This morning, Janet Yellen, the President of the San Francisco Fed, spoke about the state of the economy. Below are key excerpts from the speech, as well as my reaction to them (spoiler alert: I am in overall agreement with her).

“This is the first talk I’ve given since the economy has officially been reported to be growing again. The economy’s return to growth after a year and a half of recession marks a major turn, and it looks like more than a flash in the pan. It seems to me that the economy has entered a sustained period of expansion.

“We’ve seen meaningful upturns in areas as diverse as housing, consumer spending, industrial production and foreign trade. And, a number of factors bode well for the future, including a better functioning financial system, low mortgage interest rates, a resurgent stock market, a stabilization of house prices and stronger growth abroad.”

Yes, overall, things are much better now than they were a year ago, with the glaring exception of unemployment. Rising output, but done with fewer workers means that productivity is rising, but that is sort of a double-edged sword given the level of slack in the economy (see Economic Productivity Surges).

“All the same, I am not going to paint an entirely rosy picture for you. The strength and durability of the expansion is in question. Some of the rebound is due to temporary government programs and a swing in inventory investment that will not provide an ongoing source of growth.

“Financial conditions have improved markedly in some respects, but many financial institutions are still hobbled with bad loans.  The outlook for consumer spending is in doubt because households remain burdened with debt, and they have taken enormous hits to their wealth from declines in house and stock prices in recent years.

“And it’s particularly sobering that labor markets continue to deteriorate badly, leaving many millions of our fellow Americans unable to find jobs. Just last week, we found out that the unemployment rate passed 10 percent in October. The 10.2 percent jobless rate is the highest since 1983.

“Today I will consider this mixed picture in some detail and focus on two subjects of professional interest to many of you — the residential and commercial real estate markets. I want to stress that my comments are my own and do not necessarily reflect the views of my Federal Reserve colleagues.”

It would be too much to ask to have everything perfect just a year after the biggest financial freeze-up in 70 years. Bad debt is still choking the system, particularly at the consumer level, which then flows back to the banks. This is going to take a long time to fix. And the burden of debt is, of course, much higher when you are unemployed than when you have a job.

“As we look at the national economy, it’s important to keep things in perspective. It’s not fun to ponder a subdued recovery. But a year ago, after the near-collapse of the global financial system, there was a real possibility of an outright depression.

“Fortunately, we avoided that. But what we did suffer through was bad enough — the worst downturn since the Great Depression of the 1930s. The recession began at the end of 2007. Economic output has dropped by just over 3½ percent. Over seven million jobs have been lost in the nonfarm sector of the economy. And the unemployment rate has soared by over five percentage points.

“Few, if any, parts of the economy were unscathed. The labor market was devastated, and housing, consumer spending, business investment, exports and imports all fell off the table.”

Imports “falling off the table” actually provided a substantial lift to the economy. The rest of the stuff falling really hurt, though. The decline in business investment, to the lowest share of the economy in the post-war era, is particularly troublesome  (see The Shape of GDP).

“Against this backdrop, the nation’s third-quarter return to growth was a great relief. Real gross domestic product — which is the economy’s total output of goods and services — increased at a solid annual rate of 3½ percent. The recession hasn’t officially been declared over, but a wide array of data suggests that the corner has been turned.

“In the third quarter, residential investment — which was at the center of the downturn — rose at nearly a 25 percent annual rate, albeit from a very low level. Home sales, prices and housing starts are once again climbing. Meanwhile, manufacturing is also beginning to show signs of strength. This was helped by a rebound in motor vehicle production, boosted by the government’s temporary Cash-for-Clunkers program. Our exports surged as growth abroad picked up. And, importantly, consumer spending finally is growing.”

In the short-term, growing consumer spending is a good thing, but in the long term it is the last thing we need. Sort of like a shot of Jack Daniels can help a bit with a hangover.

“To me, the explanation for this turnaround is clear: Massive and concerted responses by governments and central banks around the world rescued the financial system, brought down interest rates, provided emergency support and broke the economy’s downward spiral. On the monetary policy side, the Fed has pushed its traditional interest rate lever — the federal funds rate — close to zero. And, in order to provide additional stimulus, we put in place an array of unconventional programs to spur the flow of credit to households and businesses.

“These measures provided funding to banks and restored liquidity to a range of markets. We’ve increased the flow of credit for securities backed by small business loans, consumer loans, and other assets.  Our large-scale purchases of Fannie Mae and Freddie Mac debt and mortgage-backed securities (MBS) helped lower mortgage rates and bolstered the housing market. We’ve also bought longer-term U.S. Treasury debt to help bring private borrowing rates down.”

These policies are likely to stay in place for a while to come, and will only gradually be lifted, particularly the low fed funds rate. What happens to mortgage rates once the Fed stops buying every scrap of paper ever issued or backed by Fannie (FNM) and Freddie (FRE) is very much of an open question. Oh, the buying of longer-term treasuries was just to bring private rates down — it had nothing to do with keeping the interest costs to the government down .

“These initiatives appear to have eased financial conditions. Clearly, the financial system is not yet back to normal, but it has bounced back notably. The stock market has soared since its low in the winter. That rally has helped households recover some of their lost wealth and provided a much-needed psychological boost.

“Investors perceive that economic risks are not as dire as they once seemed to be. Interest rates on corporate bonds — especially for less-than-prime firms — have dropped sharply and issuance has been brisk. And the markets that financial institutions and corporations rely on for short-term funding are functioning reasonably well again, due in part to Fed intervention.”

Big firms that can tap the credit markets on their own are in much better position than small firms that have to rely on bank loans. Remember that spreads on low-grade corporate debt last winter were higher than the spreads during the Great Depression. While the Fed intervention has not helped everyone, it clearly has helped many.

“Federal government policies also have contributed, including the fiscal stimulus program passed by Congress in February. Tax cuts have raised disposable income, and government spending is directly adding to payrolls. Much of the stimulus money authorized by Congress remains to be spent and will spur growth in coming quarters. Other government initiatives contributed to the third-quarter expansion as well, including the Cash-for-Clunkers program and the $8,000 tax credit for first-time homebuyers.

“The normal dynamics of the business cycle have also turned more favorable. Demand for houses, durable goods such as autos, and business equipment is beginning to revive as households and businesses replace or upgrade needed equipment and structures. A particularly hopeful sign is that inventories of unsold goods, which have been shrinking rapidly, now seem to be in better alignment with sales. Manufacturers had slashed production dramatically in the face of slumping sales. Recent data suggest that this correction may be near an end, setting the stage for more production.”

It is hard to tease out how much of the increased demand for housing and autos is due to the government subsidies, and how much is “real” pent-up demand. The October auto sales were somewhat encouraging in this regard, since Cash for Clunkers was not a factor. The rebound to profits at Ford (F) was real, even if it could be laid at the feet of the Clunkers program. The inventory bounce is real, but is probably temporary.

“The big issue is how strong the upturn will be. With such enormous reservoirs of slack in the form of high unemployment and idle productive capacity, we need a strong rebound to put unemployed people back to work and get underutilized factories, offices and stores humming again. Unfortunately, my own forecast envisions a less-than-robust recovery for several reasons. As the impetus from government programs and inventories diminishes in the quarters ahead, private final demand will have to fill the breach. The danger is that demand may grow at too anemic a pace to support vigorous expansion.”

While many criticized the stimulus program as being too back-end loaded, as we move into next year people should be thankful that there is still some of it at work. However, it is the change in stimulus that provides the momentum for growth, which after all is the change in GDP. Thus as we move into the second half of next year, while the stimulus spending might be $75 billion in the third quarter, if it was $100 billion in the second quarter, it will be a net drag on growth.

“First, it may take quite a while for financial institutions to heal to the point that normal credit flows are restored. The credit crunch hasn’t entirely gone away. In the face of massive loan losses, banks have clamped down on underwriting and credit terms for both businesses and consumers.

“Smaller businesses without direct access to capital markets are particularly feeling the pinch. Lenders have had to run hard just to stay in place: Rising unemployment, business failures and delinquencies in real estate markets have fed additional credit losses and made it more difficult for financial institutions to get their balance sheets in good order.

“Second, households have been pummeled and prospects for consumer spending are cloudy. Consumers have surprised us in the past with their free-spending ways, and it’s not out of the question that they will do so again. But I wouldn’t count on them leading a strong recovery. They face high and rising unemployment, stagnant wages and heavy debt burdens. Their nest eggs have shrunk dramatically as house and stock prices have fallen, and their access to credit has been squeezed.

“It may be that we are witnessing the start of a new era for consumers following the harsh financial blows they have endured. We often hear the word ‘deleveraging’ used to describe the push by financial institutions to scale back debt and build equity. Households too have now begun to pay down debt and rebuild their savings. This phenomenon can be seen not only in the United States, but in most countries that experienced similar housing booms.

“The United States was hardly the only country where households borrowed heavily just before a severe housing bust set in. And those countries with greater increases in debt relative to income before the crisis experienced greater declines in consumption spending once the crisis began.”

The consumer spending question is a huge conundrum. At almost 71% of the economy in the third quarter (a post-war record, by the way), it is hard to see how the economy moves forward if it is contracting.

However, it is simply not healthy to have such a large percentage of the economy based on consumption. We need more savings in the economy, and more productive capacity. By not saving we are eating our seed corn, but if we don’t eat that seed corn now, we will be malnourished. True, that it is happening in other countries as well, but the need for consumer deleveraging is much greater here than anywhere else.

Ideally, the savings rate would be rebuilt by income rising a lot, and spending growing very slowly. But if consumers are not spending, then companies will not hire, and incomes will tend to fall not rise, making it even harder to rebuild our savings.

“In the United States, the personal saving rate, which had fallen to an incredibly low 1 percent in early 2008, has averaged 4 percent so far this year and may well rise higher. In the current environment, such belt-tightening makes great sense from the standpoint of individual households. In fact, some households may have no other option because their access to credit has been crimped.

“Over the long run, higher saving is surely a good thing for our economy because it provides capital that can be devoted to modern infrastructure, technology and other productive investments that enhance our standard of living. All the same, the transition to a higher saving plane could be painful if it reduces the growth rate of consumer spending for an extended period.”

Back in the 1950’s and 1960’s a savings rate of 9 to 10% was normal. That was the period when U.S. economic dominance was at its greatest. We have had the wind at our backs for decades now as the savings rate declined as a falling savings rate translates into higher economic growth, at least in the short term. We have finished coasting downhill, and now have to climb back up. You go slower and have to work harder to ride a bike up a hill than down it.

“Weakness in the labor market is another factor that may keep the recovery sluggish for quite some time. Payroll employment has been plummeting for more than a year and a half, and even though the pace of the decline has slowed, unemployment now stands at its highest level since 1983. In addition, many workers have seen their hours cut or are experiencing involuntary furloughs.

“To bolster earnings in the face of weak revenue growth, employers have been aggressive in cutting labor costs and jobs, and my business contacts say they will be reluctant to hire again until they see clear evidence of a sustained recovery. Weak demand for workers is also putting a lid on paychecks. Wages are barely rising. A well-known measure of overall employment costs rose by only 1¼ percent over the past year, the smallest increase in the history of the series. High unemployment, weak job growth and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery.”

Yup, hard to save more when you are unemployed or have seen your hours cut back drastically. The only way is to spend less, and that means a slow recovery.

There was much more to the speech, you can read it in its entirety here:
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