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Why the US Economy Is in a Tricky Spot


QE2 is winding down at a time when it seems unclear whether organic monetary forces will pick up the slack left by the Fed. Some signs are promising. Others raise concerns.

As explained in The End of QE2: Does It Matter? the US economic recovery will be negatively impacted unless private sector economic activity and concomitant credit growth accelerates as Fed asset purchases are wound down.

Unfortunately, data released in the past few days, including manufacturing PMIs (NY and Philly Fed), small business sentiment (NFIB) and some other sources have suggested a waning of economic momentum during April of 2011.

The upshot is that the US economic recovery is in a tricky spot, and the situation will need to be monitored continuously for the next few weeks.

The Timing and Sources of the Current Ebb

April data reflect a lag with respect to present conditions as the data reported for any given month generally reflect conditions during the early part of that month and the month prior. For example, even though this is not the way it is supposed to work, purchasing managers' surveys taken during mid to late April will tend to reflect managers' subjective assessment of what has been going on for the prior few weeks stretching back to the last survey period in mid to late March.

In my view, the rather sharp slowing of economic momentum in April is due to two main factors. First, remarkably unseasonal weather has unquestionably affected retail and business spending. Second, the psychological impact of external crises in MENA (Middle East and North Africa), Europe and Japan peaked from late March to early April, thereby depressing consumer and business sentiment.

Concurrent indicators for the month of May give credence to the notion that the April lull may have been due to transitory factors. First, after rising abruptly in April, probably due to bad weather, weekly initial unemployment claims have started to trend sharply lower, even though weather conditions have only partially normalized. Furthermore, consumer sentiment data are rebounding in May after an April swoon. This can most plausibly be explained by the heightened attention drawn by the media toward fresh crises in MENA, Europe and Japan in April versus the relative media relegation of these issues to the "back pages" in May.

Is It Really All About Psychology?

Quantifiable structural factors seem accommodative to a pick-up in aggregate demand. I believe an actual acceleration of economic activity hinges on improving consumer and business psychology. The financial wherewithal to spend on the part of consumers and businesses seems to be there; it is the willingness of consumers and businesses to "pull the trigger" on spending decisions that seems in question.

Regarding the consumer, deferred decisions on purchases of homes, autos and other consumer durables means that there is substantial pent-up demand. At the same time, financial conditions seem to be in place for consumers to pick up the rate of spending. Home affordability measured by the median mortgage payment as a percent of median disposable income is as favorable as it has been since the early 1970s. Deleveraging in the consumer sector has been impressive with debt service as a percent of disposable income having plunged to levels that are below average for the past few decades. In short, consumers are able to spend, on aggregate. Whether they do or not is a matter of psychology.

Similarly, businesses have rarely been so enabled to spend. Cash levels at businesses are at all-time record levels. Profitability is at record highs. Interest rates are low. Credit availability, while not at giddy levels, does not appear to be an obstacle to growth, according to business surveys. The issue is confidence and the propensity of businesses to spend and invest. Again, this is largely a matter of psychology.

Monitoring Money and Credit

As I have explained in various articles, I believe that in the current context, weekly financial sector statistics such as credit growth, M2 and excess bank reserves can serve as important concurrent indicators of aggregate demand. Looking at aggregate demand through this lens, the outlook seems ambiguous.

On the one hand, the repair of consumer credit portfolios has been spectacular. Furthermore, ongoing default rates on consumer credit have been improving in a very impressive way. On the other hand, despite some promising growth in a few key areas, overall consumer credit growth can only be said to be stabilizing; it is not yet growing.

Industrial and commercial credit seems to be picking up, and this is promising. However, real estate lending is still contracting.

Overall, credit statistics reflect the fact that the economy seems to be poised on a sort of knife's edge. Private sector credit seems to have stabilized. However, the kind of moderate growth dynamic that is needed has not yet been ignited.

A statistic that concerns me is that excess reserves at banks, which were already at historically unprecedented highs, have been skyrocketing in recent weeks and months. This "hogging up" of QE2-provided liquidity by the banks has largely neutralized the stimulative effect of the Fed's program. In my view, it is worrisome that banks have not been able to find better things to do with their huge stash of cash than to deposit it at the Fed at a 0.25% interest rate. It suggests either that banks have been reluctant to lend, or that credit-worthy customers and businesses have been reluctant to borrow – or both.

If credit does not start expanding organically as the Fed winds down QE2, overall liquidity could contract and private sector credit spreads could widen. This would tend to throw cold water on the economic recovery.


The US economy is in a tricky spot. The situation seems similar, in some ways, to that of an injured patient that is currently using crutches to walk. If the patient heals quickly, at some point the crutches become an impediment to the patient's mobility and health. However, if the patient heals slowly and the crutches are taken away too soon, the patient's mobility will suffer and his ultimate recover could be jeopardized.

QE2 is winding down at a time when it seems unclear whether organic monetary forces will pick up the slack left by the Fed. Some signs are promising. Others raise concerns.

Notwithstanding the recent softness in the economic data, my base case is that US consumers and businesses are ready to start spending at a stronger pace. Indeed, it is my view that a positive turn around could unfold just as quickly as the recent worsening that was reflected in the data for April. Weather patterns, which have restrained consumer and business spending, should normalize after June. Furthermore, the atmosphere of crisis related to foreign events has receded palpably. Therefore the drag on business and consumer sentiment related to these external shocks should cease to be a drag on the economy going forward, and the improvement in sentiment should provide a boost.

It is important to keep an open mind. It is even more important to monitor the appropriate data. In addition to the monthly activity data reflected in PMI surveys and various government releases, I believe investors should carefully monitor weekly data on such indicators as credit, M2 and excess reserves for important clues regarding the evolution of aggregate demand. Sentiment indicators such as the University of Michigan survey, as well as market gauges of sentiment such as credit spreads, should also be monitored closely.
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