Tuesday, July 1, 2014

Manufacturing still healthy, but problems still remain

The June ISM manufacturing report came in as expected, and it is one more reason to ignore the -2.9% annualized contraction of the economy in the first quarter of this year. Growth will almost certainly rebound in the current quarter. There is no sign whatsoever in the manufacturing sector of an imminent or emerging recession. Period.

This is not an excuse for what remains an unimpressive period of economic growth. The economy could be doing a lot better if fiscal policies were more growth-friendly. Instead, we have an economy that is heavily burdened by high marginal tax rates (especially the corporate sector), and egregious regulatory burdens (e.g., Obamacare, Dodd-Frank). The after-tax rewards to new investment are barely enough to offset the uncertainties that arise from a lack of U.S. leadership in world affairs, and from monetary policy that remains highly accommodative despite five years of an economic expansion which shows no sign of faltering.

The chart above shows two key, market-based measures of the Fed's monetary policy stance: the real Fed funds rate, and the slope of the Treasury yield curve. Note that every recession on this chart was preceded by a significant rise in real short-term interest rates (the blue line) and a yield curve that was flat or negatively sloped (the red line). Tight money, in other words, was the proximate cause of previous recessions. The Fed tightens monetary policy by raising real interest rates, and the bond market confirms that policy is very tight when long-term yields are equal to or less than short-term rates. What this tells us today is that monetary policy policy is just about the exact opposite of tight. Real short-term interest rates haven't been this low for so long at any time in modern history, and the yield curve, while not extremely steep, is quite steep by historical standards and has been for over 5 years.

Despite trying its best to help the economy, the Fed is nevertheless powerless to create growth; we've had over five years of super-easy monetary policy and yet growth has been unimpressive and the economy is operating far below its potential. Here's a better way to characterize what the Fed has been doing: they've been doing all they can to avoid placing obstacles in the economy's path. That's fine, and it has been quite helpful to the extent that if they hadn't engaged in massive QE, the world would have suffered from a severe shortage of much-needed safe assets during and following a period of great uncertainty, deleveraging, and risk aversion. But it's not sufficient to generate stronger growth. For that we need the help of fiscal policy. Only the private sector can create meaningful growth if given the proper incentives. We've simply got to increase the after-tax rewards to work and investing, and we've got to reduce the regulatory burdens that have been placed on new, growing, and existing businesses.

And a little more leadership in world affairs sure wouldn't hurt.

I remain hopeful that the November elections will lay the groundwork for favorable changes in policies in the years to come.

Argentina, Venezuela, and the U.S. are the canaries in the government coal mine that are telling us what happens when government forcibly redistributes incomes and when government over-reach suffocates private sector initiative. Fortunately, the political pendulum in the Americas and in Europe is already swinging in a more growth-favorable direction. It started with the November 2010 elections in the U.S., and it is gaining momentum with the ongoing collapse of the Venezuelan economy and the inability of the Argentine government to service its debt obligations. The expansion of the Eurozone received some much-needed pushback in recent elections, and the U.K. and France have seen the negative results of trying to push marginal tax rates to unreasonably high levels. In the U.S., the utter failure of massive fiscal stimulus and the unravelling of the attempt to reorganize the entire healthcare sector of the economy were the beginnings of the end of the leftward-swing in the political pendulum. But the swing to more private-sector and growth-friendly policies won't be obvious for a few more years. When it does become obvious, equity markets all over the world are going to be much higher.

With so much going wrong in the world, it pays to remain optimistic. Things can change for the better, and important changes on the margin are already underway.


Anonymous said...

Then there is this, "Similarly, there is scant appreciation of the limitations of an expansionary fiscal policy during a balance sheet recession; indeed, the prevailing view is that fiscal policy is more effective under such conditions."

Which of course Benjamin Cohen advocates strong reforms also.

More, "The first is to recognise that the only way to sustainably strengthen growth is to work on structural reforms that raise productivity and build the economy's resilience."

Take that you %&**(_* Keynesians.

Benjamin Cole said...

Joseph Constable:

Did I hear you call?

In fact, I agree with Scott Grannis and his excellent blog on most issues, and I always appreciate his posts. This is great stuff.

If I disagree sometimes, so what? I can talk to myself in an echo-chamber if I seek that. I like to read other points of view; I guess I am the only man in Internet-land like that.

Yes, I disagree with Scott Grannis on monetary policy.

If the Fed, or any central bank, "had over five years of super-easy monetary policy" then we would see a round of inflation.

Really? Really. The definition of easy money is that it first boosts real output, than a mix of real output and inflation, and then ultimately only inflation. We ain't even close.

Scott Grannis contends that our central bank has had an "easy" monetary policy that has resulted in the lowest rates of inflation in the postwar era, and even deflation in unit labor costs. For five years running.

That's like the anorexic who insists she eats too much, has only lost a pound this week.

The Fed is not "easy"--you have to judge monetary policy by the results.

BTW, this current fixation on inflation is newish.

We are not even halfway to the 4 percent rate of inflation we had in the 1980s, when Fed Chairman Paul Volcker declared victory on his fight on inflation. Volcker is regarded as the central bank's greatest inflation-fighter, btw.

Yes, I would like to see a more-aggressive, pro-growth Fed policy, and yes, I would rather have robust growth and endure a couple of percentage points higher inflation. When there is so much slack everywhere, I do believe mor demand will bring more supply.

Remember, the USA has global supply chains, and the world accepts and loves dollars. Tough to create inflation in that situation.

Japan is having success with a more-aggressive QE policy. I would like to see a more-aggressive QE policy here, and perhaps a reduction in the interest paid on excess reserves. It may be the IOER actually creates a "tight" monetary policy, and John Cochrane has hinted at that. I wonder what Scott Grannis thinks.

On fiscal policy, I would like a balanced federal budget, and I would cut the warfare-workfare outlays blob in half.

Of course, regulations have to be pro-growth. Tell that to the USDA. The ethanol lobby. The huge Pink Wonderland that is Rural America.

I advise every state get back roughly what is sends to DC. Why some states (always small states with two Senators) are always subsidized is awful--but part of the permanent rural socialist empire.

A truth you never will hear at a Tea Party gathering: Right now, the federal government would been in surplus, if it were not for the effective subsidies of rural states. The big urbanized states send more to DC than they get back.

Health care is mess, and Obamacare made it messier. I would rather go with single-payer than this fix. Other nations spend far less and get about the same results.

Dodd Frank? John Cochrane says we should go to 100 percent equity-backed banks, and no other regs. Maybe that is the cure. I note Canada has never had systemic major bank failures, so whatever they do might be worth copying. Dodd-Frank strikes me as Rube Goldberg operating on a dead patient.

BTW, Canada does not have home mortgage interest tax deductions.

Some cures are just not popular.

Remember, cut food stamps, but leave the VA "disability" system alone.

Deregulate, but keep ethanol.

Cut federal spending and cut the marginal tax rate on income and capital gains taxes, but increase the $1 trillion a year spent on the DoD, VA, DHS, and intelligence.

Wipe out Fannie and Freddie, but leave that home mortgage interest tax deduction right there!

Actually, I like Ron Paul. But you could probably tell that.

Anonymous said...

Wow, did the BIS ever justify Mr. Calafia Beach in its 84th Annual Report.