FYI | Mar 01 2011
Bill Evans, Global Head of Economics at Westpac, issued a report on his personal observations and insights from a recent trip to the US. FNArena believes Evans' summary of meetings with corporate and institutional customers, and others, makes for interesting reading, in particular the underlying theme in his personal observations. We decided to re-publish in full.
By Bill Evans
Over the last 2 weeks I have been visiting with corporate and institutional customers; officials and other economists in New York; Philadelphia; Washington; Boston and the west coast.Apart from my main objective which is to convey Westpac's current views on the outlook for Australia/New Zealand and the Asian region, I was also interested in gauging views on the most important policy issue of the day – QE2 and prospects for QE3. The note below sets out my understanding of these issues and our views for the
future.
There is a solid Consensus that the US economy will grow by around 3.5% – 4% in 2011 and 3.25% – 3.75% in 2012. That will be largely driven by consumption growth of around 3 – 3.5% in each year and business investment growth of 8 – 10%. Housing investment is expected to grow by 6 – 12% in 2011 and 10 – 15% in 2012. The housing numbers look extraordinarily optimistic although it must be remembered that housing has contracted so much that housing investment is only around 2% of GDP and cannot do much directly to support growth for many years. That is in sharp contrast with previous recoveries when housing added 1% to GDP growth in the recovery phase.
Government spending/tax policy was expected to subtract 1.5% – 2% from growth before the December fiscal initiatives. Now that drag is only expected to be around 0.5% of GDP due to the ongoing drag from the state and local governments as they struggle with their revenue shortages and limited support from the federal government.
This is based on the assumption that the House Republicans will significantly moderate their demands to cut $100 bn (annualised) out of this year's Budget. The extreme nature of those demands can be seen in the fact that the $100 bn has to come out of discretionary/non defence expenditures. Non discretionary (medicare; medicaid; social security; interest payments) is about 65% of expenditure; defence about 20%; so the cuts are all focussed on the remaining 15% (government payrolls; foreign aid; education; payments to the states). The $100 bn represents about 25% of this "rump" and would be a disastrous fiscal tightening – shut down the government to save on payrolls!
Assuming we get a resolution to this dilemma and the Republicans also support the necessary increase in the debt ceiling – which they are also threatening to oppose then the prevailing consensus is that this growth profile will evolve. These growth numbers are higher than our own view since they still seem to be overlooking 2 key issues:
1) Current growth has been driven by sporadic bursts of car purchases and technology investment but the normal growth "engines" of the early stages of a recovery – house building and expenditure on household goods – is missing. The 8 – 10% jump in investment may be a catch up for years of underinvestment (the capital stock actually shrank during the GFC as depreciation exceeded new investment) as well as a further push for technology based labour saving which might run out of steam.
2) Household leverage is still in need of major reduction so any view that household savings rates are likely to fall is vulnerable.
Regardless of whether growth is 3.5% or 2.5% the bottom line is that using (the still reliable) Okun's Law the unemployment rate falls by about half the margin of growth over potential growth) the unemployment rate is still likely to be 8.5% – 9% by year's end. It is currently estimated by the FED that of the 9% unemployment rate 4% have been unemployed for more than 6 months.
Low churn implies that because the unemployment rate will still be so high even after 2 years there will be a large and growing pool of long term unemployed. That will raise the NAIRU; create long term social problems (15% of population on food stamps) and reduce potential growth.
WHAT PROSPECT FOR QE3?
Under those circumstances I was surprised to see the implacable opposition from the customers; the other economists and the officials to extending Quantitative Easing (QE 2) beyond July when QE 2 is scheduled to end.
(Quantitative Easing has been the policy adopted by the FEDERAL RESERVE to purchase Treasury bonds in the market. It is NOT printing money since the banks which have been the beneficiaries of the extra cash have been depositing the funds back with the FED in the form of more reserves. The money multiplier only works when the banks draw down these reserves and lend them out to their customers).
My assertion is that once the Fed stops being a net buyer of Treasuries policy will have effectively tightened. Just as the move from keeping the balance sheet stable to increasing it by $600 bn from November was an easing, the decision to stop expanding it in July will be akin to a tightening. Most customers and the officials disagree arguing that it is about the stock of bonds – QE2 is aimed at taking an extra $600bn out of the system and it is the reduction in the level of the stock which reduces the term premium not the flow of constantly reducing the stock.
This is a very important distinction since even the most bullish of analysts would not think that the US economy will be in sufficiently robust state by July to justify a policy tightening. Current speculation about the rise in the oil price permanently raising inflationary expectations which would require a rate hike is totally off the mark. In fact the higher oil prices will slow growth as households are unable to extract a wage rise (with such a huge output gap) to compensate for higher prices. Effectively, increases in the price of this highly price inelastic good will only reduce expenditure on discretionary goods and lower growth prospects.
It was not unanimous amongst customers that the end of QE2 was neutral – some agreeing with me that part of the reason behind the rise in treasury yields was in anticipation of the FED stopping its purchase program – the parts of the curve where the FED has been concentrating its purchases have underperformed, partly reflecting that concern.
Of course the reason put forward by the officials, and others, for the rise in bond rates is the improvement in the data and the fiscal compromise in December.
The argument is that part of the reason behind the improvement in the economic outlook is the lowering of the risk premium due to QE. In turn that lowers the discount rate for valuing equities; and the yields available to investors in USD assets thus supporting equity markets and weakening the USD. Ironically, the key advantage of kick starting the housing market through lower mortgage rates and increased refinancings seems to have been underplayed due to analysts "writing off" of the housing market for some time to come (prices still falling;foreclosures increasing) although that is not consistent with their "rosy" growth forecasts.
The officials' argument about the fact that rates have increased since the program began is that without the program the outlook would not have improved as much and term premiums are lower than they would otherwise have been.
The area of genuine improvement from the officials' perspective appears to be core inflation – particularly because of the rise in rents – core inflation appears to have bottomed out last year at 0.7% and the deflation "scare" has been averted.
The FED has attracted severe criticism by tying the QE2 decision to the objective of raising inflation – on the basis that if inflation is too low then an exogenous shock might push the economy into deflation – a bit of "breathing room" needs to be established between current inflation and zero. However the public which is now dealing with rising gas prices and food prices cannot understand why the FED would want to "print money to raise inflation".
Clearly if the FED did decide to introduce QE3 it would have to justify it in the public's eye by emphasising the other part of the dual mandate – jobs; jobs; jobs. It is reasonable to expect that public opinion (if not Congress) would then be on their side.
But it does not look likely that QE will be extended in July. Customers believe that the Chairman would have to start preparing the market in his Humphrey Hawkins speech in March – way too soon given the prevailing mood.
That does not mean that if the labour market and economic momentum fade as we saw last summer it would not be considered again.Certainly the "sweet spot" from the fiscal stimulus is likely to fade through 2011. The impact on household budgets and confidence of the rise in oil prices is likely to see consumer spending slow (monthly trend through the December quarter is pointing to momentum slowing even before the oil effect). Certainly because the market does not expect any extension of QE there would be a very solid
fall in bond yields and the USD – just as you would expect when an easing of policy is introduced unexpectedly.
As with my trip a year ago when the market and the analysts "got it wrong" there was much discussion about the profile of how the tightening cycle would evolve (last year around February the market had FED rate hikes priced in for October 2010 just as it now has hikes by end 2011). The consensus amongst customers was that the first stage of the tightening would be to raise rates.
That might be preceded by the FED curtailing its policy of reinvesting the proceeds of the maturing mortgage assets which is around $30 bn per month.
Keeping the balance sheet flat in the first stages by reinvesting maturing mortgage assets is not part of QE2 and is expected to continue beyond July.
Of course, once the market was informed that the policy of reinvesting the proceeds of maturing mortgage backed securities was to be curtailed its focus would move very quickly to the Federal Funds rate.
The FED has also developed another policy instrument of paying interest on reserves held with the FED. That policy is aimed at providing some flexibility to slow the move by the banks to draw down reserves once the demand for credit returns. The argument is that a sharp increase in the rate on reserves may encourage banks to continue to hold reserves rather than see a rapid explosion in liquidity. That might prove to be an ineffective policy since once risk appetites are restored bankers will be able to push rates much faster than the FED is likely to be moving (Nevertheless the existence of the policy does imply that the FED will be committed to a much faster pace of rate hikes than in the 2004/2007 period).
Conclusion
The timing and existence of another round of quantitative easing is the most important policy issue of the day. With markets fully ruling out such a policy there would be quite a response in currency; debt and equity markets should officials start hinting at such a prospect.
The policy makers are focussed on inflation; growth and the labour market in the US. I do not think there is much sympathy for attributing the rise in food and commodity prices to FED policy. Stimulating US growth is seen to be the best contribution to the global economy. Years of underinvestment in supply;and surplus nations falling behind on their tightening schedules are seen to be the real reason behind recent food/commodity inflation. With no options left for fiscal policy any growth "shock" in the US is likely to reopen the QE debate.
High oil prices; faltering spending momentum; a likely reversal in participation rates; minuscule progress in closing the output gap; and a stubbornly high unemployment rate all point to the implacable resistance to QE3 being unrealistic and transitory.
While it now seems unlikely that there will be a surprise extension of QE2 in July we expect that another round of quantitative easing is likely over the course of the second half of 2011.
Such an unexpected policy change would have a profound impact on markets.
The views expressed above are the author's, not FNArena's (see our disclaimer).
