"In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable."
- Ben S. Bernanke, "Rebalancing the Global Recovery," November 19, 2010
With short-term interest rates already at zero, the measured inflation rate approaching zero and the unemployment rate stubbornly remaining near 10%, a deflation-haunted Fed decided to experiment with a policy characterized as quantitative easing. (See Figure 1) On November 3rd, the Fed announced that it would expand its balance sheet by $600 billion dollars over the next eight months by buying intermediate-term Treasury bonds. Its purpose was not so much as to increase bank reserves, which it will do, but rather to lower long-term interest rates and as a consequence raise asset prices, thereby stimulating consumption and investment.
The unstated goals of this exercise in money printing are to lower the exchange value of the dollar and to lower real wages by causing inflation to
Figure 1 Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1- 2012Q4F
Source: Federal Reserve Board and UCLA Anderson Forecast
increase relative to money wages. The former set off a firestorm of criticism at the G-20 meeting in Seoul, Korea increasing the risk of growth-dampening trade policies and as for the latter, although a theoretically appealing way of lowering the unemployment rate, it’s hard to see how a lower real wage in the construction industry, for example, will stimulate housing construction. Nevertheless, from an aggregate perspective a path to a more fully-employed economy could very well be through the wage adjustment process. That process is well underway in many sectors of the economy with the growing use of two-tier wage contracts and mandatory furloughs.1
The risks associated with the policy are that by monetizing the Federal deficit, it could lead to far more inflation than the Fed forecasts; it could engender a dollar crisis that would make it far more difficult to fund our fiscal deficit and it could negatively impact the dollar as the world’s reserve currency. Obviously, the additions to the Fed balance sheet will make it more difficult to unwind the extraordinarily easy monetary policy of the past few years.
Nevertheless, we must be mindful of the fact that the Fed has a dual mandate from Congress, which in the words of Chairman Bernanke "are to promote a high level of employment and low, stable inflation."2 Simply put, the Fed, as a creature of the Congress, has to try to fulfill its mandate or face the political consequences. To be sure, there are many critics who believe that rather than increase employment, the Fed will increase inflation, but with fiscal policy constrained by high deficits and stalemated politics; the Fed is the only game in town.
To us, a real risk is that the policy doesn’t work in reducing unemployment thereby lowering the Fed’s credibility. Indeed, clear signs of the Fed losing some of its credibility where a sell-off in the bond market more than undid the interest rate declines that took place in September and October and a surge in the prices of globally traded commodities that took place in anticipation of the quantitative easing policy. In essence, market fears of future inflation and/or dollar weakness have offset much of the positive effects that were to come from rising bond prices
Although it wasn’t called quantitative easing at the time, the Fed followed a balance sheet expansion policy in the context of near zero short-term interest rates during the 1930s. Then Fed chairman, Mariner Eccles characterized the effectiveness of monetary policy as "pushing on a string."3 All it did was increase bank reserves without transmitting any stimulus to the real economy, much like today.
After all, from late 2007 to the present, bank reserves increased nearly 30-fold with minimal upside effects on the economy. (See Figure 2) That is why Chairman Bernanke is stressing the asset market channel rather than the banking channel to transmit monetary policy. Of course it certainly can be argued that reserve expansion put a floor underneath the economy preventing something far worse. But, we must keep in mind a Fed without credibility is a clear negative for the economy, think the 1970s. While a Fed with credibility certainly aided the 25 year 1982- 2007 boom.
Figure 2 Total Bank Reserves, 2007Q4 – 2012Q4F
Source: Federal Reserve Board UCLA Anderson Forecast
Our Forecast
Our view is that the new Fed policy will be modestly helpful and the most recent economic data have been encouraging. As a result, we have revised up both our real GDP and inflation forecasts from last quarter, but unfortunately even with jobs gains averaging 150,000 a month in 2011 and 200,000 a month in 2012, unemployment will remain above 9% through the third quarter of 2012. (See Figure 3) We expect that real GDP will grow at a 2% plus annual rate through the third quarter of 2011 and then ramp up to a 3% or so growth rate. (See Figure 4) With respect to inflation, we are less fearful of deflation than Chairman Bernanke and we expect consumer price inflation to be at or above the Fed’s informal 2% target by late next year. (See Figure 5) The higher apartment rents now being reported by the publicly traded apartment REITs will soon find their way into the consumer price index.
Figure 4 Real GDP Growth, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 3 Unemployment Rate, 2005Q1-2012Q4
Figure 5 Headline vs. Core Inflation,
2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Why with such high unemployment is economic growth so sluggish? Historically, steep downturns are followed by steep upturns, but not this time. As we argued last quarter and previously, the economy is suffering from a debt hangover that will require many years of deleveraging to recover from.4 Consumption growth, instead of running at an historical 3% rate is now slogging along at a 2% clip as consumers increase their savings rate to repair their tattered balance sheets. (See Figures 6 and 7) Furthermore, with real wages stagnant, debt constrained consumers do not have the wherewithal to go on a consumption binge. (See Figure 8)
In fact, the economy just might be suffering from a new version of Keynes’ paradox of thrift. In the 1930s, Keynes argued that whereas savings for an individual was a virtue, for an economy in recession it is a vice because if every household cuts back on consumption the entire economy remains mired in a slump. Today, however, with very low interest rates, consumers and pension funds have to save more and/ or increase their contributions to achieve their target stock of savings. Moreover, it goes without saying that those consumers who are already retired are being forced to cut back on consumption because of reduced interest income. Thus, one of the challenges facing the Fed’s quantitative easing policy is that lower interest rates could have the perverse effect of lowering consumption rather than increasing it.
Figure 7 Personal Saving Rate,
2000Q1 – 2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 8 Employment Cost Index, Real Private Sector Wages and Salaries,
2000Q1 -2012Q4F
Figure 6 Real Consumption Growth,
2000 – 2012F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Furthermore, much of the increase in consumption is going to imports. Where a year ago net exports were contributing to growth, it is now inhibiting growth. (See Figure 9) That is why a weaker dollar is necessary part of the adjustment process in that it would work to reduce imports and increase exports. (See Figure 10) Of course, the adjustment process would be made easier if China moved with greater alacrity with respect to the upward revaluation of its currency. Nevertheless, in order for net exports to structurally improve, the savings rate has to rise. Why? The U.S. now consumes more than it produces and borrows the difference from abroad. If consumption were reduced to equal production the savings rate would rise and the trade deficit would disappear.
Housing continues to be in the doldrums. We had hoped to see a meaningful recovery in 2011, but that has been pushed back into 2012. The near complete breakdown in the foreclosure paperwork process has dramatically slowed the price discovery process and introduced a new element of uncertainty. We are now forecasting housing starts to be 757,000 and 1,196,000 units in 2011 and 2012, respectively, compared to an estimate of 604,000 units for 2010. (See Figure 11)
The Restructuring of State and Local Government
Although most business cycles have similar characteristics, each cycle is different in its own way. In the current one instead of the state and local sector
Figure 9 Net Exports, 2005Q1 – 2012Q4
Figure 11. Housing Starts, 2005 – 2012F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 10 U.S. $ Trade-Weighted Exchange Rate
Sources: Bureau of the Census and UCLA Anderson Forecast
Source: IHS Global Insight and UCLA Anderson Forecast
gradually increasing throughout the business cycle, this time it is in decline. Simply put, the state and local government is now undergoing the same type of restructuring that the private sector has endured over the past two decades. As a result, we do not expect any meaningful growth in state and local spending over the next several years. (See Figure 12) That is to say, the tax base cannot keep up with the growth in public employee pension and Medicaid outlays and as a consequence other sectors of state and local budgets will be squeezed. This phenomenon will be reinforced by the election of a flock of new budget cutting governors last November. Over the long-run, the growth path of Medicaid and pension expenditures, of necessity, will be lowered.
Fiscal Imbalances Remain
As we noted earlier, high deficits are constraining the Federal government to engage in further fiscal stimulus. Indeed, the newly elected Congress might just be in the mood for fiscal consolidation on the spending side of the budget. As for the tax side, we are assuming for modeling purposes a tax compromise where all of the Bush tax cuts get extended for one more year and in 2012 high income taxpayers will see their tax rates rise. However, we caution a highly partisan Congress might fail to compromise on the tax issue leaving the economy vulnerable to a massive tax hit in January.
Figure 12 Real State and Local Government Expenditures, 2000 – 2012F
Figure 13. Federal Surplus/Deficit, FY 2000-FY2020F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Source: Office of Management and Budget and UCLA Anderson ForecastUCLA Anderson Forecast
Until Congress grapples with the long-term nature of our fiscal problems, we will be living a period of ongoing uncertainty with respect to taxation. The chairman’s mark of the Bowles-Simpson Deficit Reduction Commission offers a good start, but the politics don’t seem to be there for a meaningful solution. Congress does not seem to be in the mood to cut entitlements will raise taxes even if taxes are meaningfully reformed with lower rates and fewer deductions.
In the meantime, we forecast mega-fiscal deficits for as far as the eye can see. (See Figure 13) Thus, in our opinion, gridlock is bad. Without the two parties coming together there cannot be any meaningful solution to the long term fiscal imbalances we now face.
Conclusion
Despite all of the issues outlined above, the economy will continue to muddle through with modest growth and distressingly high unemployment. The economy is healing, albeit at too slow of a pace, but we forecast there will be an acceleration of growth in late 2011 that will gradually work to lower the unemployment rate. Inflation will pick up quicker than the Fed now expects and as a consequence the extraordinary policy measures taken will gradually be reversed and a gradual tightening cycle might begin in early 2012.
Endnotes
1. See, Uchitelle, Louis, "Unions Yield on Pay Scales To Keep Jobs," The New York Times, November 20, 2010, p.1
2. Bernanke, Ben S., "What the Fed did and why: supporting the recovery and sustaining price stability," The Washington Post, November 4, 2010.
3. Meltzer, Allan H., "A History of the Federal Reserve Volume 1, 1913-1951," (Chicago: University of Chicago Press, 2003), p. 62.
4. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.
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