“Generally speaking, large firms in good financial condition can obtain credit in capital markets easily and on favorable terms. Larger firms also hold considerable amounts of cash on their balance sheets. By contrast, surveys and anecdotes indicate that bank-dependent smaller firms continue to face significantly greater problems in obtaining credit, reflecting in part weaker balance sheets and income prospects that limit their ability to qualify for loans as well as tight lending standards and terms on the part of banks.”
This also makes the big blue chip type companies very attractive investments at current levels.
“Although output growth should be somewhat stronger in 2011 than it has been recently, growth next year seems unlikely to be much above its longer-term trend. If so, then net job creation may not exceed by much the increase in the size of the labor force, implying that the unemployment rate will decline only slowly. That prospect is of central concern to economic policymakers, because high rates of unemployment — especially longer-term unemployment — impose a very heavy burden on the unemployed and their families. More broadly, prolonged high unemployment would pose a risk to consumer spending and hence to the sustainability of the recovery.”
Fostering conditions of full employment is also a key part of the legal mandate of the Federal Reserve, i.e. why it exists at all. Sitting back and doing nothing when unemployment is close to double digits and expected to stay there for a prolonged period of time is simply fiddling while Rome burns. Federal Reserve Governors and regional bank presidents who do not understand that are guilty of dereliction of duty and should resign.
“Generally speaking, measures of underlying inflation have been trending downward. For example, so-called core PCE price inflation (which is based on the broad-based price index for personal consumption expenditures and excludes the volatile food and energy components of the overall index) has declined from approximately 2.5 percent at an annual rate in the early stages of the recession to an annual rate of about 1.1 percent over the first eight months of this year.”
This morning, the core CPI was unchanged for the second month in a row, and over the last three months is up at an annualized rate of just 0.4%. Bernanke is making the case about falling inflation (ex-food and energy) but he is understating his case.
“The decline in underlying inflation importantly reflects the extent to which cost pressures have been restrained by substantial slack in the utilization of productive resources. Notably, the unemployment rate remains fairly close to last fall’s peak and is currently about 5 percentage points above the rates that prevailed just before the onset of the financial crisis.”
To get a real old fashioned wage price spiral going, there has to be some way for wages to go up. With so many people out of work, anyone who demands a raise can easily be replaced. On the other side, with lots of capacity sitting unused, firms that try to jack up prices will quickly see other firms ramp up production to undercut them.
“In gauging the magnitude of prevailing resource slack and the associated restraint on price and wage increases, it is essential to consider the extent to which structural factors may be contributing to elevated rates of unemployment.
“For example, the continuing high level of permanent job losers may be a sign that structural impediments — such as barriers to worker mobility or mismatches between the skills that workers have and the ones that employers require — are hindering unemployed individuals from finding new jobs. The recent behavior of unemployment and job vacancies — somewhat more vacancies are reported than would usually be the case given the number of people looking for work — is also suggestive of some increase in the level of structural unemployment.
“On the other hand, we see little evidence that the reallocation of workers across industries and regions is particularly pronounced relative to other periods of recession, suggesting that the pace of structural change is not greater than normal. Moreover, previous post-World-War-II recessions do not seem to have resulted in higher structural unemployment, which many economists attribute to the relative flexibility of the U.S. labor market.
“Overall, my assessment is that the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity that occurred in the wake of the financial crisis and the continuing shortfall of aggregate demand since then, rather than to structural factors.”
Structural unemployment has two basic causes: skills mismatch and geographical mismatch. Historically, geographical mismatch has not been a big problem in the U.S. People would simply pick up and move to where the jobs are. However, being underwater on you house can make it very hard to move If someone offers you a new job for $50,000 a year, but you have to move, does it make sense to take it if it means you have to sell your house for $250,000 when it has a $300,000 mortgage on it. You would have to bring that entire year’s salary to the closing. Thus the job might just as well not exist for you.
There is no particular reason to think that the skills mismatch has increased dramatically over the last few years. Most of the rise in the unemployment rate has been because of a lack of aggregate demand.
“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve’s dual mandate in the longer run.
“In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable. Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue.
“In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation — setting aside the inevitable short-run volatility — will be less than the mandate-consistent inflation rate for some time.
“As of June, the longer-run unemployment projections in the SEP had a central tendency of about 5 to 5-1/4 percent — about 1/4 percentage point higher than a year earlier — and a couple of participants’ projections were even higher at around 6 to 6-1/4 percent. The evolution of these projections and the diversity of views reflect the characteristics that I noted earlier: The sustainable rate of unemployment may vary over time, and estimates of its value are subject to considerable uncertainty.
“Nonetheless, with an actual unemployment rate of nearly 10 percent, unemployment is clearly too high relative to estimates of its sustainable rate. Moreover, with output growth over the next year expected to be only modestly above its longer-term trend, high unemployment is currently forecast to persist for some time.”
In the interest of space I did not put in several passages before this one, in which he argued that price stability means a little bit of inflation, not zero inflation, and that the rate of inflation to aim for is also not zero, but the lowest level that will not cause inflation to start to surge. The key point here is that inflation is too low, and likely to remain too low for some time, and unemployment is too high.
Thus, the Fed should be easing monetary policy, but with the Fed Funds rate at zero, that means using unconventional tools. In short, he is endorsing QE2. That should be a good thing for the stock and commodity markets, but will be bearish for the dollar.
It will help forestall any threat of deflation, but could lead to higher inflation down the road. If so that would be a bad thing for the bond market, even though the Fed would be buying lots of bonds, thus putting short term downward pressure on interest rates.
There is much more in this speech, and you can read it in its entirety here:Fed Chairman Ben Bernanke made an important speech this morning in which he discussed monetary policy in a low interest rate, and low inflation environment. Below I present key passages from the speech along with my interpretation/translation.
“Although the attainment of price stability after a period of higher inflation was a landmark achievement, monetary policymaking in an era of low inflation has not proved to be entirely straightforward. In the 1980s and 1990s, few ever questioned the desired direction for inflation; lower was always better.”
Now, with a very real threat of deflation, that is no longer the case. At any given level, deflation is a much more serious economic problem than inflation. The economy can do very nicely with 3% inflation, but with 3% deflation, it would come to a near stop. High inflation is a bad thing, but negative inflation (aka deflation) is even worse.
“A second complication for policymaking created by low inflation arises from the fact that low inflation generally implies low nominal interest rates, which increase the potential relevance for policymaking of the zero lower bound on interest rates. Because the short-term policy interest rate cannot be reduced below zero, the Federal Reserve and central banks in other countries have employed nonstandard policies and approaches that do not rely on reductions in the short-term interest rate.”
We are still learning about the efficacy and appropriate management of these alternative tools.
In a “normal” recession, the best policy tool available is generally monetary policy. The economy slows and the Fed cuts the Fed funds rate. However, the Fed cut interest rates almost to zero almost two years ago. The rate that they would like to cut it to, based on the normal monetary policy rules of thumb (most notably the “Taylor Rule” would imply that the rate should be about -4.0%, but the rate cannot fall below zero).
The conventional ammunition was spent a long time ago, and the Fed has had to turn to unconventional methods. Because the unconventional methods have not really been used much before, trying to gauge things like how much is enough, how much is too much and what is the optimal timing and pace of moves is very difficult.
“An economic recovery began in the United States in July 2009, following a series of forceful actions by central banks and other policymakers around the world that helped stabilize the financial system and restore more-normal functioning to key financial markets. The initial upturn in activity, which was reasonably strong, reflected a number of factors, including efforts by firms to better align their inventories with their sales, expansionary monetary and fiscal policies, improved financial conditions, and a pickup in export growth.
“However, factors such as fiscal policy and the inventory cycle can provide only a temporary impetus to recovery. Sustained expansion must ultimately be driven by growth in private final demand, including consumer spending, business and residential investment, and net exports. That handoff is currently under way. However, with growth in private final demand having so far proved relatively modest, overall economic growth has been proceeding at a pace that is less vigorous than we would like.”
We got a nice pop from the inventory cycle, and the fiscal stimulus from the ARRA did help for awhile, but now inventories are back to normal, and the effects of the ARRA are starting to wear off. The de-stimulus at the state and local levels continues as strained budgets are forcing them to cut spending and raise taxes.
The lack of residential investment has been the key reason why this has been such an anemic recovery, and that is not likely to change anytime soon, given the massive overhang of existing homes for sale and the whole foreclosure mess. Exports are growing, but unfortunately imports are growing faster, and it is net exports, not exports alone, that is important to economic growth. It is not clear if the hand-off will be fumbled or not.
“In particular, consumer spending has been inhibited by the painfully slow recovery in the labor market, which has restrained growth in wage income and has raised uncertainty about job security and employment prospects. Since June, private-sector employers have added, on net, an average of only about 85,000 workers per month — not enough to bring the unemployment rate down significantly.
“Consumer spending in the quarters ahead will depend importantly on the pace of job creation but also on households’ ability to repair their financial positions. Some progress is being made on this front. Saving rates are up noticeably from pre-crisis levels, and household assets have risen, on net, over recent quarters, while debt and debt service payments have declined markedly relative to income.”
People who are out of work, or are afraid that they might be soon, don’t spend as freely as people with secure jobs. The loss of wealth from the bursting of the housing bubble has been huge, and people are struggling to offset that by saving more out of current income, thus depressing overall demand, and resulting in high unemployment.
But it is very hard to save when you are out of work. Still, those who still have jobs have increased their savings enough that we have seen a fairly dramatic increase in the savings rate, although it still remains far below what was considered normal back in the 1960’s and 1970’s. While a high savings rate is good over the long term, and increasing savings rate is a powerful brake on economic growth. Unfortunately, there is no way to go from a low savings rate to a high savings rate without the savings rate increasing.
“In the business sector, indicators such as new orders and business sentiment suggest that growth in spending on equipment and software has slowed relative to its rapid pace earlier this year. Investment in nonresidential structures continues to contract, reflecting stringent financing conditions and high vacancy rates for commercial real estate.”
With lots of unused capacity businesses see little reason to invest in creating more capacity. Most of the investment in equipment and software was probably aimed at equipment that cuts costs (mostly by allowing a single employee to do the work several would have had to have done without the new equipment) rather than increases output. On the construction side, why build when there are so many existing vacant buildings that could be used?
“Generally speaking, large firms in good financial condition can obtain credit in capital markets easily and on favorable terms. Larger firms also hold considerable amounts of cash on their balance sheets. By contrast, surveys and anecdotes indicate that bank-dependent smaller firms continue to face significantly greater problems in obtaining credit, reflecting in part weaker balance sheets and income prospects that limit their ability to qualify for loans as well as tight lending standards and terms on the part of banks.”
This also makes the big blue-chip type companies very attractive investments at current levels.
“Although output growth should be somewhat stronger in 2011 than it has been recently, growth next year seems unlikely to be much above its longer-term trend. If so, then net job creation may not exceed by much the increase in the size of the labor force, implying that the unemployment rate will decline only slowly. That prospect is of central concern to economic policymakers, because high rates of unemployment — especially longer-term unemployment — impose a very heavy burden on the unemployed and their families. More broadly, prolonged high unemployment would pose a risk to consumer spending and hence to the sustainability of the recovery.”
Fostering conditions of full employment is also a key part of the legal mandate of the Federal Reserve, i.e. why it exists at all. Sitting back and doing nothing when unemployment is close to double digits and expected to stay there for a prolonged period of time is simply fiddling while Rome burns. Federal Reserve Governors and regional bank presidents who do not understand that are guilty of dereliction of duty and should resign.
“Generally speaking, measures of underlying inflation have been trending downward. For example, so-called core PCE price inflation (which is based on the broad-based price index for personal consumption expenditures and excludes the volatile food and energy components of the overall index) has declined from approximately 2.5 percent at an annual rate in the early stages of the recession to an annual rate of about 1.1 percent over the first eight months of this year.”
This morning, the core CPI was unchanged for the second month in a row, and over the last three months is up at an annualized rate of just 0.4%. Bernanke is making the case about falling inflation (ex-food and energy) but he is understating his case.
“The decline in underlying inflation importantly reflects the extent to which cost pressures have been restrained by substantial slack in the utilization of productive resources. Notably, the unemployment rate remains fairly close to last fall’s peak and is currently about 5 percentage points above the rates that prevailed just before the onset of the financial crisis.”
To get a real old fashioned wage price spiral going, there has to be some way for wages to go up. With so many people out of work, anyone who demands a raise can easily be replaced. On the other side, with lots of capacity sitting unused, firms that try to jack up prices will quickly see other firms ramp up production to undercut them.
“In gauging the magnitude of prevailing resource slack and the associated restraint on price and wage increases, it is essential to consider the extent to which structural factors may be contributing to elevated rates of unemployment.
“For example, the continuing high level of permanent job losers may be a sign that structural impediments — such as barriers to worker mobility or mismatches between the skills that workers have and the ones that employers require — are hindering unemployed individuals from finding new jobs. The recent behavior of unemployment and job vacancies — somewhat more vacancies are reported than would usually be the case given the number of people looking for work — is also suggestive of some increase in the level of structural unemployment.
“On the other hand, we see little evidence that the reallocation of workers across industries and regions is particularly pronounced relative to other periods of recession, suggesting that the pace of structural change is not greater than normal. Moreover, previous post-World-War-II recessions do not seem to have resulted in higher structural unemployment, which many economists attribute to the relative flexibility of the U.S. labor market.
“Overall, my assessment is that the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity that occurred in the wake of the financial crisis and the continuing shortfall of aggregate demand since then, rather than to structural factors.”
Structural unemployment has two basic causes: skills mismatch and geographical mismatch. Historically, geographical mismatch has not been a big problem in the U.S. People would simply pick up and move to where the jobs are. However, being underwater on you house can make it very hard to move If someone offers you a new job for $50,000 a year, but you have to move, does it make sense to take it if it means you have to sell your house for $250,000 when it has a $300,000 mortgage on it. You would have to bring that entire year’s salary to the closing. Thus the job might just as well not exist for you.
There is no particular reason to think that the skills mismatch has increased dramatically over the last few years. Most of the rise in the unemployment rate has been because of a lack of aggregate demand.
“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve’s dual mandate in the longer run.
“In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable. Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue.
“In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation — setting aside the inevitable short-run volatility — will be less than the mandate-consistent inflation rate for some time.
“As of June, the longer-run unemployment projections in the SEP had a central tendency of about 5 to 5-1/4 percent — about 1/4 percentage point higher than a year earlier — and a couple of participants’ projections were even higher at around 6 to 6-1/4 percent. The evolution of these projections and the diversity of views reflect the characteristics that I noted earlier: The sustainable rate of unemployment may vary over time, and estimates of its value are subject to considerable uncertainty.
“Nonetheless, with an actual unemployment rate of nearly 10 percent, unemployment is clearly too high relative to estimates of its sustainable rate. Moreover, with output growth over the next year expected to be only modestly above its longer-term trend, high unemployment is currently forecast to persist for some time.”
In the interest of space I did not put in several passages before this one, in which he argued that price stability means a little bit of inflation, not zero inflation, and that the rate of inflation to aim for is also not zero, but the lowest level that will not cause inflation to start to surge. The key point here is that inflation is too low, and likely to remain too low for some time, and unemployment is too high.
Thus, the Fed should be easing monetary policy, but with the Fed Funds rate at zero, that means using unconventional tools. In short, he is endorsing QE2. That should be a good thing for the stock and commodity markets, but will be bearish for the dollar.
It will help forestall any threat of deflation, but could lead to higher inflation down the road. If so that would be a bad thing for the bond market, even though the Fed would be buying lots of bonds, thus putting short term downward pressure on interest rates.
There is much more in this speech, and you can read it in its entirety here.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
