Stephen Foley: Only the Federal Reserve can jump-start the recovery at this stage
Saturday 07 August 2010
US Outlook: Is the financial market tail wagging the economic dog?
The reaction to yesterday's poor US employment figures sent the Dow Jones Industrial Average down more than 130 points at its worst, and the equity market here has made basically no progress at all this year. In the credit markets, spreads have not returned to their narrowest levels before the freak-out over European sovereign debt in the spring.
This, despite the fact that the global economy and the US economy are each progressing along the recovery track that had been expected, at least so far, and demand from consumers and business customers has not taken a turn that would indicate anything like a double-dip recession.
The underperformance of the financial markets is becoming a problem. It has sapped the confidence of American business leaders and has a real impact on the cost of capital, both of which are holding back investment and job creation. After a strong start to 2010, private sector job growth is now running consistently below the roughly 100,000 per month level that economists say is needed to start bringing unemployment down.
Businesses are still making their employees work longer hours and average earnings are going up, so yesterday's numbers from the Labour Department show a more nuanced picture than the missed-expectations of the headline number.
But the reluctance to hire shows – more concretely than any survey, although most of those show the same thing – that uncertainty over the future is trumping relatively sanguine current conditions. As Tim Geithner, the US Treasury Secretary, likes to say, business leaders are still traumatised by the credit crisis. Hoarding cash and strengthening corporate balance sheets is also an economically rational move, given what we have learnt about how quickly access to capital can vanish, and businesses should not return to running a just-in-time financing model reliant on continual access to the money markets.
But we would be running out of patience with the "time heals everything" approach to the private sector recovery around now, even if financial markets weren't putting downward pressure on the economy.
Policymakers need to look at where to place the electrodes for some quick electric shock treatment for the private sector.
If only the federal government was functional. There could be some easy hits were the Obama administration and Congress able to introduce some business-friendly tax gesture. A change of tone in the White House would be helpful too, since the notion that it is somehow "anti-business" has seeped into the received wisdom.
But there are more vital matters that look likely to swamp these efforts. Reports in Washington last night were suggesting that House of Representatives Democrats might be going wobbly on the $26bn (£16bn) aid package to state and local governments, designed to keep local teachers, firefighters and policemen in their jobs.
If that measure failed, it really would introduce austerity to the US. The 50 states' budgetary problems were behind the shockingly high public sector lay-off figures in the July jobs report.
The partisan battles over fiscal measures are so intense here that there can be no consensus on the economic effectiveness of any particular plan, and that means they are pretty poor as the basis for a restoration of confidence.
Once again, we must look to the Federal Reserve. Since the electrodes are best placed as far away from the political arena as possible, and because the financial markets belie a lot of the caution being felt across corporate America, a lot hinges on next week's meeting of the Federal Open Market Committee. The absence of inflation in the US economy gives the Fed a great deal more room for manoeuvre than, say, the Bank of England. Ben Bernanke, the Fed's chairman, would be in no danger of having to write a letter explaining himself, even if he had acted on his urge to set a formal inflation target.
An extension of sorts of last year's quantitative easing is on the agenda. The Fed bought $1.1trn of mortgage-backed securities to push down mortgage rates and boost the housing market, and is considering changing its policy with regard to that portfolio.
The Fed has allowed the portfolio to shrink as the bonds get paid off, but is considering, instead, reinvesting the cash in more mortgage-backed securities, a move that will neutralise what is otherwise modestly contractionary monetary policy.
All the smoke signals were that change will be approved on Tuesday, precisely because it is a technical and uncontroversial-sounding plan. But it would seem to me to be a missed opportunity.
Boosting the housing market is not the priority right now. By shifting the money from mortgages into the purchase of US Treasuries, the Fed would ease conditions for businesses more generally, and signal that it sees Treasury-based quantitative easing as an insurance policy against a double-dip or deflationary economy.
Not for the first time, the US economy needs bold moves from the Fed, because politicians here seem unable to get their act together.
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