Thursday, July 19, 2012

Fear of Recession / Deflation Will Compel Fed Into QE3

The bleak economic news continues to emerge on a weekly basis. The U.S. and global economies are slowing and the numbers behind it are troubling.

U.S. retail sales fell 0.5% in June, the third straight monthly decline. Consumers cut spending on most goods and services, reflecting a sharp slowdown in economic growth in the second quarter.

The last time the U.S. experienced three straight monthly drops in retail spending was in the second half of 2008, midway through the Great Recession.

As a result of the pullback in spending, the U.S. grew at a 1.5% pace in the second quarter. That’s down from 2% in the first quarter and 4.1% in the last three months of 2012.

It is clear that American consumers do not have the capacity to spend the U.S. into recovery. Consumer spending accounts for about 70% of the economy. Without stronger retail sales, the U.S. economy cannot expand fast enough to lower the unemployment rate. Yet, absent more jobs, such spending cannot occur. We're stuck in a vicious cycle.

The Labor Department reported the U.S. economy created 80,000 jobs in June, less than many economists expected. Hiring slowed sharply in the second quarter, with job growth averaging 75,000 a month versus 226,000 in the first quarter.

In another signal of a slowing U.S. economy, the services sector grew at its slowest pace since January 2010. The Institute for Supply Management said its services index dropped to a reading of 52.1% in June from 53.7% in May. Though readings above 50% indicate expansion, that margin is now getting uncomfortably slim.

Yet, the ISM services index was not as worrisome as the ISM manufacturing index, which in June dropped into contraction territory for the first time in three years. This trend, along with declining retail sales, may be the most worrisome of all.

Bill Gross, co-founder of PIMCO, Tweeted on Monday that the U.S. economy is "approaching recession when measured by employment, retail sales, investment, and corporate profits."

Gross told Bloomberg last week that he thinks the U.S. economy will grow an average of 1.5 percent per year, on average, over the next decade. That would be really bad for the U.S., which needs economic growth of at least 2.5% annually just to keep up with the growing labor force.

Nouriel Roubini, the famed economics professor at NYU, Tweeted this week that the U.S. economy is "at stall speed" and that it could grow at an annualized rate of "well below 1 percent" between July and September.

All of this troubling news has gotten the attention of policy-makers, who seem to have similar concerns.

Speaking to Congress on Tuesday, Fed Chairman Ben Bernanke stressed that the central bank was prepared to take further action to try to give the struggling economy a jolt.

That has many economists wondering if the Fed will embark on another round of quantitative easing as soon as the next Federal Open Market Committee meeting. The FMOC meets again on July 31-August 1. Others believe the Fed will wait to launch more easing at the September 12-13 meeting.

The Fed has expanded its balance sheet by nearly $3 trillion buying Treasurys and housing-related assets to try to lower long-term interest rates and spur the economy.

The Fed pushed short term rates down to a range between 0% and 0.25% in December 2008 and has kept them there ever since. The central bank has even pledged to keep rates extraordinarily low until late 2014.

Those unprecedented efforts have led many of us to ask, what more can the Fed do?

Besides buying more bonds, the Fed also could change the forward guidance on how long rates will remain close to zero, Bernanke said.

Will the Fed Chairman promise to keep rates historically low through 2015? Despite rates that are already phenomenally low, the Fed hasn't been able to compel Americans to borrow en masse.

The Fed also could lower the interest rate on the reserves that banks keep parked at the central bank. The idea would be to compel banks to put that money back into the economy, instead of leaving it to sit idle at the Fed.

Whenever the Fed ultimately elects to engage in even further quantitative easing, it will be creating hundreds of billions of additional digital dollars with computer key strokes. This will be yet more money backed by nothing, created out of thin air, without regard to the amount of goods and services in the economy. This sort of money/currency inflation, as history shows, usually leads to price inflation.

However, the greater concern for policy-makers — for the moment, at least — is deflation.

The global economy has been slowing for months. Europe is already in recession and the fear is that the U.S. could soon follow. Recessions are, by definition, deflationary.

In a deflationary environment, prices fall and money becomes more valuable. People hang onto their cash waiting for prices to fall even further before making major purchases. That creates a sort of economic death spiral.

It is for this reason that, as soon as the Fed smells an oncoming U.S. recession, it will most assuredly fire up the printing presses once again, flooding the economy with even more money — on top of the $3 trillion already pumped into the system. It has no other choice. Such action is the last, best weapon in its dwindling arsenal.

Since much of this money will invariably find its way into the equities markets, Wall St. must be salivating right now, just thinking about that prospect.

As I've said repeatedly, the problem is that despite all of the extraordinary and historic interventions already undertaken, the Fed hasn't been able to prevent a looming double-dip recession.

The sense of powerlessness to halt an oncoming economic storm has got to be alarming to Fed policy-makers. And it reinforces the reality that there are limits to their powers. Some things can't be controlled.

It appears that the Fed is finally out of bullets, and out of ideas, in its war against economic forces that are clearly beyond its reach.

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