Running Out Of Options
It is remarkable how quickly summer set in. In June we were running heavy volumes and spastic, wide-ranging trading, almost no matter what the asset. In July, suddenly, volumes and volatility have dropped sharply. Some of that is probably due to the fact that much of Europe goes on vacation for a good part of July and August, but that surely is just at the margin.
Of course, the news wire has been slow. Today’s report of Retail Sales was as-expected, which is to say a little bit weak. The recent fade in Retail Sales, the ebbing in Consumer Credit, and some other metrics do support the idea that the economy is straddling the growth/contraction line, either growing slowly or not at all, but so far nothing really supports the grimmer expectations of the punditry. I think there is plenty of time for those expectations to be realized (see below), but probably not yet unless something implodes in Europe in the near-term.
The FOMC minutes were also not particularly surprising, although equities initially reacted poorly as the consensus growth estimates at the Fed were revised downward slightly and the Board’s projections for unemployment raised a bit. The tenor of the minutes were captured in the notation that the Committee felt the risks to the economy had “shifted to the downside,” but none of this should be surprising and stocks managed to recover and close flat.
The Fed also “revised down modestly” the outlook for inflation, which is classic since we are pretty close to a bottoming of the CPI. Recall that core inflation, ex-housing, is around 2.8%. It is only the fall in Owner’s Equivalent Rent, which is responding to the bursting of the housing bubble, which is dragging down core inflation. Now, housing is a big part of the consumption basket so this matters, but in terms of asking whether the decline in core inflation has any momentum, whether it will persist into 2011, the question is really all about whether housing will continue to drag. (N.b. We might also consider the argument that, since the Fed can’t control the bubble unwind anyway, the proper policy target may be core-ex-housing, which has shown a significant response to the Fed’s aggressive easing last year).
I think you can make a pretty good case that, absent a secondary collapse in home prices, we are probably as likely to see Rent increases as decreases in the next year. See the chart below, which plots Owners’ Equivalent Rent against the Existing Home Sales Median Price. You can clearly see the bubble, and you can clearly see that the bubble has substantially unwound. This doesn’t mean we can’t continue to implode – after all, the shadow inventory of homes remains huge – and it doesn’t mean that (implosion or not) we have seen all of the mortgage-related losses yet. We surely have not. But it probably means that home prices are back to being somewhat fairly valued against rents, which further suggests that we ought not to count on any further drag from housing to help to contain the core CPI.
So this is classic. The FOMC is looking at the wrong measure of inflation (core, rather than core adjusted for the bubble unwind), and naively projecting recent trends to continue. I continue to think that core inflation will bottom in Q3 or early Q4.
Now, this forecast has more than the usual amount of uncertainty partly because we have to forecast through a curtain at the moment. That curtain is the November mid-term elections in the U.S., the outcome of which may very well determine how the Congress and Administration responds to the ongoing recession. I noted above that the current temperature readings on the economy are consistent with an economy simply stumbling along sideways. The earlier signs of life now appear to be almost completely due to artificial stimulus and, now that the stimulus is basically over, we can see that it left no mark. It seems to have triggered no organic growth.
It isn’t quite true, though, that it left no mark. It left a big red mark on the checkbook, and a big hole in the government’s pocket. Prognosticators are talking about what the impact will be in 2011 if the scheduled deficit reduction measures (which had to be included in the original stimulus bill to “lower the cost” by increasing revenues in the out years) take place as currently legislated. Economists at Goldman recently wrote that if there is no move to (for example) extend unemployment benefits, the fiscal drag should be around 2% toward the end of this year and the beginning of next year. This says nothing, by the way, about the drag coming from the states themselves, who are in similar position.
Now, here is where the election figures in. We can’t convincingly forecast beyond the election, because unlike in any previous election in my lifetime one of the main topics of debate will be the deficit. Polls indicate that Republicans have gathered considerable momentum not because of their own clever ideas, but because Americans by large majorities want deficit reduction and a repeal of the health care bill.
I think that means that regardless of whether the Republicans gain control of one or both houses of the legislature or not, they are likely to make considerable inroads and the electorate will make clear their point that they are not excited about continuing to rack up huge deficits. That means this fiscal drag is very likely to actually happen, and there could even be multiplier effects on the negative side if consumers, companies, and investors retrench for what looks like it could be a rough ride.
In that situation, I believe it is fairly likely that we will get some action from the only agency with the power to arrest what will begin to feel like a three-year-plus recession with no end in sight. That is to say, I think the Fed will be pushed and prodded to play the only card that we will have left, and to churn out the quantitative easing again.
There are many ways that this could play out, of course, and the elections look like a big wild card. Perhaps, however, they aren’t as big a wild card as it seems. After all, we are running out of options.