The Muddle Through Fed

The Muddle Through Fed

By John Mauldin | 23 February 2008

This week the Fed offered us their forecasts for 2008 - 2010 for the economy, inflation and employment. We will look at some of the details which I think will be of interest. Then we glance at some data on the savings rate which suggests consumer spending may be in for more of a challenge than many think. There is a lot of ground to cover.

The Muddle Through Fed

Long time readers know I coined the term 'The Muddle Through Economy' early this decade to describe an economy that was growing, but doing so below the long term growth trend. The first time I used the term was in January of 2002, and it was an apt description of the economic landscape for the next two years, before the economy began to grow around the long term trend of 3%.

Last year, I suggested we would see a return to The Muddle Through Economy for 2008 and probably through 2009. If the Bush tax cuts are not kept largely intact, 2010 could be challenging as well. I still think we are in a recession and that absent large policy mistakes it will not be a deep recession, but it will be longer than the last two we have been through. And the recovery will be slower than is usual.

This week, the Federal Reserve joined the Muddle Through camp, as we will see below. The Fed now makes three year projections every quarter. I applaud the transparency but I wonder if they are going to enjoy the process after they have built a very public track record in a few years. Let's look at their projections and then make some observations. We will look in depth at the minutes because they contain some important insights.

The process of producing the forecast is interesting. The members of the Board of Governors (up to 7, though currently at 5) and the presidents of the Federal Reserve Banks (12), all of whom participate in the deliberations of the FOMC, provide projections for economic growth, unemployment, and inflation in 2008, 2009, and 2010. Each of the members has their own economists on staff, and they each independently come up with their own forecast (more on this later). From the minutes:

"Projections were based on information available through the conclusion of the January meeting, on each participant's assumptions regarding a range of factors likely to affect economic outcomes, and on his or her assessment of appropriate monetary policy."

The table below is directly from the minutes of the January 30-31 meeting. It includes both current projections and how they have changed since October. The average Fed member is considerably more bearish than they were in October. Note that of the 17 (my count) forecasts, they disregarded the three most bearish and the three most bullish, to come up with a central tendency, and then they give us the range. While they offer ranges, I will compute the average of that range. (You can read the minutes here.)

The Fed forecast suggests that GDP will be 1.6% for this year and 2.4% for 2009. That is decidedly Muddle Through territory. Last October they thought the economy would grow 0.5% faster than this, so that is a significant drop in their forecast in just three months. Interestingly, inflation for the year is projected to be 2.1% - 2.4% and core inflation will be 2.1%, quite the difference from what we are experiencing now. To get to that average, they are clearly expecting that inflation is going to slow significantly in the latter part of the year [[the 'infamous' second half of the year when all good things come to pass— NOT! : normxxx]].

This helps explains their recent aggressive rate cuts. Normally, you would think they would be worried about creating even more inflation as a result of rate cuts. Their projections are for significantly lower inflation for the latter half of the year. This is not intellectually inconsistent, as recessions are generally disinflationary.

So, let's look at the table.


Click Here, or on the image, to see a larger, undistorted image.

Risks To The Downside

The minutes from the January Fed meeting are quite frankly bearish. In just one paragraph on the housing market, they used the words "fell," "plunged," "dropped," "moved down," "declined," and "restrained." The one positive word was "rebound," which was used in the context of a rise in multi-family housing starts. But multi-family starts are likely to continue to rise as families losing their homes will be looking to move into apartments.

Reading these minutes, you get the distinct feeling that this is a Fed that is very concerned about the immediate future of the economy. You can take it to the bank that there will be more rate cuts. A 2% Fed funds rate by this summer would not surprise me. Nine of the seventeen forecasts were for a 2008 GDP of between 1% and 1.5%. And then think about the following paragraphs from the forecast:

"Most participants viewed the risks to their GDP projections as weighted to the downside and the associated risks to their projections of unemployment as tilted to the upside. The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment. In addition, despite some recovery in money markets after the turn of the year, financial market conditions continued to be strained— stock prices had declined sharply since the December meeting, concerns about further potential losses at major financial institutions had mounted amid worries about the condition of financial guarantors, and credit conditions had tightened in general for both households and firms. The potential for adverse interactions, in which weaker economic activity could lead to a worsening of financial conditions and a reduced availability of credit, which in turn could further damp economic growth, was viewed as an especially worrisome possibility."

So, they think it could get worse. And that last sentence was discussed again in the minutes, and referred to as an "adverse feedback loop." Let's look at that paragraph:

"The availability of credit to consumers and businesses appeared to be tightening, likely adding to restraint on economic growth. Participants generally viewed financial markets as still vulnerable to additional economic and credit weakness. Some noted the especially worrisome possibility of an adverse feedback loop, that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening in credit conditions."

One last paragraph of Fed speak and then we'll move on, but this is important. It deals with their thoughts on inflation:

"Regarding risks to the inflation outlook, several participants pointed to the possibility that real activity could rebound less vigorously than projected, leading to more downward pressure on costs and prices than anticipated. However, participants also saw a number of upside risks to inflation. In particular, the pass-through of recent increases in energy and commodity prices as well as of past dollar depreciation to consumer prices could be greater than expected. In addition, participants recognized a risk that inflation expectations could become less firmly anchored if the current elevated rates of inflation persisted for longer than anticipated or if the recent substantial easing in monetary policy was misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation. "On balance, a larger number of participants than in October viewed the risks to their inflation forecasts as broadly balanced, although several participants continued to indicate that their inflation projections were skewed to the upside."

The minutes clearly and specifically conveyed the concern that there was a great deal of uncertainty due to a wide variety of factors, including the crisis in the credit markets and inflation. And they should be concerned about inflation. The CPI is up from 2% in August to 4.3% in January, even as the economy was slowing in the 4th quarter [[however, this was not unanticipated because of earlier events in the economy, whose expression was delayed until the 4th quarter: normxxx]] Normally, a slowing economy is disinflationary. That is reflected in their forecast, and I agree. But it is a concern.

Now, some of my thoughts and speculation. This is about as bearish a forecast as we [are likely] see from the Fed. While it could go slightly lower next quarter, what do you think the reaction of the markets would be if the Fed came out and forecast an outright recession? Or for unemployment to go to 6%, or for inflation to hang around 4% while they are cutting rates? There would be knee deep blood in the streets.

It will be interesting to see how the forecasts change over time. If we are in a recession, how will they factor in past known performance? If we have negative growth for the first two quarters of this year (a real possibility), then to get to the average 1.6% growth in GDP forecast for 2008, that would mean a rather robust recovery of 3% growth in the latter half of the year! But they forecast a slow economy in 2009 [[maybe only the first half?: normxxx]]

If the recovery in the latter half of this year is in the 2% range, then overall growth for the year will be well below 1% for 2008, assuming we are in recession. When they make their forecast this summer, will we see that reflected? The Fed has picked a particularly tough time to start making quarterly projections. I don't think it is politically possible for them to forecast a recession. Then, a year or two from now, they will have clearly missed it, and then how much confidence will people have in their forecasts? I don't envy them.

Consumers Gone Wild

Dennis Gartman brought some very interesting research by the Fed to my attention, on the savings rate and consumer spending. We all know that the savings rate for US consumers is dropping. Just take a look at the following chart:


Click Here, or on the image, to see a larger, undistorted image.

Let's go to Dennis's letter from this morning:

"The Federal Reserve Board notes that savings rates for three groups: The first is that of homeowner's who have no line of home equity credit; the second is the entire US population, and the third is that of homeowners with home-equity lines of credit. Rounding the averages off to the nearest percentage point, the data shows that back in 1991, all three groups had savings rates very near to 10%. The differences between the three were effectively nothing. "Nine years later, all three groups had had their savings rates turn negative, but the differences between the three had become quite large. Those without a home-equity line of credit had a savings rate of approximately -3%; the population at large had a savings rate that was marginally worse, but only barely so. "However, those with a home equity line of credit allowed their savings rate to deteriorate to approximately -9%. By '05, the 'spread' had become even worse, as the first group had a 0% savings rate; the second group had a rate of approximately -2%, and the third group had allowed its fiscal circumstances to deteriorate to such a degree that its savings rate had fallen to -13%! "Last year, the first group had returned to a small positive number, with a savings rate of 1%; the second group, the population at large had a savings rate of 0%, while the third group was either trying to move in the proper direction or was being forced to do so, for although it still had a negative rate of savings, it had moved from the disastrous -13% to a somewhat less disastrous -7%. To paraphrase Shakespeare, 'some are borne to savings; some achieve savings, and some have savings thrust upon them.'"

This is indicative of something I have been writing about for some time: the collapse of the housing market and a recession is going to be a wake up call for consumers, and especially those approaching retirement. The thought that "You better be careful what you wish for, you might just get it good and hard" comes to mind when people bemoan the low savings rate in the US. There are several points we can take away from this research. Even when the current credit crisis gets resolved (and let's hope the rumors which made the stock market go to the moon in 15 minutes today about Ambac getting financial backing are true), we are not going to see a return to the days of loose credit. It is going to be harder and more expensive to get a loan for all sorts of consumer credit.

Those who have used their homes as piggy banks to spend more than they make are going to have considerably more difficulty in the future. With housing values likely to drop another 15%, there is going to be less equity to borrow. It is just that simple. Further, just as there was a positive wealth effect from rising home prices, there is going to be a negative wealth effect from falling home prices. Homes are the largest portion by far of the US consumer's net worth. Consumers, and especially those who are close to retiring, are going to realize that the home value they thought they had is drifting away. They will realize they are going to need to save more.

On an individual basis, saving more is a good thing. But when an entire economy goes back to saving a mere 3% - 5%, that is going to have to come directly out of consumer spending. And since consumer spending is 70% of the economy that will be a serious 1% - 2% annualized head wind for GDP growth for several years— until businesses adjust. Muddle Through, indeed.

Yes, I realize that the savings rate does not include contributions to retirement plans, growth or capital gains in the value of stocks, etc. Thus, it is not quite as dire as it sounds. And that is why savings rates will not go back to 10%. But it will rise. Count on it.

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Normxxx    
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