John C. Williams, Director of Research for the Federal Reserve Bank of San Francisco, made a presentation to community leaders in Portland on July 28, 2010. As we go through some of his remarks, keep in mind Mr. Williams is the “numbers guy” for the Fed on the West Coast. He probably understands the current data as well as anyone.
Recent economic data have been disappointing and there’s no denying that the economy has hit a bit of a rough patch. Still, I believe that the recovery that has been in train for about a year is still on course, albeit at a more subdued pace. We economists keep a list of words we use to describe economic growth. It’s very carefully calibrated from “torrid” at one end to “freefall” at the other. The silver lining is that we’re still better than “meager” and “anemic.” And, thankfully, we are still several notches above “double dip recession.”
The key terms above are “several notches”. He didn’t say “hanging by a thread”. He didn’t say “one notch above”, he choose to say “several notches above a double dip recession”. If you examine the current data in hand, the odds of a double-dip remain relatively low, with 30% being the high side of most forecasts. Recent consumer confidence numbers and the past few months of action in the financial markets don’t seem to match the economic data. We agree with Mr. Williams’ remarks below in that we are experiencing a lack of confidence or something more akin to a lack of trust.
Households, businesses, and investors have endured painful economic and financial trauma over the past few years. It will take considerable time for confidence and trust to heal. We know from past experience here and around the world that recoveries from financial crises take a lot longer than recoveries from “usual” recessions. Indeed, businesspeople and consumers today are extraordinarily cautious and averse to all kinds of perceived risks, whether from the economy, financial markets, or government policies. This caution is manifesting itself in a reluctance to invest or hire unless absolutely necessary.
The mood of the market and consumer continues to be somewhat skeptical at best. Ultimately, the decisions of human beings, and not mathematical models, drive the economy. Therefore, lack of confidence and lack of trust is something we need to continue to monitor.
Although discouraging, the recent softness in the economic data looks much more like a bump in the road of what we already thought would be a gradual recovery, rather than a swerve into the ditch. Importantly, monetary policy remains highly supportive of recovery. Interest rates are extraordinarily low. And we’ve seen a marked improvement in the willingness of investors to take on reasonable risks, as measured by interest rate spreads between corporate securities and safe Treasury securities, as well as other metrics. At the same time, even though the bank loan market hasn’t fully recovered, banks are somewhat more willing to extend credit.
Our view remains bullish into year-end based on the following:
- The economic recovery appears to be on a sustainable path.
- Technical deteriroation is not out of line with past bull markets.
- Interest rates are very supportive of asset prices and economic growth.
- Sentiment data, a contrary indicator, does not align well with past bear markets.
With a global economy still saddled with high levels of debt, the argument for deflation has some very valid points. In his remarks below, Mr. Williams refers to the risk of deflation as “small”. This is similar to the “several notches” comment above; his choice of words is important.
There is a small risk of deflation, especially if it takes longer for the economy to recover than I expect. But I view a sustained period of deflation as unlikely for a couple of reasons. First, price trends aren’t nearly as sensitive to the state of the economy as they used to be. For example, core inflation, which strips out volatile food and energy prices, was running at about an annual rate of 2.6 percent at the onset of the recession, higher than the rate of about 2 percent that most members of the Fed’s policymaking committee have said is appropriate. That inflation rate has dipped to 1.3 percent today, two-and-a-half years into arguably the worst recession since the Great Depression. In other words, despite such an awful downturn, we’re now only about as far below the desired rate as we were above it before the recession started.
Given the data in hand and with asset markets at present levels, we also believe the odds of deflation remain relatively low. However, if asset prices begin to tumble again, the risks to balance sheets will increase, along with the risk of deflation. We firmly believe the Fed will take additional, and possibly significant, action should the S&P 500 again trade between 945 and 1,010, since further balance sheet deterioration is not acceptable in their eyes. The Fed, and possible policy announcements, will make managing portfolios difficult should we revisit the July lows. Below 1,010 on the S&P 500, the odds of the Fed making a game-changing announcement would increase with every tick down in asset prices (see Fed Signals Money Printing As Possible Next Step for more). Regardless of how effective any move by the Fed would be in the longer-term, there is no question they can significantly influence asset prices, especially commodities and stocks, in the short-to-intermediate-term.