Slowing Down

The first phase of the recovery is now well and truly over. The economy is showing signs of slowing down. The issue has now become how slow will ‘slow’ be? Most of the reports being released at the moment confirm that the heady days of late last year and early this were showing an economy being propped up by stimulus rather than growing rapidly of its own accord. Even the deficit hawks will have to back away from their destructive suggestions if this keeps up. Indeed it is quite possible that by the fall we will be arguing over the need for more stimulus.

Take housing as an example.

Late last year we saw a distinct uptick in housing. All the various measures of the industry – sales, prices, and construction – had risen from the terrible levels they plummeted to after the bursting of the bubble. Frankly, given the basement into which the industry had collapsed, practically any activity would have been an improvement. The problem was that the amount of recovery was a function, not of sustainable growth being re-esatblished, but of the considerable impact due to the stimulus. In this case the tax credit for first time home buyers. Looking back at the data over the last few months we can easily see that real estate’s fortunes followed those of the tax credit almost exactly. Once the credit was announced, construction, sales, and prices up, and as soon as the credit expired they all fell again.

This up and down course of events has exacted a huge toll on confidence: the index that measures confidence of home builders has dropped back to a near all-time low, it hit an incredible 17 – out of 100 – in early June, down from 22 in May. Its lowest ever was in January 2008 when it bottomed out at 8. Just for reference: its high point was back in the balmy days of the bubble. In June 2005 it hit 72.

Given this level, or lack, of confidence, it comes as no surprise to hear that starts of new homes has dropped precipitously. they were down to 593,000, at annual rates, in May, the lowest since December. That’s a 10% drop from April. So even though starts have edged up 7.8% since May 2009, they are a full 70% down from the peak reached during the bubble. To add more color to this trend: the drop in May was the biggest one month decline since 1991.

Outside of real estate the economy is decidedly patchy. Today’s report that first time claims for unemployment assistance rose 12,000 last week gives us great pause. It seems that the economy is just refusing to generate jobs in sufficient volume to bring unemployment down quickly. The claims level remains stubbornly in the mid to high 400,000 range. Last week’s 472,000 means we have made practically no progress all year. The last two or three reports on job generation have been distorted by the number of government workers being hired by the Census Bureau. Eliminate those jobs and the private sector is adding at a much more sluggish rate. Having said that we should acknowledge that jobs are being created in small numbers, our problem remains that the gains are insufficient in the face of the enormous mass firing businesses went through at the onset of recession. For context recall that private sector job creation has averaged about 120,000 a month and new claims for unemployment assistance have averaged about 460,000 over the same period.

The patchiness of the recovery is highlighted by this week’s report of industrial production which rose 1.2% in May, the biggest one month jump since last August. This steady increase in output is crucial for the outlook in unemployment because it brings capacity utilization levels up to 74.7% – up from 73.7% in April. Historically the threshold for substantial re-hiring has been when utilization rises to between 75% and 80%. At those higher levels businesses have to become concerned about continued growth and are forced to think in terms of expanding their workforce in order to keep up. At our current pace we will reach that threshold sometime in mid or late summer. Only then can we assess whether this recovery has launched into self sustaining growth.

Meanwhile, there is no sign of inflation. On the contrary, and entirely unwelcome, we are continuing to see a reduction in inflation. As I have mentioned here before, the current risk is tilted more towards the emergence of deflation which would be a disaster. This lack of inflation is just one more aspect of the continued weakness of the economy. The Consumer Price Index dropped 0.2% in May after a 0.1% decline in April. The biggest drop within the overall index was in energy prices which fell 2.9% and thus more than offset a small 0.1% increase in rent and other housing costs. Food prices were flat in the month. Looking back over the last twelve months May’s numbers bring the annual rate of inflation to 2.0%, with the non-volatile – and more accurate – ‘core’ inflation rate being only 0.9% over that time. This is the lowest rate of inflation for 44 years.

In many previous years we would have lauded such a low inflation rate. This year, however, is different.

With interest rates at their current low levels we have no way of getting added stimulus from lower credit costs. There is just no way of dropping interest rates below zero. Except for the complication of inflation. This is a little weird, but bear with me. Interest rates are expressed in nominal amounts. That is they are not adjusted for inflation. When an interest rate is 6.0% and inflation is 3.0% the actual, or ‘real’, interest rate is only 3.0% [i.e 6.0% less 3.0%]. A borrower in such an environment is facing a real cost of credit of only 3.0% because inflation is eroding the future purchasing value of the amount the borrower has to repay. The same thing operates at zero nominal interest rates. A borrower whose loan costs 1.0% and who is facing 3.0% inflation is actually looking at a negative real interest rate of -2.0%.

Now the problems of a zero interest rate environment come into focus: in order to get increased stimulus from lowering credit costs, and the induced borrowing that would occur from those lower costs, we need inflation to rise. That way we can create negative real interest rates. So, when we see inflation declining in circumstances when nominal rates are as low as they are today, we are actually facing rising, not falling, real interest rates. This means that the disincentive to borrow is increasing just at a time when we would want it to fall. In other words the current decline in inflation is having the effect of pushing real interest rates and hence borrowing costs up. This pernicious impact of low inflation would get even worse with deflation, and is the root of my continued call for the Fed to encourage higher inflation. We need more borrowing not less if we are to get the economy rolling.

One last indicator to illustrate the new pattern we seem to have fallen into: activity in the Philadelphia region, as monitored by the Philly Fed., continues to grow. last month’s increase brings the string of months with growth to ten. Unfortunately last month also a dramatic slowing of that growth from the better rates seen earlier in the year.

The Philly story is a reflection of the entire economy: the concern is how far down we go.

I still think we will avoid a double dip recession. The risks are rising, but we have the tools to stop the decline. The big question is whether we will use those tools, or whether policy makers will misjudge and tighten too early. And I have said before: if we sink into a double dip style recession it will our own fault. This is no time to take our foot off the government gas pedal.