Vicious Circles
October 02, 2008
By Richard Berner | New York
Despite a sharp rise in the unemployment rate, US employment has declined only modestly so far in the current economic slowdown. That is giving comfort to those who believe that the economy will avoid recession. The reasoning: Modest job losses mean that consumer incomes will weather the storm, sustaining consumer spending. Such comfort is misplaced, in my view; job growth won’t hold up in the face of a slipping economy. In fact, at least two ‘adverse feedback loops’ threaten to turn the mild recession we have called for into one that is severe. One involves spreading weakness beyond housing to consumer and capital spending, and from a global slowdown to US exports, which will promote further declines in employment, in turn pressuring income, consumers and their lenders. A second vicious circle runs from tighter credit to a weaker economy, and to a deterioration in credit quality, in turn increasing reluctance to lend. Both threaten an economy now on the brink. Thus, in my view the issue now is not whether a recession is likely, but how deep it will be and how long it will last.
In that context, actions such as the proposed Emergency Economic Stabilization Act of 2008 (EESA) could reduce — but not eliminate — the downside risks associated with those vicious circles. Indeed, the core of the so-called Troubled Asset Relief Plan would use fiscal policy to provide a capital infusion to the financial system, and would thus likely be a plus for stressed financial markets and help alleviate the credit crunch. To be sure, there are legitimate questions of implementation, and any such plan would have to be used aggressively and be shown to work. It may still be possible that the combination of a weak economy and sliding stock markets will prove to be a wake-up call for lawmakers to revive or revise it. Now that the plan seems to be off the table, however, policymakers and investors will probably refocus on signs of a faltering economy both at home and abroad, and turn to global monetary policy for relief. Gap between employment and unemployment data. There’s no mistaking that, measured by nonfarm payrolls, the decline in employment has been mild. Payrolls have declined by just 0.4% or 605,000 through August from the presumed cyclical peak last December. By comparison, payrolls declined by 1.3% eight months into the recessions of 1990-91 and 2001, and by 1.7% on average in the first eight months of the six recessions prior to those. In contrast, the unemployment rate, which is based on a different survey, has risen in line with its behavior in the most recent six recessions, jumping by 1.4 percentage points just in the past year. To be sure, much of the recent rise seems to be related to an increase in the number of people seeking work, but this significant rise in the jobless rate hints that the economy and labor markets may actually be weaker than the GDP or payroll employment data indicate. Changing rules of thumb. Indeed, past rules of thumb between changes in the unemployment rate and economic growth suggest that the economy should have contracted by about half a percent over the past year, whereas we estimate it grew by about ¾%. The best known of those guidelines is Okun’s Law, which looks empirically at the inverse relationship between growth and the unemployment rate. Economist Arthur Okun was interested in deriving empirically the economy’s sustainable or potential growth rate at a 4% unemployment rate — then judged to be consistent with “full employment.” Economists also often stand this regularity on its head to decide by how much the unemployment rate might rise in recessions. Estimated over the past 60 years, the rule suggests that the economy can grow at about 3.4% annually with no change in the unemployment rate; shortfalls from that growth rate should produce a rise in the jobless rate. Based on our current estimate of a contraction in GDP of about half a percent in the quarter now ending, the relationship suggests that the unemployment rate currently should be about 5.6%, compared with the actual 6.1% reading. Put differently, given the rise in the unemployment rate, either the economy is even weaker than official data recognize, or the relationship has changed significantly, or both. In my view, future downward revisions to official data may show a weaker economy, but the primary reason for this disconnect is that the Okun’s Law relationship has changed over time (for some evidence, see Edward Knotek, “How Useful Is Okun’s Law?” Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter 2007). More broadly, the relationship between employment and the economy appears to have changed in the past two decades. Four factors have wrought that change. First, Corporate America’s unprecedented hiring discipline in the first three years of the current expansion corrected the hiring excesses that emerged in the bubble years. It took the seemingly mild 2001 recession fully to expose those excesses, and the slow-growth recovery prolonged the purging process and made firms reluctant to hire until real recovery was underway. Importantly, this slow recovery may have changed the dynamics of the relationship between hiring and the economy, lengthening the traditional lag from a pickup in output to a recovery in hiring. Consequently, the level of nonfarm payrolls after 36 months of expansion was barely above the cyclical trough, compared with a typical 9% increase in past expansions and a 4.3% advance during the “jobless recovery” of the early 1990s. As a result, productivity soared to a 3.6% average annual clip. Employment growth picked up noticeably in the next three years — from zero to 1.5% annualized. This pickup ironically prompted speculation about data inaccuracies and fears of a secular plunge in productivity growth that proved unfounded (see “The Employment Conundrum: Construction Doesn’t Nail it Down,” April 27, 2007). Combining these two mini-cycles, the employment expansion since the 2001 recession remains distinctly subpar. Second, courtesy of a shift to more stable services industries, the economy and employment have become less cyclical than in the past. Private services employment remained at a steady 55% of total private payrolls for most of the 1950s, but began to climb late in that decade. Fifty years later, that share stands at 81.4%. While many services industries, such as airlines, wholesale and retail trade, IT, and financial services, are as cyclical as some in manufacturing, healthcare, education, and leisure and hospitality, together accounting for 35%of private services jobs, are far more stable. Third, companies were able to gain flexibility in their work force and restrain full-time hiring by using part-time or temporary workers. The rapid climb in healthcare benefits made hiring full-time workers less attractive and probably intensified the downtrend in manufacturing payrolls (see Sarah Reber and Laura Tyson, “Rising Health Insurance Costs Slow Job Growth and Reduce Wages and Job Quality, Working paper, University of California at Los Angeles, August 2004). Fourth, a more open, globally exposed economy and the outsourcing and offshoring that goes with it have changed the dynamics of domestic hiring. The evidence for direct effects of offshoring on US employment is limited to perhaps half of one percent (see Mary Amiti and Shang-Jin Wei, “Service Offshoring, Productivity, and Employment: Evidence from the United States,” IMF Working Paper 5/238, December 2005). But the indirect effects, fostered by the ongoing establishment of global supply chains that relocate production and employment around the world, is likely more significant. Finally, the longer-term unemployment–economy relationship will probably change further as a slower-growing, aging population depresses labor-force participation (see Stephanie Aaronson, Bruce Fallick, Andrew Figura, Jonathan Pingle, and William Wascher, “The Recent Decline in Labor Force Participation and its Implications for Potential Labor Supply,” March 2006, Brookings Panel on Economic Activity). The upshot: Despite the mild decline in payrolls so far, the feedback loop from a slowing economy to weaker employment and income gains and back to joblessness is now a key risk to the outlook. But shifts in the relationship between employment and GDP over time — including lengthening the traditional lags from a downturn in the economy to a downturn in hiring — mean that inferring trends from one to the other is difficult (for the seminal work on this lag, see Robert Gordon, “The "End-of-Expansion" Phenomenon in Short-run Productivity Behavior,” Brookings Papers on Economic Activity, Vol 10 (1979, No. 2) pp 447-61). I am hopeful that the hiring discipline of the past few years will limit the scope of coming payroll cutbacks, but those shifts leave me concerned that this feedback loop is only beginning to play out. Back to monetary policy? Against that backdrop, the policy responses to break the two feedback loops become critical for judging how deep and how long the current downturn will be. The proposed EESA likely would mitigate the credit crunch, thus partly substituting for additional monetary ease, but its future is uncertain. Actions similar in character and scope may still be possible, but may be difficult to implement without Congressional support. If the Fed is empowered to pay interest on reserves, as the proposed legislation would permit, the job of providing liquidity to money markets would be easier. But providing liquidity, even massively as the Fed and other central banks have done, only addresses the symptoms but not the root of the problem. Two weeks ago Fed officials left monetary policy on hold and stated that they saw a balance between the upside risks to inflation and downside risks to growth. That was then. The collateral damage from the failure of a major investment bank has since frozen money markets globally. And incoming economic data portray a rapidly darkening outlook for US housing, consumer and capital spending, and growth abroad. Thus, the unfolding dynamics of frozen US financial markets and what could be a serious economic downturn may force Fed officials to ease monetary policy soon. But officials may be wary of taking unilateral actions that appear to respond to market developments. As the credit crunch and the economic slowdown have gone global, such a move would have more impact if coordinated with other central banks.
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Time to Recalibrate Monetary Policy
October 02, 2008
By Joachim Fels & Manoj Pradhan | London
An avalanche of policy responses... Over the past week, governments, central banks and regulators on both sides of the Atlantic have (been forced to) come up with an impressive range of measures that should help to contain and, eventually, resolve the financial crisis. The list of measures includes: • Massive additional liquidity injections by many central banks as money markets remained frozen; • The nationalisation of another British mortgage lender; • The takeover of a troubled US bank by another large bank with public support from the FDIC; • Joint capital injections into two multinational European banks by, in each case, three different European governments; • The extension of a blanket guarantee for all deposits and most other liabilities of six large Irish banks by the Irish government; • The joint guarantee by a consortium of private banks and the German government for the short-term liabilities of a German mortgage lender, coupled with a takeover of the management of its assets. More action is likely to follow, and we still assume that the TARP, which US Congress refused to adopt earlier this week, will pass with some more amendments in the next few days. …except for monetary policy, so far. Meanwhile, monetary policymakers have remained remarkably silent on the implications of the present crisis on the outlook for interest rates. One interpretation is that they are entirely focused on liquidity injections and interest rate cuts are simply not on the horizon. Another is – and this is the one we are leaning towards – that this could be the proverbial ‘silence before the storm’. Yes, we have been harping on about the possibility of concerted interest rate cuts for the past fortnight or so and nothing has happened on that front so far. However, in our view, the case for rate cuts is becoming stronger by the day because (1) the incoming economic data have been weaker than expected almost across the board; and (2) the ongoing strains in the money market together with weaker asset prices and balance sheet pressures are very likely to dampen economic activity and inflation further, over and above what central banks have been expecting so far. More economic weakness coming through. Regarding the first reason – weaker-than-expected incoming data – we would point out the following: • In the US, our economists’ tracking estimate of 3Q GDP growth has swung from +1.0% a week ago to -0.6% now, following the more downbeat durable goods, 2Q GDP and personal consumptions reports released since then. • In the euro area, it now appears very likely that GDP contracted again in 3Q, following the sharp declines in business confidence portrayed by the surveys. Also, the unemployment rate rose to 7.5% in August, two-tenths above expectations. Moreover, inflation dropped to 3.6% in September on the flash estimate, confirming that the peak is behind us. • In Japan, the September Tankan released today showed falling business conditions across the board and provided evidence for tighter lending conditions for banks and tighter funding conditions for companies. Our Japan economist Takehiro Sato also points out that capex plans for the coming quarter were revised down, characteristic of a recession. In all three countries, we suspect that central banks, while looking for a further slowing of growth, had not fully factored in such weak outcomes. Crisis interferes with monetary transmission. More importantly, however, the ongoing financial turbulence is likely to materially affect growth over the next several quarters as it interferes massively with the monetary policy transmission process. While official interest rates in the major economies have remained unchanged recently (or, as in the euro area, even gone up as recently as July), the financial crisis has served to tighten monetary conditions by affecting the three most important transmission channels of monetary policy to the real economy: • First, regarding the interest rate channel, the ongoing stresses in the money market have pushed up the effective rates at which banks borrow money and which they use to determine lending rates. Interbank lending markets remain dysfunctional, and the marginal rates at which banks borrow from central banks in term auctions are also significantly above actual policy rates. Anecdotal evidence from the corporate sector collected by our equity analysts suggests that banks have significantly tightened the terms on which they lend to companies recently. • Second, regarding the asset price channel, the sharp fall in equity prices has dampened investment incentives because the lower price of existing capital implied by lower share prices reduces the relative attractiveness of investing in new capital (Tobin’s q). Tobin’s q also applies to housing, as prospective homeowners are more likely to buy existing houses as house prices fall, which dampens homebuilding activity further. While the fall in house prices should already have been factored in by central banks, the recent plunge in equity prices constitutes a new impediment for monetary transmission. • Third, balance sheets of lenders and borrowers have deteriorated further with the recent financial turmoil, restricting both the demand and supply of fresh credit. Weaker balance sheets due to lower equity and other asset prices reduce the net worth of the borrower and the collateral against which they can borrow. Also, banks are likely to prefer a lower risk profile for their loans in order to safeguard precious capital. Recalibrating the stance makes sense. Against this backdrop, there are sound economic reasons for central banks to recalibrate the monetary policy stance in the light of recent data and events. Of course, policymakers do not want to be seen as panicking or over-reacting to market events. However, the severity of the financial crisis and the weakness of recent economic data suggest that inflation risks must have declined. This would seem to provide ample justification for easing policy. Next steps. What does this mean for upcoming central bank meetings and decisions? • In the euro area, we would not rule out a rate cut by the ECB as early as tomorrow. Of course, as Elga Bartsch notes (see page 6 of The Global Monetary Analyst, October 1, 2008), such a cut would mean a rather drastic swing for the Council (which until recently continued to emphasise upside risks to price stability). Elga would at least expect a change in the language at the press conference, with the Council acknowledging that the upside risks to prices are diminishing. In this context, we found it interesting that ECB President Trichet in a speech last night said that de-leveraging, increasing risk-aversion and a tightening of credit standards “may have substantial impacts on the real economy that policymakers should be aware of”. • In the UK, David Miles and Melanie Baker think that the most likely outcome at the October 9 MPC meeting is a 25bp rate cut, and they would neither entirely rule out a bigger nor an earlier move (see page 8 of The Global Monetary Analyst). • In the US, Dick Berner believes that the unfolding dynamics of frozen US financial markets and what could be a serious economic downturn may force Fed officials to ease monetary policy soon (see page 5 of The Global Monetary Analyst). • In Japan, following the weak Tankan numbers, Takehiro Sato now thinks that the Bank of Japan is most likely to cut rates early next year and would not rule out participation in an earlier, internationally concerted move (see page 7 of The Global Monetary Analyst). Of course, if central banks wanted to send a strong signal to markets and help to stabilise confidence in the household and corporate sector, rate cuts should ideally be larger than the usual 25bp and come either at the same time or in fairly quick succession. The ECB could show leadership by going first tomorrow. Stay tuned.
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Cautious Outlook Despite HKMA Liquidity Assistance
October 02, 2008
By Denise Yam, CFA | Hong Kong
HKMA Unveils Temporary Measures to Alleviate Liquidity Shortage The initial rejection of the US$700 billion financial rescue plan by the US Congress on September 29 again heightened concerns among financial institutions regarding each other’s creditworthiness. Licensed banks in Hong Kong demonstrated a strong reluctance to engage in interbank lending of late, deeming the HK$5.44 billion (US$700 million) injection into interbank liquidity over the past fortnight ineffective in lowering interbank interest rates. In response to the sustained shortage in liquidity before more constructive resolution could be reached in the developed (especially the US) markets, the HKMA unveiled some pre-emptive measures on September 30, in preparation for more volatile times ahead in the financial markets. Five temporary measures of liquidity assistance are offered to licensed banks in Hong Kong, which will remain effective for six months (October 2008 – March 2009). Measures Should Help to Curb Extremities in Liquidity Shortage and Cap Interbank Rates The temporary measures, which make liquidity more readily available to licensed banks in Hong Kong, should help to limit extremities in liquidity shortage in HK$ money markets. The temporary suspension of the penalty interest rate in discount window borrowing effectively caps overnight HIBOR at the Discount Window Base Rate (DWBR), which stands at 3.5% currently. The extension of DW borrowing to 1-month and 3-month tenors at DWBR + 25bp with no penalty rate would cap HIBOR up to 3 months below 3.75%. Under the currency board system, the HKMA maintains the DWBR at 150bp above the fed funds target rate. Should US interest rates be cut at the next FOMC meeting (October 28-29), the cap on HIBOR should edge down in tandem. In other words, the temporary measures result in an ‘unofficial’ interest rate cut, since the fixed exchange rate system deprives Hong Kong of independent monetary policy (i.e., setting its own interest rate). This should also reduce the need for Hong Kong banks to sharply raise deposit and lending interest rates, which would transmit the current monetary system woes more readily to the real economy. August Data Suggest Continued Tightening in Monetary Conditions The HKMA also released August money supply data on September 30. Broad money growth remained subdued, with HK$ M3 growing merely 0.2%Y in the month, down from 1.4% in July. Although there was no further evidence of capital outflow in August (the net foreign asset position of the banking system remained unchanged at US$35.5 billion in August) following US$13.7 billion of outflows in June-July, the HK$ loan-to-deposit ratio, an indicator of liquidity that bears an inverse relationship with interbank rates, continued to edge up for the eighth consecutive month, reaching 83.8% in August, its highest level since December 2005. Monetary Conditions Outlook Remains Unfavorable We stand by our convictions as set forth in our earlier reports (The Tide Has Turned in Monetary Conditions, August 4, 2008, and Liquidity Outflows Continued in July, August 31, 2008): easy monetary conditions that have buoyed asset markets in the past few years have made a decisive turn, and that the shortfall in credit and liquidity in developed markets in the aftermath of the US subprime crisis is set to affect Asian monetary systems, upon reduced capital inflows into emerging markets amid the sharp shrinkage in investment risk appetite. In our view, the temporary liquidity assistance measures should serve to limit the tightness in liquidity conditions and help to prevent sharp spikes in HK$ interest rates. However, they do not fundamentally alter the outlook of tighter monetary conditions in the aftermath of the worst financial crisis in more than a decade. We think that it will require the successful implementation of convincing resolution initiatives in the US to properly relieve the current stress in the financial system and allow an easing in market interest rates. Calling for a More Cautious Economic Outlook We reiterate yet again that Hong Kong is a liquidity-driven economy, in that volatile cross-border capital flows, which are driven by factors unrelated to local economic fundamentals, result in significant fluctuations in monetary conditions and asset prices, and in turn drive the domestic consumption and investment cycles. We believe that the unfavorable turnaround in monetary conditions would undoubtedly translate into less support for asset prices in Hong Kong. This calls for a more cautious outlook for the real economy. While the equity market has already corrected by nearly half from the peak in October 2007, the Hong Kong property market has yet to see any significant correction. Should the higher interest rate environment put meaningful pressure on property prices in Hong Kong (mortgage interest rates on new loans were raised by 50bp at several banks over the last week), we expect to see another round of negative wealth effect on consumption. We last downgraded our growth forecasts for Hong Kong in August (see 2Q08 GDP Contraction – Consumption Collapse, August 15, 2008). We now see further downside risks to our growth (currently 4.7% for 2008 and 4% for 2009) and inflation (currently 4.5% for both 2008 and 2009) forecasts.
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