24/09/2007
Central bank remains behind the curve – EPN
The US Federal Reserve has been under considerable pressure to alleviate the turmoil that has been afflicting the financial markets. Its initial response was to lower the discount rate and ensure sufficient liquidity was available. However, the system remained gridlocked, and the market pressured for a cut to the key Fed Funds rate. The central bank was reluctant to oblige, but eventually succumbed at its September 18th meeting, cutting by a half-point to 4.75%. Was it the right policy response, will it work and is there more to come?
The Fed had been reluctant to respond to pressures for a rate cut because they had perceived that the greater risk to the US economy was a renewed rise in inflationary pressures. The Fed has been unconvinced about the sustainability of the recent improvement in inflation, and therefore about the wisdom of loosening policy. In contrast, they considered that economic growth prospects remained sound, if unspectacular. That is why they eased the discount rate to try to free up the financial markets, rather than a move directed at the broader economy. The Fed was also acutely aware of the “moral hazard” of being seen to bail out poor investment and lending decisions.
Following the discount rate cut on August 17th, the Fed wheeled out speaker after speaker trying to persuade the markets that a rate cut would only be an appropriate policy response if the market turmoil impacted the real economy, and the regional Fed agents were reporting only limited evidence of such an outcome. Then the release of the August payroll report changed everything. The first decline in jobs for four years and a hefty downward revision to previous numbers suggested that the real economy was taking a hit. Finally, the Fed could sanction a cut based on evidence of an increased risk to the real economy, without the stigma of “moral hazard”.
The reality of the situation is that the Fed has been prevaricating while the real economy has undergone a steady deterioration over many quarters, not just the last month or two. GDP growth has been limping along at a below trend rate, and over the summer was only up 1.9% year-over-year.
The major contributory factor has been the implosion in the housing market, and that still has a very long way to go. In all the US housing booms of the last 50 years the subsequent correction has taken the overall economy close to, or actually into, a recession. At the present time the supply / demand imbalance is historically wide, and house builders have still not sufficiently adjusted down the flow of new properties. That needs to be brought down from 1.3 million to below 1 million units to afford a realistic opportunity of stabilising the market.
Housing corrections are painful
Apart from the woes of the housing market there is ample evidence of malaise in the broader economy. Through the period 2003 to 2006, a period of sustained low interest rates and a robust housing market, households withdrew equity from their homes. This added around 5% to households’ disposable income and sustained a period of strong retail sales growth. With the collapse in the housing market and the marked weakening in house prices, mortgage equity withdrawal is less of an option, and retail sales have slowed from 6-8% a year to only 2-4%. As employment weakens in coming months, that will further undermine real incomes.
Confirmation of this growing economic softness can be gleaned from the economic health of those involved in transporting goods. If demand is strong across the economy, there should be a healthy demand for all forms of transportation, as well as for paper and packaging. However, the American Trucking Association recently reported that total tonnage carried in the year to July was 2.6% lower compared with the same period last year. The Fed’s regional surveys have corroborated the widespread declines in trucking volumes; “trucking does serve as a barometer of the US economy because it represents nearly 70% of tonnage carried by all modes of domestic freight transportation.” Additionally, both Fed Ex and UPS have indicated a softer business environment and lower prospective earnings growth. This is confirmed by the weakest level of shipments of paperboard containers in over 3 years.
Despite the implosion of the housing market, and the broadening evidence of contagion, there are still many sceptics who cling to the view that “everything will be alright” if only the Fed can lubricate the money and credit markets anew. They argue that business surveys suggest that the underlying economy is still relatively robust. The survey evidence, however, appears to have become divorced from actual data and inconsistent with the available indicators of a weakening economy.
Until the most recent payroll report it was argued that a buoyant labour market reflected underlying economic resilience. August’s report of the first monthly fall in payrolls for four years, and revised estimates showing employment growth only averaged 44,000 a month over the summer, has exposed this argument as flawed. Even assuming that the payroll numbers have been accurate, the make up of new jobs was not consistent with a healthy, growing economy. They have not been in the cyclical sectors of the economy, where employment levels have been declining. Instead, over 75% of job gains so far this year have been in three sectors: health and education, government, and leisure and hospitality, not the engines of an expanding economy.
The doubts do not stop there. The government’s figures are suspect because they include a model which estimates employment from the births and deaths of new companies. Implausibly, this model has added close to a million jobs in the last six months, which other surveys supposedly missed – usually reliable reports such as the National Federation of Independent Business (NFIB) or the Institute of Supply Management (ISM). These have not reported a marked pick up in demand for labour this year.
What of inflation? If the Fed were genuinely fearful of the risks of higher inflation, then a policy of rate cutting will require an adept juggling of their various objectives. At present both headline and core CPI measures are well off their recent peaks. Nevertheless, Ben Bernanke, the Fed chairman, believes that “sustained moderation in inflationary pressures has yet to be convincingly demonstrated”. Perhaps that demonstration will follow an extended period of below trend growth.
In conclusion, was the Fed’s rate cut the right policy response? As worded, the cut was “intended to forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets …..”, and, as such, in our view, it was ‘right’. However, we would warn that the US economy is already a lot less healthy than the authorities seem to think, and it is necessary to emphasise that monetary policy changes only operate with a lag. Most research and economic models suggest that after an initial impact on confidence, it actually takes 9-12 months before the effects are seen on the wider economy. The Fed’s rate cuts will help, in the second half of 2008. Before then we would warn that the situation in the US is going to get a lot worse before it starts to get better. The change in policy has come too late to prevent a hard landing.
Douglas Roberts, Senior International Economist at Standard Life Investments.
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