Low Rates May Continue After Stimulus Programs End
Posted by Barry Simson on April 19, 2011
What a difference a quarter makes. At year end, domestic GDP was going pretty well. Unemployment is still high but enough jobs have steadily been added over the past few months to bring it down markedly. Economists were quick to revise their growth forecasts up at year end, but now they are revising them down. And those revisions were coming before $4 per gallon gasoline emerged or the catastrophic devastation occurred in Japan.
At the end of last year the Fed decided to add some additional quantitative easing to the economy to try and really get it jump started. The goal seemed to be to bring rates down to stimulate economic activity. Given there was moderate positive economic activity already, the market reacted by driving up rates, figuring the Fed was going to ignite inflation. While rates rose, cutting off what little housing activity that there was, asset prices did increase as evidenced by the stock market returns. Wealth was added to consumer balance sheets and in turn their spending behavior increased. Now a number of Fed members are stating that the easing should be withdrawn, the economy is growing and the mission of price stability should take precedence. While I do not believe the Fed will end QE2 early, I do believe it will not do any additional easing at its conclusion. Conventional wisdom said that rates would fall with additional stimulus, but instead they rose.
Perhaps the removal of stimulus will cause rates to fall?
The Fed is also doing two other noticeable programs. The first, they are going to begin selling some of the mortgage backed securities they have purchased over the past couple of years. In theory, this should cause mortgage rates to rise as more securities are available and there are fewer buyers. Without the extra stimulus of a QE3, the market may decide that the economy is not as strong as some were hoping and as a result, rates could fall. We shall see. The other interesting note is that the Fed is putting up for auction sub-prime bonds that they took from AIG. At this point, the Fed should be able to sell those bonds at a profit. AIG has been pushing the Fed to sell the bonds so that they can buy them back. If AIG acquired the bonds now, they will be able to do so at a high enough yield to compensate them for the risks involved, or so they think, just like last time. Perhaps their luck will be better this time around.
Despite the improved numbers during the 4th quarter of 2010, it is not a sure bet that the economy is going to continue getting better. Instead, it is likely to grow slowly while experiencing a number of bumps along the way. There are a few concerning factors which could interfere with economic growth.
The first potential challenge stems from the squeeze on municipal budgets and their ability to meet debt obligations. While state tax collections have increased over the past 6 quarters, property tax collections have not. In fact, they are still declining. So while many states may be improving their balance sheets, towns may continue to face significant budget pressures. The next shoe to drop could be large municipal and teacher layoffs. Since most towns are required to balance their budgets, shortfalls in property taxes could be a trigger for the upcoming budgets. As soon as the school year ends, we expect to begin hearing rumblings and layoff announcements.
The second obstacle will be the result of the current budget wrangling in Washington. The impending decisions regarding the federal budget will have a dramatic and enduring impact on all of us. Regardless of how you believe we should get there, the budget deficit has to be cut. Significantly. The PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries of Europe, those with the weakest financial strength, are beginning to experience record high interest rates because no one wants to lend money to them. While they have all taken some pre-emptive steps to bring down their budget deficits, investors do not believe they have austere enough budgets. As a result there are few buyers of their bonds, and rates have soared, cutting off most borrowing and the economies are going to slow significantly. The U.S. is not immune to this situation. We are addicted to low cost debt. If we can not get inexpensive loans our economy slows to a crawl. Consider the situation in Portugal where mortgage rates have climbed above 8%. If investor attitudes toward funding U.S. debt begin to match their view of the PIIGS, then our housing market could stop entirely. Our housing market almost shut down when rates went from 4.25% up to 5%. Think what would happen if those rates moved to 7 or 8%? While the market’s focus so far has been on the European countries, it will at some point shift attention to the U.S. Absent a deficit reduction accord, we could see the same results in the not too distant future if our budget issues become a global concern.
The final hurdle is the possibility of a Fed-induced commodity bubble. QE2 not only propped up the stock market but all commodity prices as well. With U.S. manufacturing continuing its decades-long trend of becoming a smaller part of the economy, the rise in raw material prices is not likely to show up as inflation to the same degree it might have in the past. However, commodities have definitely risen since the Fed announced QE2. The inverse of this is that the dollar is weakening against other currencies. This indicates that the global market believes other countries have better control of their finances than does the U.S. While there may be some influence on inflation, we think American consumers will certainly take notice of the amount they will be spending on gasoline and food if a commodity bubble continues. As a result people will spend less on other items, such as dinners out and travel. Retail sales may stay the same in total but a larger proportion of those expenditures will be on gasoline and less on other products.
So while the economy is doing better than we may have predicted there is still a long way to go until we can consider this a strong economy. Unemployment at barely below 9% is not a good number. Annual deficits measured in the trillions are unsustainable. Now is a critical time to have effective governance. Despite the challenges previously described, a robust economic recovery is still possible. It requires a departure from current Capitol Hill stalemates and needs legislators with strong intestinal fortitude. If elected officials can produce a meaningful deficit accord then the stage could be set for future growth and lower interest rates.