There has been a bunch of positive economic data released in the past month. GDP growth, despite its uneven composition, increased to 0.6% in the most recent quarter. Consumer borrowing fell in June indicating that consumers may finally be addressing their heavy debt burdens. Optimists will still point to rising home prices or record home sales as indications that the "fundamentals of the economy are strong".
But it is readily apparent that the jobs have still not arrived. The unemployment rate is still near a ten-year high and job creation has been insufficient to absorb even new entrants to the workforce.
Jobless claims have shown very little improvement despite the recent good news. State budgets are in abysmal shape, with difficulties that are anticipated to be worse in 2004. Our collective desire to spend now and postpone difficulty to the future is also creating employeepensionissues in upcoming years, absent a significant recovery in stock prices.
Interest rates are the most recent hurdle for the economy to overcome. Lower interest rates have made mortgage payments more affordable, and contributed greatly to strong home sales and increases in home prices. Lower monthly payments have freed up income for consumers to spend more on other things. The continuing increases in home prices have created a deep bank account for Americans to draw from to afford that new SUV, kitchen remodel, or private school for the kids. More ominously, this account has often been the sole defense for a growing number of Americans against a surprise job loss or uninsured health crisis.
The U.S. has not had an experience in recent history where interest rates have risen without the help of the Federal Reserve. Even then, the interest rate hikes have been in times of greater economic strength and resulted in a two "hard landings" and general economic distress. As the previous 21 years of lower rates have been a virtuous circle, with only two mild recessions (by historical standards) and very temporary setbacks to asset prices, there is a great worry that a rising interest rate environment could set the process into reverse.
After 13 rate cuts, the perception is the Fed is nearly powerless to stimulate the economy. Backup responsibility for restoring growth falls to the Federal Government. They are tasked to implement tax cuts and spending increases that would best increase growth and minimize suffering. The current administration has so far chosen to fight two expensive wars of dubious merit, to give the bulk of tax cuts to people who do not need it and are least likely to spend it, and to give the rest of the world economy ample incentive to withdraw their support from an increasingly dysfunctional dollar-centered system of global trade and finance. We'll now throw higher rates onto this pile of woes and see what happens, but as $800 billion in home equity was extracted in 2002, this has the potential to be a very big straw.
It is possible that consumers will just hunker in and dig deeper into debt to maintain their lifestyles after the home equity reservoir runs dry. It's also very possible that any renewed weakness in the economy will send interest rates back to their lows, setting off another refinancing binge and another short-lived "recovery". Neither of these would indicate progress in correcting our economic imbalances in savings and investment, nor mean progress on renewing economic growth.
Policymakers should pay less attention to the current data, good and bad, and focus on addressing the approaching economic headwinds. It's never too late to reorient economic policy towards helping the greatest number of Americans, and it's good political strategy as well. The data coming out measured the economy before the interest rate tornado descended. We're not in Kansas anymore.
This is who the Bush supporters are. 'Economist' Mike Norman from TheStreet.com writes an article called:
Out of Work? Become an Investor
Job growth is falling, and unfortunately, fewer jobs are being created. A lot of new jobs are going to low-cost labor markets, like China and India. The U.S. can't compete with this, nor should it try.
This doesn't mean jobs will never again be created here. New jobs will emerge, but they'll be in different industries and perhaps driven by unique demographics, like in health care, where an aging population is creating the need for workers. (The U.S. has only lost 2% of the payroll base, despite all we've been through; it's a very mild adjustment. Germany and Japan have lost much more, percentagewise.)
As for the more general job decline, such as what we're seeing in manufacturing and some services (programming, for example), the U.S. will continue to lose these jobs to low-cost labor markets. But there is a positive side to all of this, as oxymoronic as that may seem.
By outsourcing cheap labor, America has had the benefit of low inflation, steady-to-rising purchasing power, expanding capital markets and cheaper cost of capital. This has also led to other tangible developments such as falling mortgage rates, which has given millions of Americans the opportunity to own their own homes; rising GDP (even with the numerous crises the economy has been through in the past two years); and rising personal savings, from zero in 2001 to roughly $300 billion now.
In other words, although 2 million Americans may have lost their jobs in the past two years, the economy as a whole has benefited from this trend of outsourcing cheap labor. Still, many continue to wonder when new jobs will be created at home.
I'm almost drawn to the conclusion that large supplies of new jobs might never be created, or if they are, their existence will be fleeting because cheap-labor countries will quickly adapt and take them away.
The global economy and markets appear to be saying to industrialized countries, and to the U.S. in particular, that the job of their citizens is to invest, not toil away on a production line. Falling interest rates and lower capital costs have put money and credit into the hands of average individuals, offering them the chance to thrive through investment, rather than physical labor.
Yet for all its utopian significance, this paradigm is being viewed negatively. It's seen as a weakness rather than understood for what it is: the next evolution of a truly advanced society.
To many, job losses reflect some kind of flaw in our economy, a defect exploited by the laboring countries of the world, putting America at a disadvantage. They see job losses and deficits and conclude that the U.S. squandered its economic prowess, and that somehow countries like China, India and Japan have beaten us at our own game.
Nothing could be further from the truth. Our deficits (trade and budget) are being used to finance the modernization of more than half the world's population. If it weren't for the U.S. economy's engine of growth, countries like India and China would have no chance to lift their standard of living, or at the very least, the process would take longer and be more turbulent.
The citizens of cheap-labor countries also want improved lives, and the only way they can do it is to accumulate dollar assets. They sell us their products, accumulate our dollars and then use those assets to modernize and raise their living standards.
However, many see this reality in reverse, that somehow these countries are "doing us a favor" by holding dollar assets. But they need our assets more than we need their goods.
Consider the U.S. as a person who has worked hard all his life and is now enjoying the fruits of his labor. Rather than thinking of our debt as something negative, or worrying about a small loss in jobs to low-cost labor markets, we should see the huge benefits that we enjoy, like enormous capital markets that provide cheap capital, incredibly high standards of living, and an economy that has the flexibility and resilience (because of the vast amounts of capital that flow through it) to weather unprecedented events like Sept. 11, the corporate scandals and war.
No other country would have been able to get through those events as lightly. Look at Japan and its banking system. For 14 years, the country has been trying to clean up the mess with little success. On the other hand, the U.S had its own crisis with the savings-and-loan debacle back in the 1980s, but it was cleaned up and we moved on.
As more than half the world's population continues its quest to modernize, it will continue to accumulate dollar assets. As a result, the U.S. will have the world's expanding capital base flowing through its financial markets.
The job of Americans, therefore, will be to invest. Your "work" now is to accumulate and manage assets. (Of course, that doesn't mean everyone will become full-time traders. As I pointed out, even in this job environment, we still have 129 million payroll jobs.) The traditional definition of a job is fading, at least in this country. The sooner you realize this, the better off you will be. Those who don't see this shift and take advantage of it will see their standard of living decline relative to someone who embraces this new reality.
Throughout the course of U.S. economic history, this has been true. In the late 19th century, the skilled craftsmen and artisans who had been so much a part of the nation's economy were replaced by assembly lines, which eventually dominated the way things were produced. Before that, the agrarian way of life was lost as a result of mass migration to the cities, where there was more opportunity and where people had a chance to earn higher wages.
Each time, the paradigm shift rewarded those who embraced it, and either impoverished or reduced the living standard of those who resisted its arrival. The same will be true now. Rather than fret over the loss of jobs to China or India, you can adapt by becoming an investor. Buy some real estate, or invest in stocks that pay dividends. When rates rise some more, buy bonds again. And when you can, use leverage to do this. That's what all this capital flowing through U.S. financial markets is allowing you to do. Credit shouldn't be viewed as bad but as an integral part of this new paradigm.
As for those who constantly harp on job loss, debt and deficits, or the fate of the dollar, they'll be left behind in the next phase of the economic evolution. Their view is incorrect; they are married to an old and obsolete way of looking at the world. They have been preaching their doom for decades while the U.S. economy continues to grow and as standards of living continue to rise. Their loss will be our gain.
Nathan Newman outlines the unconventional strategy of the Communications Workers of America in their labor dispute with Verizon.
The union is currently collecting names of Verizon customers willing to pledge to switch local service to AT&T or cut optional services if they cannot switch. They will send this list to Verizon management and AT&T "at a time of their choosing". This is a brilliant - almost libertarian - tactic. Nathan has more details as well as a link to the CWU site to join the revolt.
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.
The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed. Business pricing power and increases in core consumer prices remain muted.
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
In other words, the data is mixed, and the Fed isn't sure what to make of it. Until the CPI shows a big jump, there is no danger of higher rates. This statement is very close in spirit to the one released May 6th. Sheesh, it looks like they copied around half of it verbatim.
The May 6th communique admitted that the Fed had no visibility thanks to Gulf War II. Today's statement means they have no idea whether their 13th cut is going to work. The crucial statement is the last sentence, which for the layperson should read, "Please Mr. Bond Market, don't freak out, we're not raising rates anytime soon unless the economy miraculously starts generating hundreds of thousands of jobs a month."
The bond market reacted about as neutrally as the Fed could have hoped. Ten-year treasury yields are down around 2 basis points since the announcement and up one basis point on the day to 4.37%. This is three basis points below last week's peak at 4.4%.
The market for home mortgages has already slowed down considerably as interest rates have risen a little over one percent in the past 6 weeks. Countrywide credit reported today that home loan applications dropped 22% and loans in process dropped 15% in the month of July. Volume dropped to $2.5 billion from $3.2 billion in June. MBAA's refinance index is currently at 4047.5, down from its peak of 9900 in mid-June. Tomorrow's release should show another drop in the refi index, though purchases have remained strong as prospective homeowners are jumping in to buy lest rates move even higher.
The end of the refinancing boom will have the same effect on the economy as a drop in the money supply. The amount of money that homeowners are converting from debt to immediate purchasing power via home equity loans, cash-out refinancing, and sales, is going to drop significantly as these options become less financially attractive. The only question is how much and how soon? Unadjusted M2 and M3 money supply have been flat for three weeks, but this data is volatile and subject to considerable revision. The Fed bought some time from economists by saying they didn't know and staying put. They bought some time from bond speculators by not getting too excited about recent improvements in economic data. Time will tell. The next FOMC meeting is September 16th.
Fifty-seven percent of Americans feel the economy is more important than the War on Terrorism. For some reason, the biggest slip in the polls for Bush and the Republican Party came from those with incomes under $50,000 per year. Hmmm.
Ruy Teixeira of the Century Foundation, author of The Emerging Democratic Majority, sees Democrats with a 17 point advantage on the economy, 13 points on the Federal budget deficit, 19 points on unemployment, 12 points on education and 22 points on prescription drugs for older Americans.
Economic outlook hangs on this week's FOMC meeting
The Fed Open Market Committee is meeting Tuesday and Wednesday to set the Federal Funds rate and to voice their opinion on the outlook for the economy. The conventional wisdom is that the FOMC will leave the Fed Funds rate unchanged at 1% but change their outlook to "positive" from "neutral", an indication that they feel a recovery is on its way.
Steven Roach says that says something about what has happened to our economic expectations today.
Take the widely heralded GDP growth surprise recently released for the second quarter. Yes, the 2.4% increase was a good deal stronger than expected. But it wasn’t a strong number in the absolute sense at all. The fact that second quarter growth exceeded expectations was only because most economists -- like their Wall Street analyst counterparts -- have now lowered the bar in this post-bubble era. Yet there can be no mistaking the persistence of decidedly subpar growth. Over the first seven quarters of this so-called economic recovery, annualized gains in real GDP growth have averaged a mere 2.6%. By contrast, over the first seven quarters of the past six cyclical upturns, real GDP growth averaged 5.4% -- slightly more than double the current pace. The current recovery even falls short of the previous record slowpoke -- the 3.1% pace recorded in the first seven quarters following the 1990-91 recession.
Moreover, there was more than the usual amount of statistical noise in the latest GDP report. A 44% annualized surge in defense outlays accounted for fully 70% of the total increase in national output. Barring the outbreak of another war, that source of growth is probably tapped out. In addition, a 54% annualized surge in computers and peripheral equipment accounted for virtually all the growth in business capital spending and actually another 65% of the total increase in real GDP growth in 2Q03. Yet it turns out that fully 83% of that gain is traceable to a collapse in IT pricing, according to Commerce Department assumptions. Indeed, in current dollars, last quarter’s growth in computers and peripheral equipment accounted for only 7.1% of the total gain in nominal GDP. At the same time, personal consumption expenditures did increase at a 3.3% annual rate in 2Q03, well above the anemic 1.9% average annualized growth pace in the preceding two quarters. However, the bulk of those gains occurred for purchases of durable goods, whose share of real GDP has now risen to a record 11% -- so strong that it provides little scope for further improvement. In other words, much of last quarter’s growth surge appears traceable to nonrecurring factors rather than to the cumulative forces of cyclical revival.
But there’s more to the tale than statistics. This recovery is still missing one of the most significant cyclical ingredients of all -- job creation. Fully 20 months into this recovery, the great American job machine has yet to shift gears. Since the economy bottomed in November 2001 (as per the recent cyclical dating of the National Bureau of Economic Research), private nonfarm payrolls have contracted by 1.2 million workers. By contrast, in the first 20 months of the past six business cycle upturns, the private-sector job count increased, on average, by 2.8 million workers. That means the current hiring trajectory has fallen fully 4 million workers short of the cyclical norm -- taking the concept of “jobless recovery” that was first coined in the early 1990s to an entirely different level. This has resulted in an equally worrisome shortfall of wage income generation -- the main driver of personal income growth; over the first 19 months of the current cyclical recovery, real private-sector wage and salary disbursements have recorded a cumulative increase of just 0.3%, far short of the 6.8% average gains that have occurred by similar junctures in the past six business cycle upturns. Putting it another way, real private-sector wage generation in today’s anemic recovery is currently running $241 billion short of the profile that would have been evident had the US economy held to its standard cyclical trajectory. Little wonder that Washington’s tax cutting hasn’t made much of a difference for the beleaguered wage earner.
Thanks to their experiences in 1995 and 1998, the Fed is very keen to not replicate the bond market routs that bankrupted Orange County and LTCM, respectively. They also remember 1992 and the S&L-style lending bubble and jobless recovery that began with real estate weakness in California before spreading nationwide. Finally, there is once again a Bush in the White House and a recent war in Iraq.
Not surprisingly, the three horns of this dilemma and the trifurcation of the economic data between interest rates, growth and jobs, have damaged the consensus that distinguished the Greenspan era. While votes still tend to be unanimous, the various Fed governors now have license to go off message in their public speeches. Greenspan can testify to Congress about the wonders of productivity and growth. Bernanke can lecture on attacking deflation. San Francisco Fed Goverernor Parry can dissent for larger rate cuts.
This apparent lack of consensus within the FOMC has developed hand-in-hand with the splits without. While lower bond interest rates and higher stock prices were in sync and all investors knew "not to fight the Fed", the economy rolled along with no effort. Today, bond investors get skittish when stockholders clamor for lower rates, and the growing mass of unemployed are growing increasingly dissatisfied with the results.
Now that the 21-year trend of lower nominal interest rates seems to have ended, this meeting will begin a crucial period for the Federal Reserve. Three years removed from his "Maestro" days where he could do no wrong, Alan Greenspan now needs to be triply right: right on his outlook for the economy, right on monetary policy, and right that productivity growth will result in more jobs. Action may disappoint one group of speculators at the expense of others. Inaction may result in the economy improving on its own or slumping back into recession. Alan may sincerely wish he could teleport himself back to 1998 when the questions were much more simple. The Fed is much closer to being hostage to the markets rather than dictating policy to them. A false step could have grave consequences.
As a banking entity, the Fed will want to err on the side of their constituency. But even within that constituency, cracks are developing. Guiding rates back lower will stimulate lending but hurt lending margins. Speculators have begun to dwarf banks in the size and leverage of their positions and unlike banks are not monitored by the Fed. Like the recent fall in the dollar, a letting rates rise may not result in irreparable economic harm. However, it does set the stage for an unprecedented increase in volatility, as the competing constituencies slug it out in the market for expectations. A Fed that does not manage these expectations properly could quickly let things spiral out of control.
The American economic system is wheezing on a rocket of debt. If people believe we can squeak through this, they will vote Republican, because Bush will say "Someone will pay for this, and it won't be YOU!". If people believe we must bear down and make sacrifices to get through this, then the Democrats will have a landslide, because people trust Democrats to be fair.
GSE's in the headlights as the economy runs on the fumes.
Higher interest rates have increased the visibility of the government-sponsored enterprises that operate in the home mortgage market. The NY Times has an article critical of Fannie Mae's computer models which simulate changes in mortgage interest rates. The models, leaked by a former Fannie employee, show the GSE losing $7.5 billion in a hypothetical situation where mortgage interest rates rose quickly by just 1.5%. Fact is rapidly approaching fiction. Freddie Mac's new CEO is under continued scrutiny for his role in recent accounting restatements regarding its treatment of derivatives. Meanwhile, the swaps market takes a short break from Mr. Toad's wild ride, and potential homebuyers grab at their last chance to buy a home on the cheap.
The flurry of stories about the impact of the spike in interest rates means that the media has finally noticed the elephant in the corner of the room. But will it really matter in the future? We seem to have plenty of crises in the recent past: record federal and trade deficits, state budget woes, junk bonds having one of their best years ever on the back of one of their worst, Argentina's implosion, Uruguay's partial implosion, Brazil's near implosion, three years of declining stock prices, corporate scandal, massive pension underfunding, the worst job growth since Hoover, and yet the economy on the surface retains the veneer of normalcy, with Americans still banking on a real recovery in the very near future.
Yet as pointed out in an earlier post, things are not necessarily what they seem. Economic recovery has been promised for three years and has yet to appear. A lot of this expectation has come from economic data that looks good on the surface, yet looks much less sustainable when the details are examined.
A lot of the credit can go to the brave (as opposed to the more commonly used "resilient") consumer. When the money has been there, they have spent it. When the money has not been there, they have borrowed it. Where alternative sources have been available, such as home equity from massive housing inflation, they have tapped it. All of this depended on lower interest rates. Every time there was another "double-dip" threat to the economy, long-run interest rates fell to new lows sparking another refinancing boom and another subsequent jump in home prices as new swath of homes became affordable. The new equity refilled the gas tank as consumers threatened to run dry.
We may have just entered a period when this process will no longer be able to function. Alarmed by the restatements at Freddie Mac and the risks they posed, the EU recommended it's member central banks sell agency debt. Mortgage rates have backtracked nearly the entire 1.5% needed to wipe out half of Fannie Mae's equity. Not much evidence suggests we will revisit the recent lows in interest rates without a major slowdown in the economy.
But the economy still has a lot of momentum built up from the previous refinancing boom. Auto sales have tended to peak the quarter after refinancings peak. As July sales turned in their best month of the year, this points to GDP momentum in consumer durables into the third quarter, but also indicates a significant potential dropoff in the fourth quarter.
Another indicator to gauge the effect of higher rates would be consumer debt. June consumer credit fell, but this data was collected as the refinancing boom was still in full swing. Post boom, with less available equity to pay down other debts, we should expect consumer credit to balloon as homeowners adjust to the loss of their major reserve account. If interest rates do not return to levels that would touch off another refinancing boom, then the next step would be a significant decline in consumer spending, once again due around the fourth quarter. There may be enough equity out there to carry consumer spending for several quarters - if homeowners are willing to continue to draw down equity - but homeowners will no longer be getting the free ride of lower monthly payments.
In any case, recent consumer spending growth has been sluggish despite the ability to draw down equity. The critical indicator, the perceived availability of jobs, is clearly constraining consumer spending at current debt levels. The heavily indebted consumer, much more worried about the catastrophic effects of unemployment, has slowed their spending, though not enough to improve their balance sheet. Consumer spending has grown at or below a 3% annual rate in 8 of the 13 quarters since 1Q2000, significantly slower than the 4-5% annual rates during previous expansions. Remove the four double-digit quarters of annual growth in consumer durables, which we can attribute to one-off events like refinancing booms and zero-percent incentives, and we have only a single quarter of significant growth in consumption spending (3Q2000) in over three years.
Clearly, without a significant acceleration in the job market, there will continue to be little momentum in consumer spending. This means a significant, persistent growth in hiring, not a small downward blip in unemployment or a drop under 400,000 new jobless claims. We will need more than the 150,000 jobs created per month just to absorb new entrants to the job market, and some extra every month to reabsorb the nearly two million more continuing claims. After three years, real improvement is going to be needed to convince Americans they can increase spending at the rates they spent during the boom years. The confidence level needed to increase spending while debts are at >100% of disposable income in any job market is naturally going to be much greater than doing so at the >80% levels at the end of the last recession. Otherwise, without lower interest rates, consumption, and big ticket consumption in particular, is very likely to come to a screeching halt by the end of the year as the willingness to dig a deeper debt hole dries up with the ability to do so.
The nonpartisan atmosphere of fear remains prevalent in today's economy. Many Americans know very well how they have been able to remain so resilient. Most are still employed, and despite smaller raises and greater monthly expenses on cable, health insurance, taxes and the like have had plenty of room to borrow. They still have great optimism that the economy will begin to recover soon; that the Fed can "do something", and failing that the Federal government can spend more. The record deficit announced for fiscal 2003 would seem to prove the cavalry is on its way. The optimism remains shaky, however, because the jobs have not showed up. Most people have at least one or more friends that have lost jobs, and experienced second-hand the struggles to find a job in the current environment.
The conunudrum remains how to restore consumer demand to levels that would increase investment and employment at the same time many consumers are losing their reserve account of home equity.
Without a boost in domestic consumer spending, the responsibility shifts to foreigners or the government to increase growth and imports to provide the necessary demand. But the historical transmission of consumption and growth has been the opposite direction for many years and America still seems to be the index case for a global economic pandemic. Foreign countries seem unwilling to accede to the alternative prescription of increasing U.S. exports via a lower dollar. Finally, as budget deficits grow without generating sustainable growth in output and jobs, the circle closes and we are returned to the impediment of higher interest rates.
We'll find out real soon how this rise in rates affects the economy by the impact on the consumer, particularly consumer credit and especially mortgage credit. I couldn't agree more with the folks at Contrary Investor when they opine:
... it's our feeling that any type of slowdown in macro credit creation will ultimately throw up a huge roadblock to Fed efforts to reflate. And that roadblock is money supply expansion. Remember that the academic definition of deflation is money supply contraction, the flipside being inflation that is money supply expansion. We'd guess that probably the last thing the Fed would like to see now is a slowdown in the growth of the monetary aggregates (M1, M2, M3, MZM). For now we're a good ways away from that, but the potential for a significant slowing in money growth or even a trip into the land of real contraction would be transmitted through activity, or lack thereof, in the mortgage credit markets, consumer credit and corporate debt markets. It is clear to us in the following chart [note: see their site for the chart] that money growth and interest rate movements are highly correlated...Unfortunately, the Fed is powerless to force folks to borrow.
Alan and Co. are going to have to tread very carefully at the FOMC meeting this Tuesday. Any lenders that interpreted the Fed's deflation preoccupation as a sign that rates would not rise for the forseeable future have just been burned badly. They should rightly be assumed to be very skittish at any exposure to higher interest rates. A more optimistic outlook is now a very risky proposition for the FOMC, particularly with GSE's in the headlines and the risk of agency securities coming under increasing skepticism. The consumer is going to be depending on the speculators for any chance of another refinancing fix. But at the same time, the more positive economic news, the less need for further stimulus from the Fed. They also need to be mindful that their remaining conventional ammunition is approaching the levels of the marines after the first assault in Aliens. There remains the "unconventional" methods proposed by Bernanke, but once they are used there is no going back.
What to do? As this has gone on long enough I'll reserve that for another post.