A Shot of Espresso: Rousing a Sluggish Economy

All things need to be re-energized from time to time. A flashlight, for example, may need new batteries to brighten its glow. Long hours at the office often require a second cup of morning coffee (and sometimes a mid-afternoon cup, as well). Even the U.S. economy can’t escape feeling lethargic. After the 5% growth in the fourth quarter of 2009, there has been a steady decline in the U.S. gross domestic product (GDP). Because of this deceleration, the Federal Reserve (Fed) needs to step up to the challenge and provide the economy a “shot of espresso” to help propel it through the soft patch and return to acceleration.

Background

The Fed is trying to avoid Japan’s “lost decade,” which was characterized by deflation and no economic growth. This notion was once brushed off by many economists, but is now gaining more traction. There is still the belief that a double-dip recession is unlikely; however, little or no economic growth is a distinct possibility. There are many reasons why: The unemployment rate remains at unhealthy levels; consumption is wavering; and the government’s initiatives and policies (many of which can be looked at as potentially restrictive to economic growth) are creating uncertainty among investors and consumers alike. Fed Chairman Bernanke echoed this sentiment best during his testimony to Congress, describing the U.S. economy as “unusually uncertain.”

Although it was once front and center, quantitative easing (which helped rescue the economy from the financial meltdown during 2008 and 2009) had started to move to the back seat of many discussions since its official conclusion on March 31, 2010. Chairman Bernanke’s recent actions have led the market to believe that quantitative easing is not a thing of the past, and that it may be rekindled in some fashion. Newly ignited deflation discussions led by St. Louis Fed President James Bullard helped support the view that the Federal Open Market Committee (FOMC) will embark on another round of quantitative easing.

Baby Steps

The FOMC had a lot to talk about leading up to its August 10 meeting. Current levels of yield within the Treasury market are contributing to concerns about the recovery. The two-year remains at an abnormally low yield of 50 basis points, the five-year is staying around 1.40% and 10-year is well below 3% (currently at 2.6%). Investors expected the Committee to further discuss any and all measures it would take to stimulate the wavering economy. Although divided by its members’ opinions, the FOMC didn’t disappoint the market. The Committee’s decision to reinvest principal payments from its balance sheet assets within the Treasury market was viewed by many market participants as a baby step toward another round of quantitative easing. This action by the Fed may mean that the economy is in worse shape than previously thought—a new problem for the Committee to address. Another issue this creates is the potential for the loss of the Fed’s credibility.

The Committee’s decision, though, should come as no surprise, as Chairman Bernanke has commented before that the Fed could purchase long bonds, and even corporate debt. From the perspective of the economy and consumer, it would create a larger monetary base in the banking system to help promote lending and lower borrowing costs. In this way, quantitative easing would be a much-needed shot of espresso to the stalling economy. Inflation, which was once thought to be the next headache for the Fed, has recently fallen by the wayside due to deflationary concerns.

Keep in mind that some types of quantitative easing do not directly stimulate the economy. For example, if the Fed purchased Treasuries, it would lower interest rates. However, rates are already at abnormally low levels. The Fed’s purchases would also increase liquidity within the markets. This sounds promising—except for the fact that the markets are already extremely liquid. Consumers need to feel comfortable with prospects for employment and the economy in order to borrow from financial institutions. It doesn’t matter how enticing rates are; if the unemployment rate remains elevated, consumers are unlikely to borrow. Another step in the stimulus plan could be placing a mandatory requirement on the number of loans financial institutions are required to make. In other words, banks would be forced to lend.

Troubled Times Ahead?

There are a number of factors that point to the possibility of troubled times ahead. Sentiment within the small-business community is one such indicator, as shown in Exhibit 1. Confidence within this sector, as measured by the National Federation of Independent Business (NFIB) Index of Small Business Optimism, recently fell to its lowest level in four months, driven by significantly lower expectations for healthier business conditions six months from now. This is alarming because small-business sentiment is a key contributor for future economic growth. Still, it is understandable why small businesses are reluctant to hire, as uncertainties continue to loom around the potential for tax increases, additional healthcare costs and the overall economic outlook.

Exhibit 1: NFIB Index of Small Business Optimism

Another measure of economic health is the velocity of money, or the rate in which money is spent over a period of time. The money supply can be used to assess and forecast the health of economic conditions, where an increase in the money supply tends to help lower interest rates and encourage economic growth. However, if the economy overheats, there is an increased chance for inflation, something that isn’t a current worry for the U.S. economy. On the other hand, a drop in money supply normally means problems. Currently, the M2 measure of the money supply has moved below its average, signifying what some may believe are unhealthy levels. Exhibit 2 shows the relationship between M2 and GDP, where M2 is a leading indicator for GDP. If we don’t see a pickup in M2, we may experience falling GDP as we saw in early 2008. The question at hand is whether we are witnessing another version of the shrinking money supply situation we saw in 2003 and 2008, which was followed by shrinking GDP, or, more concerning, whether we will see a more severe scenario similar to what occurred in the 1930s.

Exhibit 2: M2 Money Supply vs. GDP, 2000 – Present

Source: St. Louis Federal Reserve

Cautionary Signs

 Even as the yield curve remains steep (a signal that historically points to recovery), signs of a stalling economy continue to emerge. The unemployment rate remains at 9.5%, retail sales are slowing and manufacturing activity is decelerating as well. It is fair to say that the consensus view is that economic growth has stalled. As a result, riskier assets are being repriced and the Treasury market has continued to rally. There is no doubt that rhetoric from the last FOMC statement carried a more negative tone, which contributed significantly to the view of stalled economic growth. Whether or not the Committee’s statement and member comments exacerbated the situation, a solid plan needs to be constructed for economic stimulus. More importantly, the Committee needs to articulate the plan with conviction in order to instill confidence in investors, consumers and the market. The decelerating economy is now moving to a new phase, as the Fed has done almost all it can through the use of monetary policy. The next phase must come from the current administration in the form of fiscal policy. Tax cuts are one form of stimulating a sluggish economy. Another option would be increasing government spending, although it would have adverse effects on the already ballooning deficit. Both of these topics will likely create numerous debates as we enter midterm elections, but we should have a clearer picture on these topics in the coming months. What this means for the markets is yet to be determined; we will need to see whether a single shot of espresso will wake the economy, or if a double shot of espresso is needed.

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This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

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