1 market insights
US Economic Uncertainties and the
Lack of Long-Term Policy Framework
for Monetary and Fiscal Policy
6 July 2012
2 market insights
A Rebuilt, Solid Economic Foundation for
the Private Sector
Following the financial panic of...
6 July 2012
3 market insights
We see China’s real GDP slowing into the 7% range in 2012, on
its way to an average of 6.5% ...
6 July 2012
4 market insights
Looking ahead to 2013 and beyond, the real potential game-
changer for the employment outloo...
6 July 2012
5 market insights
Our analysis rests on two key points. First, the use of
quantitative easing and expansion of...
6 July 2012
6 market insights
in line with current low inflation and modest economic growth.
This would not be a tight pol...
6 July 2012
7 market insights
Current Federal Reserve policy does not recognize the progress
the economy has made producin...
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US Economic Uncertainties and the Lack of Long-Term Policy Framework for Monetary and Fiscal Policy


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Lack of Policy Framework and Market Confidence Lower Confidence and 2013-2014 US Economic Projections

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US Economic Uncertainties and the Lack of Long-Term Policy Framework for Monetary and Fiscal Policy

  1. 1. 1 market insights US Economic Uncertainties and the Lack of Long-Term Policy Framework for Monetary and Fiscal Policy nsightsMarket All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience. The economy in the United States is set to post real GDP growth in 2012 of approximately 2.5%, as shown in Table 1 below. After a strong start in the first few months of 2012, a bout of market fears generated by the disarray and confusion in Europe and rising concerns over the pace of the slowdown in global trade had the effect of freezing corporate expansion plans and slowing the pace of net new job creation. Progress in the European sovereign debt and banking system debacle along with more economic stimulus from China suggests second half US economic growth will be slightly better than the first half. While the 2012 hurdles for the US economy were largely sourced from the international arena, longer-term challenges are more likely to be home grown, in the form of a lack of market confidence in both fiscal and monetary policy that may slow growth prospects for 2013. This report focuses first on the relatively solid and robust condition of the US private sector. The private sector has completed its deleveraging process following the financial panic of 2008 and has established a solid foundation. What is missing is confidence in the future, which brings us to our main arguments for consideration. Consumer and business confidence in the US economy is being held back both by fiscal and monetary policy. The fiscal policy issues are relatively well-known; however, the drag on the economy going forward from a highly accommodative monetary policy is less well appreciated. While quantifying the impact of a lack of confidence in long-term fiscal and monetary policy is fraught with issues, we can say that our real GDP growth projections for 2013 and 2014 would be about a full percentage point higher if the Federal Reserve was not still in emergency mode and there was more clarity on tax rates and federal spending for the upcoming year, let alone the decade. 6 July 2012By Blu Putnam, Chief Economist, CME Group
  2. 2. 6 July 2012 2 market insights A Rebuilt, Solid Economic Foundation for the Private Sector Following the financial panic of 2008, the US private sector found itself with unrealistic expectations of future income and wealth, giving rise to a strong desire to reduce its debt. In the Great Recession of 2008-2009, the only solution available to the private sector was to cut spending and pay back (or default) on debt.The actions of the private sector were swift and brutal in terms of their impact on the economy. Real GDP fell just over 5% from its pre-recession peak in Q4/2007 to its recession low in Q2/2009. Corporate profits were decimated in 2008 and 2009. The unemployment rate soared from a low point of 4.4% in March 2007 to a peak of 10.0% for October 2009. January 2008 was the height of reported payroll employment at 138 million jobs. Between January 2008 and February 2010, which was the low point for payroll employment, a net 8.8 million jobs were lost. The housing market, which had gone into recession before the rest of the economy did, absolutely collapsed. New single-family home sales had peaked all the way back in 2005 with an average of 1.279 million units. That number had declined 70% to 374 million units for the 2009 average. There is good reason that 2008-2009 has become known as the Great Recession, given the abrupt cutbacks in economic activity spawned by the financial crisis of 2007 and 2008. As severe as the recession was, recovery started quickly partly because the private sector made its adjustments in such a rapid fashion and partly due to the initial quantitative easing program by the Federal Reserve to stabilize the banking system. The US economic recovery can be dated as commencing in the third quarter of 2009. From the Q3/2009 quarter onward through Q2/2012, the US economy has average annualized real GDP growth of approximately 2.35%, reeling off 12 consecutive positive growth quarters through mid-2012. During the same time frame, almost 4 million net new jobs have been recovered from the low point in 2009 through the first half of 2012. A Job-Creation Challenged Economic Expansion What has policy makers and the public concerned is that while the level of the real GDP measure of the economy exceeded its previous peak in the third quarter of 2011, a little less than half the net jobs lost have been recovered, even through mid-2012, three full years into the new economic expansion. Thus, while there is no question that the economy has embarked on a steady economic expansion over the last three years, what is at issue is why the economic expansion following the Great Recession has been relatively modest, creating net new jobs at a much slower pace than previous economic cycles. The answer to the slow pace of employment recovery lies in several places. First, the relative cost of labor compared to capital is higher than it was 10, 20, or 30 years ago, due to various tax and labor laws than bias corporations toward expanding capital instead of labor. This is not a new trend, but it means that after each recession, when jobs get cut, the process of recovering the lost jobs takes longer and longer. This is a structural problem that is not subject to influence from monetary policy, but can be impacted by fiscal policy and other legislated initiatives. Second, and as we will explain in the next section, our view is that the new job creation process in this economic expansion also involves the confidence corporations have in the future. As we assess the current situation, corporations have the profits and they have the cash to fund expansion. What corporations in the US are lacking is the confidence to grow their businesses more aggressively. And, confidence has been badly damaged by four key elements: two from the international scene and two home grown. The international challenges for corporate confidence have come, first, from the sovereign debt and banking system debacle in Europe; and secondly, from the pace of economic deceleration in China and other emerging market countries which has been worse than was the general consensus in 2011. With regard to the Euro-zone problems, we see real progress toward a financial safety net that will prevent banking system issues in Spain and sovereign debt issues in Greece, Portugal, Spain, and Italy from causing a highly disruptive break-up of the Euro. Europe is going to be economically stagnant for a long-time due to the required fiscal austerity, but the crisis atmosphere is slowly abating. Our long-held view on China was that it would, indeed, see its economic growth decelerate more rapidly than the general market consensus, as we discussed in our December 2011 report,“China: Slower Export Growth, End of the Infrastructure Boom Years”.
  3. 3. 6 July 2012 3 market insights We see China’s real GDP slowing into the 7% range in 2012, on its way to an average of 6.5% for the decade. This is impressive economic growth for any major country, but it pales beside the 10% annual average growth rate of the previous two decades. But this deceleration of economic growth is part of a natural process toward a more mature economy, and there is every sign that the Chinese government is increasing stimulus programs to soften the slowdown. In short, we view developments in Europe, and to lesser extent in China (since we had anticipated its slowdown), as the proximate causes for why the US economy appears unable to ramp back toward a 3%-plus real GDP growth path during this economic expansion, and more specifically as to why the additional economic momentum we had projected at the end of 2011 for 2012 was setback in the first half of 2012 and has not materialized. Given a stagnant Europe and 6.5 – 7.5% real GDP growth path for China in 2012 and 2013, we would still be able to project US real GDP in 2013 getting back above 3% to around a 3.5% annual growth rate if it were not for the home grown storm clouds on the horizon coming from US fiscal and monetary policy. We see the current prognosis for US fiscal and monetary policy as the main impediments left to rebuilding corporate confidence and thus leading to a more rapid pace of net new job creation. Let us explain. Rebuilding Corporate Confidence Consumer spending growth and affordable access to capital are necessary conditions for corporations to make the key decisions to expand their businesses and hire new workers. But neither of these factors represent sufficient conditions for hiring expansion, they are just essential parts of the puzzle. For the record, though, consumers largely completed their deleveraging process by the middle of 2011, as reflected in a turning point and then steady increase in the use of consumer credit (See Figure 2). There was some pent-up demand from the recession for previously deferred purchases of big ticket items, such as automobiles. This meant that after an early surge, the growth 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 occurring in the US had the effect of initially reducing spending, before the money saved from these typically essential expenses is eventually redirected to discretionary purchases. This means retail sales growth slowed in the second quarter, but is likely to accelerate a little in the second half of 2012. And, after years in the doldrums, we are seeing life in the housing sector as we had projected earlier this year. Corporate profits have been strong enough since 2010 to generate healthy internal cash flow (See Figure 3). And, corporations appear to have regained access to bank financing, reflected in the recent increases in banking sector commercial and industrial loans and leases. As already noted, one of the challenges for corporations in the US is adjusting to slower economic growth from overseas, as discussed in the last section. This is critical since roughly half of US corporate cash flow from the S&P 500 companies comes from outside the US. We see 2012 as a transition year toward realistic expectations of future business potential from a stagnant Europe and slower-growing emerging market countries, and from our perspective most corporations have adopted reasonably appropriate business expectations. Figure 2 Figure 3
  4. 4. 6 July 2012 4 market insights Looking ahead to 2013 and beyond, the real potential game- changer for the employment outlook is the confidence, or lack thereof, driven by fiscal and monetary policy. From our perspective both fiscal and monetary policy are working to lower our 2013 and 2014 economic projections for the US economy, and for net new job creation in particular. The fiscal policy arguments are well understood, so we will cover them first and only briefly. The reason monetary policy, as accommodative as it might appear on the surface, now has started to hinder the development of more rapid economic growth prospects is a more complex and less well understood line of reasoning, so we will tackle that topic in a little more detail. Fiscal Policy Uncertainty Remains the Base Case The primary obstacle to an increase in business confidence is the elevated uncertainty concerning US tax and fiscal policy for 2013 and beyond. The Bush-era tax cuts were enacted with sunset clauses, and they are due to expire at the end of 2012. In addition, severe and automatic spending cuts were legislated to commence in Fiscal Year 2013, if the joint Congressional taskforce failed to produce a long-term fiscal policy plan. Since no long-term compromise fiscal plan was agreed, the cuts in both defense and discretionary spending are due to hit with the start of the new fiscal year in October 2012. We will also see the debt ceiling breached again late in the first half of 2013, adding to the possibility of fiscal policy disarray. If we really thought the most likely case was for a big tax hike and massive spending cuts, our 2013 real GDP forecast would have the economy moving back into recession. Instead, our high probability case is that Congress engages in its now standard ritual of brinkmanship, but eventually passes temporary measures that will prevent an abrupt turn toward recession even if they fail to agree to a long-term framework for fiscal policy. On the spending side, our most likely scenario includes a stop-gap measure that postpones the draconian spending cuts through 2013 or 2014. With regard to tax policy, from an economic perspective, it is the pervasive rise of the alternative minimum tax rules through the next decade that will be the largest drag on economic activity and a direct hit to the middle class if it stays in effect as planned. The rise in the maximum marginal tax rates for upper income individuals is a headline issue for the press, but will have a much smaller impact on future economic activity than the increases in the alternative minimum tax. We also think the US Congress will raise the debt ceiling, as it always has, but also as usual, it will do it at the last minute – maybe even after a few months of buying time with accounting tricks. This“most likely”scenario is not confidence inspiring and it does not provide the framework for long-term planning that would most assist the job creation process. On the other hand, brinkmanship and stop-gap measures have become the norm, and both consumers and corporations have learned to cope with this messy process, if not enjoy it. Of the three items on the fiscal agenda for the new Congress in 2013, postponing the automatic spending cuts is the most critical to our economic projections. Tax policy and the debt ceiling, however, are extremely important in setting the tone for long-term consumer and business confidence. The potential upside“surprise”factor is that the US Congress is able to reach a long-term compromise for a fiscal tax and expenditure policy for the next ten years or so. While the details matter, this is one of the few cases when the devil is less in the details and more about whether we get a long-term stable fiscal policy that will support planning and confidence-building or not. Can Extended Monetary Accommodation Hinder Economic Confidence? We have come to the conclusion that a failure of the Federal Reserve to take a few baby-steps toward interest-rate policy normalization will become increasingly a major hindrance to the growth of the economy in 2013 and 2014. This line of reasoning focuses on the potential negative impact on consumer and business confidence from a Federal Reserve that remains in emergency policy mode even after three full years of economic expansion. This line of reasoning is not about the potential for future inflation from an overly accommodative Federal Reserve. Inflation may surface as a problem down the road, but it is not a problem today and it is not the issue which is confronting the Federal Reserve. The issue we must assess for our 2013 and 2014 economic projections is whether the current“keep dry power at the ready”approach hinders corporate confidence and is not as conducive to future economic growth as it might appear on the surface.
  5. 5. 6 July 2012 5 market insights Our analysis rests on two key points. First, the use of quantitative easing and expansion of the Federal Reserve’s balance sheet has an absolutely critical role in preventing an implosion of the banking system during a financial crisis and has virtually no role in enhancing economic activity once the crisis has been averted. Second, extreme or emergency mode interest rate policies are highly distortive of the yield curve and once the economy has been growing for a few years, the continuation of emergency mode policies tends to disrupt the return to normal economic activity through direct and indirect ways. When the sub-prime mortgage crisis erupted into public view 2007, the financial system was in trouble. Then in September 2008, with the messy bankruptcy of Lehman Brothers and the next-day hasty bail-out of AIG, the banking system literally froze. The use by the Federal Reserve of its balance sheet expansion powers to purchase some trillion dollars of mortgage-backed securities and other assets from banks in distress, in our view, was an essential element in preventing the crisis from becoming a Great Depression, possibly worse than the 1930s. By contrast, our analysis does not support the contention that further rounds of quantitative easing and, later, operation twist have had any discernible impact toward encouraging a more rapid pace of net new job creation than was already occurring. We have come to this conclusion because we believe that financial crises lead to consumer and corporate deleveraging that is largely insensitive to monetary policy – low rates or asset purchases. The reason is that perceptions of future income and wealth that were ratcheted downward by the financial crisis mean that debt and spending must be cut to achieve a new and more realistic balance among income expectations, current assets and liabilities, and future spending. Whether the Federal Reserve buys another trillion dollars of US Treasury bonds or twists the yield curve so long-bond yields are lower has very little impact on consumer spending or on corporate investment plans during a deleveraging phase. During the deleveraging phase, the main policy responsibility of the central bank is to do what it can to maintain a secure and well-functioning banking system, which is what the Federal Reserve did with round one of quantitative easing at the end of 2008. Once the economy has been growing steadily for several years and once the job creation process is making inroads on unemployment, even if the economic progress is not as rapid as policy makers might prefer, then a continuation of emergency policies can actually slow down the recovery. By way of illustration, once a heart attack patient has been stabilized and the required surgery has been completed, remaining for a long time in the intensive care unit of the hospital is not conducive to the recovery process. After the financial crisis has past, the decisions by the Federal Reserve to embark on a second round of quantitative easing and then operation twist, even after the economy was growing again, was made with the best of intentions but not necessarily without a full appreciation of the distortions and costs of further balance sheet activity and what an extended period of near-zero rates may mean for the economy. Market distortions are not without costs. In this case, an extended periods of low rates across the yield curve means we are seeing a wholesale transfer of wealth away from long-term savers and pensioners with the objective of making capital cheaper for companies to expand production and increase hiring. Business investment and expansion decisions, however, are much more dependent on corporate views of the future demand and risks than on the cost of capital. That is, even if capital is cheap, businesses will be reluctant to expand if they perceive elevated risks in future demand. And, with the population aging and savings and pensions under stress, the Federal Reserve has effectively engineered a drag on consumer demand as an unintended and unappreciated consequence of staying in emergency mode and promising the possibility of further balance sheet and quantitative easing actions. Comparing Market Expectations with the Taylor Rule The original Taylor Rule provides a very useful framework for analyzing the trade-offs in the dual mandate of the Federal Reserve to promote price stability and encourage full employment. Our calculations indicate that a few small baby- steps in the direction of normalizing interest rate policy would make sense in terms of the twin objectives of price stability and encouraging full employment. That is, our Taylor Rule calculations suggest a federal funds rate of around 1% would be
  6. 6. 6 July 2012 6 market insights in line with current low inflation and modest economic growth. This would not be a tight policy by any means, since short-term real interest rates (adjusted for inflation) would remain negative and the yield curve would more than likely retain a strongly positive maturity shape – both of which are indicators that policy would remain characterized as highly accommodative. Regardless of what actions the original Taylor Rule might imply, currently only six members (voting and non-voting) on the Federal Open Market Committee (FOMC) appear to share this view that policy normalization should occur sooner rather than later. Moreover, the implied expectation from CME federal funds futures of when the Federal Reserve will raise rates is quite far off into the future. As illustrated in Figure 5, as of the 5th of July 2012, one had to go three years into the future before the implied federal funds rate even gets to a half percent. [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 commences baby-step rate hikes. Our perspective is that it would be an “upside”surprise for the economy if the Federal Reserve decided to start the monetary policy normalization process sooner rather than later. In particular, the commencement of the process of removing the current distortions in the yield curve would aid the return on savings and eventually spur consumption as fixed income coupons move higher. Second, there would be little to no negative impact on corporate 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. Figure 4 Figure 5
  7. 7. 6 July 2012 7 market insights Current Federal Reserve policy does not recognize the progress the economy has made producing 12 quarters of consecutive real GDP growth and creating almost 4 million net jobs while reinforcing the impression of a fragile economy that is only a step away from relapsing back into recession and must remain in the intensive care unit. From the point of view of patient confidence and potential recovery, having the doctor keep one in intensive care when one is clearly over the crisis is almost always likely to prolong rather than encourage recovery. We believe it works the same way with economies, in that once the financial crisis has been averted, the faster the distortions are removed, such as those caused by quantitative easing, operation twist, and near-zero rates, the more likely the economy will gain the balance and confidence to move ahead faster without assistance. Our 2013 real GDP growth projections are about 1% lower than otherwise to reflect the hindrances to confidence from both monetary and fiscal policy, suggesting the economy could slow to a sub-2% performance next year following about 2.5% real GDP growth in 2012, instead of moving up toward 3.5% real GDP growth. Our 2014 economic projections include the prospect of several members of the FOMC, including Chairman Bernanke, shifting toward a slow, incremental approach to policy normalization during the latter half of 2013 – assuming, and it is a big assumption, that there is no economic relapse caused by disarray in fiscal policy. This would go against current Federal Reserve guidance, but as we have warned before, the Federal Reserve provides guidance not commitments. If the facts change – and avoiding a fiscal policy crisis in 2013 would be a major change of assumptions – then the Federal Reserve is certainly within its prerogative to move up the timing for when the first federal funds rate increase could occur. CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile. Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. New York Mercantile Exchange and NYMEX are registered trademarks of the New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. Copyright © 2012 CME Group. All rights reserved. Additional Resources For more market insights, visit www.cmegroup.com/marketinsights “Energy Prices and the Economic Outlook” AOL Energy, video interview with Blu Putnam http://energy.aol.com/2012/07/10/energy-prices-and-the-economic-outlook/