Can We Avoid Another Lost Decade?
Despite record doses of monetary and fiscal support, the U.S. recovery appears to be stumbling. First-time claims for jobless benefits are on the rise and economic growth estimates for the April-June quarter have fallen to just over 1%. Many are now asking if we are on our way to a double-dip recession or even a Japanese-style "lost decade."
These concerns are not without merit. Although the Federal Reserve expanded its balance sheet massively in 2008-2009, most of the high-powered money (currency plus bank reserves) that it's provided has piled up as excess bank reserves on deposit at the Fed.
Growth in commercial bank credit and broad money (which consists of currency plus bank reserves plus deposits in the banking system) is decidedly weak. That's a reminder that interest-rate cuts and money printing don't have the same traction when households are debt- and savings-constrained, and financial institutions are uncertain about the value of the collateral underpinning their loans.
But there are key differences between where we are now and where Japan was 50 months after the 1990 peak in its real-estate market. These differences make it less likely that we'll succumb to a deflationary double-dip recession or a lost decade.
For example, industrial commodity prices are about 75% above comparable levels in Japan just over four years from the peak of its real-estate bubble, suggesting a lower risk of a deflationary slump here. Corporate profits in the U.S. are more than 50% above where earnings were at this point of the cycle in Japan, despite the fact that the S&P 500 is actually lower than the Nikkei 225 was at this point in Japan.
Although broad money is currently expanding slowly in the U.S., the level of the broad money stock is 20% higher here than it was in Japan 50 months from the peak in its real estate market. This gap owes to the more aggressive early efforts of the Fed as compared with the Bank of Japan.
Those concerned about a Japanese-style lost decade occurring here will point out that the Treasury yield-curve spread (the gap between long-term interest rates and short-term interest rates) is actually narrower in the U.S. now than it was in Japan 50 months from its real estate peak. This gap not only gives us a picture of monetary policy, it also tells us about the behavior of inflation expectations. The yield-curve spread actually widened after the Fed announced the planned purchases of $1.75 trillion in agency, mortgage and Treasury debt in early 2009, as deflation expectations were replaced with expectations for modest inflation.
But the yield-curve spread peaked in February 2010—the same month the level of the monetary base peaked—and has since narrowed sharply. Treasury Inflation Protected Security (TIPS) spreads have compressed during this period. These indicators suggest the need for the Fed to remain accommodative, as the Fed statement on Tuesday suggested would be the case.
The current economic situation looks like the first few years of economic recovery following the 1990-91 U.S. recession, which were also characterized by weak broad-money growth and a contraction in bank lending. The M2 money supply (a measure of broad money) expanded by only 1.4% per annum through 1994 from 1992, but the velocity of money (the frequency with which a unit of money circulates) turned higher, allowing real GDP growth to average 3.7% per year nonetheless.
Putting fiscal policy on a sustainable, pro-growth track may help reduce uncertainty and improve velocity now.
One problem that dogged Japan during its lost decade was a stop-and-go fiscal policy in which stimulus packages were administered in an "on again, off again" fashion and taxes were lowered and then raised. There is a risk that the U.S. could fall into this trap in an effort to strike a balance between short-term fiscal support and long-term budget integrity.
This strongly suggests that congressional leaders of both parties should embrace a pro-growth fiscal reform that would help to create long-run fiscal stability and foster certainty about future tax rates. With the 2001-2003 tax cuts set to expire at the end of 2010, the time is now to move ahead with broad-based reform.
A good starting point would be the bipartisan Wyden-Gregg tax reform bill. This bill is not incredibly bold, but is probably the best we could do in the current environment and is much better than the current tax code.
Wyden-Gregg would be revenue-neutral; it would simplify the tax code by reducing the number of personal income tax brackets to three from six and would do so without raising marginal income tax rates. The bill also would cut the top corporate tax rate to 24% from 35% in exchange for eliminating corporate tax loopholes.
This would surely be preferable to raising marginal tax rates at a time of high economic anxiety. Raising tax rates on capital, which will occur if the 2003 tax cuts expire at the end of this year, generally has not been an effective source of revenue for the Treasury and could do damage to the recent strong productivity trends the U.S. has enjoyed.
The most likely course for the U.S. economy from here is for a choppy recovery cycle to continue until households have increased their savings and reduced their financial obligations to sufficient levels and financial institutions have more confidence that loan losses have peaked.
Avoiding policy mistakes during this period will be critical. While the Fed is the ultimate source of liquidity and thus "demand," congressional leaders could help reduce uncertainty and increase confidence by embracing a bipartisan tax reform that focuses on broadening the tax base and preserving incentives for growth.
Stéfane Marion, chief economist at the National Bank of Canada, discusses another factor which people should bear in mind before drawing too many parallels with Japan's lost decade:
A growing number of market watchers are beginning to draw parallels between the hardships that the Japanese experienced in the aftermath of their real-estate induced recession in the early 1990s and upcoming problems for Americans. Is the U.S. about to experience a Japanese-style lost decade? Three years after the onset of the recession, it is reassuring to see that the timing and size of policy response in the U.S. has so far enabled its economy to fare much better than Japan did at the same point in the cycle on a number of fronts (production, money supply and inflation).But while the US is not Japan, some see major problems ahead as interest rates are kept at historic lows. The Associated Press reports, Fed official sees bigger risks in future, not now:
Even if we do not deny that the Americans still face a period of deleveraging, we doubt that it will be as painful as that suffered by the Japanese. That’s because of a key difference between the two countries: demographic trends. It is important to keep in mind that Japan’s deflationary problems have been exacerbated by a decline in the population of prime-age house buyers (defined as the number of people in the 20-to-44 age group).
Unlike Japan, the U.S. is at a positive inflection point for that specific age cohort. According to the U.S. Bureau of Census, the population of people aged 20-44 is expected to increase through the next twenty years (13 million people). Japan, for its part, has already experienced a decline of 6% for that cohort (or 3.2 million people).
When it comes to the economy, Thomas Hoenig seems more worried about the future than the present.I happen to agree with Hoenig that the US economic recovery is well underway, and that things aren't half as bad as doomsayers will have you believe. But I disagree with him is that the Fed should raise rates anytime soon.
Hoenig, president of the Federal Reserve Bank of Kansas City, has been sending up flares all year that the Federal Reserve's easy-money stance could hurt the economy down the road. His big concerns: keeping rates low will unleash inflation and spur new speculative bubbles.
And, he's sticking to that stance even as the recovery has lost a lot of momentum. Concerns are growing among private economists that the economy could stall out, or worse, slide back into recession.
Hoenig, in a speech delivered Friday, suggested that those fears are overblown. As he sees it, the economy is growing modestly and has the "wherewithal to recover." During recoveries, economic barometers often bounce up and down, he said.
While some private economists looking at recent economic data are seeing the glass as half empty, Hoenig views it more as half full. He points out that private companies have created 630,000 jobs so far this year. While that's less than hoped for, it's "positive nonetheless," he said. He notes gains in manufacturing and Americans' incomes over the last 12 months.
"While we are not where we want to be, the economy is recovering" and it should continue to grow over the next several quarters, he predicted.
For now, the economy still needs the support of ultra-low rates, he said. Interest rates have been at record lows near zero for nearly two years.
But he worries that keeping rates too low for too long could create problems later on. For instance, low rates could spur bubbles in the prices of commodities, bonds or other asset prices. Or, they could encourage people and businesses to take on too much debt again and overly leverage themselves, he suggested.
"If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring," Hoenig said in a speech in Lincoln, Neb.
Critics like Hoenig blame the Fed for keeping rates low for too long a period after the 2001 recession. Those low rates fed a housing bubble that eventually burst and plunged the economy into a severe recession in late 2007, they say.
"I believe that zero rates during a period of modest growth are a dangerous gamble," Hoenig said.
That's why Hoenig has dissented at all five Fed meetings this year. The latest one came Tuesday, when he broke from the Fed's decision to take an unconventional step to strengthen the recovery by buying government bonds.
One of the many challenges of being a Fed official is having to make decisions on interest rates and other policies actions now - based on your best thinking of what the future will hold.
When James Bullard, president of the Federal Reserve Bank of St. Louis, looks ahead he worries that the weak recovery could push the United States into a deflationary period, like the "lost decade" Japan suffered through in the 1990s. Low rates help combat deflation, a widespread and prolonged drop in prices of goods and services, values of stocks and homes, and in wages.
Hoenig, however, said he sees "no evidence that deflation is the most serious threat to the recovery today."
These differences of opinion within the Fed provide a glimpse of the challenge Fed Chairman Ben Bernanke tries to straddle as he tries to steer the economy into a sustained recovery.
Hoenig does acknowledge that the economy is going through "trying times" - especially with unemployment now at 9.5 percent.
Low interest rates cannot solve every problem faced by the United States, he argued.
"In trying to use policy as a cure-all, we will repeat the cycle of severe recession and unemployment in a few short years by keeping rates too low for too long," Hoenig, said. "I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no short cut."
Unlike the UK, inflation expectations remain low in the US, and some reputable fund managers are positioning their portfolios, fearing the danger of US deflation:
So there you have it, even the experts are divided as to where we're heading. One thing is for sure, markets will remain choppy until we get some clear signs that the threat of deflation has been averted. Until then, expect more volatility, and watch for a few potential bubbles which are forming as all this sorts itself out.
A year ago, Pimco, the world’s second biggest bond fund manager, assembled its financial wizards and instructed them to put a number on the chances of deflation in the US. They came up with 10 per cent. Today, Mohamed El-Erian, who presides over Pimco’s $1,117bn in assets, puts it at 25 per cent.
“We are still attaching the highest probability to outcome ‘C’ – what we call the new normal, which involves muted growth, high unemployment and choppy markets,” says Mr El-Erian. “But we are moving toward the ‘C-minus’ camp now.” The repercussions of the sharp global recession that followed the 2008 financial crisis are still unclear, with economic conditions far removed from those that most people have experienced. The Federal Reserve showed its concern this week when it downgraded its outlook for US economic growth. It took a first step towards further monetary easing despite near-zero official interest rates.
Investors are divided over what will happen next: can the US economy be stopped from sliding into another recession – the feared “double-dip”? Can the Fed prevent Japanese-style deflation, a period of falling prices associated with economic stagnation, from taking hold? Or might the easing lead to rampant inflation later?
Mr El-Erian says Washington’s influence over the outcome makes predictions tricky: “If the mindset in Washington doesn’t move from a cyclical approach to a more structural approach to grapple with fundamental problems, the probability of deflation increases.”
Pimco favours government bonds, with five- to 10-year US Treasuries likely to fare the best.
The split among investors is acute in the hedge fund industry. John Paulson – founder of the $33bn Paulson & Co, which profited spectacularly from the collapse of the US subprime mortgage market – has been consistently bullish on the US economy.
As well as having launched a fund to take advantage of a US upswing, Mr Paulson has denominated over a third of his entire funds under management in a gold-linked share class, constructed specifically as an inflation hedge.
But other leading fund managers, including Peter Thiel of Clarium Capital, Seth Klarman of Baupost and Ray Dallio of Bridgewater, are taking a different stance and have positioned their portfolios with deflation, not inflation, in mind. Buying US government bonds and placing bets on volatility are central to their strategies.
Market participants seem to be heeding their concerns. Expectations of inflation – measurable in the so-called “breakeven” rate on 5-year US Treasury bonds versus their inflation-linked equivalents – have been falling sharply since a peak on April 30, hedge fund managers say. Current prices imply an expected rate of inflation of just 1.3 per cent, the lowest since October last year.
“Inflation proponents are capitulating at the moment,” says Jamil Samaha, portfolio manager at CQS, which manages $7.5bn. “It’s not necessarily that they have changed their minds, but that the market has gone against them for longer than they can afford it.”
Managers say markets are poised at a critical juncture. “For several years I have believed that we will go through a period where the markets will alternate between fearing inflation and deflation – though unless policymakers make a huge mistake, I don’t think either is necessarily poised to be realised,” says Sushil Wadhwani, a former member of the Bank of England’s monetary policy committee and founder of quantitative hedge fund Wadhwani Asset Management.
With the economic situation so fragile, though, the unexpected could have big repercussions. “Markets are particularly vulnerable to event risk at the moment; that could push the economy into brief deflation,” Mr Wadhwani says. “The sort of events that could materialise in Europe would make Lehman look like a garden party.”
“We’re clearly in a deflationary episode, but so far there has been a belief that the Fed can fight it,” says Ben Funnell, a portfolio manager at GLG Partners, which manages $23bn. “If longer-term inflation expectations go negative, though, equity earnings will be crushed, corporates will scale back investment.”
David Kelly, chief market strategist at JP Morgan Funds, which manages $400bn in the US, does not believe there will be another US recession, even if growth is slowing. He questions the wisdom of US investors who have placed more money into bond funds than equity funds for 31 months in a row.
“Anybody who’s investing in mutual funds or stocks should not be looking at the next six months,” he says. “People’s psychological time horizon shrinks when they are worried. But they should be thinking: when do they need the money? If it’s five or 10 years down the road they should be buying stocks.”
Neil Woodford, head of investment at the UK’s Invesco Perpetual, says: “We’re in the early phases of a long period of adjustment ... government bond markets are clearly concerned about deflation.” But some equity valuations are compelling, he says.
Jim Rogers, the veteran investor, does not expect deflation but is not favouring stocks. “There is a physical shortage of many commodities. If anything goes wrong we will see higher prices,” he says.
“I would rather own commodities than stocks. If the economy gets better, more will be bought and, if it gets worse, then they are going to print money, which is good for silver and gold.”
“I am going to sell bonds short,” he adds. “But I’m not going to short them now because the central banks have more money than I do.”