United States
US Economic and Interest Rate Forecast: Don't Fear the Double Dip
October 09, 2009

By Richard Berner & David Greenlaw | New York

Double-dip fears are returning as the ‘second-derivative' in the economy has turned negative, with incoming data calling into question both the strength and sustainability of the recovery.  That's consistent with our view that a hearty 3Q revival would give way to a wobbly 4Q.  But in our view this bumpy start to recovery neither presages a double dip nor serves as a harbinger of a ‘new normal' 2% growth path for the US economy.  Rather, we continue to think that a moderate, sustainable expansion will emerge, one that eventually stabilizes inflation, revives private credit demands, and lifts real bond yields.  Consequently, we're still comfortable with our view that the Fed will begin to renormalize interest rates in mid-2010. 

US: Forecasts at a Glance

%Y change	2009E	2010E	2011E
Real GDP	-2.5	2.7	2.8
Inflation (CPI)	-0.4	2.1	2.5
Core inflation (CPI)	1.6	1.4	2.0
Unit labor costs	-1.0	-0.7	1.1
After-tax ‘economic' profits	-11.9	12.2	8.8
After-tax ‘book' profits	-11.1	12.4	8.2

Source: Morgan Stanley Research estimates

The slowdown in incoming data is not surprising; indeed, we have been expecting a significant ‘payback' in 4Q output and demand growth as the summer surge in motor vehicle output slows, the ‘cash-for-clunkers' vehicle incentive expired, and the effects of the first-time homebuyer tax credit wind down (see Recovery Arrives - but Not a ‘V', September 8, 2009).  Moreover, it is common for production snapbacks in the early stages of recovery to promote temporary surges in output followed by temporary relapses. 

Disappointing data.  Despite our 4Q caution, incoming data have been disappointing relative to our expectations.  Existing home sales fell and new home sales flattened in August, while one-family housing starts retreated.  We expected weakness in non-residential construction and capital goods outlays, yet they have been weaker still.  Likewise, light vehicle sales have fallen slightly more than expected in September.  It appears that imports satisfied more demand than expected in the summer quarter, and we wouldn't be surprised to see some retracement in recently strong exports.  Payrolls and thus wage income were weaker than expected, limiting spending wherewithal for consumers.  September's decline of 263,000 jobs and a six-minute decline in the private work week pushed private pay down by 0.5% on the month.  As a result, we have marked down our 2H annualized growth estimates from 3% to 2.75%, with 3Q now estimated to be 3.5% and 4Q running at just 2%.  Weak labor markets underscore the near-term downside risks.

Four ingredients for sustainable growth.  But this slowdown does not change our view of 2010.  On the contrary, we believe that four ingredients for sustainable growth are even more evident than a month ago.  In brief, monetary policy won't exit prematurely, fostering market healing; fiscal thrust is poised to translate into fiscal impact; global demand continues to improve; and economic and financial excesses are abating.  On the last point, housing and inventory imbalances are diminishing, companies have slashed capacity, and employment is now running below sustainable levels.

Exit talk is just that.  Despite the discussion of exit strategies by Fed Vice-Chairman Kohn and Governor Warsh, officials are not about to change their extremely accommodative policy stance soon.  This gives us comfort that financial markets will have more time to heal before policy support dwindles, increasing the chances for sustainable recovery.  The Fed has made its intentions abundantly clear in post-FOMC meeting statements, in the minutes of FOMC meetings and in speeches by Fed officials.  At the September FOMC meeting it affirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period".  With inflation likely to stay below the Fed's preferred level for some time, and the growth outlook uncertain, the costs of moving too soon are probably higher than those of being somewhat late, so Fed officials would thus rather err on the side of accommodation.  In fact, continued asset purchases and the recently announced wind-down of the Treasury's Supplemental Financing Program (SFP) could significantly expand the Fed's balance sheet and excess reserves in coming months unless offsetting action is taken. 

However, the Fed also does not want to foster new asset bubbles or overstay its welcome and risk escalating inflation expectations.  So it is winding down liquidity facilities; some automatically become less attractive for participants to employ as markets heal, and the Fed is reining others in.  The Fed is ‘tapering' its large-scale asset purchase programs to avoid ‘cliff effects' while assuring their termination.  And it is emphasizing the eventual need for a pre-emptive exit from its current stance, noting that it has or will have all the tools it needs to do the job, while at the same time stressing that it is too early to execute such a strategy. 

The risk in such a balanced message is that the Fed confuses market participants.  In our view, that risk is small, provided that the Fed provides a continued flow of information about how it sees the outlook, and how it will test its operational capacity to drain reserves.  Such a test is coming this week as the open-market desk at the New York Fed is gearing up to conduct some ‘test' reverse RP operations. 

Lasting fiscal impact.  A second support for sustainable recovery comes from fiscal policy.  We have emphasized that there are significant lags between fiscal thrust and fiscal impact, with the latter providing ongoing support for growth, so worries that the effects of fiscal stimulus will soon peter out are overblown.  Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag.  But because we suspect that there are lags of anywhere from 3-9 months between thrust and impact, we believe that fiscal impact will remain positive well into 2011.  This is especially the case for infrastructure outlays, which at the state and local government level have yet to show any improvement in monthly data through August, although there is anecdotal evidence of a pick-up.  Meanwhile, we are slightly more concerned about the impact of another part of the fiscal drag story than last month.  Spending cuts and tax increases at the state and local level are offsetting federal stimulus.  Especially concerning is the loss of 160,000 state and local government jobs over the past four months - about one in eight jobs lost over that period - which is eroding confidence and spending wherewithal.  As we noted a month ago, however, such cutbacks always occur late in recessions as budget pressures trigger a pro-cyclical response.  Indeed, such job cuts were far more severe in the 1981-82 downturn, amounting to 400,000 jobs over an 18-month period at a time when those government payrolls were one-third smaller. 

Exiting excess.  Progress on reducing four areas of excess also increases the odds for sustainable recovery (see Exit from Excess: Setting the Stage for Sustainable Growth, September 14, 2009).  First, housing imbalances are shrinking.  Single-family homeowner vacancy rates declined from their peaks of 2.9% to 2.5% in 2Q, and further declines likely occurred last quarter; the inventory of unsold new homes dropped to 7.3 months' supply.  We do worry that rising foreclosures could increase housing imbalances and the pressure on home prices, given the ‘shadow inventory' of yet-to-be foreclosed homes, reckoned by some to be 5-7 million.  But the bust in housing starts has slowed the growth in the housing stock to less than 1% and, with demand improving, fundamental imbalances are dwindling.  Second, inventory liquidation likely peaked in 2Q, and a slower pace will add to growth.  Third, companies are reducing excess capacity at record rates: Capacity in manufacturing excluding high-tech and motor vehicles and parts industries has shrunk by 0.9% over the past year - a pace comparable to the post-tech bubble bust.  And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2.2% over the past year.  As a result, operating rates are rising again, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains.

Jobless recovery less likely.  Finally, we've argued that aggressive payroll cuts make a ‘jobless recovery' less likely.  Clearly, limited or no job gains would stifle recovery in spendable income and consumer outlays, further suppressing what we see as a moderate recovery.  But past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand.  A month ago, we measured the extent of hiring excess or shortfall by cumulating the errors made by a relatively standard relationship used to forecast labor hours worked (and, with a projection for the average workweek, employment).  If positive, the cumulative differences between actual hours and those predicted by the relationship suggest that there is an overhang of labor to work off.  Through 2Q09, the errors cumulate to zero, suggesting that the aggressive job cuts seen in this recession have eliminated any excess.  Declines over the past three months - of 638,000 private payrolls - likely pushed those cumulative errors sharply negative, especially if we are correct that output rose at a 3.5% annual rate.  Moreover, early estimates indicate that non-farm payrolls were 824,000 lower in the year ended in March 2009 than currently estimated.  This implies, if those revisions were all in private payrolls, that the current private job tally is lower than at the trough in the last recession in July 2003.  As we see it, far from suggesting an ongoing pace of job loss, this implies some underlying pent-up demand for labor that should materialize at some point down the road. 

Declining inflation should stabilize, critical for our Fed call.  Bond bulls argue that inflation is going to zero, reflecting massive slack in the economy.  We disagree.  Courtesy of that slack, measured by an output gap of roughly 7% of GDP, US inflation is now falling and will likely head towards 1%.  But operating rates are starting to rise, and housing imbalances are narrowing (which will stabilize rents).  It's worth noting that all of the deceleration in core CPI inflation that has occurred over the past few years has been attributable to a rapid moderation in the shelter category.  Specifically, since the start of 2007, the core CPI has slowed from +2.7% to +1.4% while the shelter category (which has a weight of 43%) has slowed from +4.3% to +0.9%.  Shelter costs will no doubt stay soft for a while longer, but further downside from here is probably limited.  This reinforces the notion that there is limited deflation risk and that core inflation could begin to drift up a bit in coming years - despite a still-sizeable output gap.  Moreover, thanks to a sliding dollar, we believe that import prices will also soon turn higher, stabilizing and eventually lifting inflation.  With a sustainable recovery well underway by mid-2010, we believe that the Fed will want to begin to normalize policy rates around that time. 

The case for higher real rates.  Bond bulls argue that real yields can go lower because credit demand is weak and will stay that way.  Admittedly, private credit demand is still falling, so the supply of alternative assets for investors to buy is low.  Correspondingly, however, we believe that real yields will rise when private credit demand revives.  This will occur when businesses' external financing needs - at a record-low minus 2.5% of GDP in 2Q - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace.  When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again.  Then the combination of reviving credit demand and still-high Treasury supply will push up real rates. 

Who will buy Treasuries?  However, many believe that rising household saving and bank buying will provide a significant boost to demand for Treasuries.  We disagree.  Recent flow of funds data hint at the likelihood of a supply/demand imbalance in the Treasury market over the course of coming quarters that will push up real rates.  In the four quarters ended 2Q09, net issuance by the Treasury amounted to about US$1.9 trillion.  Roughly 70% of these securities were purchased by foreigners and ‘households' (note: in the flow of funds accounts, the household category is a catch-all that includes all sectors for which the Fed does not have data - i.e., hedge funds, endowments, foundations, etc.).  We suspect that much of this buying in the ‘household' sector reflected a one-time asset reallocation to risk-free investments by endowments and foundations during the height of the financial crisis.  Also, there have no doubt been a lot of short-term trading bets in the Treasury market on the part of leveraged investors.  It's worth noting that the household sector has been a net seller of Treasuries over the longer run.  Thus, we suspect that household demand - which already showed signs of a dramatic pullback in 2Q - will slow quite a bit more in coming quarters.  Indeed, even if the personal saving rate were to rise dramatically - as some (but not us) believe likely - households are not going to be big buyers of Treasuries.  That is simply not a favored investment for either the typical household investor or for the other non-profit organizations that are lumped into the category.

Looking at the other investor categories, Fed buying reflects purchases under the large-scale asset purchase program (LSAP) that will expire in October.  Commercial banks are not typically big buyers of Treasuries, but loan demand has softened and some banks have boosted their securities holdings.  We suspect that loan demand will remain weak for a while longer and that banks will continue to load up on securities.  So, we have factored in a further jump in their Treasury purchases over the next few quarters.  However, we strongly disagree with the notion that the share of Treasuries on bank balance sheets will return to the levels seen in the 1980s and early 1990s.  Meanwhile, money market mutual funds bought a lot of T-bills when issuance of these securities skyrocketed in 2H09.  But we expect the Treasury to pay down a lot of bills going forward.  Moreover, money market conditions are healing and the MMMFs will be moving back into traditional assets such as commercial paper.  According to the flow of funds data, the only other big net buyer over the last year is the broker/dealer category.  However, we believe that this is largely a TSLF story (dealers took in Treasuries and gave the Fed mortgage collateral).  Dealers are not typically big net buyers of Treasuries and in our view won't be going forward because TSLF is winding down.

Making reasonable assumptions for the other miscellaneous classifications and assuming that foreign investors purchase the same amount of Treasuries over the next four quarters as the past four - an aggressive assumption, given the indications that foreign central banks are planning to diversify out of both dollars and Treasuries - this would still leave about a US$600 billion hole on the demand side.  Moreover, because the Treasury is shifting so much issuance out of bills and into longer-dated coupons, the duration of the Treasury supply will be rising rapidly in coming quarters.  All of this highlights the looming supply/demand imbalance that we believe will eventually contribute to a significant rise in real yields.

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Global
Up but Not Tight
October 09, 2009

By Spyros Andreopoulos, Joachim Fels & Manoj Pradhan | London

Up down under: So, the Reserve Bank of Australia (RBA) became the first G10 central bank to hike rates in this cycle on Tuesday, following the example set by the Bank of Israel (BoI) in late August, which serves to underscore our view that, slowly but surely, the global monetary policy cycle is turning (see "As the Policy Cycle Turns...", The Global Monetary Analyst, September 30, 2009).  But, interestingly, global markets didn't seem to attach much significance to this move, with risky assets continuing to rally.  In fact, our updated liquidity metrics suggest that global excess liquidity has continued to grow until recently and looks set to rise further in the foreseeable future, even though more central banks look set to join the BoI and the RBA over the next several months. Still, the RBA's move offers an interesting lesson that is worth keeping in mind when thinking about other central banks' prospective behaviour in the upcoming tightening cycle: strongly rising asset prices may induce central banks to start lifting rates early from record-low emergency levels even if growth is still below-trend and inflation below-target.

Excess liquidity still making new highs: We have updated our favourite metric of excess liquidity for the five-biggest industrialised economies and the four-largest EM economies to include 2Q09 data.  Unsurprisingly, with the growth rate of the monetary aggregate M1 (cash and sight deposits held by non-banks) outpacing nominal GDP growth, excess liquidity has risen to yet another record-high both in the G5 and in the BRICs.  As we have argued repeatedly, this has been the main driver behind the impressive rally in risky assets over the past six months, in our view.

As we see it, excess liquidity has probably continued to grow during 2H09, though likely at a slower pace than previously. M1 growth is likely to continue to surge for now, reflecting super-low short rates and a continuation of QE in the major countries. In fact, banks have been big buyers of government bonds until recently, which is one way how banks create deposits.  At the same time, some of this liquidity is likely to have been absorbed by the ongoing economic recovery, which should have led to a pick-up in nominal GDP growth.  Still, with rates in the major economies unchanged for some time to come and QE still ongoing, we see no early end in sight for the global liquidity bonanza.

Asset prices more important in the future: The RBA's move holds an interesting lesson that is worth keeping in mind when thinking about other central banks' prospective behaviour in the upcoming tightening cycle: strongly rising asset prices may induce central banks to start lifting rates early from record-low emergency levels even if growth is still below-trend and inflation below-target. The RBA expects growth to return to trend next year, and also remarks that "dwelling prices have risen appreciably over the past six months".

On the opposite corner of the globe, Norway's Norges Bank is even more articulate in its concern about house prices. In an important speech last week, Governor Gjedrem stated that "house prices in Norway have risen sharply and probably excessively". He then went on to note that the Norges Bank reaction function "already gives weight to asset price movements and credit growth", even if asset prices are not part of NB's objective function (which only includes output and inflation). We expect Norway's central bank to be the next one to hike (on October 28), and even see risks for a 50bp move.

Of course, Australia and Norway can afford to worry about asset prices at the moment since their economies have been the least affected (in the G10) by the global crisis. Still, we think that the emphasis the RBA and Norges Bank place on asset prices is important. In the past, smaller central banks have often pioneered significant institutional or operational changes in monetary policy. For example, New Zealand's RBNZ was the very first central bank to convert explicitly to inflation targeting, while the Bank of Canada is currently giving price level targeting a serious consideration. And Sweden's Riksbank has, in the past, justified policy rate increases by pointing to house prices even though consumer price inflation was expected to be on target.

Other central banks haven't voiced concerns about asset prices yet, but this could change soon. With the asset price channel having done most of the work so far, the interest rate and the credit channel should pick up the baton soon to restore a better balance between the different monetary transmission mechanisms (see "Between a Rock and a Hard Place", The Global Monetary Analyst, August 19, 2009). Sometime in the new year, if risky assets keep feasting on the liquidity glut, equity and house prices could come into focus as runaway asset price inflation creates a dilemma for central banks: hiking into a weak economy could stall or even reverse the recovery; but staying on hold for too long would risk inflating the next bubble. With the ‘mop up after the bubble bursts' orthodoxy having fallen victim to the crisis, at the very least the risk exists that central bankers will be forced to sound hawkish - even if not ‘leaning against the wind' outright.

It is also worth bearing in mind that the arrival of the first hikes, at this stage, simply means ‘less easy' rather than ‘tight'. We expect few central banks to rush back to neutral. Even out of the early hikers, our colleague Gerard Minack thinks that the RBA will increase rates only by another 25bp by the end of this year, and then pause for two quarters. For the major central banks, an orderly exit from their extraordinary policy measures will likely require even more caution (see "QExit", The Global Monetary Analyst, May 20, 2009).

Last point - watch the currencies: Both early hikers' currencies - the Australian dollar and the Norwegian krone - have rallied recently. Further strong appreciation may well reduce the appetite of other CBs to move early, at least for those who preside over export-oriented economies (e.g., Sweden's Riksbank or Canada's BoC). Yet another asset price to worry about!

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