The Outlook: Part 2

Following up on my short post yesterday about the Federal Reserve Board’s outlook for the economy, today I received the Congressional Budget Office [‘CBO’] forecast which takes the form of a briefing to Congress. The story is pretty much the same. But there are small differences we ought to be aware of.

The CBO takes a dimmer view of the outlook for unemployment. The Fed predicts the unemployment rate topping out at between 9.5% and 9.75%. The CBO expects it to go beyond 10.0%. The news this morning that jobless claims moderated very slightly seems to indicate that the job situation is settling down a little. The key statistic to watch is not the week to week data because that can easily be distorted by a single and unrepresentative event: last week’s figures was much higher because it included a rash of Chrysler lay-offs. Instead we should pay attention to a moving average stretching back a month or two. This allows us to remove distortions like the one caused by Chrysler and thus get a better reading on trends. When we do this the ‘bottoming out’ effect is more noticeable. It is clear that job losses are still very high, but that there is no discernible worsening. There’s a hint of stabilization. And I mean only a hint.

Nevertheless given the continued high level of job losses, and the very high degree of difficulty workers are encountering as they try to find new jobs – which is also embedded in this morning’s data release because continuing, as opposed to new, claims for unemployment benefits are still at record highs – I expect the CBO prediction to be more accurate. Plus I have a feeling the Fed deliberately erred on the optimistic side when talking about the job outlook because it wanted to use unemployment in its bank stress tests, and as you know, I think they wanted to soften those test for political reasons.

So unemployment will be a very significant drag on the economy right through the next year or two.

Having said that the CBO still predicts that the recession will end later this year and that we will see very slow growth during the third and fourth quarters of 2009 followed by a slightly better outlook in 2010. Currently the CBO is predicting GDP to grow by about 2.9%, adjusted for inflation, next year. There are two ways of looking at that. One is that it is quite low given that ‘normal’ recoveries usually get off to a flying start and then settle down later. The second is that it is quite good given the huge hole we are climbing out of and the ongoing risks we still have to overcome. I am in the second school.

There are huge imbalances still to be reduced. Consumer debt reduction will cramp consumption and business investment still looks very weak. And exports simply will not be a factor. The collapse in world trade has hammered economies that rely on exports: Japan’s economy dropped like a stone in the first quarter this year – it fell at an annualized rate of 15.2% from January through March which is astonishing by any standard – so it is extraordinarily unlikely that the US economy will be lifted by trade. That leaves government spending as the lynchpin of growth for a while to come. The Federal Deficit is the essential fuel we need until consumption adjusts to the new less indebted world of the future.

The problem with that is the glut of US government bonds that are now out on the world markets. There are signs that our ability to fund the debt will run into difficulty if the rate of deficit spending is not curtailed soon. Already recent bond auctions – the Treasury sells its debt through an auction process – have been less than enthusiastically received and there are even rumblings that the US may lose its AAA bond rating later this year. For those who doubt this I point to the UK as exhibit ‘A’: their bond rating was lowered by Standard and Poor’s just today. Rumors of a US downgrade are picking up steam. While not a catastrophe a downgrade would signify a historic moment for the US economy and would not just raise the interest rates the government has to pay, but, because so much domestic US debt is priced at spreads from Treasuries, it would cause the entire nation’s interest rate structure to shift upwards also. Plus, historians may well look back on such a downgrade as the defining moment in America’s transition from world economic dominance to mere parity with China or the European Union.

Who would benefit from higher rates?

The banks.

The CBO report documents that the credit markets have climbed back from the edge of doom: the apocalyptic spreads we saw in the immediate aftermath of the Lehmann debacle have fallen away to being merely high. Confidence is evidently flowing back into the world’s financial system -as it should given all the taxpayer money that we have thrown at it. Nonetheless as banks start to look forwards at earnings trends over the next few years their ability to grow profits will depend heavily on the nature of the yield curve – the difference between short and long term rates. Without a resurgence of inflation I expect the Fed to keep short term rates quite low for years ahead in order to help growth. The potential of higher US bond rates will tend to drive longer term rates upward and thus widen the yield curve. Why will this help banks? Because the essence of banking is to borrow short and lend long: their cost of funds lies at the lower end of the curve and the prices they charge on loans lies at the higher end. So the steeper the yield curve, the more profitable banking becomes.

This will make Tim Geithner smile since he is relying on the banks to ‘earn they way’ back out of their capital malaise. But it will tend to press down on borrowers, both consumers and businesses, and will thus slow the recovery.

Finally the CBO highlights an essential conundrum we should all be aware of: there is a massive conflict between the near term requirements of fiscal policy and the longer term requirements.

Near term we need to run huge deficits. That is the only way we know to stop the economy falling into a depression. It is testimony to the efforts that have been necessary so far to avoid total collapse that the US budget outlook over the near term is, frankly, terrible. The Federal Deficit has shot up as a result of things like TARP and the stimulus package. This is as it should be and follows the prescription of Keynesian economics perfectly. But: fiscal policy cannot remain that loose. At some point we will have to start work on reducing all this debt we are now issuing.

I have said before that our task has been made much worse by the Reagan/Bush legacy. We ran horribly lax fiscal policies through both the 1980’s and the 2000’s. The result is the world is awash with our bonds just as we need to flood the market even more. Hence the glut I mentioned above. Instead of running fiscally conservative policies both Reagan and Bush ran incredibly irresponsible ones. It was Cheney who famously said that ‘deficits don’t matter’. Well they always did. And they matter very much right now.

There is no doubt that fiscal policy will have to revert to very tight standards in a couple of years. That implies both higher taxes and less spending.

Once again this will put a lid on consumption.

So for all these reasons: debt reduction, the collapse of trade; higher cost of debt; and the need for higher taxes, I just cannot see a return to strong GDP growth for a while.

In fact that 2.9% GDP forecast by the CBO looks ambitious to me.

Let’s hope they’re right.