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United States It's Bumpy and Slow...but it Will Be a Sustainable Recovery Global What Will Tightening Look Like? View GEF Archive

		The Global Economics Team

		Read about other GEF team members

US Forecast at a Glance

(Year-over-year % change)	2008A	2009E	2010E
Real GDP	0.4%	-2.6%	2.6%
Inflation (CPI)	3.8	-0.4	2.1
Core Inflation (CPI)	2.3	1.6	1.5
Unit Labor Costs	1.9	-0.7	-0.4
After-Tax "Economic" Profits	-2.0	-11.1	12.4
After-Tax "Book" Profits	-11.5	-13.4	11.8

Source: Morgan Stanley Research   E= Morgan Stanley Research Estimates

Our view contrasts sharply with that of many who dismiss recent signs of stronger growth as a one-time, motor vehicle and restocking-driven bounce in output.  The debate won't end quickly because the recovery likely will be bumpy, with surges in output followed by slower growth.  Longer term, the recovery will be relatively slow, as financial and economic headwinds are only gradually giving way to tailwinds.  Absent the more straightforward V-shaped recovery that typically follows a sharp downturn, investors may assume the worst.  In our view, that would be a mistake: Just as this was not a typical recession, the coming recovery is unlikely to follow a time-honored, cyclical script.  The key point for investors is that we think the recovery will be sustainable and private credit demand will expand, eventually helping to set the stage for higher interest rates along the yield curve.

Near term, a vigorous recovery is virtually assured.  A strong revival in motor vehicle output is pacing the upturn, adding 3-4 percentage points to 3Q GDP.  It is now clear from recent data that July's 45% production increase and planned increases for August and September will boost 3Q real motor vehicle output by nearly 50% (not annualized).  This pick-up accounts for virtually all the 3.5% overall real growth we expect in 3Q.  Although the vehicle industry's contribution to GDP will likely fade sharply in 4Q after production has adjusted to the current pace of demand, a ‘double-dip' payback in vehicle output is highly unlikely.  Inventories are down to normal levels, and even if demand did not continue to improve, a sharp reversal in motor vehicle output would make them too lean.  Also, the tripling of the cash-for clunkers program to a total of US$3 billion together with matching automaker incentives should boost demand enough to prevent a near-term payback.

Moreover, there are signs that demand is rising outside of vehicle sales.  Demand is starting to improve in housing and infrastructure outlays, so even as vehicle output levels off in 4Q, overall growth should slip but remain positive.  Already, better-than-expected gains in housing and construction will probably add a half point to 3Q output.  With sales improving, one-family vacancy rates down to 2.5% and inventories of new, one-family homes down to 8.8 months' supply, activity is poised to increase, if slowly.  Meanwhile, fiscal stimulus is beginning to boost state and local infrastructure outlays; such construction rose 8.2% over the five months ended in June. 

Finally, incoming data hint that income growth - essential for sustaining even a moderate pace of consumer spending - is beginning to turn positive.  July's loss of 247,000 non-farm payrolls was the smallest decline since last August, and the workweek and average hourly earnings both rose last month.  The increase in the workweek, while a modest six minutes, is a classic cyclical sign that labor markets are starting to improve as employers first extend hours before committing to hire workers.  Together with the increase in hourly earnings, the leveling in hours worked signals the first increase in wage income in nearly a year, even though gains may be subdued.  Declining jobless claims hint that payroll losses will likely slow further in August and that income gains may be sustained, and industry payroll diffusion indices rose in July.  The household employment survey showed a rise in job leavers, a decline in job losers, and a decline in workers holding part-time work for economic reasons, all encouraging signs. 

Longer term, we think that three factors are making recovery sustainable.  First, financial conditions continue to improve, and the feedback loop between the economy and credit is gradually changing from vicious to virtuous.  Spreads in interbank lending markets have narrowed to their lowest level since 2007, and quality spreads in the commercial paper market have narrowed to about 40bp.  In equities, financial stocks have led markets to the highest levels since October.  Although they have widened lately, on balance, credit spreads have continued to narrow, with the investment grade CDX index moving to 114bp, the narrowest since May 2008.  The high yield CDX index has declined about 250bp since June 22, while leveraged loan spreads have plummeted by around 400bp since late June.  Finally, increasing optimism about the legacy TALF and Treasury PPIP programs has triggered big buying waves in both AAA and lower-rated CMBS.  Investors are piling into the primary issuance markets, betting that new deals will be clean and offering companies the best access to credit on favorable terms in more than a year.  While loan losses continue to rise, the Fed's August Senior Loan Officer survey is likely to show that fewer banks tightened lending standards over the past three months. 

Second, the delayed effects of fiscal stimulus will soon be more broadly in evidence.  We've long believed that the influence of the American Recovery and Reinvestment Act (ARRA) on infrastructure outlays would take several months to show up.  State and local construction outlays appear to be rising, and we expect the pace to quicken late this year and into 2010.  Third, reduced inventory liquidation is now contributing to growth and should do so through 2010.  Some investors think that the surge in motor vehicle output is triggering inventory restocking that will soon peter out unless demand rises strongly.  That's not the case in motor vehicles: OEMs are realigning production with sales to prevent inventories - already at normal levels - from falling too low.  Outside of motor vehicles, inventories are still elevated in relation to sales, warranting further production adjustments.  But if sales rise, producers can still liquidate inventories by raising output more slowly than demand.  That's exactly what we expect over the next few quarters.  Because the change in the change in business inventories is positive, and that change is what matters for output, we expect that reduced inventory liquidation will contribute to output growth through 2010. 

Core inflation to approach 1%.  We believe that the deep recession has increased slack in the economy to near record depths, so that inflation will drop further in coming months.  Updated estimates of ‘core' consumer prices show a deceleration to 1.5%Y in June, 1.1 pp lower than a year ago.  Modest pay gains suggest that labor costs won't be a factor in the inflation outlook any time soon.  And productivity exploded in 2Q to 6.4% annualized, as output fell far less than hours worked.  That strong pace should continue for a few months as output rises faster than hours, confirming that the underlying trend is around 2%.  Combined with a moderate recovery and significant slack in the economy, this trend implies that inflation will probably decline further in the next several months.  .

The Fed winds down Treasury purchases.  Following its meeting this week, the FOMC's policy statement was similar in tone to Chairman Bernanke's Humphrey-Hawkins testimony, although the spin on recent economic developments was a bit more positive, saying that "economic activity is leveling out."  Most important, the FOMC maintained its conditional "extended period" language for keeping rates steady; that helped partly reverse the recent apparent increase in market expectations of rate hikes before the end of the year.  We continue to believe that the first rate hike will come around mid-2010.  On the other hand, officials are taking measured steps to wind down other programs constituting the Fed's extraordinary monetary accommodation, such as the Treasury purchase program.  As we expected, the Fed reaffirmed that it will continue "the process of buying US$300 billion of Treasury securities".  And rather than change the mix among Treasuries, Agencies and MBS, officials decided to avoid "cliff effects" by winding down its purchases of Treasuries over time, beginning on August 19 and concluding by the end of October.  At the previous pace, the U$300 billion program would have been completed by mid-September.

Our surveys of the Morgan Stanley trading desk and some key clients last week revealed a wide dispersion of responses around this issue, hinting that there would be some market reaction regardless of which option the FOMC chose.  However, after the survey was taken, expectations seemed to converge on something similar to the option chosen, and consequently reactions were mixed. The affirmation of steady rates, a slightly more positive spin on the outlook, and the decision not to expand the Treasury purchase program promoted a steepening of the yield curve, primarily through a dip in 2-year yields to 1.14%. 

Rates eventually to move higher along the curve.  Responding to stronger-than-expected economic data and a relentless rally in risky assets, rates have backed up along the yield curve.  The recent back-up in interest rates may reflect a rise in risk premiums rather than stepped-up expectations of Fed tightening, but even following the FOMC meeting, we still think there is too much tightening priced in this year.  Looking ahead, however, a sustainable recovery means that rates will likely rise significantly over the next 18 months.  That expectation will continue to affect back-end yields, possibly steepening the curve from bills to bonds.  Yet as the Fed's rhetoric shifts from lingering strains that are holding the economy back to a more favorable outlook for growth, investors will likely begin in earnest to recalibrate their expectations about monetary policy and just how high short rates need to go to bring them back to normal.

Global
What Will Tightening Look Like?
August 13, 2009

By Manoj Pradhan | London

Even before the dust settles on the monetary easing cycle, markets have started a watch for the beginning of monetary tightening. Unlike past cycles where the focus was solely on policy rates, the unconventional element of monetary easing means that the assets and liabilities of central banks are key variables in the tightening equation. Central bank balance sheets will undoubtedly be observed as closely as indications of policy rate hikes. But we caution investors against equating a contracting balance sheet with a withdrawal of monetary expansion. Instead, we provide a laundry list of measures that would constitute monetary tightening. None of these measures indicate that tightening is imminent any time soon.

Easing still not easing up. The BoE fired a shot across the bow last week by announcing an additional £50 billion to purchase government securities as part of its ‘active' QE programme. (‘Active' QE purchases refer to purchases made via the MBS or Treasury purchase programmes run by the Fed or the APF run by the BoE. ‘Passive' QE refers to an expansion of balance sheets via the various liquidity programmes. For more details, see "QE2", The Global Monetary Analyst, March 4, 2009.) The Fed, the ECB and the BoE have around US$700 billion, €55 billion and £50 billion, respectively of asset purchases to go to reach their current targets, with a possibility that these programmes could be extended further, in line with the BoE's actions. At its current pace, the Fed's asset purchases are likely to end around December 2009, just a month before the FOMC meeting for which markets have priced in 25bp of rate hikes. And it is not just in the US, euro area, UK and Japan that monetary expansion is still underway. Central banks are still cutting rates in the CEEMEA region while fixed exchange rate regimes are facilitating the import of monetary stimulus from the major economies. Of particular interest is the case of China, where this imported monetary stimulus is adding to a large, domestic monetary and fiscal stimulus package. Turning such an extensive policy expansion around quickly is neither salutary nor easy, and central banks will likely tread with caution as they map uncharted territory in unwinding QE. While the monetary tap remains open, excess liquidity continues to remain extraordinarily high, providing support for risky assets and economic recovery (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27, 2009).

Central bank balance sheets will become a focus in the process of unwinding QE. We intend to monitor these balance sheets on an ongoing basis. Some central bank balance sheets (notably that of the Fed and the ECB) have already started contracting. However, investors should not take that to be a sign of withdrawal of monetary stimulus.

 

Rather, passive QE programmes - liquidity programmes whose size was largely determined by the needs of financial institutions - have become smaller in size as markets have started to function again and provide financial institutions with better terms (see "Fed Exit Strategy: When and How", The Global Monetary Analyst, June 24, 2009, and "QExit", The Global Monetary Analyst, May 20, 2009). Thus, far from indicating some tightening by central banks, we believe that any contraction in the balance sheet due to lower demand for liquidity assistance from central banks actually means that monetary easing will be better delivered to the wider economy, since healthier financial markets mean a more robust transmission mechanism for monetary policy.

At the height of the financial crisis, financial institutions used liquidity lifelines extended by central banks extensively. They preferred, though, to park the funds with central banks in the form of reserves, given the extreme uncertainty not just regarding the economy but also about their own financial health. Conditions are quite different now. Surveys of lending standards suggest that commercial banks are becoming less reluctant to lend. This implies that a larger proportion of funds at the disposal of these banks could find its way into the economy rather than languishing on the books of central banks. This would effectively reduce bank reserves and the size of the central bank's balance sheet and lead to an increase in M1. Again, a contraction in the balance sheet of central banks driven by this trend would be a salubrious development rather than a sign of monetary tightening.

So what would monetary tightening look like? Monetary tightening could take any or all of the following forms: (i) allowing lending rates to drift higher, or encouraging such a move with hawkish talk; (ii) stalling an expansion in money supply; (iii) contraction of the central bank's balance sheet, driven by the unwind of ‘active' QE programmes; and (iv) policy rate hikes.

It could be argued that the first form of monetary tightening is already underway, with markets pricing in a sustained series of policy rate hikes by central banks starting early next year. However, the market-implied path for policy rates has not (yet) led to a rise in lending rates charged by commercial banks. Interbank borrowing rates as well as interest rates that banks in the US, euro area and the UK charge households and corporates have continued to fall, and even mortgage rates in the US have backed off from their recent highs in June. This could change, though, if central banks are slow or reluctant to reiterate their commitment to lower rates for longer. Our global economics team expects that policy rates will be hiked later than markets anticipate (with the notable exception of the UK), and by less than is currently priced in.

Money supply growth has been consistent and strong in the US and the euro area, with M1 growing by 17% and 10%, respectively. Since QE started in September 2008, US M1 has increased by over US$250 billion. Given the amount of assets yet to be purchased by the major central banks, stalling money supply growth seems unlikely and certainly not the objective of policymakers at this point in time. Indeed, to bring money supply back down to pre-QE levels, monetary authorities would have to soak up liquidity by selling a significant chunk of assets into the market and/or raising policy rates above neutral. Both seem quite a long way away.

Our view on policy rate hikes and unwinding ‘active' QE has not changed (see "QExit", The Global Monetary Analyst, May 20, 2009). Central banks will likely ideally prefer a parallel shift of the yield curve when they start their tightening campaign, aiming for a judicious mix of rate hikes and asset sales to soak up excess liquidity. The lack of experience in dealing with unconventional policy measures and the prospect of slow economic recovery over the medium term will probably put some sand in the wheels of the tightening cycle (see "V Shapes", The Global Monetary Analyst, August 5, 2009).

In summary, only the first measure of monetary tightening shows any risk at the moment. Convincing guidance from central banks about their plans for unwinding policy easing will likely deflate this risk. On all other measures, monetary tightening is likely to be weaker than markets currently anticipate. Having worked so hard to engineer a recovery, it is difficult to see why central banks would aggressively tighten policy, risking a strong adverse reaction from markets and putting the fragile medium-term outlook in jeopardy.

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