Transcript of "US Economic Uncertainties and the Lack of Long-Term Policy Framework for Monetary and Fiscal Policy "
Market nsights By Blu Putnam, Chief Economist, CME Group 6 July 2012US Economic Uncertainties and theLack of Long-Term Policy Frameworkfor Monetary and Fiscal PolicyAll examples in this presentation are hypothetical Consumer and business confidence in the US economy is being heldinterpretations of situations and are used for explanation back both by fiscal and monetary policy. The fiscal policy issuespurposes only. This report and the information herein should are relatively well-known; however, the drag on the economy goingnot be considered investment advice or the results of actual forward from a highly accommodative monetary policy is less wellmarket experience. appreciated. While quantifying the impact of a lack of confidence in long-term fiscal and monetary policy is fraught with issues, we canThe economy in the United States is set to post real GDP growth say that our real GDP growth projections for 2013 and 2014 would bein 2012 of approximately 2.5%, as shown in Table 1 below. After about a full percentage point higher if the Federal Reserve was nota strong start in the first few months of 2012, a bout of market still in emergency mode and there was more clarity on tax rates andfears generated by the disarray and confusion in Europe and rising federal spending for the upcoming year, let alone the decade.concerns over the pace of the slowdown in global trade had theeffect of freezing corporate expansion plans and slowing the paceof net new job creation. Progress in the European sovereign debtand banking system debacle along with more economic stimulusfrom China suggests second half US economic growth will be slightlybetter than the first half. While the 2012 hurdles for the US economywere largely sourced from the international arena, longer-termchallenges are more likely to be home grown, in the form of a lack ofmarket confidence in both fiscal and monetary policy that may slowgrowth prospects for 2013.This report focuses first on the relatively solid and robust conditionof the US private sector. The private sector has completed itsdeleveraging process following the financial panic of 2008 and hasestablished a solid foundation. What is missing is confidence in thefuture, which brings us to our main arguments for consideration. 1 market insights
6 July 2012A Rebuilt, Solid Economic Foundation for net jobs lost have been recovered, even through mid-2012, threethe Private Sector full years into the new economic expansion. Thus, while there is no question that the economy has embarked on a steady economicFollowing the financial panic of 2008, the US private sector expansion over the last three years, what is at issue is why thefound itself with unrealistic expectations of future income and economic expansion following the Great Recession has beenwealth, giving rise to a strong desire to reduce its debt. In the relatively modest, creating net new jobs at a much slower paceGreat Recession of 2008-2009, the only solution available to the than previous economic cycles.private sector was to cut spending and pay back (or default) ondebt. The actions of the private sector were swift and brutal in The answer to the slow pace of employment recovery lies in severalterms of their impact on the economy. Real GDP fell just over 5% places. First, the relative cost of labor compared to capital is higherfrom its pre-recession peak in Q4/2007 to its recession low in than it was 10, 20, or 30 years ago, due to various tax and laborQ2/2009. Corporate profits were decimated in 2008 and 2009. laws than bias corporations toward expanding capital insteadThe unemployment rate soared from a low point of 4.4% in March of labor. This is not a new trend, but it means that after each2007 to a peak of 10.0% for October 2009. January 2008 was recession, when jobs get cut, the process of recovering the lost jobsthe height of reported payroll employment at 138 million jobs. takes longer and longer. This is a structural problem that is notBetween January 2008 and February 2010, which was the low subject to influence from monetary policy, but can be impacted bypoint for payroll employment, a net 8.8 million jobs were lost. The fiscal policy and other legislated initiatives.housing market, which had gone into recession before the rest of Second, and as we will explain in the next section, our view is thatthe economy did, absolutely collapsed. New single-family home the new job creation process in this economic expansion alsosales had peaked all the way back in 2005 with an average of 1.279 involves the confidence corporations have in the future. As wemillion units. That number had declined 70% to 374 million units assess the current situation, corporations have the profits andfor the 2009 average. There is good reason that 2008-2009 has they have the cash to fund expansion. What corporations in thebecome known as the Great Recession, given the abrupt cutbacks US are lacking is the confidence to grow their businesses morein economic activity spawned by the financial crisis of 2007 and aggressively. And, confidence has been badly damaged by four2008. key elements: two from the international scene and two homeAs severe as the recession was, recovery started quickly partly grown. The international challenges for corporate confidence havebecause the private sector made its adjustments in such a rapid come, first, from the sovereign debt and banking system debacle infashion and partly due to the initial quantitative easing program Europe; and secondly, from the pace of economic deceleration inby the Federal Reserve to stabilize the banking system. The US China and other emerging market countries which has been worseeconomic recovery can be dated as commencing in the third than was the general consensus in 2011.quarter of 2009. From the Q3/2009 quarter onward through With regard to the Euro-zone problems, we see real progressQ2/2012, the US economy has average annualized real GDP toward a financial safety net that will prevent banking systemgrowth of approximately 2.35%, reeling off 12 consecutive positive issues in Spain and sovereign debt issues in Greece, Portugal,growth quarters through mid-2012. During the same time frame, Spain, and Italy from causing a highly disruptive break-up of thealmost 4 million net new jobs have been recovered from the low Euro. Europe is going to be economically stagnant for a long-timepoint in 2009 through the first half of 2012. due to the required fiscal austerity, but the crisis atmosphere isA Job-Creation Challenged Economic slowly abating.Expansion Our long-held view on China was that it would, indeed, see itsWhat has policy makers and the public concerned is that while economic growth decelerate more rapidly than the general marketthe level of the real GDP measure of the economy exceeded its consensus, as we discussed in our December 2011 report, “China:previous peak in the third quarter of 2011, a little less than half the Slower Export Growth, End of the Infrastructure Boom Years”.2 market insights
6 July 2012We see China’s real GDP slowing into the 7% range in 2012, on redirected to discretionary purchases. This means retail salesits way to an average of 6.5% for the decade. This is impressive growth slowed in the second quarter, but is likely to accelerate aeconomic growth for any major country, but it pales beside the little in the second half of 2012. And, after years in the doldrums,10% annual average growth rate of the previous two decades. But we are seeing life in the housing sector as we had projected earlierthis deceleration of economic growth is part of a natural process this year.toward a more mature economy, and there is every sign that the Figure 2Chinese government is increasing stimulus programs to soften theslowdown.In short, we view developments in Europe, and to lesser extent inChina (since we had anticipated its slowdown), as the proximatecauses for why the US economy appears unable to ramp backtoward a 3%-plus real GDP growth path during this economicexpansion, and more specifically as to why the additional economicmomentum we had projected at the end of 2011 for 2012 wassetback in the first half of 2012 and has not materialized. Given astagnant Europe and 6.5 – 7.5% real GDP growth path for China in2012 and 2013, we would still be able to project US real GDP in 2013getting back above 3% to around a 3.5% annual growth rate if itwere not for the home grown storm clouds on the horizon coming Corporate profits have been strong enough since 2010 tofrom US fiscal and monetary policy. We see the current prognosis generate healthy internal cash flow (See Figure 3). And,for US fiscal and monetary policy as the main impediments left to corporations appear to have regained access to bank financing,rebuilding corporate confidence and thus leading to a more rapid reflected in the recent increases in banking sector commercialpace of net new job creation. Let us explain. and industrial loans and leases.Rebuilding Corporate Confidence As already noted, one of the challenges for corporations inConsumer spending growth and affordable access to capital are the US is adjusting to slower economic growth from overseas,necessary conditions for corporations to make the key decisions to as discussed in the last section. This is critical since roughlyexpand their businesses and hire new workers. But neither of these half of US corporate cash flow from the S&P 500 companiesfactors represent sufficient conditions for hiring expansion, they comes from outside the US. We see 2012 as a transition yearare just essential parts of the puzzle. toward realistic expectations of future business potential from a stagnant Europe and slower-growing emerging marketFor the record, though, consumers largely completed their countries, and from our perspective most corporations havedeleveraging process by the middle of 2011, as reflected in a adopted reasonably appropriate business expectations.turning point and then steady increase in the use of consumercredit (See Figure 2). There was some pent-up demand from the Figure 3recession for previously deferred purchases of big ticket items,such as automobiles. This meant that after an early surge, thegrowth rate of retail sales seems to be settling into the 5% range,which is comfortably above the current 2% core inflation rate.Also, the decline in gasoline prices at the pump which is occurringin the US had the effect of initially reducing spending, before themoney saved from these typically essential expenses is eventually3 market insights
6 July 2012Looking ahead to 2013 and beyond, the real potential game- the maximum marginal tax rates for upper income individualschanger for the employment outlook is the confidence, or is a headline issue for the press, but will have a much smallerlack thereof, driven by fiscal and monetary policy. From our impact on future economic activity than the increases in theperspective both fiscal and monetary policy are working to alternative minimum tax. We also think the US Congress willlower our 2013 and 2014 economic projections for the US raise the debt ceiling, as it always has, but also as usual, it willeconomy, and for net new job creation in particular. The do it at the last minute – maybe even after a few months offiscal policy arguments are well understood, so we will cover buying time with accounting tricks.them first and only briefly. The reason monetary policy, as This “most likely” scenario is not confidence inspiring and itaccommodative as it might appear on the surface, now has does not provide the framework for long-term planning thatstarted to hinder the development of more rapid economic would most assist the job creation process. On the othergrowth prospects is a more complex and less well understood hand, brinkmanship and stop-gap measures have become theline of reasoning, so we will tackle that topic in a little more norm, and both consumers and corporations have learneddetail. to cope with this messy process, if not enjoy it. Of the threeFiscal Policy Uncertainty Remains the items on the fiscal agenda for the new Congress in 2013,Base Case postponing the automatic spending cuts is the most critical to our economic projections. Tax policy and the debt ceiling,The primary obstacle to an increase in business confidence is however, are extremely important in setting the tone forthe elevated uncertainty concerning US tax and fiscal policy long-term consumer and business confidence. The potentialfor 2013 and beyond. The Bush-era tax cuts were enacted with upside “surprise” factor is that the US Congress is able to reachsunset clauses, and they are due to expire at the end of 2012. In a long-term compromise for a fiscal tax and expenditure policyaddition, severe and automatic spending cuts were legislated for the next ten years or so. While the details matter, this is oneto commence in Fiscal Year 2013, if the joint Congressional of the few cases when the devil is less in the details and moretaskforce failed to produce a long-term fiscal policy plan. Since about whether we get a long-term stable fiscal policy that willno long-term compromise fiscal plan was agreed, the cuts in support planning and confidence-building or not.both defense and discretionary spending are due to hit with thestart of the new fiscal year in October 2012. We will also see the Can Extended Monetary Accommodationdebt ceiling breached again late in the first half of 2013, adding Hinder Economic Confidence?to the possibility of fiscal policy disarray. We have come to the conclusion that a failure of the FederalIf we really thought the most likely case was for a big tax hike Reserve to take a few baby-steps toward interest-rate policyand massive spending cuts, our 2013 real GDP forecast would normalization will become increasingly a major hindrancehave the economy moving back into recession. Instead, to the growth of the economy in 2013 and 2014. This lineour high probability case is that Congress engages in its of reasoning focuses on the potential negative impact onnow standard ritual of brinkmanship, but eventually passes consumer and business confidence from a Federal Reserve thattemporary measures that will prevent an abrupt turn toward remains in emergency policy mode even after three full yearsrecession even if they fail to agree to a long-term framework of economic expansion. This line of reasoning is not about thefor fiscal policy. On the spending side, our most likely scenario potential for future inflation from an overly accommodativeincludes a stop-gap measure that postpones the draconian Federal Reserve. Inflation may surface as a problem downspending cuts through 2013 or 2014. With regard to tax policy, the road, but it is not a problem today and it is not the issuefrom an economic perspective, it is the pervasive rise of the which is confronting the Federal Reserve. The issue we mustalternative minimum tax rules through the next decade that assess for our 2013 and 2014 economic projections is whetherwill be the largest drag on economic activity and a direct hit the current “keep dry power at the ready” approach hindersto the middle class if it stays in effect as planned. The rise in corporate confidence and is not as conducive to future economic growth as it might appear on the surface.4 market insights
6 July 2012Our analysis rests on two key points. First, the use of Once the economy has been growing steadily for severalquantitative easing and expansion of the Federal Reserve’s years and once the job creation process is making inroads onbalance sheet has an absolutely critical role in preventing an unemployment, even if the economic progress is not as rapid asimplosion of the banking system during a financial crisis and policy makers might prefer, then a continuation of emergencyhas virtually no role in enhancing economic activity once the policies can actually slow down the recovery. By way ofcrisis has been averted. Second, extreme or emergency mode illustration, once a heart attack patient has been stabilized andinterest rate policies are highly distortive of the yield curve the required surgery has been completed, remaining for a longand once the economy has been growing for a few years, the time in the intensive care unit of the hospital is not conducive tocontinuation of emergency mode policies tends to disrupt the the recovery process.return to normal economic activity through direct and indirect After the financial crisis has past, the decisions by the Federalways. Reserve to embark on a second round of quantitative easingWhen the sub-prime mortgage crisis erupted into public view and then operation twist, even after the economy was growing2007, the financial system was in trouble. Then in September again, was made with the best of intentions but not necessarily2008, with the messy bankruptcy of Lehman Brothers without a full appreciation of the distortions and costs ofand the next-day hasty bail-out of AIG, the banking system further balance sheet activity and what an extended period ofliterally froze. The use by the Federal Reserve of its balance near-zero rates may mean for the economy. Market distortionssheet expansion powers to purchase some trillion dollars of are not without costs. In this case, an extended periods of lowmortgage-backed securities and other assets from banks in rates across the yield curve means we are seeing a wholesaledistress, in our view, was an essential element in preventing transfer of wealth away from long-term savers and pensionersthe crisis from becoming a Great Depression, possibly worse with the objective of making capital cheaper for companies tothan the 1930s. By contrast, our analysis does not support expand production and increase hiring. Business investmentthe contention that further rounds of quantitative easing and, and expansion decisions, however, are much more dependentlater, operation twist have had any discernible impact toward on corporate views of the future demand and risks than onencouraging a more rapid pace of net new job creation than the cost of capital. That is, even if capital is cheap, businesseswas already occurring. will be reluctant to expand if they perceive elevated risks in future demand. And, with the population aging and savingsWe have come to this conclusion because we believe that and pensions under stress, the Federal Reserve has effectivelyfinancial crises lead to consumer and corporate deleveraging engineered a drag on consumer demand as an unintended andthat is largely insensitive to monetary policy – low rates or asset unappreciated consequence of staying in emergency modepurchases. The reason is that perceptions of future income and promising the possibility of further balance sheet andand wealth that were ratcheted downward by the financial crisis quantitative easing actions.mean that debt and spending must be cut to achieve a new andmore realistic balance among income expectations, current Comparing Market Expectations with theassets and liabilities, and future spending. Whether the Federal Taylor RuleReserve buys another trillion dollars of US Treasury bonds or The original Taylor Rule provides a very useful frameworktwists the yield curve so long-bond yields are lower has very for analyzing the trade-offs in the dual mandate of thelittle impact on consumer spending or on corporate investment Federal Reserve to promote price stability and encourage fullplans during a deleveraging phase. During the deleveraging employment. Our calculations indicate that a few small baby-phase, the main policy responsibility of the central bank is to do steps in the direction of normalizing interest rate policy wouldwhat it can to maintain a secure and well-functioning banking make sense in terms of the twin objectives of price stabilitysystem, which is what the Federal Reserve did with round one of and encouraging full employment. That is, our Taylor Rulequantitative easing at the end of 2008. calculations suggest a federal funds rate of around 1% would be5 market insights
6 July 2012 Figure 5in line with current low inflation and modest economic growth.This would not be a tight policy by any means, since short-termreal interest rates (adjusted for inflation) would remain negativeand the yield curve would more than likely retain a stronglypositive maturity shape – both of which are indicators thatpolicy would remain characterized as highly accommodative. Figure 4 [Note: The CME Group FedWatch tool for analyzing market expectations related to potential Federal Reserve decisions on interest rates is available on the web at www.cmegroup.com/ trading/interest-rates/fed-funds.html.] US Economic Projections for 2013 and 2014 We have chosen to disagree with the market consensus. Our projections include the assumption of near-zero rates through the first half of 2013, before the Federal Reserve commencesRegardless of what actions the original Taylor Rule might imply, baby-step rate hikes. Our perspective is that it would be ancurrently only six members (voting and non-voting) on the “upside” surprise for the economy if the Federal ReserveFederal Open Market Committee (FOMC) appear to share this decided to start the monetary policy normalization processview that policy normalization should occur sooner rather than sooner rather than later. In particular, the commencementlater. Moreover, the implied expectation from CME federal of the process of removing the current distortions in the yieldfunds futures of when the Federal Reserve will raise rates is curve would aid the return on savings and eventually spurquite far off into the future. As illustrated in Figure 5, as of consumption as fixed income coupons move higher. Second,the 5th of July 2012, one had to go three years into the future there would be little to no negative impact on corporatebefore the implied federal funds rate even gets to a half percent. expansion plans from the small rate hikes, since these plans are much more related to an assessment of future business conditions than to a small, marginal increase in short-term borrowing costs. And third, the impact on consumer and corporate confidence could be large and positive.6 market insights