Signs of overheating in the US economy?
The US economy grew at an unsustainable 4.9 percent rate in the third quarter of 2007, which includes almost two months since the ‘official’ start of the financial crisis on August 9. Admittedly almost a full percentage worth of this growth was inventory accumulation. If his was unplanned, it may predict future planned inventory decumulation. Even 3.9 percent GDP growth, though, is still well above the Fed’s estimate of the growth rate of US potential output (recently revised down to 2.5 percent per annum) and even above the slightly more optimistic estimate of potential output growth of around 3.0 percent per annum of the Bush administration and many private forecasters. So the recent evolution of the output gap makes for higher inflationary pressures.
It’s true that the US housing market is a little shop of horrors, with further horrors to come. Falling domestic construction activity cut about 1 percent off the economy wide GDP growth rate last quarter. However, residential construction, at barely 4.5 of GDP is a small (and shrinking) contributor to economic activity. Its weakness has been more than offset by the strength of the internationally exposed part of the US economy, boosted by the vanishing US dollar and a still-strong level of global economic activity. Exports (about 12% of US GDP now), grew 19 percent and contributed 1.4 percent to economy-wide growth. A further contribution to demand growth for US production will have come from the import-competing sectors.
Domestic inflationary pressures coming from a growing output gap are reinforced by the decline in the US dollar and the increase in the dollar price of oil and gas. The rise in the real price of oil and gas also increases the output gap, as it lowers the path of US potential output because of the role of oil and related energy inputs in US production.
The rising inflationary pressures are reflected in elevated inflation expectations. On Thursday November 29, US break even inflation (calculated from nominal and index-linked bond yields) were 2.32 at a 2-year horizon and 2.51 at a twenty-year maturity.
There are indeed many pointers to a slowdown of domestic demand growth. Although there should be no significant negative wealth effect on US consumption from the decline in US house prices (what the average American consumer loses as a homeowner (s)he gains as a consumer of housing services), the decline in housing wealth will impact consumption negatively through the ‘housing wealth as collateral for consumption loans’ channel. The financial turmoil has raised the cost and reduced the availability of external funds to the household sector. Three-month Libor has recently stood more than 60bps above the official policy rate rate, and the spread of three-month Libor over such measures of the market’s expectation of the official policy rate over a three month horizon as the overnight indexed swap rate (OIS), is close to 100bps. Because many loans to households and non-financial corporates are priced off three-month Libor, there has been a significant degree of effective interest rate tightening, countering the relaxation of monetary conditions associated with the weakening of the US dollar.
The cost of external finance to the non-financial corporate sector has also gone up, but I doubt whether there has been a corresponding tightening in the availability of external finance for established non-financial corporates. The balance sheets of the non-financial corporate sector are strong and they are, on average, saving more than they are investing. Established non-financial corporates may well look like attractive borrowers to banks who are no longer willing to lend to other financial institutions because of the pandemic of mutual mistrust among the financial institutions. Of course, new businesses without a track record will be badly affected by the credit crunch.
Groans and moans from a bloated financial sector
Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is nigh. It’s not. There used to be a time when most financial institutions were intermediating directly between the ultimate private spending units in the economy – households and non-financial corporations. Most financial markets also had either households (or their direct representatives – institutional investors like pension funds or insurance companies) or non-financial corporates or the state as participants. No longer. Many, perhaps most, financial institutions are involved only very indirectly and peripherally with the intermediation between ultimate savers and ultimate investors or with the management of portfolios of ‘outside’ assets. Their counterparties are other financial institutions. Both sides of their balance sheets include mainly ‘inside’ financial instruments.
This layering or pyramiding of financial institutions and the explosion of new financial instruments created by them was to a significant degree driven by the twin motives of regulatory avoidance and tax avoidance. Part of it reflected genuine institutional and technical innovation not driven by regulatory and tax efficiency. This may well have contributed to more efficient risk trading during normal times and under orderly market conditions. These developments also make abnormal times and disorderly market conditions more likely and the associated financial crises deeper. The failure of regulators to keep up with the proliferation of instruments and institutions, the lack of transparency of many of the new instruments and institutions (negligible reporting obligations, mysterious governance practices) has reinforced the periodic eruptions of euphoria and hubris that are inherent in financial capitalism.
The good news in all this is that much of the financial sector has become quite detached from the real economy. The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect. Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic significance happens. Much recent financial intermediation amounts to the creation of vast artificial lotteries that are used not to hedge previously unhedgeable and non-diversifiable fundamental risk, but rather to allow the taking of larger unhedged positions by speculators with more resources (mostly other people’s money) than sense. Imagine, for instance, a world without hedge funds, SIVs and conduits. That world would be somewhat more stable and transparent than the one we have now, but not significantly different.
All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment. In my view, rather little of it does.
Prospects for US aggregate demand
Direct effects of the financial crisis on investment are so far limited to household investment (construction) and investment in the financial sector. While any decline in investment, no matter where it occurs, has a negative impact on aggregate demand, from a medium- to long-term perspective, a contraction in the size of both the residential construction sector and the financial sector is necessary and desirable, as both had expanded way beyond what made fundamental sense. We will come out of this crisis with secularly smaller residential construction and banking sectors (I include in the banking sector: private equity funds, sovereign wealth funds, hedge funds, SIVs, conduits, other off-balance-sheet vehicles created by investment banks and commercial banks, as well as investment banks and commercial banks; after all, a hedge fund is just a bank without capital, reporting obligations, governance, supervision or regulation).
Corporate investment outside the financial sector should not, for reasons outlined earlier, be significantly adversely affected by the effect of the financial crisis on the cost and availability of external finance. Retained profits are significant and strong balance sheets make established non-financial corporates attractive borrowers for financial sector lenders that no longer wish to lend to other financial intermediaries. But a material contraction in aggregate demand would depress investment, especially if that weakness of demand were expected to last significantly longer than in the cyclical downturns of the recent past, which all were short-lived.
What can we say about the prospects for non-investment aggregate demand in the US? Government spending on goods and services, especially at the Federal level, is unlikely to fall as a share of potential GDP in the run-up to an election year. If anything, a fiscal stimulus of some kind, working either through public spending on goods and services or through the tax-transfer side of the Federal budget, and then through household disposable income, or through current and expected future business profitability, is likely. The external contribution to aggregate demand is likely to continue to roar along, both through export demand and through import-substituting domestic production. That leaves private consumption.
There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly. And so it should. The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the contribution of the US (necessary and long overdue) to global rebalancing. Consumption growth will have to fall significantly and may well have to become negative for a year or two.
The notion that higher private saving means lower private consumption, barring a disposable income miracle, is apparently news to such distinguished economists as Larry Summers and Martin Feldstein. Both have argued for many years (in the case of Feldstein indeed for decades) that the US saving rate has to increase significantly. While some of this increase in the national saving rate could occur through an increase in public sector saving, the bulk will have to come through an increase in the private saving rate. Indeed, I have not heard any recent plea for tax increases or public spending cuts from either Summers or Feldstein. So private consumption growth needs to weaken; indeed, the level of private consumption may well have to fall temporarily, to enable the real-exchange-rate-depreciation-assisted ‘crowding in’ of a smaller US trade deficit.
However, as soon as there is any sign of weakness in consumer demand, both Feldstein (who mooted a 100bps Fed rate cut at the August 2007 Jackson Hole conference) and Summers (who wants the Fed to cut aggressively to forestall a recession brought about by weaker construction activity and consumer demand) run to the nearest exit from the home of intertemporal sustainability screaming for a Fed bail out. Summers in particular appears to be willing to make any opportunistic sacrifice of economic good practice in order to minimise the risk of a short-term slowdown. He has proposed, for instance, that the two GSEs (government sponsored enterprises) Fannie May and Freddie Mac be allowed to weaken their balance sheets further to make off-budget (from the point of view of the government) quasi-fiscal transfers to financially challenged home owners unable to service their mortgages. He has also argued in the FT’s Economists’ Forum of 25 November 2007, that "…fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens."
Where is the logic in calling for a higher saving rate when whenever a higher saving rate threatens to materialise, policies and gimmicks are invoked to lower the saving rate again? Summers’ recommendations for avoiding a downturn are an example of the kind of weak-kneed opportunistic approach to demand management policy in the US that has reinforced what appears to be structurally low private saving propensities in the US these past 40 years or so. There are serious consequences, both internal and global/external of this opportunistic myopia. Domestically, private and public provision for old age and retirement is becoming progressively more inadequate. Externally, the US has moved inexorably from being the world’s largest external net creditor to being the world largest external net debtor. This has weakened and will continue to weaken the global power and influence of the US and its government. It is difficult to go against the wishes and interests of those who own a growing chunk of you.
Surely the time for a consumption slump in the US is now, when the weakness of the US dollar and the strength of global demand will mitigate the impact on aggregate demand and employment? If not now, then when or under what circumstances?
Is the Fed kak-handed or a captive of the markets – or both?
Throughout the crisis, the Fed’s communication policy with the markets has been atrocious. My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.
The speeches by Vice Chairman Donald L. Kohn on November 28 and by Chairman Ben S. Bernanke on November 29 had as their sole purpose to clean up the mess left by careless speeches earlier in November by assorted FOMC members who had left the impression that it would take a miracle (or a disaster) for the Fed to cut rates at the December 11 meeting. The self-evident superiority of a strategy where FOMC members say nothing in public that in anyway anticipates future Fed rate decisions has obviously not occurred to anyone. The Fed’s monetary policy actions (decisions on the Federal Funds target rate) and its liquidity policy actions (decisions on the discount rate, on eligible discount window collateral policy, on eligible discount window counterparties and on its open market operations, both through repos and through outright purchases) speak louder than any words. The written statements released following FOMC meetings and other policy actions fill the rest of the information gap. Anything else is, at best, cheap talk. At worst, it confuses the markets and puts the Fed in the awkward position it has found itself in so many times recently. Too often, ambiguous signals extracted from unnecessary speeches by FOMC members force the Fed to choose between appearing to be a captive of the markets (by validating the markets’ expectations – which tend to be very close to the markets’ wishes – regardless of whether these expectations make any sense) or appearing to be desperate to re-establish its operational independence and room for manoevre by deliberately surprising the markets – ‘teaching them a lesson’.
There obviously are deeper divisions among the Board members and in the FOMC as a whole, than I have ever witnessed before. The Vice Chairman, Kohn, is an unreconstructed anti-inflation targeting old-style dual mandate man. Mishkin believes in inflation targeting and appears to be genuinely convinced of the merits of the dual mandate. Bernanke is an inflation targeter who can live with the dual mandate, but only because he believes that the best, or even the only possible, way to stabilise the real economy is to pursue a low and stable rate of inflation in the medium term. Several of the Regional Fed Governors only pay lip service to the dual mandate and are lexicographic price stability targeters at heart. Janet Yellen, however, is a committed dual mandate proponent.
What is equally striking as the disagreement about the operational mandate is the fear of the financial markets among key Board members, regardless of their view on the Fed’s mandate. They fear a large fall in the stock market; they fear financial market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks. We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy. The collapse of the multilateral trading system was the final nail in the coffin. Perhaps our central bankers have studied the 1930s too much.
Financial markets and private financial institutions deserve the attention of the policy makers. They are an important part of the transmission mechanism of monetary policy and an important source of shocks that could have implications for systemic stability; the information conveyed by asset prices and other market indicators must be monitored carefully and interpreted thoughtfully. But they only matter to the extent that they impact on the real economy. Today’s overgrown, bloated and highly vocal financial markets and institutions are getting more attention than they deserve.
The Fed and other US policy makers appear to be constitutionally incapable of taking the long view. Instead they are flailing about in a desperate attempt to minimize any short-run economic pain. By doing this, they also prevent necessary and unavoidable medium-term and long-term adjustment. This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming. It is probably the clearest evidence that we can expect an accelerated decline in the global role of the US.
To answer the question in the title of this blog: probably not yet. But I would not cut the Federal Funds target rate either.