June 2013

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 - More of the same

  • According to the Bureau of Economic Analysis' revised estimate, real gross domestic product (GDP) grew 2.4 percent at an annual rate in the first quarter of 2013, led by a surge in real consumer spending, another solid gain in residential investment and a rebound in business inventory accumulation. In fact, despite a much larger-than expected decline on government spending, overall first-quarter real GDP growth was slightly faster than anticipated in the March forecast.

  • Government spending has been a drag on real GDP growth in ten of the last eleven quarters, primarily reflecting budget cuts for defense and state and local governments. The sequestration is expected to extend this drag into the current quarter, contributing markedly to slower second-quarter real GDP growth than anticipated earlier. However, the drag from government spending is expected to ease considerably in the second half of 2013, as Congress continues to relax the cuts associated with sequestration and state and local government budgets continue to improve.

  • The average rate of real GDP growth for the first half of 2013 likely will be little different from the March forecast, as the slightly stronger first quarter essentially offsets any slowdown in the second quarter. The second-half pace of real GDP growth still is expected to accelerate somewhat.

  • U.S. economic growth may be slower than typically seen at this stage of a business cycle but it is still fast enough to absorb some of the available capacity in the labor market (push the unemployment rate lower). Less potential to grow is the key.

  • Headline inflation should continue to be tame over the remainder of 2013, even though there may be upward pressure on energy and core inflation by yearend. The bulk of the pickup in core prices is likely to be in services.

  • The Fed still is expected to scale back its quantitative easing later this year, even though it likely will keep short-term interest rates near zero. My guess is that the stock market corrects on such a change, reflecting investors' concerns that the economy would stumble without extensive quantitative easing. However, once it is clear that the Fed will not derail the expansion, at least not yet, the stock market should rebound rather quickly keeping a positive wealth effect in play.

Forecast at a glance

chzrt 1 - 4

Forecast details

Forecast Details

More of the same

The Laufenberg Quarterly (LQ) forecast is little changed from the March issue; paraphrasing the old adage "if it works, don't fix it." On balance, the U.S. economy appears to be on track to grow about as expected over the first half of the year, as a somewhat stronger than expected pace in the first quarter is offset by a now slightly slower growth rate in the second quarter. Consumer spending was the biggest surprise in the first quarter and it is likely to continue to be mildly surprising over the next year at least, led by solid gains in spending on services and durable goods. Job growth and a positive wealth effect should provide the wherewithal for consumers to increase such spending.

Also in the first quarter, a sharp increase in residential investment, albeit from a still low level, and a rebound in business inventory accumulation added to real growth, while a larger-than-expected drop in government spending and a wider trade deficit detracted from growth. Over the rest of this year, further increases in residential investment and a moderate acceleration in nonresidential fixed investment should be more than enough to offset any drag from government spending, net exports and inventory building. The bottom line is that consumer spending will be a key driver of real growth in 2013.

Headline inflation, which was tame in the first quarter, should remain very subdued in the second quarter. However, this could change somewhat in the second half, as higher energy prices, as well as upward pressure on core prices (excluding the more volatile components of food and energy), push overall inflation moderately higher. The bulk of the pickup in core prices is likely to be in services.

Fiscal restraint is expected to continue to plague the discretionary spending budget of the federal government, with some moderate spillover effects on state and local government spending. Nevertheless, if the spending restraints become too painful, Congress simply will relax the spending cuts as needed. Indeed, several steps in this direction have already been taken, including budget enhancements to the Federal Aviation Administration, the Department of Homeland Security, the Department of Defense, as well as Medicare. According to the Congressional Budget Office, the federal budget deficit for the current fiscal year ending September 30 will shrink to $642 billion, the smallest shortfall since 2008 and considerably smaller than originally estimated. This will give Congress some cover to relax spending cuts even further. Unfortunately, it also provides an excuse for Congress not to agree on a budget, which means that another continuing resolution will be needed later this calendar year (before the end of the current fiscal year) to prevent a government shutdown. Moreover, the federal debt limit was reached in mid-May, forcing the Treasury to implement several extraordinary measures to provide temporary headroom under the limit. In the absence of legislation to raise the debt limit, the federal government will be unable to pay its bills sometime after Labor Day, which will technically put the government in default. Clearly fiscal policy will have several scheduled roadblocks to either remove or maneuver around before the end of the calendar year. Despite these potential stumbling blocks, I remain optimistic that fiscal policymakers will do something to avoid a crisis, if not the right thing.

The Fed still is expected to scale back its quantitative easing later this year, even though it likely will keep short-term interest rates near zero. My guess is that the stock market corrects on such a change, reflecting investors' concerns that the economy would stumble without extensive quantitative easing. However, once it is clear that the Fed will not derail the expansion, at least not yet, the stock market should rebound rather quickly. After all, much of the Reserve Bank credit extended since the previous recession never found its way into the economy—most of it ended up on deposit at the Fed. As such, removing it may not be as problematic for the economy as many now seem to fear.

A surprisingly robust consumer in the first quarter

According to the revised estimate from the Bureau of Economic Analysis, real gross domestic product (GDP) grew 2.4 percent at an annual rate in the first quarter of 2013, led by a surge in real consumer spending, another solid gain in residential investment, and a jump in inventory accumulation. In fact, despite government spending detracting more in the first quarter than shown in the March forecast, overall first-quarter GDP grew slightly faster than was anticipated.

Apparently returning the payroll tax rate to its prior level after a two-year break was not as much of a problem for consumers as many feared. Indeed, the consensus expected consumer spending to retrench in a significant way in the first half of 2013, as the temporary reduction in the payroll tax expired.

The key to this puzzle may be the word "temporary." When the payroll tax was cut, everyone knew it was temporary. However, consumption theory contends that temporary tax cuts are saved and not spent. For that reason, the cut in payroll taxes probably did more for saving than for spending in 2011 and 2012. As shown in Chart 1, the saving rate jumped at the onset of the recession, as consumers were forced to pullback on mortgages and home equity loans as home prices plummeted. What was interesting was that the saving rate remained high despite the payroll tax cut. It wasn't until the payroll tax was restored that consumers lowered their saving rate. The implication is that a lower tax, if viewed as temporary, has very little impact on permanent spending, which in turn suggests that a return to the higher tax rate would not have much of an impact on spending in the other direction. Other facts, such as permanent income growth and the wealth effect may influence spending more than temporary shifts in taxes.

In fact, real personal consumption expenditures in the first quarter jumped 3.4 percent at an annual rate, the strongest quarterly gain since the fourth quarter of 2010. What was even more noteworthy was the fact that spending on consumer services increased at a 3.1 percent annual rate, the fastest quarterly pace of the current expansion. This is important because consumers must spend on services for the expansion to be sustained, since the bulk of new jobs generated will be in the service sector. And job growth is essential to sustaining expansions.

Three factors may explain this upturn in consumer spending. First, the recovery in the housing market has provided a substantial boost to household consumption expenditures. After all, consumer spending on housing is an imputed value that is highly correlated with housing starts. And housing starts, which have averaged 935 thousand units at an annual rate over the first four months of 2013, are well above the 554 thousand units started in 2009. More importantly, they still have considerable room for improvement.

Second, the wealth effect also helped drive consumer spending, especially on durable goods and services. Indeed, given the improvement in the stock market, spending on financial services saw the second largest gain. But even more importantly, every major category of consumer spending on services registered a gain in the first quarter. Consumer spending on durable goods, which is also aided by the wealth effect, increased at a solid 8.2 percent annual rate in the first quarter. Although this seems impressive, it actually was slower than the 13.6 percent surge in the prior quarter.

chart 1

Third, low interest rates make borrowing more affordable, but not always easier. One area where low interest rates may be helpful to the real economy is that it makes spending on big ticket items, such as durable goods and housing, more affordable for consumers. The reason is that in most cases, such purchases are debt financed. Of course, there is still concern that the lending standards of banks remain too stringent, making it difficult for many consumers to take advantage of the low loan rates. For the most part, that may be changing, as consumer credit rose markedly over the last few weeks.

The bottom line is that consumers should continue to acquire the wherewithal to spend at a slightly stronger pace than has been the case so far during the current expansion but not as fast as typically seen by this time in past expansions. And given the potential drag on near-term GDP growth from sequestration, an uptick in consumer spending growth will be an important ingredient to the expansion continuing.

Sequestration with adjustments

The Budget Control Act of 2011 (BCA) established separate caps on defense and nondefense spending for fiscal years 2012-2021, while creating the Joint Select Committee on Deficit Reduction. This Committee was charged with proposing by January 15, 2012 an additional $1.2 trillion of deficit reduction over the ten-year period starting with fiscal year 2012. Failure of the Committee to do so would trigger "automatic" cuts in spending of roughly $110 billion per year relative to the spending caps, with the cuts split equally between defense and nondefense outlays. For 2013, the reductions were to be implemented by cancelling budget authority in a process called "sequestration." The Committee did fail to proposed additional deficit reduction, starting a year-long countdown to the sequestration. The more recently enacted American Tax Relief Act of 2012 made slight adjustments to the original caps enacted under BCA, reduced the size of the sequestration in 2013 to $85 billion and delayed its implementation until March 1. That is effectively how we got to where we are today.

Since the sequestration took effect on March 1, it had a profound adverse effect on government spending in the first quarter and is likely to have another in the second quarter, causing slightly slower second-quarter real GDP growth than I anticipated in March. There seems to be two policy reasons for this change. First, although some adjustments to sequestration have been made, they were not made in time to prevent cuts in the first quarter or to a lesser degree in the second quarter. In particular, an official federal budget remains elusive. We have gone four of the last five years without an official federal budget, living instead on continuing resolutions. I was hopeful that the pain of sequestration would overwhelm the intense level of partisanship currently in Washington, and deliver a budget. It has not. Instead, Congress has offset some of the more politically painful aspects of sequestration, including an agreement to provide the Department of Homeland Security with a full budget, another agreement to prevent some regional airports to close and some air traffic controllers from being furloughed, and provisions in the last continuing resolution to provide some relief for food inspectors, student grants and loans, and the Department of Defense. They also agreed to remove the small cut in Medicare spending that was in the original sequestration and replace it with a small increase.

Second, many policymakers are convinced that sequestration, although not ideal, is the only available way to reduce government outlays. The problem is that sequestration only applies to about a third of all federal government spending. More importantly, the pain from sequestration is confined to government operations rather than to income transfer programs. And while this may look like a good decision in the short run, it could prove disastrous in the long run. As shown in Chart 2, outlays as a percent of GDP exceeded 25 percent at its peak during the last recession and have improved considerably since. More importantly, the Congressional Budget Office (CBO) projects that outlays as a percent of GDP, under current law including sequestration, will continue to drift back toward its 40-year trend line over the next several years, but still will fail to reach it before it starts to drift higher again. And this occurs under what is assumed by CBO to be a very favorable economic outlook; that is, no recession through 2023.

On the other hand, revenues as a percent of GDP, which has improved since the end of the last recession, is projected by the CBO to continue to drift higher over the next few years. And while it does rise above its trend line for the previous forty years, the federal budget remains in deficit over the entire forecast horizon. Indeed, any near-term improvement in the budget deficit may prove fleeting, suggesting that things could get complicated even if the U.S. economy does not experience another recession. Of course, if it does, the budget situation could become extremely complicated. The bottom line is that if we decide to continue the so-called entitlement programs (income-transfer programs) then we better make sure that we collect sufficient tax revenue to pay for them. In my opinion, it may be okay to borrow from the future to pay from some government programs, but not entitlement programs. We either cut benefits or raise taxes; there is no "silver bullet" option to deal with this situation. Indeed, from this perspective, sequestration may be misleading the public into thinking the budget is being fixed, when actually it is far from it.

chart 2

This is illustrated by the fact that despite sequestration, the U.S. Treasury hit the debt ceiling in mid-May, as the level of Treasury debt outstanding continues to expand. It is important to remember that the debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past.

Because Congress did not approve normal borrowing authority after May 18, the Treasury Department has begun to implement the standard set of extraordinary measures that enable them, on a temporary basis, to pay the nation's bills. The extraordinary measures currently available are: (1) suspending sales of State and Local Government Series Treasury securities; (2) redeeming existing, and suspending new, investments of the Civil Service Retirement and Disability Fund and the Postal Service Retirees Health Benefit Fund; (3) suspending reinvestment of the Government Securities Investment Fund; and (4) suspending reinvestment of the Exchange Stabilization Fund. So far, all but the last measure has been implemented by the Treasury.

Nevertheless, these extraordinary measures are limited and therefore can postpone briefly the need for an increase in the statutory debt limit. On average, the public debt of the United States is increasing by approximately $100 billion per month (although there are significant variations from month to month). In total, the extraordinary measures currently available free up approximately $260 billion in headroom under the limit. That means that the Treasury has freed up enough room under the limit to continue paying the bills until after Labor Day.

In other words, despite the appearance to the contrary, the budget has not been fixed and, given the high level of partisanship currently, it is unlikely to be fixed anytime soon. The last continuing resolution continues to provide funding for the government through the end of the current fiscal year, which means that another continuing resolution most likely will be needed before October 1 to avoid another potential government shutdown.

Slow but not sluggish

The government sector has been a drag on real GDP growth in ten of the last eleven quarters, which is one of the reasons the pace of the current economic expansion has been disappointingly slow. Although sequestration probably was a factor in the government sector being a drag again in the first quarter, it cannot be blamed for earlier weakness. There must be more to the story.

I contend that the slow pace of the current expansion is more a function of changing demographics than sequestration. For that reason, the economy may be slow but it may not be sluggish. Arguing that the U.S. economy is slow but not sluggish may seem like splitting hairs, but I contend there is an important difference. It is a matter of fact that the U.S. economy has expanded at an average annual rate of 2.1 percent over the first 15 quarters of the current expansion, well below its long-term historical average of 3.25 percent, yet the unemployment rate in April at 7.5 percent was down considerably from its previous peak of 10 percent in October 2009. In other words, the expansion so far has been slow but not sluggish. More importantly, the pace of the expansion, albeit still below trend, is expected to accelerate over the forecast horizon. But even this moderate acceleration in real GDP growth over the next year and a half should provide a more pronounced decline in the unemployment rate.

Changing demographics, especially the slow growth in the labor force since the end of 2007, seems to be the reason. This is shown in Chart 3, which plots the civilian labor force from January 2000 to April 2013. Also plotted are the trend lines for labor force growth from January 2000 to November 2007 and from November 2007 to the present. Clearly, the trend rate of growth in the labor force shifted dramatically at the end of 2007. In the earlier period, the labor force grew at an average annual rate of 1.0 percent. This changed in the latter period, when labor force growth slowed to an average annual rate of only 0.2 percent.

Some analysts argue that this slowdown reflected workers who looked for employment and were still available to work but became discouraged and gave up looking. They also argued that once labor markets improved somewhat, many of these discouraged workers would return to the labor force. Although these analysts were correct, they exaggerated the importance of discouraged workers on the slowdown in labor force growth. I contend that the primary factor was the aging of the population, as an increasing share of the population retired—many voluntarily but some not. And the boomers are just getting started; the first of the boomers did not reach full retirement age until last year. Of course, not all the boomers will be strong enough financially to retire, even at their full retirement age, but most of the early boomers will. The younger boomers may not be so fortunate.

Slower labor force growth has important implications for the potential growth rate of the U.S. economy. Potential real output growth can be calculated roughly as the sum of labor force growth and labor productivity growth (see Chart 4). Since labor force growth slowed to 0.2 percent from 1.0 percent since the end of 2007, it seems reasonable to expect that the potential growth rate of the U.S. economy slowed by an equal amount. In other words, the economy can grow at a pace 0.8 percentage points slower than it did prior to 2007 and still keep the unemployment rate the same.

chart 3

chart 4

However, this is only part of the calculation. The other component used to derive the potential growth rate is labor productivity. Obviously, a slowdown in labor force growth could be offset by an equal improvement in productivity. That is, labor productivity growth since 2007 may have accelerated enough to offset any lost potential from slower labor force growth. Unfortunately, that has not been the case. As shown in Chart 4, labor productivity growth has also experienced a mild downshift since the end of 2007, slowing to an annual rate of 1.4 percent from an annual rate of 2.6 percent. The implication is that the potential growth rate of the U.S. economy has slipped to less than 2.0 percent from a much heralded rate of 3.6 percent.

From a utilization standpoint, this suggests that the average annual growth rate of 2.1 percent during the current expansion is actually fast enough to cause the unemployment rate to fall—and it has. Indeed, to the extent that the LQ forecast expects the pace of the expansion to accelerate a bit over the next year or so, the drop in the unemployment rate is expected to intensify. I would not be surprised if the unemployment rate was down a full percentage point over the next year, which would put it at 6.5 percent. This is also the unemployment rate that the Federal Reserve has identified as a possible threshold for higher short-term interest rates.

Reducing quantitative easing a necessary first step

With signs that the U.S. economy may be on the mend, many analysts and commentators warn that the Fed must be careful navigating the exit from quantitative easing (QE). The concern is that a premature exit could jeopardize the fragile recovery, but waiting too long could be just as problematic. The implication is that quantitative easing has had a pronounced impact on the economy. I contend that its impact has been limited, suggesting that the exit may not be nearly as threatening as many claim. After all, most of the liquidity provided through QE has been used to build excess reserves held at the Fed by depository institutions rather than used to make loans and investments. This is suggested in Chart 5, which plots excess reserves, required reserves, and Reserve Bank credit on a monthly basis from January 1991 to April 2013.

Prior to 2008, Reserve Bank credit grew at a relatively steady pace and excess reserves were near zero. Since then, both have taken off, reflecting the start of the QE programs (December 2008) and the Fed paying interest on reserve balances (October 2008). Both make the current circumstances unique for the Fed. That is, the Fed has no experience exiting from QE but then it also has no experience stimulating the economy while paying interest on reserves.

Historically, the factors affecting reserve balances of depository institutions were important to understand the effects of open market operations. Before Fed transparency, I remember putting together a worksheet on factors affecting reserves every Thursday evening after the Fed's weekly H-1 release to determine the purpose of open market operations. The factors included Reserve Bank credit, foreign currency denominated assets, gold stock, special drawing rights, and Treasury currency outstanding. However, once the Fed started telling us what they were up to, there was no need for this Thursday night ritual. Since 2008, there has been some renewed interest in the H-1 release, if only to get more details about the Federal Reserve's holdings of Treasury, agency, and mortgage-backed securities. Although Reserve Bank credit includes other factors, such as discount window lending and foreign central bank liquidity swaps, it has been the holdings of securities that have driven the aggressive growth in Reserve Bank credit in recent years.

Also, prior to 2008, there was no interest paid on reserves. As such, the level of excess reserves was typically very low, since there was no incentive on the part of banks to hold reserves in excess of requirements. Required reserves typically accounted for the bulk of reserves. Now, depository institutions earn interest on the end-of-day balances they hold at the Federal Reserve. The interest paid on required reserve balances reportedly reduces the incentive for depository institutions to use otherwise productive resources to avoid reserve requirements. Moreover, the Fed claims that the interest rate paid on excess balances gives it an additional tool for the conduct of monetary policy. Although that may be the case, the Fed still needs to learn how to use this tool for policy objectives. With the Fed paying an interest rate of 0.25 percent on excess reserves, there is very little incentive for banks to reduce excess reserves in favor of other highly liquid assets, given that the federal funds rate is a mere 0.10 percent, the one-month Treasury bill rate is 0.04 percent, and the one-month LIBOR rate is 0.19 percent. Moreover, only the Treasury bill represents the same credit risk as excess reserves at the Fed.

chart 5

It seems to me that if the Fed wants to encourage banks to reduce their excess reserves, they only need to lower the rate they pay banks on such deposits. Indeed, maybe the Fed should not pay the same rate on all reserves but rather make a distinction between excess and required. Under such circumstances, when the Fed wants to stimulate the economy, the rate on required reserves could be higher than the rate on excess reserves, and when the Fed wants to tighten its policy stance, the interest rate paid on required reserves would be lower than the rate on excess reserves. I contend that the average federal funds rate would be slightly above the rate paid on excess reserves in the first case and that the average federal funds rate would be slightly below the rate paid on excess reserves in the second case.

The bottom line is that when the Fed starts to reduce its QE program, it may have a much greater impact on the level of excess reserves than on bank loans and investments. In fact, as QE is unwound, longer-term interest rates are likely to rise, creating more of an incentive for banks to purchase longer-term obligations, which could also reduce excess reserves.

Investment implications

These are interesting times for investors, with short-term interest rates near zero, credit spreads extremely narrow, and the major stock price indexes at record highs. It begs the question: What do I do now? Indeed, it makes me a bit nervous that a lot of the good news for the U.S. economy may already be priced in financial assets. In other words, the outlook for the economy may be better than the outlook for financial assets.

Let's start with short-term interest rates. Recent discussion has focused more on coming up with a fancy sound bite to describe the process of the Federal Reserve winding down its unconventional QE policy than on the policy shift itself. I continue to believe that the Fed will have the excuse it needs to start "tapering" (the leading candidate for the sound bite) the amount of QE before the end of this year. I believe that the Fed will need to exit the QE strategy completely before it starts to raise its federal funds rate target. That too will be gradual, as long as the Fed does not wait too long to do so. The concern is that the Fed will miss the mark—either start tapering too soon or wait too long. I think the greater risk is that the Fed waits too long. After all, this is the politically easier option. Congress never likes it when the Fed is raising rates, especially in an election year. And 2014 will be an election year.

What happens when the Fed first begins to taper QE and then later begins raising its federal funds rate target? Obviously, bond and stock prices most likely will fall initially, reflecting a higher interest rate used to discount future income flows. Indeed, the corrections could be quite dramatic by historical standards, especially for bonds. However, higher interest rates offer investors more options than they currently have. Credit spreads also are likely to rise initially, reflecting concern that the expansion will be derailed. It seems too soon for that to happen. As such, I doubt that the Fed will shove the economy back into recession, but it could ruffle it a bit.

I firmly believe that the expansion is now strong enough to sustain itself for now without the aid of the Fed's extremely accommodative stance. The one thing that QE did was make it easier for the federal government to carry its heavy debt burden, which essentially provides a false sense of well-being to fiscal policymakers as well as taxpayers. Indeed, for macroeconomic purposes, it may be more important how the federal government spends its money than how much it spends. With fiscal macroeconomic policy in such disarray, this important distinction gets even more blurred than normal.

______________________________

 

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.


ECONOMIC COMMENTARY
Mid-term updates to the Quarterly Reports

ARCHIVES OF LAUFENBERG QUARTERLY ECONOMIC REPORTS

November 2009 - LEQ (PDF)
February 2010 - LEQ
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August 2010 -LEQ

November 2010 - LEQ

February 2011 - LEQ

May 2011 - LEQ

August 2011 - LEQ

November 2011 - LEQ

February 2012 - LEQ

May 2012 - LEQ
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December 2012 - LEQ
March 2013 - LEQ


 

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