Monday, October 18, 2010

What the Fed Sees

From Bernanke's speech on Friday:

The arbiters across the river in Cambridge, the business cycle dating committee of the National Bureau of Economic Research, recently made their determination: An economic recovery began in the United States in July 2009, following a series of forceful actions by central banks and other policymakers around the world that helped stabilize the financial system and restore more-normal functioning to key financial markets. The initial upturn in activity, which was reasonably strong, reflected a number of factors, including efforts by firms to better align their inventories with their sales, expansionary monetary and fiscal policies, improved financial conditions, and a pickup in export growth. However, factors such as fiscal policy and the inventory cycle can provide only a temporary impetus to recovery. Sustained expansion must ultimately be driven by growth in private final demand, including consumer spending, business and residential investment, and net exports. That handoff is currently under way. However, with growth in private final demand having so far proved relatively modest, overall economic growth has been proceeding at a pace that is less vigorous than we would like.

In particular, consumer spending has been inhibited by the painfully slow recovery in the labor market, which has restrained growth in wage income and has raised uncertainty about job security and employment prospects. Since June, private-sector employers have added, on net, an average of only about 85,000 workers per month--not enough to bring the unemployment rate down significantly.

Consumer spending in the quarters ahead will depend importantly on the pace of job creation but also on households' ability to repair their financial positions. Some progress is being made on this front. Saving rates are up noticeably from pre-crisis levels, and household assets have risen, on net, over recent quarters, while debt and debt service payments have declined markedly relative to income.1 Together with expected further easing in credit terms and conditions offered by lenders, stronger balance sheets should eventually provide households the confidence and the wherewithal to increase their pace of spending. That said, progress has been and is likely to be uneven, as the process of balance sheet repair remains impeded to some extent by elevated unemployment, lower home values, and limited ability to refinance existing mortgages.

Household finances and attitudes also have an important influence on the housing market, which has remained depressed, notwithstanding reduced house prices and record-low mortgage rates. The overhang of foreclosed properties and vacant homes remains a significant drag on house prices and residential investment.

In the business sector, indicators such as new orders and business sentiment suggest that growth in spending on equipment and software has slowed relative to its rapid pace earlier this year. Investment in nonresidential structures continues to contract, reflecting stringent financing conditions and high vacancy rates for commercial real estate. The availability of credit to finance investment and expand business operations remains quite uneven: Generally speaking, large firms in good financial condition can obtain credit in capital markets easily and on favorable terms. Larger firms also hold considerable amounts of cash on their balance sheets. By contrast, surveys and anecdotes indicate that bank-dependent smaller firms continue to face significantly greater problems in obtaining credit, reflecting in part weaker balance sheets and income prospects that limit their ability to qualify for loans as well as tight lending standards and terms on the part of banks. The Federal Reserve and other banking regulators have been making significant efforts to improve the credit environment for small businesses, and we have seen some positive signs. In particular, banks are no longer tightening lending standards and terms and are reportedly becoming more proactive in seeking out creditworthy borrowers.

Although the pace of recovery has slowed in recent months and is likely to continue to be fairly modest in the near term, the preconditions for a pickup in growth next year remain in place. Stronger household finances, a further easing of credit conditions, and pent-up demand for consumer durable goods should all contribute to a somewhat faster pace of household spending. Similarly, business investment in equipment and software should grow at a reasonably rapid pace next year, driven by rising sales, an ongoing need to replace obsolete or worn-out equipment, strong corporate balance sheets, and low financing costs. In the public sector, the tax receipts of state and local governments have started to recover, which should allow their spending to stabilize gradually. The contribution of federal fiscal stimulus to overall growth is expected to decline steadily over coming quarters but not so quickly as to derail the recovery. Continued solid expansion among the economies of our trading partners should also help to support foreign sales and growth in the United States.

Although output growth should be somewhat stronger in 2011 than it has been recently, growth next year seems unlikely to be much above its longer-term trend. If so, then net job creation may not exceed by much the increase in the size of the labor force, implying that the unemployment rate will decline only slowly. That prospect is of central concern to economic policymakers, because high rates of unemployment--especially longer-term unemployment--impose a very heavy burden on the unemployed and their families. More broadly, prolonged high unemployment would pose a risk to consumer spending and hence to the sustainability of the recovery.

First, Bernanke -- along with practically everybody else (us included)-- sees a slow growth economy. This really isn't news; this has been the case for the last few months, as the markets and economy have calmed down from the EU/Greece situation in the late Spring. Notice the both 1 month and 3 month libor are now back near pre-crisis levels.

Secondly, the lack of major news is in fact good news. Since the EU crisis, we've seen the markets calm down and appear to settle into an expectation of below to average trend growth. (I should add, I don't think the current mortgage gate will sink the economy -- which I will explain in another post.)

Third, notice that Bernanke notes that things are lining up for future growth. Monetary policy is expansionary but more importantly, the consumer is retrenching and doing so effectively. Savings are up, consumers are paying down debt as evidenced by the drop in the financial obligation ratio. In addition, consumer are also still buying things: PCEs have increased at between 1.5% and 2% for the last four quarters. But the reports from the Beige Book indicate that consumers are more cautious with their purchases and are extremely price sensitive. In other words, they're the kind of consumers they should have been all along.

Last week, I highlighted that if we start to get good jobs numbers for a long-enough period to boost consumer confidence (say, 4-5 months?) we may have the ingredients for a turnaround in housing. I did this to highlight that we're seeing basic events lines up in a way that would lead to more growth. But, largely because of the employment situation, we're in an economic holding pattern.