August 7, 2006
Fed is in panic mode about the risks of a recession
By Nouriel RoubiniIt is now clear that the Fed is in panic mode about the risks of a U.S. recession; they hoped to get a soft landing but, obviously, the Three Ugly Bears that I have been warning about since last fall - high oil prices, a slumping housing and rising inflation leading to higher short and long term interest rates - are now killing the economy. The Fed is particularly scared now about the effects of the housing slump, as John Berry’s (being the most insider of all Fed watchers) latest column clearly suggests and as the speech today by SF Fed President Janet Yellen also signals.
Last Friday, commenting on the dismal Q2 GDP report I stated, while arguing that a U.S. recession is coming soon:
* Residential housing investment was falling in Q2 at an annualized rate of 6.3% (and I expect it will fall at an even faster rate in H2, close to 10% negative growth for the next few quarters).
* Real private consumption (that is 70% of aggregate demand) was growing only 2.5% in Q2, with durable goods consumption actually falling 0.5% led by lower purchases of cars and of goods related to housing: as housing slumps consumers are buying less furniture, home appliances, etc. Expect even worse consumption growth in H2, as a further slumping housing sector, higher oil prices and high interest rates are seriously shaking saving-less, debt-ridden consumers whose real wages are falling.”
Today Yellen expressed similar serious worries. First, she worried about the downturn in the housing sector becoming disorderly: "there is more reason to worry that house prices would fall sharply than that they would rise sharply." Second, she clearly linked the wealth effects of a housing slump to the risk of a sharp fall in consumption. She argued that the flattening – if not falling - price of houses "makes the chance of a sizable drop-off in consumer spending seem larger than the chance of a big surge."
Given her statements today, and those by St Louis Fed President Poole suggesting that a tightening on August 8th is only a 50/50 chance now, it is clear that the Fed is really worried about the U.S. slowdown and much more worried about it now than the rising headline and core inflation. Given these statements and development it is clear now that, with high likelihood the Fed will pause in August. Whether this would be only a pause or a stop followed by an easing depends on how fast the economy slows down relative to how much higher inflation will go.
There is now in the market a wishful hope that a Fed ease, possibly followed by an easing in the fall, will prevent a serious slowdown and allow a soft landing of the economy (something in the 2.5%-3% growth rate in H2 2006 followed by a 3% growth in 2007).
beg to disagree. The Fed will not be able to avoid coming recession even if it were to pause now and ease in the fall. Let us consider the best possible scenario for growth now, one in which the Fed pauses on August 8th and then eases twice in the fall by 25bps – i.e. eases twice out of three meetings in the fall - pushing the Fed Funds rate down to 4.75%. This does not mean that I believe that the Fed will actually ease so much, especially if inflation keeps on rising. The experiment is done for the sake of the logical argument.
Then, would an August pause followed by an easing in the fall prevent the U.S. recession that I am predicting? The clear and strong answer - based on many factors - is no.
The reasons are as follows:
* In 2000 the Fed stopped tightening in June 2000 (after a 175bps hike between June 1999 and June 2000). That early pause/stop did not prevent the economy from slowing down from 5% plus growth in Q2 2000 to 0% growth in Q4 2000. Also, the Fed started to aggressively ease rates – in between meetings in January 2001 – when it dawned on the FOMC that they had totally miscalculated the H2 2000 slowdown (they were worrying about rising inflation more than about slowing growth until November 2000 when it was too late). And this aggressive easing in 2001 did not prevent the economy from spinning into a recession by Q1 of 2001. This time around you will get into the same patterns: today’s 5.25% Fed Funds rate reflects the effects on the economy of a Fed Funds rate closer to 4% given the lags in monetary policy and the effects of tightening in the “pipeline” as Bernanke and Yellen put it. So, pausing or stopping now will not help (like the June 2000 pause/stop did not help) and easing in the fall will be too late, in the same way in which easing in early 2001 did not help.
* The current slump in housing will have a much more severe effect on the economy than the tech investment bust of 2000 for several reasons. The wealth effect of the tech bust was limited to the elite of folks who had stocks in the Nasdaq. The wealth effect of now falling housing prices affects every home-owning household. The link between housing wealth rising, increased home equity withdrawal (HEW) and consumption of durable and non durables is very significant (see RGE’s Christian Menegatti brief on this), much more than the effect of the tech bubbles. This is exactly what Yellen is worrying about now. Last year, out of the $800 billion of HEW at least $150 or possibly $200 billion was spent on consumption and another good $100 billion plus went into residential investment (i.e. house capital improvements/expansions). It is enough for house price to flatten – as they did until now – let alone start falling – as they are also beginning to fall in major markets – for the wealth effect to disappear, the HEW dribble to low levels and for consumption to sharply fall.
* A housing slump is a triple whammy, as Yellen correctly worries. First, the 6.3% fall in residential investment in Q2 will be followed for the next few quarters by a much larger fall, at least 10% and possibly 15%. Second, the effects on consumption of housing will be severe: already in Q2 durable consumption is falling as falling home purchases lead to lower purchases of furniture, home appliances and other housing related durables. Third, the employment effects of housing are serious; up to 30% of the employment growth of the last three years was due – directly or indirectly – to housing. As housing slumps, the job and income and wage losses in housing will percolate throughout the economy.
* Could a Fed pause and easing rescue the housing sector? Of course not, for the same reasons why the Fed pause and easing in 2000-2001 did not rescue the collapse in investment in the tech sector. The reasons why the Fed cannot rescue housing are clear. First, Fed policy in 2001-2004 fed an unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed the tech bubble. Now, like then, it payback time: with huge excess capacity in housing (then in tech capital capacity) even much lower short and long rates will not make much of a difference. Real investment fell by 4% of GDP between 2000 and 2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone believe that a 50bps or even 150bps easing by the Fed will undo the housing investment bust that is coming for the next two years? No way. Second, a Fed easing in the fall may be too small – at most 50bps plus or minus 25pbs – and will have too little of an effect on long rates to affect debt servicing ratios of overburdened households. Long rates will not be affected much by a Fed ease for the same reasons – the global conditions that determined the “bond conundrum” of 2004-2005 – that a Fed tightening did not affect long rates. Some easing by the Fed will have little downward effect on long rates and, if inflation is actually rising because of oil and other stagflationary shocks, long rates may actually go up if the Fed easing likely causes increases in long term inflation expectations. Since we are facing stagflationary shocks, the Fed can ill afford to ease too much and too much easing will be counterproductive for bond rates and for housing. Thus, either way households burdened with ARMs and overburdened with housing debt at the time when housing values are slumping, can expect little relief from lower short rate or long rate. The Fed just cannot rescue housing; it can only very modestly dampen its free fall.
* With aggregate demand slumping for structural reasons that I have extensively discussed before, Fed easing and lower long rate will have very little, if any effect, on private consumption of non-durables and durables (the latter already falling in Q2), non-residential investment (that is already falling in Q2 in its equipment and software component) and residential investment (as discussed above).
* It payback time now for all the bubbles that the Fed created in the last few years: the housing bubble, the equity markets bubble (as P/E ratios are still too high based on cyclically adjusted P/E ratios), the bond bubble. Thus, Fed easing will have limited effect in preventing a bursting of these bubbles. And the Fed easing in 2001-2004 is also behind the commodities (both energy and non-energy) of the last few years. So, we can thank the Fed for causing, in part the oil, energy and commodities spike that is now driving the economy into a severe slowdown.
* The Fed can ease as much as it wants or can. But it has limited control on global liquidity conditions. And now that Asia, Japan and EU are – for the time being but not for too long – decoupling from the US slowdown, ECB and BoJ and EMs central banks are in tightening – not easing mode. So, the Fed ability to affect global short term interest rates and long term interest rates is limited. Only when the US recession will burst the decoupling myth when the US slowdown leads – with a lag – to a global slowdown you will see other central banks starting to pause.
* A Fed easing will not rescue the economy via a positive effect on the stock market. If the Fed pauses in August you will have a significant and temporary rally (as the instant knee jerk reaction of the stock market last Friday to the GDP report showed). But, as I argued Friday, this would be a “sucker relief rally as the short term benefits for stocks of a Fed pause will, in short time, lead to the realization that the pause signals that the Fed is panicking and realizing that an ugly recession is coming (as in 2000 but only worse). Thus, once the signals of this recession build up, the slowing demand, sales, profits, earnings will severely batter the stock market. Expect 10-15% losses on the major equity indexes between now and year end as the bearish reality of a recession sinks in delusional investors still hoping for a soft landing of the economy.” And indeed, as I predicted Friday, this was a “suckers’ relief rally”: today equity markets took a turn down based on the reality check that lower growth means lower earnings. And expect a true bear market in US equities once the reality of a recession sinks in.
Thus, do not expect the Fed to be able – even if it wanted to by pausing in August and then easing in the fall – to rescue the U.S. economy from the coming recession. It failed to do so in 2001 and it will fail to do so this time around. In almost every previous episode of serious Fed tightening since the 1950s we ended up with a recession. The only exception was 1994-95. But then conditions were very different from now:
a) even then the 300bps tightening in 1994 led to an almost 0% growth by Q1 of 1995;
b) then the economy was coming out of a sharp recession and sluggish recovery (1990-93) and had very little of the macro vulnerabilities that we are facing today;
c) the economy was then on the verge of the IT technology and internet productivity miracle of the 1990s;
d) inflation was then – unlike today – very mild;
e) it took an aggressive easing in 1995 to prevent the real sharp tightening of 1994 from spinning the economy into a recession in 1995 and even then growth close to 0% in Q1 of 1995 and sluggish through H1 of 1995.
This time around, the vulnerabilities are much larger than in 1994 and than in 2000-2001. There will no so soft landing and the recession will be painful. And the Fed will be able to do little to prevent the coming recession. The recession train wreck is having too much of its own unstoppable momentum now – as it did in 1974, 1980, 1990, and 2000 – for the Fed to be able to stop it. Fed pause or easing will not avert the coming recession. We will now pay for living above our means for too long, for making serious fiscal and monetary policy mistakes that allowed only a drugged recover, and for creating unsustainable macroeconomic and financial imbalances that festered for too long. Thus, the coming payback will be unavoidable - whatever the Fed does or does not - and most painful for the U.S. and for the global economy.
RGE Monitor
Last Friday, commenting on the dismal Q2 GDP report I stated, while arguing that a U.S. recession is coming soon:
* Residential housing investment was falling in Q2 at an annualized rate of 6.3% (and I expect it will fall at an even faster rate in H2, close to 10% negative growth for the next few quarters).
* Real private consumption (that is 70% of aggregate demand) was growing only 2.5% in Q2, with durable goods consumption actually falling 0.5% led by lower purchases of cars and of goods related to housing: as housing slumps consumers are buying less furniture, home appliances, etc. Expect even worse consumption growth in H2, as a further slumping housing sector, higher oil prices and high interest rates are seriously shaking saving-less, debt-ridden consumers whose real wages are falling.”
Today Yellen expressed similar serious worries. First, she worried about the downturn in the housing sector becoming disorderly: "there is more reason to worry that house prices would fall sharply than that they would rise sharply." Second, she clearly linked the wealth effects of a housing slump to the risk of a sharp fall in consumption. She argued that the flattening – if not falling - price of houses "makes the chance of a sizable drop-off in consumer spending seem larger than the chance of a big surge."
Given her statements today, and those by St Louis Fed President Poole suggesting that a tightening on August 8th is only a 50/50 chance now, it is clear that the Fed is really worried about the U.S. slowdown and much more worried about it now than the rising headline and core inflation. Given these statements and development it is clear now that, with high likelihood the Fed will pause in August. Whether this would be only a pause or a stop followed by an easing depends on how fast the economy slows down relative to how much higher inflation will go.
There is now in the market a wishful hope that a Fed ease, possibly followed by an easing in the fall, will prevent a serious slowdown and allow a soft landing of the economy (something in the 2.5%-3% growth rate in H2 2006 followed by a 3% growth in 2007).
beg to disagree. The Fed will not be able to avoid coming recession even if it were to pause now and ease in the fall. Let us consider the best possible scenario for growth now, one in which the Fed pauses on August 8th and then eases twice in the fall by 25bps – i.e. eases twice out of three meetings in the fall - pushing the Fed Funds rate down to 4.75%. This does not mean that I believe that the Fed will actually ease so much, especially if inflation keeps on rising. The experiment is done for the sake of the logical argument.
Then, would an August pause followed by an easing in the fall prevent the U.S. recession that I am predicting? The clear and strong answer - based on many factors - is no.
The reasons are as follows:
* In 2000 the Fed stopped tightening in June 2000 (after a 175bps hike between June 1999 and June 2000). That early pause/stop did not prevent the economy from slowing down from 5% plus growth in Q2 2000 to 0% growth in Q4 2000. Also, the Fed started to aggressively ease rates – in between meetings in January 2001 – when it dawned on the FOMC that they had totally miscalculated the H2 2000 slowdown (they were worrying about rising inflation more than about slowing growth until November 2000 when it was too late). And this aggressive easing in 2001 did not prevent the economy from spinning into a recession by Q1 of 2001. This time around you will get into the same patterns: today’s 5.25% Fed Funds rate reflects the effects on the economy of a Fed Funds rate closer to 4% given the lags in monetary policy and the effects of tightening in the “pipeline” as Bernanke and Yellen put it. So, pausing or stopping now will not help (like the June 2000 pause/stop did not help) and easing in the fall will be too late, in the same way in which easing in early 2001 did not help.
* The current slump in housing will have a much more severe effect on the economy than the tech investment bust of 2000 for several reasons. The wealth effect of the tech bust was limited to the elite of folks who had stocks in the Nasdaq. The wealth effect of now falling housing prices affects every home-owning household. The link between housing wealth rising, increased home equity withdrawal (HEW) and consumption of durable and non durables is very significant (see RGE’s Christian Menegatti brief on this), much more than the effect of the tech bubbles. This is exactly what Yellen is worrying about now. Last year, out of the $800 billion of HEW at least $150 or possibly $200 billion was spent on consumption and another good $100 billion plus went into residential investment (i.e. house capital improvements/expansions). It is enough for house price to flatten – as they did until now – let alone start falling – as they are also beginning to fall in major markets – for the wealth effect to disappear, the HEW dribble to low levels and for consumption to sharply fall.
* A housing slump is a triple whammy, as Yellen correctly worries. First, the 6.3% fall in residential investment in Q2 will be followed for the next few quarters by a much larger fall, at least 10% and possibly 15%. Second, the effects on consumption of housing will be severe: already in Q2 durable consumption is falling as falling home purchases lead to lower purchases of furniture, home appliances and other housing related durables. Third, the employment effects of housing are serious; up to 30% of the employment growth of the last three years was due – directly or indirectly – to housing. As housing slumps, the job and income and wage losses in housing will percolate throughout the economy.
* Could a Fed pause and easing rescue the housing sector? Of course not, for the same reasons why the Fed pause and easing in 2000-2001 did not rescue the collapse in investment in the tech sector. The reasons why the Fed cannot rescue housing are clear. First, Fed policy in 2001-2004 fed an unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed the tech bubble. Now, like then, it payback time: with huge excess capacity in housing (then in tech capital capacity) even much lower short and long rates will not make much of a difference. Real investment fell by 4% of GDP between 2000 and 2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone believe that a 50bps or even 150bps easing by the Fed will undo the housing investment bust that is coming for the next two years? No way. Second, a Fed easing in the fall may be too small – at most 50bps plus or minus 25pbs – and will have too little of an effect on long rates to affect debt servicing ratios of overburdened households. Long rates will not be affected much by a Fed ease for the same reasons – the global conditions that determined the “bond conundrum” of 2004-2005 – that a Fed tightening did not affect long rates. Some easing by the Fed will have little downward effect on long rates and, if inflation is actually rising because of oil and other stagflationary shocks, long rates may actually go up if the Fed easing likely causes increases in long term inflation expectations. Since we are facing stagflationary shocks, the Fed can ill afford to ease too much and too much easing will be counterproductive for bond rates and for housing. Thus, either way households burdened with ARMs and overburdened with housing debt at the time when housing values are slumping, can expect little relief from lower short rate or long rate. The Fed just cannot rescue housing; it can only very modestly dampen its free fall.
* With aggregate demand slumping for structural reasons that I have extensively discussed before, Fed easing and lower long rate will have very little, if any effect, on private consumption of non-durables and durables (the latter already falling in Q2), non-residential investment (that is already falling in Q2 in its equipment and software component) and residential investment (as discussed above).
* It payback time now for all the bubbles that the Fed created in the last few years: the housing bubble, the equity markets bubble (as P/E ratios are still too high based on cyclically adjusted P/E ratios), the bond bubble. Thus, Fed easing will have limited effect in preventing a bursting of these bubbles. And the Fed easing in 2001-2004 is also behind the commodities (both energy and non-energy) of the last few years. So, we can thank the Fed for causing, in part the oil, energy and commodities spike that is now driving the economy into a severe slowdown.
* The Fed can ease as much as it wants or can. But it has limited control on global liquidity conditions. And now that Asia, Japan and EU are – for the time being but not for too long – decoupling from the US slowdown, ECB and BoJ and EMs central banks are in tightening – not easing mode. So, the Fed ability to affect global short term interest rates and long term interest rates is limited. Only when the US recession will burst the decoupling myth when the US slowdown leads – with a lag – to a global slowdown you will see other central banks starting to pause.
* A Fed easing will not rescue the economy via a positive effect on the stock market. If the Fed pauses in August you will have a significant and temporary rally (as the instant knee jerk reaction of the stock market last Friday to the GDP report showed). But, as I argued Friday, this would be a “sucker relief rally as the short term benefits for stocks of a Fed pause will, in short time, lead to the realization that the pause signals that the Fed is panicking and realizing that an ugly recession is coming (as in 2000 but only worse). Thus, once the signals of this recession build up, the slowing demand, sales, profits, earnings will severely batter the stock market. Expect 10-15% losses on the major equity indexes between now and year end as the bearish reality of a recession sinks in delusional investors still hoping for a soft landing of the economy.” And indeed, as I predicted Friday, this was a “suckers’ relief rally”: today equity markets took a turn down based on the reality check that lower growth means lower earnings. And expect a true bear market in US equities once the reality of a recession sinks in.
Thus, do not expect the Fed to be able – even if it wanted to by pausing in August and then easing in the fall – to rescue the U.S. economy from the coming recession. It failed to do so in 2001 and it will fail to do so this time around. In almost every previous episode of serious Fed tightening since the 1950s we ended up with a recession. The only exception was 1994-95. But then conditions were very different from now:
a) even then the 300bps tightening in 1994 led to an almost 0% growth by Q1 of 1995;
b) then the economy was coming out of a sharp recession and sluggish recovery (1990-93) and had very little of the macro vulnerabilities that we are facing today;
c) the economy was then on the verge of the IT technology and internet productivity miracle of the 1990s;
d) inflation was then – unlike today – very mild;
e) it took an aggressive easing in 1995 to prevent the real sharp tightening of 1994 from spinning the economy into a recession in 1995 and even then growth close to 0% in Q1 of 1995 and sluggish through H1 of 1995.
This time around, the vulnerabilities are much larger than in 1994 and than in 2000-2001. There will no so soft landing and the recession will be painful. And the Fed will be able to do little to prevent the coming recession. The recession train wreck is having too much of its own unstoppable momentum now – as it did in 1974, 1980, 1990, and 2000 – for the Fed to be able to stop it. Fed pause or easing will not avert the coming recession. We will now pay for living above our means for too long, for making serious fiscal and monetary policy mistakes that allowed only a drugged recover, and for creating unsustainable macroeconomic and financial imbalances that festered for too long. Thus, the coming payback will be unavoidable - whatever the Fed does or does not - and most painful for the U.S. and for the global economy.
RGE Monitor
same time.
