Citius, Altius, Fortius
by Carl Tannenbaum
Countries Across the Globe Seek Faster, Higher, Stronger Growth
- Central banks in the United States and Europe are both seeking new ways to stimulate economic activity.
- Recent news from the housing market has been encouraging, but the race to recovery is likely to be a marathon, not a sprint.
- Headwinds blowing from Europe and China will continue to present significant downside risks to U.S. economic growth.
Like many of you, Ive enjoyed starting my recent days watching the Games from London. For those of you wondering about this months title, its the Olympic motto: from the Latin for faster, higher, stronger.
I always wanted to be an Olympic athlete, but when my swim coach told me that Id have to spend six hours a day in the pool instead of three, my ambition waned. However, my wife decided last week that she would like to train for the shooting competition should I be worried about that?
The worlds athletes work awfully hard to prepare for their events. But chance also plays a role in separating the gold medal winners from the also-rans. Even the most practiced competitors have periods of poor form or fitness that can, unfortunately, occur during the Olympic fortnight.
Economic policy makers on both sides of the Atlantic met last week to figure out how to engineer faster, higher, and stronger rates of growth. With both the U.S. and Europe still working through the fallout from real estate collapse and consequent financial crisis, achieving this ideal is dependent on both sound preparation and good fortune. And the struggle is having consequences across the five continents represented by the Olympic rings.
The Fed: Steady for Now, But Leaning
We went one for two with our predictions for the FOMC meeting. The group opted not to change the interest rate on excess reserves (see the July 24 View from Here), but also declined, for now, to initiate a third round of quantitative easing. Our pre-meeting analysis suggested that the case for additional stimulus measures was sufficient, but the committee opted to hold off and await additional readings on activity.
The first entry into the dossier for the September 12-13 meeting was somewhat less worrisome: July payroll growth was stronger than it had been during the second quarter. Yet the unemployment rate remains elevated, and job creation during the recovery has been skewed to part-time and lower-wage categories. Further, the risks to the outlook (primarily Europe and the fiscal cliff) seem massed on the downside.
Our most likely case continues to call for a third round of quantitative easing to be announced at the next FOMC meeting. Timing is important here: the October monetary policy meeting will take place just two weeks before the Presidential election, and the Fed will likely not want to risk accusations of political favor by taking any bold steps at that time.
Analysts have actively debated the merits of various types of stimulus, but outright purchases of mortgage-backed securities (MBS) hold the most promise. As shown in the table below, agency MBS have composed about half of Fed bond buying to date.
FRB Target Levels of Large Scale Asset Purchases
And these acquisitions have had a pronounced effect on mortgage spreads, both directly and by reducing the uncertainty premium demanded by lenders.
Mortgage spreads have widened since the Fed completed QE II in mid-2011. This would seem to represent an opportunity for stimulus; lower mortgage rates have reliably kindled additional refinancing, which adds to household spending. Promoting home sales is a little trickier, as well discuss in the next section.
As the Fed attempts to address its frustration with the slow pace of labor market improvement, it may think outside of the box. The minutes of the June FOMC meeting included this quote: "(S)everal participants commented that it would be desirable to explore the possibility of developing new tools to promote more accommodative financial conditions."
Among the possibilities is more direct lending to banks or industrial companies. The Federal Reserve took this tack during the Great Depression, and continued it until well into the 1950s. It also featured prominently in the response to the 2008 crisis.
Providing credit in this manner is permitted under section 13-3 of the Federal Reserve Act, the one which contains the now-familiar prerequisite of unusual and exigent circumstances. The Dodd-Frank Act placed additional restrictions on the Feds direct lending activity: programs must be broad-based, cannot be used to support insolvent firms, and must be approved by the Secretary of the Treasury. Still, some see potential in extending credit directly to mortgage underwriters, for example, as a means of generating additional economic momentum.
The ECB: Lots of Talk, Little Action
Across the Atlantic, the ECBs search for new tools is aimed at simply catching up with what the Fed already has at hand. Growth has come to a near standstill in Europe, with banks and financial markets there under extreme pressure.
ECB President Mario Draghi temporarily arrested the negativism a couple of weeks ago by pledging to do whatever it takes. But the statement that followed the central bank meeting on August 2 was decidedly less aggressive, reflecting inherent limitations on translating word into deed.
First, we should note that the ECB was not set up to respond to a financial crisis. It had a single mandate (price stability), no regulatory authority over the Continents banking system, and very limited ability to grow its balance sheet. Whereas the Fed has purchased $2.5 trillion in securities since 2009, the ECB has purchased a little over 200 billion in government debt to stimulate an economy which is collectively larger than that of the U.S.
In order to gain the authority and the tools to close this gap, the ECB is dependent on financial support from member states and changes to its operating mandate. Both rely on approval from individual countries, which can run into political hurdles. Even if these elements were secured, getting the European Stabilization Mechanism (ESM) fully operational will take time.
With the exception of the host country, European nations have underperformed expectations at London 2012. It looks like the ECB is heading for the same outcome.
Housing: Home Run or Head Fake?
The U.S. housing sector often leads our economy out of recession with significant rates of advance. That hasnt been the case this time around, as the sector has proved a significant hindrance to progress.
Recent readings offer some hope. Housing starts have risen by almost 25% over the past year, and house prices finally seem to be stabilizing.
Some of the energy returning to the single family home market is the result of thin vacancy in rental property (less than 5% at the moment, down from a peak of 8% two years ago). Rents are consequently firming, tipping the economics back a little bit in favor of home ownership.
Encouragingly, the "shadow inventory" of homes working through delinquency and foreclosure is diminishing, thanks in part to some sales of distressed properties. According to CoreLogic, an industry monitor, this dark pool has declined about 25% from the peak it reached last year. Bulk sales to managers who intend to rent the properties for a time have been prominent.
While this all seems promising, there remain a number of hurdles to normalizing housing conditions. Among them are lending standards for mortgages, which have not eased much in the past year, even as terms for other types of lending have become more accommodative.
There are many reasons for continuing conservatism among banks, including regulatory uncertainty, constrained underwriting capacity, and secondary mortgage markets which remain a shadow of their former selves. Well have a more extensive discussion of these limitations in an upcoming View from Here commentary.
But the overriding reality is that many households which had down payments and credit ratings that would qualify for a mortgage in 2006 no longer do. Perhaps a quarter of current homeowners are underwater on their current mortgages, limiting their mobility. So no matter how low prices and interest rates go, homes will remain out of reach for many prospective buyers.
Ripple Effects from Europe and China Present Significant Risk
Asha Bangalore comments on how Europes travails are hitting close to home.
The European economic turmoil and a deceleration of economic momentum in China are two major events (both of which are still evolving) that will weigh significantly on the growth trajectory of the U.S. economy in the near term.
A year ago, policymakers in Europe held the view that if the periphery could be supported, Italy and Spain would have time to address their problems. But the European crisis has transformed from economic turbulence in the periphery to a pan-European event. Consequently, European financial and economic stresses have shaken the fragile U.S. economic recovery and will continue to have an adverse impact until a solid resolution is in place in Europe.
The degree to which the European crisis will affect the U.S. economy can be conceptualized in terms of the likely course of the crisis. There are essentially two paths that can emerge in the months ahead. One path, often termed as the tail risk, is a complete unraveling of financial and capital markets followed by a severe setback in global economic growth. A low probability is attached to this tail risk, implying a great deal of optimism and faith in the ability of policy makers to prevent this scenario. The second path, the most likely one, is one where economic spasms in Europe will chip away global economic growth, including that of the United States, for an extended period.
Shock waves from the eurozone have been transmitted to equity markets across the globe for several months. Equity markets took a big hit prior to the ECBs announcement of the LTRO (longer term refinancing operation) program in December 2011 (see Chart 5) when markets were wary of the sovereign debt and banking crisis in the eurozone. However, year-to-date, the S&P 500 has moved up roughly 12%, implying that the relative strength of the U.S. economy has protected U.S. equity prices. But, the recent recovery of stock prices in the United States has to be viewed with caution for the eurozone crisis will continue to cast a dark cloud on the U.S. economy through financial and non-financial linkages.
Economic stagnation in Europe has translated directly into lower imports from the U.S and the rest of the world, with this trend projected to prevail until a turnaround in economic activity is visible in the eurozone. The reduction in eurozone imports from non-US trading partners will have secondary effects on the U.S. economy as the wherewithal of these nations to import from the United States is reduced as imports of the eurozone decline.
In addition to ties through trade with the eurozone, Europe is the major destination of US direct investment overseas. Financial and non-financial U.S. affiliates in Europe will be subject to additional balance sheet stress as the crisis remains unresolved. A part of this is already reflected in a decline in corporate profits from the rest of the world in the first quarter of 2012 (see Chart 7). A related issue to bear in mind is that unstable financial markets modify sentiments of households and businesses and restrain spending. In a nutshell, the eurozone crisis is a source of major downside risk to U.S. economic growth.
Economic developments in China will present another set of issues to reckon with in the months ahead. Chinas real GDP growth has slowed to a 6.4% pace in the second quarter, which puts the year-to-year gain at 7.6%, the smallest since 2009. The deceleration in economic activity is the result of policy actions to moderate economic growth to a sustainable pace.
The eurozone crisis poses a major risk to this strategy because Europe is the largest collective consumer of Chinas exports. Therefore, it follows that Chinas growth momentum remains vulnerable to developments in the eurozone. Data indicate that exports from China have slowed noticeably in the past year, to an average growth rate of 4.8% in the first seven months of 2012 as compared with 31% jump in 2010 and 14.8% increase in 2011.
Chinas efforts to prop up investment spending and maintain robust growth after the 2008 financial crisis gave global demand a boost. The growth in investment reaped significant benefits to exporters of not only primary commodities but also capital equipment and machinery. About 7.0% of U.S. exports head to China. This is a direct channel through which the U.S. stands to suffer a setback if Chinese economic growth slows swiftly.
The key question is whether China can manage a soft landing in a global environment marked with slowing economic conditions, particularly in Europe. Incoming economic data have planted doubts about Chinas ability to repeat the performance seen after the 2008 financial crisis.
THE NORTHERN TRUST COMPANY
ECONOMIC RESEARCH DEPARTMENT
SELECTED BUSINESS INDICATORS