The Economy Ain’t Hummin’ Along

Banks, consumers and businesses are rapidly deleveraging. The process was so abrupt that it was though someone slammed the brakes on the global economy. (Please note if you cannot read a graph or insert double click on it and it will appear larger and less fuzzy on your computer). First, the housing market began to deleverage in 2006 sparking the financial sector to begin to deleverage in 2007 causing the consumer to deleverage in 2008 and in September the rest of the world followed. When so much liquidity is pulled from the markets and economy so rapidly the dislocations and shock waves are massive. Now only one entity is large enough to get the economy moving again, the U.S. government. The government is now moving forward rapidly to stimulate the economy as unemployment soars and economic growth stalls.
The unemployment rate is approaching the levels reached in the early 1980s. Given the recent severe declines in retail sales, business spending and employment, it is highly unlikely that the economy will improve anytime soon. It is clear that the job market will continue to deteriorate for most of 2009. It is entirely possible that we will reach the levels of unemployment experienced in 1982. Even if the much-needed stimulus bill passes soon, the economy is likely to end 2009 in roughly as bad a shape as 1982.

Currently, the unemployment rate was 7.6% in December 2008 if you include discouraged workers. In addition, another 5.2% of the labor force was involuntarily working part time. Combined the rate approaches 13%. However, this still understates the unemployment rate, because the Labor Department’s definition of discouraged workers is too narrow. If everyone looking for a full time job were counted, the rate could reach over 14%. It is estimated that unemployment reached over 30% during the Great Depression and it is doubtful we would approach this level given the size of the government’s proposed stimulus package. It is possible that we could come close to the 1982 peak rate of unemployment of 16%.
Almost half of the current work force is too young to have any real memory of how tough it was to navigate through the early 1980s recession. They only remember the mild recessions of 1990-91 and 2001. Many are unprepared for layoffs and tough times. It is a generation that spends and does not save, a generation that has systematically borrowed from future income to finance today’s wants. Now the bill has just come due and the delinquency rates on Consumer Loans and Residential mortgages are climbing rapidly. Consumers are leveraged to the hilt, and as they lose their jobs they begin to default on their car, home and credit card debt. There is no buffer, no savings since they have not prepared for the end of the leveraging party.

The Economic News

I regularly attempt to explain the current state of the economy, the Federal Reserve’s policy stance, and other news items that could impact the markets. It is difficult to present the general state of the economy in just a few paragraphs, so I was thrilled when I discovered this scorecard designed by JPMorgan. I’ll try to regularly include it in my future newsletters. If the chart seems unclear just click on it to get a larger clearer view.

Many economists believe that we are close to full employment (5% or less unemployment is considered full employment by economists and the Fed). These gurus fear that full employment could lead to rising wages which could then cause inflation. The Federal Reserve is focused on the core rate of inflation (inflation less the volatile food and energy segments). Inflation is currently at the high end of the Fed’s defined range of acceptable. So the Fed’s board members want the core inflation rate to fall but don’t want to raise interest rates again to achieve it. The Fed wants the market to adjust itself.

When Bernanke became Federal Reserve Chairman he stated that he wanted to communicate the Fed’s intentions more clearly to investors. The unintentional result has been the inversion of the yield curve (short term interest rates are higher than long term rates). In order to get long term interest rates up, the Fed has begun to abandon its policy of clear communication and transparency. It is instead refusing to send a clear message. The Fed recently changed its stance to neutral (instead of signaling its intention by stating a bias towards raising or lowering rates) but it is all posturing. The most recent Fed minutes from its last meeting are meandering and unclear. Consider, for instance, this excerpt from the minutes:

…the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee’s predominant concern.

The Fed's mixed reactions regarding inflation are unsettling to many analysts and economists. It is all part of an elaborate game of chicken as the Fed desperately tries to balance the need to moderate inflation with keeping the economy growing. If the Fed has to raise short term rates to check inflation it might also destabilize the financial markets. If the Fed states a bias towards lowering short term rates, it could cause the markets to grow too quickly the old boom followed by bust pattern). The Fed hopes to avoid these scenarios by convincing the market to raise long term rates which should help moderate full employment and wages and hence cool the core inflation rate. It will be interesting to see who blinks first, the markets or the Fed.

The Financial Pragmatist

Libby Mihalka

Consumer Prices, Inflation, Unemployment, and Corporate Profits

Great News! U.S. consumer prices were flat in November. Most economists were expecting a small rise of 0.2% rise for the month. This could allay inflationary fears at the Federal Reserve. The market will now expect the Fed to focus on lowering interest rates towards the middle of 2007 and stop thinking about further rate hikes. Stocks and bonds will trade up on this news.

In other good news, the Labor Department reported that the number of Americans filing for unemployment benefits dropped for a second week. This will begin to allay another fear investors have had that the economy might cool quickly. A long gradual landing of this bull market is what investors are hoping for in 2007.

Robust quarterly profit reports keep rolling in, with Costco, Honeywell and Citigroup all reporting good news.

Consumer spending is now the worry. The economy is a three legged stool with spending by the government, businesses and the consumer. Government and Business spending is expected to be moderate. It is the consumer that has been driving economic growth. Will Americans decrease their spending as housing prices contract? Will a decrease in wealth (caused by falling housing prices) translate into consumption? Many economists and investors have been waiting for most of 2006 for consumers to feel this falling wealth effect and moderate their spending. It appears that the low unemployment rate could be bolstering consumer confidence because consumer spending has not abated. If the consumer stops shopping, then this bull market is probably over.

The Federal Reserve Meeting, Inflation and Interest Rate Changes

The big news this week is the Federal Reserve's scheduled meeting tomorrow (Tuesday). However, the Fed is not expected to make any big moves and should keep interest rates steady at 5.25%. Despite some of the recent gloomy news, the economy has been performing well. Why? The Service Sector of the U.S. economy is chugging along on all cylinders; it’s the manufacturing part of the economy that is causing some economists to worry. That’s the sector that manufactures things and builds homes, which appears to be on the brink of recession while the Service Sector continues to surge. The simple truth is that the Manufacturing Sector represents only one-fifth of the economy, and is not as important as it used to be. The Service Sector is the motor that now drives our economy. So what will the Fed focus on? It will look intently for any signs of inflation in the Service Sector. The members of the Federal Reserve will scrutinize all the employment and labor cost statistics. They will be worried about the low unemployment figures and the recent increase in wages. The Fed will remain cautious on inflation but they won’t take action. Do not expect a rate cut anytime in the near future.