More slack, lower inflation. Slack in the economy likely will widen slightly in this below-trend outlook, implying a slower rise in inflation. With 2Q growth now at just 1.6%, our new 2H forecast implies growth of 2% for the last three quarters of 2010 - below the 2.5% that we think represents the trend. Such tepid growth implies a higher unemployment rate at year-end, perhaps 9.7% rather than the 9.4% we had assumed. Other measures of slack may either stall or perhaps widen as well. For example, with housing demand weaker than expected, there is a risk that vacancy rates will rise again.
The implications for inflation are important: While we still think core inflation has bottomed, more slack will mean that ‘speed' effects - the effect of shrinking slack on pricing and inflation - will fade, and the rise from today's 0.9% CPI likely will be even slower, keeping inflation below the Fed's comfort zone for longer.
The Fed shifts to an easing bias. Against this backdrop, Fed Chairman Bernanke this morning clearly indicated that the Fed is prepared to ease monetary policy further, if appropriate. The key paragraph from his speech follows:
We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.
In our view, our new outlook and the downside risks associated with it require the Fed seriously to consider such additional easing. But the odds of such action are still far from certain. That's because there are still hurdles to actually doing something as opposed to thinking about it.
Three hurdles to action. First, despite the weaker data so far, easing is a big step. There is a possibility that recent data are just a head fake. What would be the costs of taking out deflation insurance that turns out to be unnecessary? In our view, the real risks in easing aren't so much that it would make policy too accommodative in the near term. Rather, they stem from the potential confusion among market participants about policy targets and tools.
In that regard, and second, officials must decide whether they need to articulate more fully the model or framework for additional easing, including spelling out intermediate yardsticks for gauging success and more specific ultimate goals. In that context, it's hardly surprising that market participants are looking for more clarity.
What do we mean by model or framework? We mean clarifying why policy actions to date haven't produced the desired results, and what the Fed thinks is needed to achieve them. Specifying yardsticks to gauge policy success might be helpful in a world of zero policy rates. For example, if additional easing - through quantitative easing (QE) or some other means - were aimed at bringing down real rates, will simply announcing additional purchases make clear the Fed's intentions? Or might the Fed specify a nominal cap on interest rates as an intermediate target? Regarding specific ultimate goals, might the Fed specify an explicit inflation target to guide the path of policy and the exit strategy? Careful thought is required before acting.
Third, despite the easing bias, the FOMC is not unanimous either about the need for additional easing or how to implement it. Chairman Bernanke must sell the doubters on the need and the benefits. More dovish members likely believe that QE is working but that more large-scale asset purchases (LSAPs) are needed. Skeptics still doubt the efficacy of QE and are worried about the exit strategy from an even larger balance sheet. Others are concerned about the potential for persistently low interest rates to create financial imbalances.
Benefits and costs of three tools to implement easing. Chairman Bernanke discussed three tools that the Fed could use to implement ease: Ramped-up quantitative easing, stronger language committing the Fed to accommodative policy, or cutting the rate paid on excess reserves (IOER). He ruled out suggestions to raise the Fed's inflation target.
These three steps all have costs and benefits, but Bernanke indicated a clear preference for additional QE. Changing communications strategy - perhaps along the lines of the Bank of Canada's commitment to keep rates unchanged until 2Q10, announced in April 2009, or the Bank of Japan's to sustain ZIRP until inflation turned positive, announced in 2001 - would be difficult for the Fed to implement "with sufficient precision and clarity". And investors already "are not anticipating any significant policy tightening by the Federal Reserve for quite some time". Cutting the IOER from the current 25bp to 10bp or zero would likely have a "relatively small impact" on financial conditions and "could disrupt some key financial markets and institutions".
Problems with ramped-up QE seem more minor. The Fed does not have "very precise knowledge" of the likely impact, raising the "difficulty of calibrating and communicating policy responses". Also, ramped-up QE would be more difficult to reverse and "could reduce public confidence in the Fed's ability to execute a smooth exit from its accommodative policies at the appropriate time" - which clearly is not a pressing concern at this point.
Given the "difficulty of calibrating and communicating policy responses" with any unconventional tools, it's not surprising that the Chairman did not mention the potential for using additional tools along the lines he laid out in his November 2002 speech or elaborate further on the framework for monetary policy beyond his emphasis on the Fed's ultimate goals. While the FOMC has not "agreed on specific criteria or triggers for further action", Chairman Bernanke strongly stated the Fed's resolve to prevent deflation and support the economic recovery. And if downside risks were to increase, the "benefit-cost tradeoffs of some of our policy tools could become significantly more favorable".
That makes upcoming data the focus in the weeks ahead of the September 21 FOMC meeting, such as the employment report, other key data that will impact expectations for 2H GDP growth, and gauges of inflation expectations like TIPS breakevens and surveys. The central tendency for the FOMC's forecast for 2H GDP growth compiled in late June was about 3.25%, which would have been fast enough to continue gradually reducing slack in the economy (including lowering the unemployment rate) and to contain risks of further disinflation. If the FOMC growth outlook moves materially below this towards 2.5% or worse, then the unemployment rate would instead be expected to drift gradually higher, slack in the economy to start to rise again, and downside inflation risks to rise.
Why has the economy weakened? There's no mistaking the weakness of incoming US data, from slowing employment gains and bigger-than-expected ‘paybacks' in home sales to a sharper-than-expected decline in capex bookings and shipments.
However, unless we know why the economy has weakened, we have trouble assessing the future. In our view, the main culprit for weakness relative to our forecast is waning or less-than-expected support from global growth, which we had expected to offset a slower pace of domestic demand. Net exports have been a drag on output this year, and even a positive swing in 2H won't make up for the 2Q downdraft, when surging imports substituted for US output. On the export side, global domestic demand growth among our trading partners also seems to be weaker than we had expected.
Other factors likely also played a role. Congress did temporarily terminate unemployment insurance (UI) benefits and aid to the states in May and June; that may have created as much as $60 billion in fiscal drag, even though these programs have been reinstated. In addition, uncertainty about the direction of tax and other policies may have caused businesses to hesitate. Beyond the weakness in incoming data, the battle in Congress over reinstating and finding ‘pay-fors' for UI probably underscored the perception that policy is handcuffed. The gridlock in Washington over near-term and longer-term fiscal policy goals may also have created the perception that the Administration and Congress will not and cannot respond to weakness in the economy.
Implications for 2011. Given that diagnosis, we don't think this slowdown will last beyond 2H, much less morph into a downturn. In his Jackson Hole speech, Chairman Bernanke seemed to agree that the current economic weakness does not augur a weaker outlook for 2011. We agree. Among the reasons: Downside risks probably will prompt policy actions, balance sheet repair will be more advanced, and we expect net exports to improve in 2H10 and into 2011. In fact, we see no reason to downgrade 2011 and possible reasons to upgrade, especially if policy turns more stimulative.
Treasuries ended a volatile week slightly lower, as a further rise in already serious pessimism about the economic outlook following a run of terrible mid-week reports on home sales and capital goods orders was reversed when Fed Chairman Bernanke made clear in his Friday speech in Jackson Hole that the Fed now has an easing bias and is prepared to act if needed to counter rising downside risks to growth and inflation. At the market's most pessimistic point Wednesday morning after the run of plunging existing home sales, new home sales and orders for core capital goods, the 30-year yield was down another 20bp on the week and nearly 60bp since the FOMC meeting and the 10-year inflation expectation in the TIPS market had broken below 1.5% after a nearly 40bp drop since the FOMC meeting. But as investor expectations started to rise that the deteriorating 2H growth outlook was likely to prompt a more meaningful Fed response if it continues after the disappointment with the Fed's announcements at the August 10 meeting, some of the huge post-FOMC meeting bull flattening of the yield curve and plunge in inflation expectations started reversing over Wednesday and Thursday. And when Fed Chairman Bernanke made clear Friday that the Fed has an easing bias heading into the September 21 FOMC meeting, this shift towards a less dire outlook was sharply extended with a sizeable bear steepening of the yield curve and major outperformance by TIPS. The odds of the Fed ramping up quantitative easing at the next FOMC meeting (which clearly seemed to be Bernanke's preference among the options for further easing he discussed) are considerably less than certain, in our view, and will likely hinge on additional weakness in the incoming data, with a very busy week of key releases on tap for the coming week. But to the extent that the recently softer tone to the data suggests that the 2H growth outlook has shifted from slightly above trend to slightly below trend, slack in the economy in coming months will likely rise gradually instead of fall and downside risks to inflation will reemerge after the recent stabilization in core inflation. Incorporating the very weak results for home sales and capital goods orders and shipments and taking a broadly more cautious outlook for other data assumptions, we now see 2H growth running at 2-2.5% instead of 3-3.5%, which we expect will leave the unemployment rate at 9.7% at year-end instead of 9.4%, while other measures of slack may stall or reverse course as well (see US Economics: Changing Our H2 US Growth Outlook, August 27, 2010). The ongoing shift in the Fed's outlook may be similar - the central tendency for the FOMC's forecast for 2H growth compiled in late June was about 3.25%. If Fed views are being downgraded towards 2.50% or worse, then its expectations would also likely be that the unemployment rate will gradually drift higher instead of fall, slack in the economy broadly start to rise again, and downside inflation risks to rise - potentially calling for a policy response.
On the week, benchmark Treasury yields rose 2-5bp after a major reversal off the Wednesday morning lows of about 25bp for the 30-year and 20bp for the 5-year. The old 2-year yield rose 5bp to 0.54%, 3-year 5bp to 0.83%, old 5-year 2bp to 1.47%, old 7-year 2bp to 2.07%, 10-year 3bp to 2.65%, and 30-year 4bp to 3.70%. TIPS also strongly reversed course to strongly outperform in the second half of the week, and the long end of the TIPS market did well all week after a very strong 30-year TIPS auction on Monday. The 5-year TIPS yield fell 2bp to 0.14%, 10-year rose 1bp to 1.02%, and 30-year fell 10bp to 1.65%. Mortgages traded much better through the week after a terrible run in relative terms for a while after the FOMC meeting (far less so in absolute terms as general yield levels were falling). After hitting another all-time low below 3.3% on Thursday, current coupon MBS yields ended near 3.4% Friday, modestly stronger on the week as Fannie 4% issues outperformed the small net Treasury market losses by about a quarter point. The lengthening run of record-low MBS yields finally is starting to drive mortgage rates notably lower, narrowing what has been an unusually wide gap between market rates and consumer rates. At the level current coupon MBS yields have been running the past couple of months, average 30-year mortgage rates might be expected in normal times to already be down to 4.125% or lower. But they were stuck near 4.50% through July and early August as the shrunken and consolidated mortgage origination industry cited capacity constraints. Rates have started to break significantly lower recently, however, and averaged 4.36% this week according to Freddie Mac's national survey. This has started to drive a big refinancing wave in the 4.5% coupon MBS in recent weeks that should continue in coming weeks and further accelerate the already greatly advanced progress in healing consumer balance sheets and bringing down consumer debt service ratios and debt to income ratios to long-term sustainable levels that haven't been seen in a very long time.
A positive reaction to Chairman Bernanke's speech helped risk markets end the week on a positive note and partly reverse a more negative tone through the first part of the week. The S&P 500 ended the week down 0.7%. The cyclical energy, financials, industrials and materials stocks led the upside Friday, but for the week as a whole the more defensive utilities and consumer staples sectors did best. Credit also gained Friday to pare the losses through Thursday. For the week, the investment grade CDX index widened 2bp to 111bp, and the high yield index widened about 15bp to near 590bp.
Existing home sales plunged 27% in July to 3.82 million units annualized, a record low in the 12 years of available data, showing a severe payback from the boost to sales ahead of the April expiration of the homebuyers' tax credit (existing home sales are counted at closing, while the tax credit only required a sales contract be signed, when new home sales are counted, by then end of April). Single-family sales fell 27% to 3.37 million, a low since 1995, while condo sales fell 28% to 460,000, a low since January 2009. The number of homes listed for sale at the end of July ticked up 2.5%, which combined with the plunge in the sales pace resulted in the months' supply of unsold homes spiking to 12.5 months from 8.9 months, a high since 1983 and more than double a balanced level of around six months. Meanwhile, new home sales fell 12% in July to a 276,000 unit annual rate, moving to a new low after a 12% rebound in June following the initial 32% post-tax credit plunge in May. The months' supply of unsold new homes rose to 9.1 months from 8.0, but only because of the drop in the sales pace. The level of new homes for sale was steady at a 42-year low in July, as there is almost no new home construction going on at this point, with the number of homes completed in July and the number of homes under construction at the end of the month both plunging to all-time lows. These results pointed to a big drag from the small brokers' commissions component of GDP. This category makes up about 20% of residential investment and only 0.5% of GDP, but it surged 86% in 2Q and added 0.3pp to the 1.6% rise in overall GDP. Another tax credit also boosted 2Q, with the ‘cash for appliances' incentives helping drive a 20% rise in home improvements spending. These two categories accounted for three-quarters of the 27% surge in 2Q residential investment. But the terrible July home sales results point to about a 65% drop in brokers' commissions in 3Q, and we expect that the surge in improvements will be reversed, which would put 3Q residential investment on pace for a decline near 25% in 3Q, more than reversing the 2Q gain.
The outlook for business capital spending doesn't look nearly this bad, but after a dismal durable goods report it looks like equipment and software investment will only post a modest further gain in 3Q after the 25% surge in 2Q was the key driver of the rise in overall GDP. Durable goods orders rose marginally in July, thanks to a spike in volatile aircraft bookings, but underlying orders fell sharply, with non-defense capital goods ex aircraft bookings plunging 8.0% to reverse an 8.5% surge over the prior two months - continuing a persistent seasonal adjustment problem over the past couple of years that has resulted in orders plunging in the first month of the quarter and then rising sharply in the next two months. Core capital goods shipments fell 1.5% in July, and the much larger-than-expected drop in orders resulted in a small decline in unfilled capital goods orders, pointing to much slower growth in business investment in 3Q. We see equipment and software investment at this point rising about 4% in 3Q after surging 25% in 2Q and 20% in 1Q. Structures investment seems likely to turn negative again in 3Q after posting a fractional gain in 2Q, so we see overall business investment growth slowing to +1.5% from +18%.
Consumption at this point seems to be on pace for a third-straight muted quarterly rise near +2%, and we see government spending growth also gaining around 2%. Combined with the big drop that now seems likely for residential investment and the only small gain in business investment, this would put final domestic demand growth on pace for a gain of only about +1% after the 4.3% surge recorded in 2Q. On top of this, some reversal of the extraordinary -3.4pp drag from net exports in 2Q, the second biggest ever after 1Q 1947, and a modest further boost from inventories, with production in 3Q off to a very solid start in the July IP report, would leave overall GDP in 3Q running around +2% - about 1.25pp below our prior estimate and not a strong enough pace to lead to any further narrowing in the slack in the economy. For 2H as a whole, we now see growth running at 2-2.5% instead of 3-3.5%, and we suspect that a similar shift is ongoing among Fed officials. While not numerically all that big an adjustment, such an outlook change from slightly above to slightly below potential has important implications for the medium-term expected direction of change in the unemployment rate, inflation and monetary policy.
The upcoming week is very busy (before a nearly empty calendar during the week of Labor Day) with key economic releases highlighted by the employment report Friday. If the data are as uniformly dismal as the key releases the past week, then the odds of a near-term Fed move back into easing mode will probably be reasonably high at week-end. We are expecting generally sluggish results in the key numbers but probably only enough that the near-term Fed policy outlook looking ahead to September 21 will probably still appear a close call. The minutes from the August FOMC meeting will be released Tuesday, but the policy discussion has clearly shifted significantly in the weeks since then, and Wall Street Journal Fed reporter Jon Hilsenrath already provided probably a more interesting overview of the apparently somewhat divisive discussions in his article this week than is likely to be revealed in the official minutes. More supply is right back on tap, with the 10-year TIPS reopening to be announced Monday and auctioned Thursday and the post-Labor Day run of 3s, 10s and 30s also scheduled to be announced Thursday. Key data releases include personal income and spending Monday, consumer confidence Tuesday, ISM, construction spending and motor vehicle sales Wednesday, chain store sales, revised productivity and factory orders Thursday, and employment and non-manufacturing ISM Friday:
* We forecast 0.4% gains in both personal income and spending. The employment report pointed to a good gain in wage and salary income as average hours and earnings expanded solidly even as payroll growth was sluggish. Meanwhile, although underlying retail sales were soft, upside in autos and a boost to services from heavy air conditioner use during the summer heat wave should still drive a good rise in overall consumption. Finally, the core PCE price index is expected to be +0.14% in July, which would leave the year-on-year rate at +1.4%.
* We look for about a 3.5-point rise in the Conference Board's measure of consumer confidence to 54.0, reflecting the modest improvement seen during early August in other sentiment gauges - such as the University of Michigan and ABC/Washington Post polls. Note that even with the expected advance, the Conference Board index would still be stuck near the midpoint of the range that has prevailed since mid-2009.
* We forecast a 3-point drop in the manufacturing ISM in August to 52.5, as weak results from regional surveys released so far point to a pullback in the ISM after it held at a high level in July with help from a surge in motor vehicle assemblies.
* We look for a 0.3% gain in July construction spending. A continued upswing in state and local government activity, which has surged at a 19% annual rate in the past four months after falling 10% over the prior year, as the infrastructure spending from the early 2009 fiscal stimulus bill has started to materialize, should boost overall construction spending modestly even with flat expected private sector activity.
* We look for August motor sales to tick up to 11.7 million units annualized, which would be near the best level since the big ‘cash for clunkers' boost of a year ago. However, despite a sharp rise in assemblies in July, sales still appear to be constrained by a lack of dealer inventories.
* We expect 2Q productivity growth to be revised down to -1.9% and unit labor costs up to +1.2%. The measure of output relevant for this report was revised down a bit more than overall GDP growth, pointing to a one-point downward adjustment to productivity growth and a corresponding upward revision to unit labor costs.
* We look for a 0.1% gain in July factory orders. The spike in aircraft orders in the durables report that offset substantial weakness in underlying capital goods bookings along with an assumed flattening out in non-durable goods should lead to a fractional rise in overall factory orders.
* We forecast a 75,000 decline in non-farm payrolls in August and a 40,000 gain excluding temporary census workers. Although we suspect that there may be some distortions in the jobless claims figures that have been released over the past month or so, it does seem that the underlying improvement in labor market conditions has stalled. Thus, we look for another modest rise in private payrolls in line with the performance seen over the prior three months. Census jobs were down about 115,000 this month, and we are assuming another 10,000 drop in state & local government employment (implying a +50,000 forecast for private jobs). By sector, we look for a sharp rebound in the temp help category to be partially offset by flattening out of job growth in manufacturing. The unemployment rate is expected to tick up a tenth, and the average work week is likely to hold steady this month.
The recent sell-off in the Mexican peso - which traded near the weakest levels of the year - seems to reflect mounting concerns about the strength and sustainability of the US' and Mexico's economic recoveries. At first sight, these fears may seem overblown given that, even as the industrial sectors in both countries remain as synchronized as ever, the Mexican economy soared at a 13.5% sequential annualized clip in 2Q - the strongest quarter in at least three decades - while the US decelerated to an anemic 1.6% annualized. And though the most recent batch of monthly data - from exports to retail sales and leading indicators - suggests that the pace of growth in Mexico has cooled off, employment levels are well above pre-crisis levels while the already sluggish underlying improvement in US labor market conditions seems to have stalled out (see US Economics: Changing our H2 Growth Outlook, August 27, 2010).
Mexico's encouraging pace of hiring and decline in the rate of unemployment, however, mask a less favorable trend: the quality of employment creation has been relatively poor even one full year since the economy bottomed out. The low quality of new jobs in Mexico, in our view, suggests that a self-sustained, domestic-led growth dynamic has yet to take hold. And the lack of good jobs, in turn, suggests that Mexico's job-driven recovery in consumption remains fragile, reinforcing our concern that absent a supportive global backdrop - and US industry in particular - Mexico is unlikely to find much support from domestic demand to propel the economy ahead (see "Mexico: The Link Is What Really Matters", This Week in Latin America, August 23, 2010).
Where Have the Good Jobs Gone?
An important feature of the ongoing economic recovery is that it has been associated with robust employment growth - in sharp contrast with the episode that followed the recession in 2001, which was largely jobless. As soon as the first signs of a firming in external demand appeared in mid-2009, industry began hiring and, by late 2009, job growth in the formal sector had broadened into other areas of the economy as well. Indeed, formal market data indicate that employment levels by June of this year - after a year-long expansion at a strong average pace in excess of 4.5% annualized - had recovered for all the jobs lost during the Great Recession, topping the previous high levels of July 2008. Meanwhile, as of 2Q10, total (formal and informal) employment in the economy hit a record level of 44.7 million - nearly 4% above the deepest point in the recession - according to the broader survey by Mexico's statistical institute INEGI.
But one year since the economy turned the corner in mid-2009, measures of employment quality still leave a lot to be desired, as indicated by various gauges including levels of informality, the reliance of employers on temporary workers and wage trends. Focusing solely on the positive story of absolute levels of employment likely provides an overly bullish picture of the potential resilience for consumption to a deterioration in external conditions.
After rising sharply during 2009, levels of informality increased further through 1H10. By mid-year, in fact, nearly 13 million workers were considered informal, representing 28.8% of the total. Since the national statistics institute's (INEGI) comprehensive employment survey began in 2005, the ratio of informality had never been higher than in 2Q10.
While in and of itself rising informality shouldn't necessarily be a bearish development for consumption - and higher informality is usually associated with economic downturns - it underscores the challenge of creating good jobs for a growing Mexican economy. For example, the surge in informality is in part linked to strong growth in so-called micro businesses, which employed an unprecedented 18.6 million people in 2Q10 or 41.6% of all workers. Of the total number of micro businesses, some 55% are included in the group classified as without locale, which includes such jobs as street vendors.
In addition to informality, other measures of quality of employment are also at elevated levels. The index of workers in critical conditions, though off its peak in 2Q09, remains at elevated levels. Workers facing critical conditions - which is a combination of people working fewer than 35 hours in the survey-reference week due to market conditions, those working over 35 hours on less than 1 minimum salary and people working over 48 hours making up to 2 minimum salaries - amounted to a still-high 11.9% of the total in 2Q10 or more than 1.5pp above the early 2008 lows. In addition, an alternative measure that combines the unemployment rate and the percentage of employed population working fewer than 15 hours per week actually deteriorated during 2Q10, approaching the most recent highs from 3Q09.
Wage trends in the broader economy have deteriorated as well. The share of workers making up to two minimum wages has been on the rise, reaching 37% by mid-2009. With the share of non-paid workers holding steady between 8% and 9% of the total, the increase in the lowest-paid jobs has mirrored a drop in higher-paid positions. The number of workers earning more than five minimum wages declined steadily through mid-2010, while those making between three and five minimum salaries gave up during 2010 part of the improvement seen in 2009.
On the formal market front, captains of business have relied disproportionately on temporary workers to fulfill their hiring plans. Since the economy began to add formal jobs in 3Q09, temporary workers have accounted some 36% of all new jobs, which is three times the weight that temps represent in total formal employment. While the relative importance of temps has declined this year - from almost 45% of all new jobs between August and December of last year to closer to 32% so far in 2010 - it still accounts for a disproportionate share of new jobs, likely suggesting cautiousness among employers about the sustainability of the ongoing economic recovery.
Bottom Line
Mexico's strong pace of hiring has been associated with a relatively poor quality of employment creation, suggesting that Mexico's job-driven recovery in consumption remains fragile. This, in turn, reinforces our concern that absent a supportive global backdrop - and US manufacturing in particular - Mexico is unlikely to find much support from domestic demand to propel the economy ahead.
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