U.S. Review
Lower Inflation Liberates the Fed
Worries about inflation have clearly gotten ahead of themselves. While we believe inflation is a monetary phenomenon over the long run, lags between stronger money growth and rising inflation are long and variable. The Fed still has plenty of time to drain the liquidity it provided in the aftermath of the financial crisis before a troublesome inflation takes hold. Bond investors will likely remain edgy until such a plan materializes, as they should.
Bond investors, policymakers, and consumers are right to be concerned about the rapid money growth. Money supply growth, both M1 and M2, is up at a 9.5 percent annual rate since November and the monetary base is up at a 53.1 percent annual rate over this period, which means money growth would be even stronger if lending actually picked up.
Of course the whole purpose of flooding the economy with reserves was to stabilize the financial markets, so that lending could revive. So the Fed’s task is now to drain the excess liquidity they provided just as the economy revives, without killing off the recovery or enraging Congress.
The Economic Environment will Make the Fed’s Task Difficult
The economic environment the Fed will likely face during this period will not make things easy for policymakers. While we see the recession ending later this year, unemployment is likely to continue rising well into 2010. The last two recessions saw the unemployment rise 15 months and 19 months, respectively, after the recession ended. If, as we expect, the recession ends this summer, and the unemployment rate rises along the lines that it did following the past two downturns, then the unemployment would peak in late 2010 or early 2011. With the unemployment rate currently at 9.4 percent, the jobless rate will almost certainly top out in the low double digits and could quite possibly rise above the post-depression high of 10.8 percent hit back in 1982.
Politics could make the Fed’s job even tougher. Next year will mark a contentious mid-term congressional election and voters are likely to be antsy, particularly in states with high unemployment rates. The latest state unemployment figures, which came out today, show that 12 states and the District of Columbia already have unemployment rates above 10 percent, including large states, such as California, Florida, and Michigan. Even if the unemployment rate peaks sooner than it did following the past two recessions, it will still likely be uncomfortably high come election time. Draining liquidity without wrecking the recovery or upsetting Congress would require skills tantamount to pitching back-to-back no hitters.
For all the worries about inflation, the latest inflation figures show little reason to be concern. The Consumer Price Index rose just 0.1 percent in May, both on an overall basis and after excluding food and energy prices. Price increases were tame pretty much across the board. One notable exception was gasoline prices, which rose 3.1 percent in May. With the economy struggling, rising gasoline prices are having more of a dampening effect on consumer spending than they are on pushing prices higher in related industries. Prices for airfares, for example, declined sharply. Food prices are also moderating, particularly for fruits and vegetables, which are among items that are most sensitive to higher fuel costs.
Looking back further in the production pipeline there is even less reason to be concerned about inflation in the near term. The Producer Price Index rose 0.2 percent overall but fell 0.1 percent after excluding food and energy prices. Price increases were even better behaved further back in the production pipeline, with core intermediate goods prices falling 0.2 percent in May and tumbling at a 5.6 percent annual rate over the past three months.
Global Review
Is the U.K. Economy Nearing Bottom?
Real GDP in the United Kingdom dropped at an annualized rate of 7.3 percent in the first quarter, the steepest sequential rate of decline in 30 years, and recent monthly indicators suggest that the economy has continued to contract, albeit at a slower rate, in the second quarter. For starters, the labor market has continued to deteriorate. The number of unemployed workers rose by 39,300 in May, which was not quite as bad as expected. However, the unemployment rate, which has shot up rapidly since last summer, rose further. Indeed, unemployment is currently at the highest rate since the late 1990s.
The weakness in the labor market has caused wage growth to slow sharply in recent months. Last autumn, average earnings (excluding bonuses) were growing at a year-over-year rate of 3.6 percent. In April, earnings were up only 2.7 percent. If bonuses are included, the slowdown is even worse (top chart). Because bonuses for most employees were cut significantly last autumn, total earnings in April were up only 0.8 percent.
With earnings growing so slowly, it is little wonder that retail spending has slowed significantly over the past year or so. Indeed, real retail sales in May were down 1.6 percent relative to the same month last year. Another factor that may have depressed real spending in May was the rise in consumer prices during the month. Although CPI inflation has receded since last year’s spike, which was induced largely by higher energy prices, the overall CPI rose 0.6 percent in May relative to the previous month. Although the increase in petroleum prices helped to lift overall consumer prices in May, the “core” CPI was up 0.4 percent as well. With prices up, consumers have less purchasing power.
Recent survey data from the manufacturing sector also are consistent with continued contraction. A widely followed monthly survey indicates that the volume of output produced remained weak through June (middle chart). That said, the survey also suggests that the contraction in output in the second quarter was not as rapid as it was in the first quarter. Indeed, “hard” data that were released last week showed that industrial production in April edged up 0.3 percent relative to March, the first monthly increase in more than a year.
In sum, the evidence suggests that the British economy, which has already contracted for four consecutive quarters, has not hit bottom yet. By our reckoning, real GDP will decline at an annualized rate between one and two percent in the second quarter. Although growth should turn positive in the second half of the year, we project that the upturn next year will remain sluggish as indebted consumers reduce leverage.
Signs that the U.K. economy may be nearing bottom have contributed to sterling’s rise versus the dollar over the past few months (bottom chart). The pound has come a long way in a fairly short period of time, so some retracement is inevitable. Sterling probably won’t fall back to the lows of early 2009, but a pullback seems likely in the months ahead as investors question the sustainability of the eventual recovery.
