February 2010invisible

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D.
Economist

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Executive summary

  • The recovery is clearly underway, given the 5.7 percent surge in real gross domestic product (GDP) growth in the fourth quarter of 2009, following a downward revised increase of 2.2 percent in the third quarter. Although the pattern of quarterly growth rates in the second half of 2009 was more volatile than shown in November forecast, the average performance for the second half of last year matched expectations.
  • In the November issue of the Quarterly, real GDP growth was expected to average 3.8 percent for the second half of 2009 and to be flat over the four quarters of 2009. According to the latest estimate from the Commerce Department, real GDP growth averaged 3.9 percent for the second half and ended the year up 0.1 percent from a year earlier.
  • Since the U.S. economy ended 2009 about as expected, there is little reason to make substantial changes to the forecast for 2010. I continue to believe that real GDP will grow 4.0 percent or so over the four quarters of 2010 and that inflation will remain very benign on average over the same period. This should be fast enough to generate job growth. The result should be a sustainable recovery, as more workers, making more money, have more power to spend. And they will.
  • In the fourth quarter, real final sales, which tend to represent final demand for all goods and services, contributed 2.2 percentage points to overall GDP growth, while the change in business inventories contributed a whopping 3.4 percentage points.
  • Many expressed concern about the sizable contribution to fourth-quarter growth coming from the change in business inventories. Inventories cannot sustain a recovery. However, the huge contribution to fourth-quarter growth from inventories was due to a much slower rate of inventory liquidation rather than inventory accumulation. Hence, there is still room for inventories to add further to growth in 2010, and I expect they will.
  • Recoveries are sustained with real final sales growth. Over the four quarters of 2010, real final sales, led by an uptick in consumer spending, are expected to grow 3.6 percent, well ahead of the flat performance for all of 2009.
  • The consumer price index increased a mere 1.5 percent over the four quarters of 2009, matching the advance in the preceding year. More importantly, inflation is expected to remain relatively benign in 2010. With inflation still in check, the Federal Reserve will be under considerable political pressure to keep short-term interest rates low, especially in an election year. Nevertheless, I expect the Fed will raise rates in 2010, but cautiously. Probably too cautiously to avoid an inflation problem in the distant future.

Forecast details

Forecast Chart

More upside surprises ahead

A sharp jump in fourth-quarter real gross domestic product (GDP), the most comprehensive measure of economic activity, provided further evidence that the recession is over and that the recovery is underway. According to the Commerce Department's Bureau of Economic Analysis (BEA), fourth-quarter real GDP surged 5.7 percent at an annual rate, following a downward revised gain of 2.2 percent in the third quarter (see Chart 1). Recall that initially the BEA had estimated third-quarter real GDP growth at 3.5 percent and that the November 2009 issue of the Laufenberg Quarterly had anticipated a gain of 4.1 percent in the fourth quarter, which would have delivered an average growth rate of 3.8 percent over the second half of last year. Based on the latest estimates, it looks as if the economy grew at an average annual rate of 3.9 percent for the second half.

chart 1

A concern of many is that a large part of the fourth-quarter surge in economic activity came from the change in business inventories. However, it was not that businesses were aggressively building inventories, but rather that they were not liquidating them as rapidly as they had been. In other words, inventories actually declined $33.5 billion in the fourth quarter, following declines of $139.2 billion in the third quarter and $160.2 billion in the second quarter. As such, despite the decline, the change in inventories contributed nearly 3.5 percentage points to real growth in the fourth quarter. The implication is that inventories still have considerable potential to contribute further to real GDP growth in 2010, and I believe it will.

That being said, there was more to the fourth quarter growth surge than the partial retracement of the earlier inventory correction. In particular, real consumer spending, nonresidential fixed investment, residential investment and net exports all contributed to growth, albeit moderately. The government sector, ironically but not surprisingly, was neutral in the fourth quarter, as the gain in federal spending was offset by the decline in state and local spending. As a result, real GDP ended 2009 at a level not that different from what was implied in the November issue of the Laufenberg Quarterly.

Since the economy effectively performed as expected in 2009, there is no reason to make substantial changes to the forecast for 2010. I continue to expect real GDP to grow about 4.0 percent over the four quarters of this year, led by solid gains in consumer spending. Overall growth in 2010 will get an assist from further improvement in inventories primarily in the first half and a further acceleration in business fixed investment primarily in the second half. There should be very little help coming from the government sector early in 2010, as any boost coming from federal spending will likely be offset by cuts in state and local spending. Any help to real GDP growth this year from the government sector probably will not materialize until the second half. The foreign trade sector should be a mild drag, as imports once again increase faster than exports.

Finally, inflation was mixed in the fourth quarter, with the overall consumer price index rising 3.4 percent but still up only 1.5 percent over the four quarters of 2009. More importantly, overall consumer inflation, despite the temporary impact of volatile commodity prices, is expected to remain benign over the four quarters of 2010. There is still considerable excess capacity in consumer products and services available around the world that will keep pricing power in check.

A sustainable recovery-for now

Although most analysts now agree that the recovery is underway, some are convinced it cannot be sustained while most of the others are convinced the pace of the recovery will be anemic at best. I obviously disagree. Not only do I expect the recovery to continue, I think that the consensus will be surprised by how robust it is likely to be. And on both counts, consumer spending will hold the key, with assists from the change in private business inventories, residential investment, and business fixed investment.

Sustainability is a matter of definition. I believe that the recovery will endure and that the U.S. economy will deliver a solid performance on average over the next few years. But I also realize that the business cycle has not been repealed and that expansions do not last forever. I am confident that eventually the fear that seems to underlie the current environment will be replaced by greed. When it does, the excesses that result will push the economy into another recession. Nevertheless, that is a development that will take a long time to materialize.

In the meantime, the recovery phase of the business cycle will continue. By recovery, I mean that the economy is in the process of regaining the real output that was lost during the recession. Typically it does not take very long for this to occur. This time, however, some are concerned that it will take much longer because the recession was so severe and the pace of the recovery will be so anemic. Undoubtedly, the severity of the recession will require a bit more time for the economy to recover, but not as long as the consensus now expects. Indeed, the U.S. economy should recover the output lost during the recession by the second quarter of this year. Hence, any growth beyond that point would be considered part of the expansion phase of the business cycle. Recovery in the jobs market will take considerably longer. With total payroll employment at 129.53 million in January 2010, down a whopping 8.5 million from its previous peak of 137.95 million in December 2007, it will take about two years to recover. As bad as this may sound, it is actually quicker than most forecasts. For example, in the relatively mild recession of 2001, it took 29 months for jobs to reach a bottom and then another 18 months for them to recover to their previous peak. So far this time, it has been 25 months and we still have not reached bottom in payroll jobs. However, I expect that we at getting close.

After being relegated to the sidelines late last year and for most of this year, the recovery skeptics have reemerged on the scene. In fact, they once again seem to dominate the guests being interviewed on most financial news networks. Of course, they have numerous reasons to be skeptical. But that is always the case in the early stage of an economic recovery. In particular, the skeptics are convinced that the solid pace of economic growth in the second half of 2009 was a fluke because it was due to changes in inventories and spending tied to government stimulus plans, neither of which is sustainable. The serious skeptics contend that it is a false recovery and that the economy is heading back into the red; there are fewer of these now than a few months ago. The less serious skeptics are willing to concede that the recovery will survive but it will be slow without inventories and new government spending programs providing an added boost.

I am skeptical of the skeptics. Clearly the economy cannot grow 5.0 percent or more every quarter but it is capable of averaging a growth rate of 3.5 percent to 4.0 percent for several quarters. For example, as shown in Chart 2, the boost coming from inventories was not because businesses were aggressively building inventories. On the contrary, businesses inventories still fell $33 billion in the fourth quarter, but that was up from the $133 billion decline in the preceding quarter. If business inventories just stop declining, which is a very conservative expectation, this component of GDP could add a percentage point of real GDP growth at an annual rate in any one quarter and a quarter of a percentage point to real growth over four quarters. For this reason, the forecast expects the change in inventories to be a mild positive for overall growth in 2010.

chart 2

Also, it is not unusual for the change in business inventories to rebound in the early stages of an economic recovery, generally retracing the inventory correction that occurred during the preceding recession. A good example of this is the change in inventories during the early stages of the 2002-2007 expansion, following what had been at the time the most severe inventory correction on record. It is interesting that the inventory corrections in the era of "just-in-time inventory management" have been so severe. Apparently, just-in-time has more significance at the micro level than at the macro level of inventory management. That is, my company may be able to operate with smaller inventories of goods and supplies, but only if another company is willing to hold them for me and deliver them to me when needed.

Finally, it is important to note that any contribution to growth from the change in inventories is short-lived. At some point, real final sales growth is needed to sustain an economic expansion. In this regard, the fourth-quarter GDP data was more encouraging than assessed at first blush. It was not that real final sales grew 2.2 percent at an annual rate but rather the widespread gains among the various components of final sales that provided that glimmer of hope.

In addition, federal government stimulus programs may have provided a small assist to consumer spending in the fourth quarter, but it certainly was not the whole story. Indeed, in the fourth quarter, consumers spending on nondurable goods and services grew faster than spending on motor vehicles and houses. The government programs, such as cash for clunkers and the tax credit for home purchases, targeted the latter more so than the former.

Consumer spending is the key

As shown in Chart 3, real consumer spending rose 2.0 percent at an annual rate in the fourth quarter of 2009 and ended the year higher than it was at the end of the prior year. The fact that consumer spending held up reasonably well in the fourth quarter had to be a surprise to the skeptics who thought that the only reason consumer spending was positive in the third quarter was because of the "cash for clunkers" program sponsored by the federal government. As it turns out, a subtle gain in real disposable income and the upturn in the stock market probably were the key factors behind the 2.0 percent annualized increase in fourth-quarter real consumer spending. As confidence improves, incomes rise, and the stock market advances, consumer spending growth should accelerate further, providing a solid foundation for 4.0 percent real GDP growth for all of 2010.

chart 3

Although the most recent data are far from convincing and subject to revision, they do tend to support the idea that real consumer spending will accelerate further in the first quarter. For example, real personal consumption expenditures (PCE) in December 2009 were already at a level nearly a percentage point higher than the average level of spending in the fourth quarter of the year. I contend that consumer spending ended 2009 with enough momentum to comport with my forecast of 3.0 percent real PCE growth in the first quarter of 2010.

With regard to the rest of 2010, I continue to believe that real disposable income, which grew 1.8 percent over the four quarters of 2009, will grow more than enough to support strong spending growth. Higher real incomes will reflect positive job growth, moderate wage gains, and relatively benign inflation, and in turn will provide consumers the wherewithal to spend. And with the positive wealth effect on consumer attitudes from the stock market being up from a year ago, I suspect that consumers will be willing to spend a larger share of their income. In other words, the personal saving rate, despite all of its measurement problems, most likely will drift lower over the next few years as consumers once again rely more heavily on debt to help finance some of its spending.

The Fed's exit strategy

Federal Reserve Chairman Ben Bernanke provided written testimony recently discussing the Fed's strategy for exiting from the extraordinary lending and monetary policies that it implemented to combat the financial crisis.1 As expected, Chairman Bernanke was vague about the timing of the exit but confident that the Fed would know what to do and had the tools necessary to carry out the assignment successfully. The Chairman noted that the Fed has substantially phased out its lending programs or will by the end of March. By then, the Term Asset-Backed Securities Loan Facility for loans backed by newly issued commercial mortgage-backed securities will be the only facility in operation, and that too is scheduled to close by June 30. The Fed contends that these facilities were designed to improve liquidity in credit markets in an effort stabilize the financial system. Since the financial system seems to have stabilized, the Fed has declared victory on this score.

Successfully exiting the extraordinarily accommodative monetary policy still in place may prove more difficult. Chairman Bernanke seems confident that the Fed will be able to do so effectively at the appropriate time. In this regard, the Fed believes it has acquired a new policy tool when it was given the authority by Congress to pay interest on banks' holdings of reserve balances. The argument is that by "increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply funds to the money markets at rates substantially below what they can earn by holding reserves at the Federal Reserve Banks." 2 I contend that this policy feature is redundant and is unlikely to add markedly to the ability of the Fed to implement monetary policy. It seems to me that the interest rate paid to banks on reserves, which reflects the credit worthiness of the Federal Reserve, will be the closest thing to a riskless rate of interest, even though it is an administered rate. Hence, the federal funds rate, which is a market rate secured by the creditworthiness of the banking industry, should be set at a level slightly above the interest rate on reserves under normal conditions. However, if we ever get ourselves into a situation similar to the one we just went through, the spread between the federal funds rate and the rate on reserves would most likely widen dramatically. This might not persist but it certainly could be temporarily counterproductive to an easier policy stance by the Fed.

Moreover, I doubt that it would bust the federal budget, but interest paid on reserves by the Fed is a drag on federal government receipts. Recall that any profit earned by the Federal Reserve System above the cost of its operations is returned to the Treasury. In 2008, the Federal Reserve recorded a profit of $35.7 billion. Obviously, if the Fed is paying interest on reserves, it will reduce the Fed's profitability and therefore the Fed's payment to the Treasury. With interest rates near zero, this is not a big problem. If interest rates return to more normal levels, this feature will simply add to the federal government's deficit and probably at a very inopportune time. For example, as of February 10, 2010, bank reserves held at Federal Reserve Banks totaled $1.15 trillion. If the Fed paid banks interest on this balance at a rate of 3.0 percent, the payment would total $34.6 billion or nearly all of the Fed's profits.

Investment Implications

Market participants continue to be more sensitive to risk than to return for now. Recall that market participants always stretch for return but not always to the same degree. For most of 2009, investors were either afraid to get on the ladder or were standing on the first rung reaching for only low-hanging fruit. More recently, investors have moved up the ladder a bit but are still a long way from where they were in 2007, which may be a good thing. In 2007, investors were not only on the top rung of the ladder, they were dangerously stretching for return with no fear of a fall. They fell, and the process of stretching for return was reset to start over. And if history is any guide, it will take time for investors to work their way to the top of the ladder again but it will happen.

I consider this caution on the part of investors a positive for the stock market. As such, I continue to believe that the improving economic fundamentals will help drive stock prices higher, but not at the same torrid pace of the last eleven months. In fact, I expect the S&P 500 stock price index to take three years to increase by as much as it did in the last eleven months. The question is whether there will be enough time for the S&P 500 to reach a new high before the next recession begins. Clearly, the extent of government intervention into the economy will have consequences and one of them will be less robust performance of financial assets worldwide. After all, for inflation to become a problem in the U.S., it must also become a problem for the rest of the world.

The Fed has started to prepare us for the inevitable. Chairman Bernanke has told us how the Fed plans to exit from the very accommodative policy stance currently in place, but not when. I remain convinced that the Fed will start its exit sometime this year, probably late in the second quarter. However, the Fed will be gradual in its approach because benign inflation will make it difficult for the Fed to be anything else but gradual in an election year. That being said, politics will not prevent the Fed from raising its target for the federal funds rate, but it could influence the extent of the Fed actions. In particular, the Fed will need to be convinced that the economic recovery can withstand a less accommodative monetary policy before they make the move.

Of course, longer-term interest rates will start to rise in anticipation of the Fed raising short-term interest rates, most likely causing an already steep yield curve to become even steeper (see Chart 4). I contend that this development has already begun and is likely to persist until the Fed actually starts to push short-term rates higher. If this is the case, then longer-term rates, which most likely will be at already higher levels, will move higher but will not keep pace with the advances in short rates. As a result, the yield curve becomes less steep in a bear market for debt obligations. The success of the Fed's exit strategy will determine the path of long-term interest rates over the remainder of 2010. If investors become convinced that the Fed has engineered a perfect landing for the U.S. economy-the combination of solid growth and low inflation, then longer-term interest rates could actually retreat a bit in late 2010. But this too will not persist forever.

chart 4

The bottom line has not changed from three months ago. Equities, non-government taxable bonds and tax-exempt bonds still look attractive, but asset selection can make a difference. In a broader sense, asset allocation standards should be followed carefully over the next several years in the wake of what is likely to be very volatile markets. This includes frequent rebalancing of investment portfolios to keep risk within investors' tolerance levels. Never forget that business cycles have not been repealed.

US job machine restarting at a slower pace

Nearly everyone agrees that jobs are needed to sustain the economic recovery now underway. Unfortunately, the jobs data so far have been disappointing, raising concern among many that the recovery will falter. According to the most recent report, payroll jobs fell another 20 thousand in January to a level that was more than 4 million below the level a year earlier (see Chart 1). Moreover, given that the economy grew at a relatively solid pace over the second half of 2009, the expectation is that jobs would follow. We are constantly reminded that jobs are a lagging indicator, but the patience of many seems to be wearing thin. This appears to be especially true of Washington politicians looking to be re-elected.

chart 1b

How long will it be before jobs turn positive? I expect it will be very soon. Businesses had to be encouraged by the 5.7 percent surge in real gross domestic product in the fourth quarter of last year, causing them to start thinking about expanding output somewhat once again. That means jobs. Of course, not everyone agrees. Some economists are concerned that business owners either are not willing or are unable to hire again. And since jobs will not materialize, the recovery cannot survive.

Some of the issues offered as headwinds for an improving labor market are that the market is far weaker than the commonly reported data suggests, policy uncertainty has paralyzed business managers, many jobs are lost forever, and the army of workers who left the labor force over the last few years will reenter as jobs return. The first item is more of a shock factor—things are a lot worse than you think. The others are viewed as factors that will restrain job growth or the potential decline in the unemployment rate.

First, there is an alternative measure of the unemployment rate reported by the Bureau of Labor Statistics (BLS) that includes not only the unemployed but also persons marginally attached to the labor force as well as persons working part-time for economic reasons as a percent of the civilian labor force plus all persons marginally attached to the labor force. This measure is referred to as U6. Some contend that U6 is a more accurate measure of unemployment because it includes those who left the labor force discouraged about their job prospects. At its peak in October 2009, it was at 17.4 percent, causing some to contend that this is a more accurate measure of the unemployment rate and thus the situation is far more severe than the civilian unemployment rate alone, at 10.2 percent might suggest. I disagree. As shown in Chart 2, the U6 measure of the unemployment rate has been available only since 1994, so we really do not have much history. However, from what we do have, it appears that the U6 measure tends to track the civilian unemployment rate (U3) rather closely. This is illustrated by the ratio of U6 to U3 shown in Chart 2, which has been very stable through all labor market environments. In other words, the civilian unemployment rate, compared over time, does a reasonably good job of measuring the underlying strength or weakness of the labor market.

chart 2b

Second, there is concern about reports that many of the jobs lost over the last decade will never return. The implication is that we are in the midst of a permanent downward shift in jobs that will hamper the economic recovery. But this is not new. Jobs always disappear. The recovery is not necessarily at risk, but the economy's potential may be lower now than it was in the 1990s. The difference may be that the jobs lost are not being replaced with new jobs in new industries like they were. Although the data are not very current, the government does report the total jobs lost or gained for the U.S. economy on a quarterly basis (Business Employment Dynamics reported by the BLS). This data series suggests that both job gains and job losses have slowed considerably over the last decade, with job gains slowing much faster than job losses over the last few years.

Demographic changes may not only explain this development but it may represent a new trend. As shown in Chart 3, there was a clear break in the trend in total employment in 1964, which also was the year that the first wave of boomers graduated from high school. Prior to 1964, it looks as if jobs grew at about a 1.2 percent annual rate. From 1965 to 2007, employment grew about 1.9 percent annually, before turning sharply downward more recently. Just as the acceleration seemed to coincide with the early boomers graduating, the recent slowdown seems to coincide with the early boomers reaching retirement age. The consequence is that the changing demographics not only exacerbate the cyclical decline in jobs, but they also could have a damping effect on future employment growth. When economists and portfolio managers talk about a "new normal," maybe this is what they have in mind.

chart 3b

In a related data series, the BLS reports job openings, hires and separations on a monthly basis (Job Openings and Labor Turnover Statistics). This data show a similar picture to the Dynamics data. Job openings as a percent of employment plus job openings have registered a secular decline over the last decade, reaching a low of 1.8 percent in the second half of 2009. Over the same period, both the hiring and separation rates (each divided by total employment) have slowed, with the former slowing more than the latter in 2008 and early 2009. In other words, as expected during a recession, there are more separations than hires. The issue is that the downward move in hires may have a more permanent element to it owing to a shift in the demographics and a more cautious approach to hiring in the wake of the financial crisis experience. Any hesitation on the part of firms to hire because of policy uncertainties is probably more cyclical than secular in nature.

Third, many economists have expressed concern that the recent sharp drop in the labor force participation rate (the percent of the population 16 years and older either employed or looking for employment) as shown in Chart 4 is temporary and that a rebound in this rate would represent a substantial headwind to further improvement in the unemployment rate. After all, if the people currently not looking for a job suddenly decide to return to the labor force, it would require even more net job creation to prevent the unemployment rate from backing up. Although the participation rate is likely to rebound some, it will not recover completely because an increasing number of workers leaving the labor force will be boomers retiring. Yes, despite the financial woes of the last two and a half years, many boomers will still be able to retire, just maybe not quite as many. Retirement cannot be postponed forever. Dying on the job is not an option for most.

Finally, when the word economic recovery is used, some refer to jobs rather than real output. That is, the recovery is not complete until the economy gains all the jobs that were lost during the recession. By this definition, it may take years rather than quarters for the U.S. economy to recover. Jobs will come but the decisions to hire have been delayed. Ironically, I doubt that these decisions will be delayed as long as they were following either of the prior two recessions in 1991 and 2001. The reason is that businesses were very quick to cut jobs in the 2008-2009 recession, which means that they may be quick to hire workers back. Also, job cuts were far more pronounced in the recent recession than either of the previous two recessions, so there are more jobs that may need to be filled once the recovery in aggregate demand looks sustainable. An interesting bit of history is that following the 1981-82 recession, which was the last really severe U.S. recession, nonfarm payroll jobs increased over one million in September 1983. I am not suggesting that payroll jobs will increase one million in a month in the current recovery, but some very large monthly gains in 2010 are certainly possible and I contend probable.

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


ARCHIVES OF LAUFENBERG ECONOMIC REPORTS

November 2009 - LEQ (PDF)
February 2010 - LEQ


INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

More Upside Surprises Ahead

A sustainable recovery-for now

spacerConsumer spending is the key

spacerThe Fed’s exit strategy

spacerInvestment Implications

US Job Machine Restarting at a Slower Pace

~ ~ ~ ~

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

More Upside Surprises Ahead

A sustainable recovery-for now

spacerConsumer spending is the key

spacerThe Fed’s exit strategy

spacerInvestment Implications

US Job Machine Restarting at a Slower Pace

~ ~ ~ ~

 

 

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

More Upside Surprises Ahead

A sustainable recovery-for now

spacerConsumer spending is the key

spacerThe Fed’s exit strategy

spacerInvestment Implications

US Job Machine Restarting at a Slower Pace

~ ~ ~ ~

 

 

 

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