Richmond Fedhead Lacker on the Economic Outlook, Fed Exit Strategy
The last time Richmond Fed's fearless leader brought us through the landmine-heavy territory of "the economic outlook" from Charleston, South Carolina, the FDIC had a few extra billion lying around, and of course we were all still licking our wounds from a rough late fall just a quarter behind us. It was late March and we'd only just begun our trip on the financial pain train. If anyone can remember that far back, certainly the overwhelming feelings of fear and panic are still fresh in one's mind? The good news is that one need not swallow a handful of Prozac before analyzing the economic outlook of today; even the most pessimistic among us can begrudgingly admit that things are looking up (myself included), at least in comparison to Q1 2009. That being said, much of that "looking up" can be attributed to accounting magic, funny money, and blatant misinformation ("the majority of US banks are extremely well-capitalized" anyone?). The free fall has slowed but we are a long way from "recovered," and it would not be unreasonable to say that we may never return to "old normal" which, frankly, I prefer to this "new normal" which means complacency and denial.
So before we get into where we are now 5 months later, let's look briefly at where we came from:
"[a]fter gradually weakening through most of the first three quarters of 2008, the economy has taken a dramatic turn downward in the last few months. We find ourselves in the midst of a deep recession that is stretching into its second year."
(see, many are quick to pat Zimbabwe Ben on the back for saying the economic outlook is "good" for the first time in months but I argue here that it is an honest assessment of the situation from one of the Fed's own that is most effective. In other words, ZB is a liar and a fat mouth, at least Lacker knows better than to try and convince us everything is just fine)
In his March version, Lacker also bemoaned the hazards of the safety net, or rather the perception thereof and insisted that before we could begin discussing recovery, we would need to address certain regulatory shortfalls that landed us in the lion's mouth. Well yes, that's just a part of the problem.
So! A little more back story and we're ready to roll. Take it away, JL (to the Danville Chamber of Commerce, Danville, VA August 27):
The year 2008 began with the economy in a recession that at first seemed to be relatively moderate. Through August of 2008, for example, payroll employment fell by an average of 137,000 jobs per month. The recession then intensified, and in the last 11 months, employment has fallen by an average of more than a half million jobs per month. I could cite many other dismal statistics, but it is clear that the decline in economic activity intensified last fall and has been large and widespread since then. The result was the worst recession since the 1930s.
I would have liked to see the dismal statistics but maybe I'm just sick that way.
As Lacker so astutely points out, things are looking up but there is no clear sign that things have actually turned. There are still critically disabled areas of concern, without which recovery will be harder to encourage, if not impossible. Jobless recovery? Bah, not possible.
The composite index of manufacturing activity published by the Institute for Supply Management has increased substantially this year to a reading just a smidgeon below the level that would indicate an expanding manufacturing sector. Closer to home, our own Richmond Fed Fifth District Index of manufacturing activity in the Fifth District has risen sharply this year to a level consistent with solid growth in manufacturing. And just as with the national index, our index of new orders has shown a striking improvement in recent months.Great, there's your outlook. I was hoping for a bit more doom and gloom from my favorite Fedhead but whatever, I'll give him a pass, he probably hasn't been doing much blog reading these days (I can imagine the man is a tad busy).
We also have seen a significant improvement in financial conditions since the turmoil last fall. Corporate borrowing costs have declined considerably, as interest rates on commercial paper and corporate bonds are now much lower than they were last year. Many major banks have sold stock successfully and now have the capital to support new lending, even if conditions turn out worse than expected. Although many borrowers face tougher credit terms in a soft economy, the banking system as a whole appears capable of supporting business investment and expansion.
Academic and industry economists have taken all this into account, and most now see the second quarter as the low point for GDP in this cycle. The typical forecast calls for positive GDP growth in the current quarter and a gradual improvement beyond that. I agree with this outlook. Indeed, since the beginning of this year I have been expecting positive growth before year-end – but I must emphasize that the recovery is likely to be slow and uneven for some time. We obviously have major difficulties to overcome before we can feel really good about the economy.
Anyway. The important part of all of this is inflation as always. Is Janet Yellen still trying to evangelize 2%+ inflation? I stopped paying attention several weeks ago and now that she's not going to take Bernanke's place (ugh!), I'm totally content with ignoring her completely for the foreseeable future. But this isn't about her, is it?
Some economists stress the importance of expectations in determining price setting behavior as an alternative source of inflation. According to this view, if expectations are firmly anchored, then the behavior of individual buyers and sellers will be consistent with the expected outcome and inflation will remain fairly steady. I have a lot of sympathy for this view, because it also matches up well with modern macroeconomics. Unfortunately, we have less than ideal measures of the expectations that form the basis of individual behavior. What we do have suggests that inflation is not likely to decline significantly from here. First, there is evidence from monthly surveys that puts the expected long-term growth in the Consumer Price Index at about 3 percent, near the center of where it has tracked over the last decade or so, a period in which inflation has averaged over 2 percent. Second, we can get an implicit measure of longer-run inflation expectations from the prices of certain financial security, and those readings imply that inflation is expected to be higher a few years down the road. While neither type of measure is without its flaws, both seem to suggest that inflation is more likely to rise than to fall.
This evidence does not illuminate why people might expect inflation to be higher. Market commentary, however, suggests that uncertainty over the likely course of monetary policy might be important.
But wait a second, JL, market commentary suggests as much because markets are only slightly skeptical of the Fed's ability to pull out in time. Can he even argue against this perception? Apparently, as he assures us the Fed has the means to get out in time. Coming from him, I'll buy it but I'm not entirely sure even he would be able to assess the gravity of the situation. How can any of them possibly know the when and how of the Fed's exit strategy? These are not only uncharted waters but shark-infested on top of it.
Market participants have at times expressed some doubts that the Fed will be willing and able to reverse course promptly enough to keep inflation in check. From a technical point of view, I do not see a problem – we do have the tools to contract our balance sheet and remove monetary stimulus when we need to do so, as Chairman Bernanke explained in detail in last month’s Monetary Policy Report to Congress. The harder problem is choosing when and how rapidly to remove stimulus as the recovery begins. I am certainly aware of the danger of aborting a weak, uneven recovery if we tighten too soon. But there can be a strong temptation to hesitate when emerging from a recession, awaiting conclusive signs of robust growth. Keeping inflation well-contained may require action before a vigorous recovery has had time to establish itself.
Judging when to withdraw monetary stimulus by raising our policy interest rate is hard enough. But assessing the degree of stimulus provided by our expanded balance sheet poses special challenges.
No shit. At least he acknowledges as much.
So where does this put us? Only slightly better off than we were before. I take from this that while the worst is obviously behind us in terms of economic decay, the scariest part is ahead in how and when the Fed chooses to implement their elusive exit strategy. I sense a thread of doubt in this speech, whether Lacker intends for it to come across or not. Or maybe that's just me reading way too much into things again, I guess only he knows what he meant and just how frightened (or not) he is by the prospect of putting this plan into action.
Good luck with that one, Fed boys, you're certainly going to need it.