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Of Rocks and Hard Places


One of the more fascinating aspects of the current cyclical recovery we are experiencing has been the qualitative differences between it and every other profits recovery in the modern era. We and others have offered a litany of data points that speak to this point, among them these two gems:

(1) Employment at this stage of the typical recovery would have added 7 million jobs; this one has added 300,000 net, all of them in healthcare, temporary services, and education.

(2) The official 2001 recession end (12/01) marks the first time ever that the US economy bottomed before the stock market (10/10/02) did.

We highlight these two to make a larger point about the conundrum that the Fed has gotten themselves into in their attempts to manage away the bad parts of economic cycles; namely, the downturns. And that conundrum is this:

Given the prevailing level of consumer debt (mortgage and non-mortgage), and the low growth rate in personal income (via wages, salaries and hours worked), the Fed is fully aware that asset prices - housing and equity markets - must not, under any circumstances, be allowed to fall.

The reason for this is straightforward: since organic wage and salary income are growing too slow to sustain consumer spending at appropriately stimulative levels, the Fed realizes that they need to stimulate the wealth effect among consumers. So they target asset prices (rising home prices and stock prices as a function of increased liquidity) since they cannot make businesses hire workers or pay them more. In this way, the disposable income that would normally come from jobs, rising wages, and more hours worked, is coming from rising house and equity prices. So instead of the boss giving you a pay raise, in this economic recovery the Fed is giving you a 50% increase in the Nasdaq composite index and a 5%-25% increase in your home price since their stimulative policies began. And they are praying that you either spend the stock gains or borrow against your home's increased value to generate some disposable income.

By and large, the policy has worked: despite lackluster job growth, despite stagnant wage and salary income, consumer spending has plowed forward. And because consumer spending is 70% of the economy, we've seen a nice profits recovery.

Thus, targeting assets price increases is the Fed's stratagem, and the reason they cannot let them fall in any meaningful way is because any decrease in dollar-denominated asset prices (1) makes debt to net worth and debt service ratios soar for the average US household and (2) endangers the positive trend (now 47 quarters old and a record) in consumer spending. Since the transition to a corporate-lead spending recovery is just starting and could take quite some time to play out (see capacity utilization and employment trends as examples of why it could take some time to do so), consumer spending needs to remains robust.

So the Fed needs to continue to pump liquidity into the system, keeping asset prices buoyant and the wealth effect alive and well. But the Fed's stratagem of pumping liquidity into the economy to keep asset prices afloat in order to keep consumer spending growing creates three problems:

(1) it creates an environment where capital is much "cheaper" than labor, skewing the relative attractiveness of capital equipment additions over additional employees,
(2) it generates ever greater trade and current account imbalances which in turn decreases the purchasing power of the US dollar and increases the costs of imported goods for US households, and
(3) it increases the risk of foreign capital flight and inflation, both of which could increase interest rates meaningfully cause a perhaps substantial decline in consumer spending, choking off the recovery

That this liquidity disrupted the normal correlation between the stock market and the economic cycle (removing "fundamentals" as a primary factor in determining asset prices) is the causa proxima of the second qualitative difference I mentioned above: consumers, flush with cash from refis and taking on some low interest rate debt to power spending, turned the economy before stocks reflected it.

So the Fed is caught in a bit of a catch-22: in order to keep the cyclical recovery on track, they must keep liquidity high in order to keep consumer spending growing. But to do so risks creating macroeconomic circumstances that could themselves slow consumer spending and thus undermine the recovery. Like I said, there's your rock and there's your hard place.

But all monetary and fiscal policies have costs, have a downside; none are uniformly good for all economic actors. To think otherwise is a triumph of hope over reality. And targeting asset prices rather than the economy has its costs. [I have always wanted a reporter to ask Greenspan et al this question: "What are the costs of the Fed's current policy stance?" The Fed's rather proselytizing in the first few weeks of 2004 has wholly been focused on the benefits of low rates. But what of the costs? Are there none? What say you Gov Bernanke?] Of the three that I listed above, the first is the most important.

One of the reasons employers have been more willing to buy capital equipment than hire workers is that the Fed's easy money policy and the administration's capex depreciation tax credit increase the cost of labor versus capital. These policies have created an environment where capital is more (in fact much more) productive than labor, so CEOs buy PCs and networking equipment rather than add employees. A Dell computer doesn't need a 401K plan, health insurance, or days off. You and I do. But a self-sustaining recovery depends on employment growth and wage and salary increases. After all, you can't buy that new SUV, home, or even a new Dell PC without having a job and a salary to pay for it or service the debt necessary to buy it on credit.

And that is the fulcrum of the economic debate currently taking place: employment. And it so happens it also highlights the very real corner the Fed has painted themselves into. They can't stop reflating or else the economic recovery risks being aborted. And they can't keep reflating or else the economic recovery risks being aborted. 2004 should be helpful in getting some clarity about this trend. No wonder Greenspan is considering retirement.
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