U.S. Economic Outlook

Open-Ended Easing

September 14, 2012
by Carl Tannenbaum, Asha Bangalore

View PDF version

Summary:

  • The Federal Open Market Committee (FOMC) took a very forceful set of steps this week, designed to stimulate what officials have called a "frustrating" job market.
  • Our updated forecast suggests that the growth trajectory of the US economy is positive but sufficiently sub-par for the Fed to have initiated additional monetary policy support.  
  • There are increasing signs that China’s economy is slowing more than the official readings would suggest. 

It's an old joke in economics that forecasters should never give a number and a date in the same sentence. The Federal Reserve seems to have had that bromide in mind during the formulation of its latest monetary policy decision.

A third round of quantitative easing was announced, with the Fed set to purchase $40 billion in mortgage-backed securities monthly. This program will start today, and continue indefinitely "if the outlook for the labor market does not improve substantially." This conditional, or open-ended program was different in form than the fixed program of $400 to $500 billion we expected, but its ultimate size will likely be very similar.

The committee also extended the period over which short-term interest rates will be held near zero "at least through mid-2015." This adds another six months or so to the timeline that was a part of the August 1 FOMC statement. “(A) highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens,” the committee said.

Today's action was thoroughly foreshadowed by both the minutes of the last FOMC meeting and by Chairman Bernanke’s speech to the Jackson Hole conference. It is clear that the Fed’s focus is on the labor market, which is not surprising given that maximum sustainable employment is one of the Fed’s mandates. The Fed’s forecasts for unemployment, released today, show a very gradual decline in coming years:

Central Tendency of Projected Unemployment Rates Among FOMC Participants

 US Economic Outlook 09-14-12 Chart 1

For the first time, policy actions have been tied directly to job readings. This association certainly makes sense, but some will likely feel uncertain about exactly what constitutes “substantial” improvement. There are a variety of labor market metrics to choose from, not all of which move in synch. Bond analysts will not know the ultimate extent of the Fed’s demand, which may make pricing mortgage-backed securities more difficult.

To us, though, tying QE III to an economic target variable seems like a meaningful formulation. If and when employment conditions reach the Fed’s acceptable threshold, we can expect language and statements from the central bank which prepare the market for an end to the program.

Several questioners during Chairman Bernanke’s press conference asked about how well the program would work. Success will rely on two key transmission mechanisms: market psychology and mortgage rates.

As shown below, the equity markets have gathered momentum since the release of FOMC minutes last month. Even as the economic news has faltered, the expectation of additional monetary stimulus has cheered investors.

US Economic Outlook 09-14-12 Chart 2

On the mortgage front, the expectation of QE III has placed important downward pressure on mortgage rates and the spread between those rates and US Treasury securities. This should open a new window of refinancing for some homeowners, and add an increment to affordability measures for prospective home buyers.

Others have openly questioned whether the action announced today will increase the risk of inflation. The FOMC has certainly not forgotten about the other side of its mandate, but it is certainly not its most pressing concern at the moment. And as the FOMC statement observed, “The Committee will, as always, take appropriate account of the likely efficacy and costs of (asset) purchases.”

Hovering over the outlook and the proceedings were two main risk areas: Europe and the US fiscal cliff. The Chairman indicated that both would be watched closely, but cautioned that American monetary policy would likely not be able to offset a bad outcome on either front.

It seems unlikely to us that there will be any major modifications to the Fed’s stance for some time. This will place the focus on fiscal policy (here and overseas), which will hopefully become less uncertain and more supportive. When, and by how much? You’re not going to get us to fall into that trap.

US Economy - More of the Same

In reality, we are obligated to give numbers and dates in the same place. Our updated economic projections are below.

US Economic Outlook 09-14-12 Chart 3

The U.S. economy is forecast to maintain moderate economic momentum during the next four to six quarters. A 1.7% annualized increase of real gross domestic product in the third quarter, followed by a slightly stronger performance in the final three months of the year should result in a 2.2% gain in GDP in 2012, which is a tad better than the 1.8% increase seen in 2011.

Consumer spending should post unimpressive growth of roughly 1-3/4% in the second half of 2012. Consumption rests on shaky ground, with households continuing to face balance sheet stress, tepid gains in employment, weakness in earned income, and tight access to some types of credit.

Although the housing sector data contain glimmers of hope, residential investment expenditures are projected to show a slower pace in the second half of the year compared with the first six months of the year. Business spending - equipment and software expenditures and structures – will add to GDP in the rest of 2012, albeit only modestly.

We do not expect the impending fiscal restraint at the Federal level, referred to as the "fiscal cliff," to damage the economy with full force. While the "cliff" will be a noticeable distraction in the near term, the likelihood is that legislators will eventually smooth some of its rougher edges. Nonetheless, the downward trajectory of federal, state, and local government outlays will continue to limit economic performance through the forecast period.

A wider trade gap is another factor holding back economic growth in the quarters ahead. The weakness in exports is a reflection of slowing global economic activity. Despite the European Central Bank's Outright Monetary Transactions program and the European Union proposal to strengthen the eurozone banking system, there is still a high level of uncertainty about adverse spillovers from Europe. Persistent weak economic conditions in Europe in the near term will have a significant negative bearing on US exports, some of which is already visible in recent trade data.

The likelihood of a significant deceleration of growth in China is another source of risk to US economic activity, as roughly 6% of American exports go to China. James Pressler, Northern Trust’s expert on China, shares an in-depth outlook in the following section.

China: Fasten Your Seatbelts
By James Pressler
Associate Economist
312.444.4109
jap10@ntrs.com

In this week’s policy briefing in Beijing, a government spokesperson offered assurances that China will achieve its target of 7.5% growth for 2012. For policymakers in other countries to boldly guarantee growth at this stage would be risky, but in China this all but puts the figure in stone. We now have little doubt that end-year GDP reports will give us 7.5% growth at a minimum.

However, our real concern will be just how this impressive feat will be accomplished. On a year-over-year basis, Q2 GDP for China was barely above 7.5% and on a downward trend. With the recent spate of indicators out of Beijing continuing to show a sharp slowdown in economic momentum, and with policymakers reluctant to take action, a somewhat less encouraging scenario may be playing out rather than the government’s more optimistic outlook. And in this scenario, there is no easy way to explain the government’s promised growth rate.

US Economic Outlook 09-14-12 Chart 4

To decipher whether growth is falling further than the Chinese government would concede, we have to first study where growth actually comes from. China’s miracle has in no small part been through investments in itself - building up a strong and productive capital base. Last year, China’s investment in fixed assets grew by a robust 25.1% - impressive, but actually behind the 27.3% pace posted during the 2005-08 period. According to the report released this weekend, the pace for the first eight months of 2012 has only been 21.8%. If the economy is building any momentum, it is not coming from this sector.

US Economic Outlook 09-14-12 Chart 5

Earlier this month, Chinese authorities announced a $158 billion infrastructure spending program. This will certainly help to soften the decline in fixed investment, but may not fully offset the downward trend.

Exports are another source of China’s growth, but this indicator is also falling below expectations this year. This is not surprising, as China’s two largest markets – the US and the Euro-zone – have not been in buying moods lately. Export growth has ground to a halt in 2012, with little suggestion that a rebound is near. On the other side of the ledger, weak imports suggest that China’s domestic demand is not spectacular. Admittedly, a significant percentage of China’s imports end up leaving another dock as exports, but imports of manufactured goods – more likely to be used in developing China’s capital rather than becoming the next iPhone – have also slowed precipitously. It is worrisome when industrialized world demand is weak, but when Chinese demand is also flagging, there is real cause for concern.

US Economic Outlook 09-14-12 Chart 6

Conventional wisdom suggests that when so many indicators and trends point in the wrong direction, policymakers are motivated to relax the monetary environment to promote growth. However, it was easy money back in the wake of the global financial crisis that sponsored the recent investment boom, and now that the party is over, the hangover is hitting with a vengeance.

Cutting interest rates now might help indebted Chinese companies refinance their massive debts, but it won’t reignite growth. The only effective tool that Beijing has at its disposal is the yuan exchange rate, and the People’s Bank of China (PBoC) allowed the currency to weaken in Q2 when it felt this was the remedy. No longer. Sustained yuan weakness would drive off investment inflows seeking an expected appreciation, so the currency has been set back on its upward drift.

The PBoC has run out of policy tools, and is now trying to build up confidence by emphasizing that any imbalances are controlled and that the economy is not experiencing a prolonged slowdown. As we have seen through numerous examples, the jawboning strategy is not a long-term fix.

The one problem overshadowing the entire monetary and policy environment is that the Chinese Communist Party leadership is going through its once-a-decade ritual of transferring power to a new president and premier. This is a very delicate time that is meticulously orchestrated to be a smooth, seamless handoff that will begin a new period of growth and promise. In short, the Party does not want even a whiff of dissent nor any talk whatsoever of an economic crisis. Social stability is the utmost consideration to all Beijing’s plans, so major policy moves will have to wait until after power is cleanly handed off.

We take the government at its word when it says growth for 2012 will be reported as 7.5%, or perhaps 7.4% with extensive explanation of why the target was missed. But the risk is that underlying economic strength may be much more modest, with no dramatic policy shifts likely to be approved until after the leadership handover.

Like other major markets, China is going through a very delicate period that will require careful handling. We are indeed blessed and cursed to live in interesting times.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
© 2014 Northern Trust Corporation
Northern Trust - Daily Economic Commentary

Open-Ended Easing

September 14, 2012
by Carl Tannenbaum, Asha Bangalore

View PDF version

Summary:

  • The Federal Open Market Committee (FOMC) took a very forceful set of steps this week, designed to stimulate what officials have called a "frustrating" job market.
  • Our updated forecast suggests that the growth trajectory of the US economy is positive but sufficiently sub-par for the Fed to have initiated additional monetary policy support.  
  • There are increasing signs that China’s economy is slowing more than the official readings would suggest. 

It's an old joke in economics that forecasters should never give a number and a date in the same sentence. The Federal Reserve seems to have had that bromide in mind during the formulation of its latest monetary policy decision.

A third round of quantitative easing was announced, with the Fed set to purchase $40 billion in mortgage-backed securities monthly. This program will start today, and continue indefinitely "if the outlook for the labor market does not improve substantially." This conditional, or open-ended program was different in form than the fixed program of $400 to $500 billion we expected, but its ultimate size will likely be very similar.

The committee also extended the period over which short-term interest rates will be held near zero "at least through mid-2015." This adds another six months or so to the timeline that was a part of the August 1 FOMC statement. “(A) highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens,” the committee said.

Today's action was thoroughly foreshadowed by both the minutes of the last FOMC meeting and by Chairman Bernanke’s speech to the Jackson Hole conference. It is clear that the Fed’s focus is on the labor market, which is not surprising given that maximum sustainable employment is one of the Fed’s mandates. The Fed’s forecasts for unemployment, released today, show a very gradual decline in coming years:

Central Tendency of Projected Unemployment Rates Among FOMC Participants

 US Economic Outlook 09-14-12 Chart 1

For the first time, policy actions have been tied directly to job readings. This association certainly makes sense, but some will likely feel uncertain about exactly what constitutes “substantial” improvement. There are a variety of labor market metrics to choose from, not all of which move in synch. Bond analysts will not know the ultimate extent of the Fed’s demand, which may make pricing mortgage-backed securities more difficult.

To us, though, tying QE III to an economic target variable seems like a meaningful formulation. If and when employment conditions reach the Fed’s acceptable threshold, we can expect language and statements from the central bank which prepare the market for an end to the program.

Several questioners during Chairman Bernanke’s press conference asked about how well the program would work. Success will rely on two key transmission mechanisms: market psychology and mortgage rates.

As shown below, the equity markets have gathered momentum since the release of FOMC minutes last month. Even as the economic news has faltered, the expectation of additional monetary stimulus has cheered investors.

US Economic Outlook 09-14-12 Chart 2

On the mortgage front, the expectation of QE III has placed important downward pressure on mortgage rates and the spread between those rates and US Treasury securities. This should open a new window of refinancing for some homeowners, and add an increment to affordability measures for prospective home buyers.

Others have openly questioned whether the action announced today will increase the risk of inflation. The FOMC has certainly not forgotten about the other side of its mandate, but it is certainly not its most pressing concern at the moment. And as the FOMC statement observed, “The Committee will, as always, take appropriate account of the likely efficacy and costs of (asset) purchases.”

Hovering over the outlook and the proceedings were two main risk areas: Europe and the US fiscal cliff. The Chairman indicated that both would be watched closely, but cautioned that American monetary policy would likely not be able to offset a bad outcome on either front.

It seems unlikely to us that there will be any major modifications to the Fed’s stance for some time. This will place the focus on fiscal policy (here and overseas), which will hopefully become less uncertain and more supportive. When, and by how much? You’re not going to get us to fall into that trap.

US Economy - More of the Same

In reality, we are obligated to give numbers and dates in the same place. Our updated economic projections are below.

US Economic Outlook 09-14-12 Chart 3

The U.S. economy is forecast to maintain moderate economic momentum during the next four to six quarters. A 1.7% annualized increase of real gross domestic product in the third quarter, followed by a slightly stronger performance in the final three months of the year should result in a 2.2% gain in GDP in 2012, which is a tad better than the 1.8% increase seen in 2011.

Consumer spending should post unimpressive growth of roughly 1-3/4% in the second half of 2012. Consumption rests on shaky ground, with households continuing to face balance sheet stress, tepid gains in employment, weakness in earned income, and tight access to some types of credit.

Although the housing sector data contain glimmers of hope, residential investment expenditures are projected to show a slower pace in the second half of the year compared with the first six months of the year. Business spending - equipment and software expenditures and structures – will add to GDP in the rest of 2012, albeit only modestly.

We do not expect the impending fiscal restraint at the Federal level, referred to as the "fiscal cliff," to damage the economy with full force. While the "cliff" will be a noticeable distraction in the near term, the likelihood is that legislators will eventually smooth some of its rougher edges. Nonetheless, the downward trajectory of federal, state, and local government outlays will continue to limit economic performance through the forecast period.

A wider trade gap is another factor holding back economic growth in the quarters ahead. The weakness in exports is a reflection of slowing global economic activity. Despite the European Central Bank's Outright Monetary Transactions program and the European Union proposal to strengthen the eurozone banking system, there is still a high level of uncertainty about adverse spillovers from Europe. Persistent weak economic conditions in Europe in the near term will have a significant negative bearing on US exports, some of which is already visible in recent trade data.

The likelihood of a significant deceleration of growth in China is another source of risk to US economic activity, as roughly 6% of American exports go to China. James Pressler, Northern Trust’s expert on China, shares an in-depth outlook in the following section.

China: Fasten Your Seatbelts
By James Pressler
Associate Economist
312.444.4109
jap10@ntrs.com

In this week’s policy briefing in Beijing, a government spokesperson offered assurances that China will achieve its target of 7.5% growth for 2012. For policymakers in other countries to boldly guarantee growth at this stage would be risky, but in China this all but puts the figure in stone. We now have little doubt that end-year GDP reports will give us 7.5% growth at a minimum.

However, our real concern will be just how this impressive feat will be accomplished. On a year-over-year basis, Q2 GDP for China was barely above 7.5% and on a downward trend. With the recent spate of indicators out of Beijing continuing to show a sharp slowdown in economic momentum, and with policymakers reluctant to take action, a somewhat less encouraging scenario may be playing out rather than the government’s more optimistic outlook. And in this scenario, there is no easy way to explain the government’s promised growth rate.

US Economic Outlook 09-14-12 Chart 4

To decipher whether growth is falling further than the Chinese government would concede, we have to first study where growth actually comes from. China’s miracle has in no small part been through investments in itself - building up a strong and productive capital base. Last year, China’s investment in fixed assets grew by a robust 25.1% - impressive, but actually behind the 27.3% pace posted during the 2005-08 period. According to the report released this weekend, the pace for the first eight months of 2012 has only been 21.8%. If the economy is building any momentum, it is not coming from this sector.

US Economic Outlook 09-14-12 Chart 5

Earlier this month, Chinese authorities announced a $158 billion infrastructure spending program. This will certainly help to soften the decline in fixed investment, but may not fully offset the downward trend.

Exports are another source of China’s growth, but this indicator is also falling below expectations this year. This is not surprising, as China’s two largest markets – the US and the Euro-zone – have not been in buying moods lately. Export growth has ground to a halt in 2012, with little suggestion that a rebound is near. On the other side of the ledger, weak imports suggest that China’s domestic demand is not spectacular. Admittedly, a significant percentage of China’s imports end up leaving another dock as exports, but imports of manufactured goods – more likely to be used in developing China’s capital rather than becoming the next iPhone – have also slowed precipitously. It is worrisome when industrialized world demand is weak, but when Chinese demand is also flagging, there is real cause for concern.

US Economic Outlook 09-14-12 Chart 6

Conventional wisdom suggests that when so many indicators and trends point in the wrong direction, policymakers are motivated to relax the monetary environment to promote growth. However, it was easy money back in the wake of the global financial crisis that sponsored the recent investment boom, and now that the party is over, the hangover is hitting with a vengeance.

Cutting interest rates now might help indebted Chinese companies refinance their massive debts, but it won’t reignite growth. The only effective tool that Beijing has at its disposal is the yuan exchange rate, and the People’s Bank of China (PBoC) allowed the currency to weaken in Q2 when it felt this was the remedy. No longer. Sustained yuan weakness would drive off investment inflows seeking an expected appreciation, so the currency has been set back on its upward drift.

The PBoC has run out of policy tools, and is now trying to build up confidence by emphasizing that any imbalances are controlled and that the economy is not experiencing a prolonged slowdown. As we have seen through numerous examples, the jawboning strategy is not a long-term fix.

The one problem overshadowing the entire monetary and policy environment is that the Chinese Communist Party leadership is going through its once-a-decade ritual of transferring power to a new president and premier. This is a very delicate time that is meticulously orchestrated to be a smooth, seamless handoff that will begin a new period of growth and promise. In short, the Party does not want even a whiff of dissent nor any talk whatsoever of an economic crisis. Social stability is the utmost consideration to all Beijing’s plans, so major policy moves will have to wait until after power is cleanly handed off.

We take the government at its word when it says growth for 2012 will be reported as 7.5%, or perhaps 7.4% with extensive explanation of why the target was missed. But the risk is that underlying economic strength may be much more modest, with no dramatic policy shifts likely to be approved until after the leadership handover.

Like other major markets, China is going through a very delicate period that will require careful handling. We are indeed blessed and cursed to live in interesting times.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
 
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