Without the artificial boosts from temporary government spending, higher inventories of unsold goods, and housing stimulus, second-quarter growth was essentially zero. Unprecedented monetary and fiscal policy measures, largely already implemented, have left us with virtually no sustainable growth going forward.
We do not have liftoff. As the "V-shaped" recovery--with stimulus launch and private-sector, second-stage boost--has fizzled, the Federal Reserve's talk of exit strategy, in the form of shrinking its balance sheet in preparation for eventual increases in the federal funds rate, has faded rapidly. That talk has been replaced by nervous murmurs about a loss of growth momentum and widespread discussions of what the Fed could do to provide--once again--more boost. The available options, as became clear during Federal Reserve chairman Ben Bernanke's July 21-22 semiannual congressional testimony on the economic outlook, are not particularly inspiring.
Deflation worries have emerged as global inflation rates drift below a 1 percent year-over-year pace, well below the informal inflation target of 2 percent. Lower growth and inflation prospects have driven interest rates on U.S. ten-year notes down to 2.9 percent--far down from the 4 percent April levels that prevailed during the days of the presumed "V-shaped" recovery. Meanwhile, Japan, with its solid deflation rate of 1.6 percent year-over-year and a re-stagnating economy, provides a vivid reminder of where other G7 countries do not want to go, notwithstanding the 1.05 percent, deflation-driven low yields on its ten-year notes.
Policy Drift
Bernanke's November 2002 speech about the importance of avoiding deflation and the many ways available to achieve that goal has been widely reread and commented upon. Bernanke's basic point back in November 2002 (when he was a Fed governor) was to move early, forcefully, and preemptively to fight deflation by sharply cutting the fed funds rate. That prescription unfortunately is of no help now that the fed funds rate has been zero for nearly two years with a tripling of the Fed's balance sheet added on and creating, by some estimates, an equivalent of a minus 5 percent fed funds rate.[2] The Fed has provided plenty of extra experimental monetary stimulus and now, in the second half of 2010--during what Vice President Joe Biden hailed as the "summer of recovery"--the economy is slowing again. The patient--the U.S. economy--has received massive doses of stimulus medicine, and as that medicine is being withdrawn, it appears that the patient has not yet recovered. "What now?" is the obvious question at this point, especially as fiscal thrust is shifting sharply from positive to negative not only in the United States, but also globally. Monetary policy options, still available, are essentially experimental drugs.
The cry emanating from the June G20 meeting for a halving of deficits over the next two years will, if implemented, crush global growth--especially given the sharp slowdown of U.S. demand appearing at midyear. The notion expressed by the G20 politicians and the head of the European Central Bank that such a collective removal of fiscal thrust will be expansionary--because the prospect of lower future taxes will boost spending--is both preposterous and dangerous. In the past, successful fiscal consolidation by countries such as Sweden, Canada, and others has worked because it has been undertaken separately by relatively small, open economies that allowed a simultaneous, sharp currency depreciation to cushion the drag on aggregate demand arising from fiscal contraction.
The weaker currency cushion for collective fiscal tightening is unavailable to G20 nations that are collectively and simultaneously pursuing tighter fiscal policy. Every currency cannot depreciate at once; if the dollar depreciates with weaker U.S. growth, as it has begun to do at midyear, the implied currency appreciation in other large economies--Japan and Europe come readily to mind--will transmit the contractionary and deflationary pressure appearing in the United States to those economies.
Given the de facto Chinese currency peg to the dollar that is still in place, a weaker dollar means a weaker yuan, which in turn means a loss of growth momentum concentrated in the rest of Asia. Should China's growth continue to decelerate, as its currency weakens against its Asian and non-Asian emerging-market trading partners (Brazil, for example), the notion of an emerging market "decoupling" from a U.S. slowdown will be severely tested. Recall that China reported on July 15 a growth slowdown from a 10.8 percent annualized pace during the first quarter of 2010 to a 7.2 percent pace in the second quarter of 2010.
Will U.S. Growth Hold Up?
It is always possible that the sharp U.S. growth slowdown emerging this summer will prove transitory. After all, optimists say, real U.S. disposable income over the three months ending in May grew at a 5.6 percent annual rate, and U.S. consumers with the wherewithal to spend constitute a powerful source of demand growth. But it is important to note that growth of personal income during March, April, and May was substantially and temporarily enhanced by government transfer payments and hiring of census workers. This point becomes clear if one looks at the year-over-year growth rate of real disposable income through May, which was a dismaying minus 0.2 percent. (The average growth rate of real disposable income during the past decade has been 2.2 percent.) While the growth of real disposable income was slightly negative over the last year, real consumer spending rose 2.6 percent, somewhat above the average for the last decade, which equaled growth in real disposable income at 2.2 percent. Spending growth in excess of income growth does not continue for long when employment is barely rising and consumer confidence is waning.
During the three months ending in May, for example, retail-sales growth was reported up at a 6 percent annual rate, reflecting the expectations of optimists. However, a month later, during the three months ending in June, the annualized growth rate of retail sales had collapsed to minus 5 percent because of weaker June spending and substantial downward revisions to spending in April and May. Further, the 2.1 percent month-over-month spending surge in March dropped out of the three-month span.
Recent international trade data have severely undercut the expectation that vibrant global growth would contribute to U.S. growth. In May, the U.S. external trade deficit surged. While exports grew, imports grew even more. A strong substitution effect emerged, wherein U.S. importers shifted to cheaper foreign suppliers as U.S. demand growth weakened. Their aim was to maintain sales and profit margins by importing less-expensive goods, especially from China and the rest of Asia, where excess capacity and a willingness to sell for less abound. The substitution away from U.S. suppliers by U.S. consumers and producers puts more pressure on the U.S. traded-goods sector to cut its prices, thereby exacerbating the move toward deflation that is starting to worry the Federal Reserve.
U.S. consumers are also reducing their outlays by deleveraging--paying off debt and reducing their reliance on credit. Consumer credit has plunged, with a three-month annualized drop through May at a 9.7 percent annualized rate. Underscoring these concerns, the University of Michigan Consumer Sentiment Index showed a sharp drop of nearly ten points in July, the largest decrease since October 2008 when the September collapse of Lehman Brothers was creating virtual panic in the U.S. economy.
Further reinforcing a slowing of U.S. consumption and cautious deleveraging is a virtual double dip in the U.S. housing market. The homebuyer tax credit that expired at the end of April expedited home purchases and temporarily flattered the data, creating a surge of home sales during March and April that in turn prompted a modest and ill-advised rise in housing starts during those same two months. Since April, sales of new and existing homes have collapsed, with more volatile new home sales falling by 32.7 percent during May from April's artificially elevated levels. Of course, housing starts have collapsed as well--dropping at a 43.8 percent annual rate during the three months ending in June--even including the artificially stimulated April rise in starts.
The post-tax-credit housing collapse is indicative both of the temporary nature of stimulus measures applied during 2009 and early 2010 and of the lack of follow-through from private demand when the stimulus measures expire. A double dip in housing that started in May after house prices had already dropped by a third on average--thereby erasing over $8 trillion (about 15 percent of total wealth) in household wealth--has severely damaged consumer confidence and cut household spending.
The resulting sharp loss of demand growth will mean a substantially weaker second half of 2010 for the U.S. economy, with the possibility of negative growth by the fourth quarter. The sharp slowing of the U.S. economy is also problematic for the global economy, especially given the extant drag from Europe's sovereign debt crisis and signs of slowing growth in China and the rest of Asia.
Currency tensions will rise in an environment of falling exports in a region where exports remain the key to growth. On July 21, a member of the monetary policy committee that advises China's central bank suggested that China will allow its currency to weaken if exports drop. Recall that just before June's G20 meeting, the Chinese stated a willingness to allow more currency flexibility. That new currency rhetoric from China was widely heralded as a signal that the Chinese would allow their currency to strengthen over the coming year as the U.S. government had been urging. With exports threatening to weaken, the Chinese, a month later, are reminding us that increased currency flexibility can cut two ways.
As the Chinese were suggesting the possibility of a weaker currency, the Bank of Japan's deputy governor Hirohide Yamaguchi was warning--on the same day, July 21--that a strong yen could hurt Japanese exports--obviously an expression of concern about the negative consequences for Japanese exporters of a loss of competitiveness in global markets that would be exacerbated by a weaker Chinese currency. In sum, the battle among export-dependent Asian nations for market share in a shrinking global market has begun.
The U.S. Policy Response
The growth trajectory into the third and fourth quarters looks very weak as fiscal stimulus turns to fiscal drag while private-sector spending, which should have been lifting off, is actually slowing rapidly. Third-quarter growth will probably slip to 1 percent or below while, as already noted, zero or negative growth looks possible for the fourth quarter. The outlook for a pickup in 2011 is not bright, given a likely further drag from higher taxes in January as the Bush tax cuts expire. The Fed's current forecast of 3.5 percent second-half growth, as long as it persists, will delay the Federal Open Market Committee's response to a rapidly weakening economy and raise the probability of outright U.S. deflation. And, as also already noted, the global economy, burdened by tightening fiscal policy and slower U.S. demand growth, is not likely to offer much help to U.S. growth.
There is no easy or obvious U.S. policy response to cushion the U.S. economy from further damage, but surely the exit strategy from monetary accommodation that was widely discussed during April and May was an ill-advised path for the Federal Reserve to contemplate. In fact, the April end to Fed purchases of mortgage securities may have produced a badly timed, modest tightening of monetary policy just as the temporary housing stimulus measure--tax credits--was wearing off. Nor is immediate U.S. fiscal tightening advisable at this point, rapid increases in deficits and government debt notwithstanding.
U.S. fiscal policy should be altered to produce reliable cuts in future deficits and debt starting in 2012 and 2013, depending on the path of the economy. Legislation should be passed early in 2011; it is too late for this year given that Congress will not be entertaining any new initiatives until after the November elections. Measures should include a legislated phase-in of a later retirement age and more accurate indexing formulae (which would result in more modest increases) for those receiving Social Security benefits. Beyond that, a phase-down of tax expenditures, such as tax preferences for owner-occupied housing, could save enough money to allow stimulative reduction in tax rates, as was done in the 1986 tax reform.[3]
Monetary policy must be aimed at the immediate task of avoiding negative growth and the deflation that may come with it.[4] The Fed should set a price-level target that implies aggressive further easing--through asset purchases and a pledge of a zero percent fed funds rate for two years--if inflation keeps falling toward zero or negative (deflation) territory. These measures should be undertaken proactively--now--in view of falling core inflation--currently at 0.9 percent year-over-year--and the abrupt slowdown of U.S. growth now occurring.
As we arrive at the point when we need to move from the normative to the positive, from "should" to "will," I am not sanguine. On the fiscal front, Congress and the White House have shown little appetite for pursuing the most basic principle of public finance--the lowest possible tax rates on a broad tax base--preferring instead to selectively raise tax rates while continuing to lose revenue on tax expenditures to aid special interests like real estate. The "cash for clunkers" stimulus for automobiles and the homebuyers' tax credit were textbook cases of counterproductive fiscal policy. Their effects were temporary and, because of the substantial resource misallocation they encouraged, costly. The housing bubble resulted from overstimulation of the housing sector. The federal government's response to its bursting was a cynical effort to reinflate a totally burst bubble.
The Federal Reserve's reaction to the midyear economic slowdown and the rising threat of deflation it entails has been tepid so far. In his midyear report to Congress on the U.S. economy on July 21, Bernanke began by saying, "The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies." Clearly the chairman is not prepared to signal a response from the Fed, either to slower U.S. growth or the threat of deflation. The chairman spent more time describing stimulus withdrawal than additional stimulus.
The current stance of the Fed, as signaled by Bernanke's July 21 testimony, looks far too complacent. The Fed will be late to move to attempt additional stimulus and therefore will face a lower chance of success in cushioning the slowdown.
We have not achieved liftoff and may be heading for a sharp reversal of the modest growth achieved so far. With lower growth will come a higher risk of deflation and a global slowdown. This pattern of central bank complacency after the acute phase of a financial crisis that allows a growth relapse in the real economy is all too common. We saw it in Japan during the late 1990s and in 2001, as well as in 1937 during the Great Depression in the United States. Let us hope that the August 10 Federal Open Market Committee meeting will signal a more decisive Fed response to the threat of negative growth, further disinflation, and deflation.
John H. Makin is a visiting scholar at AEI.
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Notes
1. On average, inventories contribute nothing to growth, but they contribute mightily to its changes from quarter to quarter.
2. Goldman Sachs and the San Francisco Federal Reserve, among others, have provided estimates of the fed funds rate equivalent of adding $1.2 trillion to the Fed's balance sheet. See Goldman Sachs, "More Thoughts on the Zero Funds Rate View," U.S. Economics Analyst 10/09 (2010): 2.
3. See Martin Feldstein's excellent July 20 op-ed in the Wall Street Journal, "The 'Tax Expenditure' Solution for Our National Debt."
4. See last month's Economic Outlook, "The Rising Threat of Deflation," and the author's July 16 Financial Times column, "It Is Time to Face Down the Threat of Deflation."
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