Delaying the Fed exit

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This post is a guest contribution by David Greenlaw of Morgan Stanley.

Friday’s employment report was very disappointing: These data, together with other recent incoming information (including last week’s ISM survey), suggest that the recovery in the US economy has paused. The question is whether this will prove to be a temporary soft patch or a more meaningful shift in momentum along the lines of what we experienced in 2010.

Our own view is that this is a temporary soft patch: We have fiddled with the US forecast to reflect the recent slippage in the tracking estimate for 2Q GDP (now +2.7%), but continue to show a stronger performance over 2H. On a 4Q/4Q basis, our forecast for GDP growth is now +3.2% in 2011 and +3.0% in 2012. Both figures are little changed from a month ago.

Sustaining the recovery requires job growth: While there weren’t too many bright spots in Friday’s numbers, there was sufficient upside in wage rates and hours worked to suggest that the income and production sides of the economy will show moderate growth in May. In particular, aggregate weekly payrolls, a proxy for private wages and salaries, rose 0.4%, about as we had anticipated and in line with the recent trend. Also, hours worked in the factory sector jumped 0.5%, pointing to solid growth in manufacturing output during May. However, these types of gyrations in wage rates and hours are probably more statistical than real, and while they buy some time in terms of providing temporary support for income and production, sustaining the economic recovery in the US at this stage of the cycle requires job growth. Any sign that the underlying trend in employment growth is slipping below 150,000 or so would be cause for concern. Thus the next employment report (due out in three weeks’ time) looms large.

From a broader standpoint, we cite four factors that should help to deliver stronger economic growth during 2H11: First, assembly schedules released by the automakers last week point to a near-term spike in vehicle production, suggesting that supply chain disruptions related to the earthquake in Japan are beginning to ebb. Indeed, we estimate that a rise in motor vehicle output aimed at rebuilding depressed inventories will add about 1.5pp to 3Q GDP. This follows on the heels of an estimated 0.8pp subtraction in 2Q, when production was disrupted by earthquake-related parts shortages.

Second, consumer spending should be supported over the next few months by a pullback in prices at the gas pump. Of course, this is just the flip-side of what we saw in 1Q, when nominal consumer spending posted its best gain since 1Q07, but rising prices led to sub-par consumption growth in real terms. The other two contributors to the 2H rebound story are a further acceleration in capital spending tied to the tax benefits that expire at year-end and a significant boost from net exports in 4Q, reflecting the calendar quirk that we have highlighted in the past (see Why Is Our Q4 GDP Estimate So High? December 15, 2010).

We are also announcing a change in the Fed call: Basically, we are pushing out the timing of the expected exit sequencing by 3-6 months relative to what we had previously thought. The logic is that the old path was simply looking too compressed, given the emergence of questions surrounding the sustainability of the recovery. Moreover, even though our inflation story is very much on track (core CPI is expected to hit +1.4%Y in May – up 0.8pp from where it was running as recently as last October), the market doesn’t seem to care, and benign inflation expectations give the Fed some breathing room.

Also, the trajectory of rate hikes in the next tightening cycle should be flatter than previously assumed because the FOMC seems committed to asset sales as part of the exit process (see US Economics: Normalizing the Fed’s Balance Sheet, May 20, 2011, for a description of viable exit strategy scenarios that might play out in the coming years). Asset sales serve as a partial substitute for rate hikes in achieving the desired magnitude of tightening in financial conditions.

What about QE3? You can never say never, but clearly the bar to a reintroduction of asset purchases by the Fed is quite high. In our view, it would probably take something like the unemployment rate moving close to or through 10% and a core inflation rate dipping back below 1% to make QE3 a realistic possibility. Either of these outcomes seems unlikely – and both together seem like a real stretch. And, even if we get to that point, the Fed may decide that an alternative form of monetary stimulus might be more appropriate than another round of Treasury purchases. QE2 appeared to be effective in terms of easing financial conditions and elevating inflation expectations. But, the beneficial impact on the real economy was muted by a spike in commodity prices that may have been at least partly related to QE2 (even though Bernanke issued a strong challenge to this notion in his recent Atlanta Fed speech). In any case, alternative forms of monetary stimulus, such as yield caps, could have a positive impact on the real economy via a mortgage refinancing and a housing affordability transmission mechanism (see Box 2 in the full report and Bernanke’s famous November 2002 speech, Deflation: Making Sure ‘It’ Doesn’t Happen Here, for more details on how yield caps might work).

Assuming no major additional fiscal tightening: Finally, we should point out that our outlook for the US economy and Fed policy assumes no meaningful fiscal policy changes beyond those already slated to occur when the payroll tax cuts and business expensing provision expire at the end of 2011. In other words, we assume that a debt-ceiling hike will get done with either: i) smoke and mirrors along the lines of unspecified spending cuts over an indeterminate timeframe, with ineffective triggers; or ii) legitimate actions aimed at reining in entitlement spending over the long run but which carry little or no meaningful near-term fiscal policy impact.

For full details, see “Delaying the Fed Exit”, The Global Monetary Analyst, June 8, 2011.

Source: David Greenlaw, Morgan Stanley, June 10 , 2011.

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