Slow Growth to Recession
We're on record for a 50% or higher probability of a second dip or another recession, whatever it would be called. The composition of the ECRI Weekly Leading Index remains proprietary, but its growth rate has fallen to the level that in the past was always associated with recessions (Chart 11). Historically, however, recessions have been propelled by shocks. The post- World War II downturns prior to 2001 were caused by Fed tightening in response to threats of economic overheating and the resulting higher inflation. Since then, other shocks have been responsible. The 2001 recession resulted from the 2000 collapse of the dot com bubble augmented by the 9/11 shock. The 2007-2009 downturn resulted from the collapse in subprime residential mortgages that commenced early in 2007.
In the current economic and financial climate, it's highly unlikely that the Fed will tighten credit for years. In fact, the central bank has shifted from planning last spring to withdraw liquidity as the economy grew to renewing quantitative easing and worrying about deflation and subpar growth. It said after its August 10 policy meeting that household spending is being retarded by high unemployment, slow income growth, lower home equity and tight credit conditions while bank lending "has continued to contract."
Pushing On A String
Conventional monetary ease is now impotent with the federal funds rate close to zero , the money multiplier collapsed and banks sitting on hoards of cash (Chart 12) and over $1 trillion in excess reserves. Sure, large banks report to the Fed that they are easing lending standards for small business, but after the intervening financial crisis, many fewer potential borrowers are deemed creditworthy than in the loose lending days. Furthermore, the small business trade group, the National Federation of Independent Business, reports that 91% of small business owners have had their credit needs met or business is so slow that they don't want to borrow. The Fed is pushing on the proverbial string.
The Fed also worries about deflation, which means that even zero interest rates are positive in real terms, as has been the case for years in deflationary Japan. Also, deflation encourages buyers to wait for still-lower prices in a self-feeding cycle, as is seen in Japan and as we have discussed often in conjunction with our forecast of 2% to 3% per year chronic deflation. In it s post- August 10 meeting statement, the Fed said that "measures of underlying inflation," already low, "have trended lower" lately and are "likely to be subdued for some time." James Bullard, President of the Federal Reserve Bank of St. Louis, recently warned of the risks of deflation.
Deflation is a scary phenomenon, but we can't resist noting that the Fed as well as many other forecasters are moving in the direction of our forecast. In contrast, an April 6 Wall Street Journal piece by Peter Eavis stated unequivocally, "No one in their right mind would bet on inflation remaining substantially below 4% for the next 10 years." Maybe we better have our head examined.
A Baby Step
So, with conventional monetary ease exhausted and further fiscal stimulus on hold because of the already-huge federal deficit, the Fed at its August 10 meeting took a baby step toward more quantitative ease by deciding to buy Treasury bonds to replace the maturing and refinanced Treasury and mortgage-backed securities in the $1.7 trillion hoard it finished buying earlier this year. With low mortgage rates, refinancings were projected to raise the Fed's portfolio contraction from an earlier estimate of $200 billion by the end of 2011 to $340 billion, with another $55 billion coming from retirement of Fannie Mae and Freddie Mac debt held by the Fed.
