Last week had two main events or influences. The first was the rise in wheat prices that led to follow on rises in other agricultural commodities, the frenzy surrounding this was increased when Russia announced a ban on grain imports from August 15th to the end of this year. This calmed down and prices retraced for wheat late on Friday with prices falling from a high of US $8.68 per bushel to US $7.25 per bushel and it is at this new level this morning. However its impact has hit other prices as for example the price of feed barley in Europe was 90 Euros per tonne in mid-June and is now 210 Euros per tonne. Adding to this we have seen the price of oil rise since the end of May, if we look at the price of Brent Crude Oil it fell to a recent low of US $70.20 per barrel on the 20th May and is US $80.76 per barrel this morning. Now commodity prices have a tendency to ebb and flow to say the least but it is curious that the world is so fixated on deflation/disinflation at a time almost to the exclusion of anything else when there are plainly some inflationary pressures around.
The second impact/event was the publication of employment and unemployment statistics by the Bureau of Labor Statistics in the US. These were disappointing numbers and I will look at them in detail in a moment but their initial impact involved a fall in equity markets as the US Dow Jones Industrial Average fell over 140 points. However in a theme familiar to regular readers we then saw US equities recover and in effect brush off the poor economic news and in the end the Dow Jones closed just some 21 points lower. European equity markets are rallying this morning with the UK FTSE the German Dax and the French CAC 40 all up by more than 1% so the net effect of these figures has quickly disappeared at least as far as equity markets are concerned. However there are clear economic implications for the US central bank the Federal Reserve which has a policy setting meeting tomorrow and faces calls for new action. Of course the cries for new action are probably influencing the recovery of equity markets as we are close to a consensus in some areas that the Fed should act and it is this which I wish to discuss today.
The Choice facing the US Federal Reserve bank
Essentially the current argument is driven by what has happened over the past two years. In response to the credit crunch the US Federal Reserve undertook an extraordinary programme of monetary stimulus to try to support the US economy. Interest rates were slashed such that the official range is now in a range between zero and 0.25% which compares with 5.25% before the crisis and the Fed undertook a programme of Quantitative Easing which expanded her balance sheet to some 2.3 trillion dollars. According to its own website the Fed had a balance sheet of US $869 billion on August 7th 2007 and as of the latest figures now has one of just under 2.33 trillion. So there has been an expansion of approximately US $1460 billion which is an extraordinary level of intervention/stimulus for the US economy.
This was expected to have follow-on effects for the US economy and provide a boost with both short-term and longer-term interest rates falling. As we there were direct effects on the rates at which US companies can borrow as the Fed intervened directly in the corporate area as opposed to the Bank of England whose own efforts were mainly indirect by buying sovereign debt.
After the falls caused by the credit crunch US economic growth did rally in response to the monetary and fiscal stimulus applied. The problem if we look at the last three-quarters of US growth is the trend. After a rise to 5% in the last quarter of 2009 we saw 3.7% in the first quarter of 2010 and then 2.4% in the second quarter. Now the US use of annualised numbers does exacerbate the trend of falling growth rates but in essence since the heady days of the last quarter of 2009 the growth rate has halved. Looking at the components of US economic growth does not help either as a reasonable proportion has been restocking of inventories which has a limit as firms will look to sell these inventories and if they cannot then they will cut back.
Now economists looking at the trends are starting to reduce their forecasts for economic growth in 2011. For example Goldman Sachs have reduced it from 2.5% to 1.9%. Looked at like this the effects of all the stimulus measures are starting to look rather weak and temporary.
US Employment and Unemployment
Fridays figures continued a disappointing trend. If we go beyond the headline figure of a fall in employment of 131,000 jobs we see that the US private sector created some 71,000 jobs. This is quite low for this stage of the recovery. To add to the gloom the employment figures for June were revised down from -125,000 to -221,000. Somehow in the midst of this the Bureau of Labor Statistics managed to report an unchanged unemployment rate of 9.5% and it managed this by reducing the estimated size of the labour force. We have seen this sort of thing in the UK where we have seen falls in employment and increases in estimates of the non-working population. It is recorded differently in the US as an example it is recorded in one section of the report as individuals “marginally attached to the labor force” and this category has risen by 340,000 over the past year to 2.6 million.
Another section which unfortunately questions the statistics being produced is the way back months are being revised. I pointed out earlier that the employment figures for June were revised down substantially. Well this is a consistent theme. If we look at 2009 we see that the figures for 11 months were revised down later and only one was revised up. The downward revisions totalled some 677,000 and the upward 60,000 leaving us with a net figure of minus 617,000 for the year.
So if the statistics from the BLS continue at the same level of reliability as 2009 then an already disappointing employment situation is in fact worse than that. As a side issue the credibility of the BLS will be hit further unless it finds a solution to its errors which seem pretty much always to be in the same direction.
One feature of US economic policy is the very low-level of interest rates which are prevalent in the US economy. At the short end they under the Fed’s control and they are below 0.25%. If we look at the rates for US government bonds we see rates which are low and they fell further on Friday. The yield on two- year government bonds fell to 0.51% and on ten-years it fell to 2.81%. I have written before on the thirty year mortgage rate which is below 4.5% but less on corporate rates.
US corporates with a good credit rating can borrow at extremely low rates. As an example of this IBM borrowed some US $1.5 billion last week for three years and paid only 1% on it so it could hardly get much cheaper!
So here we see the source of the problem to my mind. Personally I feel that the Federal Reserve did the right thing in trying to influence corporate interest rates as much as possible with its asset buying programme as compared with the Bank of England which spent its money apart from a relatively small section on government debt. As discussed above the rates at which corporate borrowers can borrow are now extremely low. Economic theory would predicts that companies would use this money to invest and thereby boost the economy. If we look at the growth figures this may have happened but the effect is looking somewhat temporary.
This leads me to a conceptual problem for those who are pushing for QE 2.0. By definition the call means that QE 1.0 has either not worked or not worked as well as expected. I have written before about “thought bubbles” well some parts of the economic profession appear trapped in one here where they can only think of one policy and ignore the fact that one has now to contemplate that the policy has only been a partial success. Indeed it is possible that it is failing. If this is so what good will more of it do? To this question they appear to have no answer.
If I had a vote this week I would vote for no change. This is for several reasons. If we put aside the fact that I have questioned QE many times on here and have voiced doubts about it then the evidence is now questioning it. If this is so then doing more of something which is failing does not seem logical. Also recoveries do not happen in a straight line and so I would want more evidence of a US economic slowdown before I added to what already are extraordinary stimulus measures. Some members of the Fed are likely to agree with me as their last meeting minutes said that conditions would have to “worsen appreciably” before they acted again.
What might the Federal Reserve do on Tuesday?
During this crisis we have seen the Fed make panic moves. I remember one weekend panic cut in interest rates of 0.75% particularly. So one cannot rule out a move on Tuesday. What might they do?
1. As interest rates are so low a cut seems valueless. Some are suggesting that the Fed. could announce that rates will stay low for an even longer period than currently expected. I struggle to see any point to this after all nobody is expecting a rate rise for ages.
2. More asset purchases. Apart from the logical flaw that they are only taking place because previous asset purchases have failed this would be such a big move it would risk undermining confidence in the economy. So this could quite easily backfire.
3. A technical change which would pump around US $250 billion a year into the economy. Should the Fed act this is the most likely move. As part of its asset purchases it bought large amounts of Mortgage Backed Securities or MBS’s. At the moment it is receiving interest and principal payments on these of some US $ 250 billion or so per year and is using this to pay down the amount of debt it has. The Fed could choose to reinvest this money in what has been described as QE-lite. The most likely place it would put this money would be in US Treasury Bonds although if you are logical then in fact it should go into the MBS market and the corporate bond sector.
The pressure from the markets appears to be building but to my mind central banks should keep a clear mind and not respond to such pressure. If they are weak they may go for option 3 above but to my mind they should be strong and wait. Unfortunately economic data is slow to arrive and often only gives partial answers.
Personally I also think that the whole debate questions QE as a policy weapon, as in if it works why are we having this debate at all? In the words of John Maynard Keynes sometime monetary policy is like “pushing on a piece of string” and what we may be seeing at this time is that the transmission mechanism between the monetary stimulus and the real economy is only partially working at best.