Popular Economics Weekly

The Federal Reserve decided to raise their nominal discount rate by 0.25 percent—the rate they charge banks to borrow Fed money—to 0.75 percent last week. The reason is to get banks off the Fed’s dole. Banks had been borrowing from the Fed, because the money was so cheap. The Fed is now saying it is time for banks to look for funds in the private sector.

But it also signaled that this wasn’t the beginning of a sustained tightening. “"The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy."

This is a sign the Fed sees business activity increasing. We have already talked about the surge in manufacturing in what is looking like a ‘V’ shaped recovery.

Industrial production posted another strong gain for January-but this time the strength was real and not weather related. Industrial production in January advanced 0.9 percent, following a 0.7 percent jump in December. The January was marginally better than the market projection for a 0.8 percent gain.

The service sector is also on a sustained recovery. The headline composite rose 1.4 points to 50.1, a level indicating very little month-to-month change in overall activity for the bulk of the economy. New orders, the life blood of business, did show a month-to-month increase at 52.1, the slowest increase over the last four months. In a reflection of the prior gains in orders, the business activity component, which can roughly be described as a production reading, rose more than 4 points to 53.7.

Lastly, consumer spending has been expanding since April 2009. This was remarked upon by the Federal Reserve in its latest Beige Book report. “Ten Districts reported some increased activity or improvement in conditions, while the remaining two–Philadelphia and Richmond–reported mixed conditions. This was an improvement from the last Beige Book that reported eight Districts with increased activity or improving conditions and four Districts showing little change and/or mixed conditions.

And is why retail sales have been increasing since last fall.

The bottom line is that the Fed has decided to no longer subsidize the so-called ‘carry trade’, whereby banks were able to borrow monies at next to zero interest and lend or invest it at prevailing market returns. This is why profits of the largest banks have been surging. The release of minutes from the January FOMC hints at why the Fed has begun to tighten.

“Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls.”

It remains to be seen how the markets will react to the first interest rate rise in more than 2 years.

Harlan Green © 2010

Popular Economics Weekly

A very good Barron’s Magazine article just out by a Japanese economist helps to explain why it is so necessary to keep stimulus spending in place for at least another 3 years. The economist, Richard Yoo of Nomura Research Institute, maintains that we could repeat Japan’s 15-year deflationary spiral, if we cut the budget deficit too soon before the recovery is in place.

Why? Because we are in what he calls a “balance-sheet” recession, where assets have been drastically devalued yet the debt used to purchase said assets hasn’t shrunk. That is what happens during a recession, unless government takes steps to bring down the debt loads, as in reducing the mortgage principal on under-water mortgages. The Treasury is considering implementing such a step in the $75 Billion HARP loan modification program.

Japan tried to reduce their deficit twice in those 15 years, according to Dr. Yoo, but on both occasions the economy collapsed and tax revenues dropped. Why? Borrowers and businesses were saving to pay down their debts rather than spending. So the question is how to stimulate enough demand that producers will continue to produce goods and services and therefore hold onto their workforce. Otherwise, if demand continues to fall, it leads to a vicious cycle—job cuts lead to a downward spiral in incomes as well as prices, leading to more job cuts.

The answer is classic Keynesian economics. Lord Keynes asked the question in the 1930s: why do governments spend money during times of war to stimulate economic growth, but not during peace time? Dr. Yoo said it took Japan 10 years to understand that it was necessary for government to stimulate enough demand to prevent deflation. “The (U.S.) economy would be shrinking quickly if the government didn’t borrow money (that is currently sitting unused in banks) so the GDP (Gross Domestic Product) could be maintained; the private sector would have income until debt minimization is over.”

So the key is how quickly debt minimization is happening. The Japanese were hampered by their Keiretsu relationships, or intermingling of bank + corporate ownerships that caused them to hide their bad assets. In fact, it led to putting good money after bad, in an attempt to prop up failing businesses and so starving healthy ones of needed credit to expand.

The good news is that consumers are paying down their debts in record numbers—mainly revolving debt—as we have discussed in past columns. So much so, that consumer revolving, credit card debt levels have returned to 2006 levels, as they cut up their cards and banks cut back on issuing new credit cards.

Consumer credit decreased at an annual rate of 8-1/2 percent in November, according to the Federal Reserve. Revolving credit decreased at an annual rate of 18-1/2 percent, and nonrevolving credit decreased at an annual rate of 3 percent. This graph shows the year-over-year (YoY) change in consumer credit. Consumer credit is off 3.9% over the last 12 months - and falling fast. The previous record YoY decline was 1.9% in 1991.

Such a balance-sheet recession is little understood by either government or business, according to Dr. Yoo. It requires a high government debt load to cure, which takes nothing away from private sector investment as long as private sector, demand side spending is still shrinking.

This recession has therefore baffled neo-classical, i.e., so-called free market economists, who tend to believe that markets cure themselves. But that makes no common sense—at least when balance sheets are so out of kilter. History has shown that businesses won’t begin to hire workers to produce more, unless they see an increase in demand, which means spending. New investment follows increased spending, in other words.

No one wants to see a repeat of Japan’s experience of the 1990s, when both its real estate and stock market bubbles burst. This is something that Chairman Bernanke and Fed officials are well aware of. In fact, it wasn’t until 2008 that Japan came out of its deflationary spiral.

“Unless the (U.S.) government issues a sufficient amount of debt and boosts fiscal expenditures, the (U.S) economy will fall into a deflationary spiral”, is Dr. Yoo’s warning.

Harlan Green © 2010

Popular Economics Weekly

The Federal Reserve’s latest Open Market Committee minutes highlighted the growing debate over when should the Fed begin to raise interest rates: “Some saw inflation risks as tilted to the downside, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation”, said the minutes. “But others felt that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits.”

This is a crucial question for many reasons-not the least is how it affects the credit markets. Record low interest rates are helping real estate to (slowly) recover, for one. The Fed should not act too soon, according to a Japanese banking expert, or we could repeat their decade-long malaise of the 1990s.

The Fed has another reason for keeping interest rates so low for this length of time, one they have not adequately explained. We are in a so-called “liquidity trap” similar to the Japanese experience. A huge mountain of money—more than $1.2 trillion in excess reserves, according to the Fed and $900 billion in MZM money at zero maturity in bank accounts earning almost zero interest—is not being put to work to grow the economy.

It is not being invested, in other words, as banks and investors have become hoarders in order to pay down record debt, rather than risk-takers. And so the Fed is pushing them to seek higher returns by keeping rates so low.

Consumers continued to pay down their debts in record amounts in November. Consumer credit has declined for a record 10 straight months - and declined for 13 of the last 14 months and is now 4.5 percent below the peak in July 2008. It is difficult to get a robust recovery without an expansion of consumer credit - unless the recovery is built on business spending and exports.

There is a danger in pushing investors to see higher investment returns, however. Fed Chairman Bernanke gave a surprising speech to the American Economic Association recently that maintained it was regulatory failures that caused the housing bubble, not interest rates being held too low.

But he is only partially right. For it was the record low interest rates of 2004-05 that pushed investors to seek higher yields elsewhere—in unregulated subprime and other Alt-A loan programs of that time. In fact, 24 of the 25 largest issuers of subprime and Alt-A loans in this decade were unregulated financial entities outside the purview of federal regulation, according to Paul Krugman.

So this could happen again, if regulatory oversight remains weak and the financial sector again finds ways to make money in the “shadow” banking system outside the control of the various regulatory agencies.

In other news, the December unemployment report was surprisingly weak, as payrolls lost another 85,000 jobs. Even government cut back on hiring. The December drop was led by an 81,000 fall in the goods-producing sector which included a 53,000 decline in construction and a 27,000 decrease in manufacturing. The service providing sector dipped 4,000 after a 62,000 gain in November. The largest decreases were in trade & transportation, down 37,000, and in government, down 21,000. The big positive was a 50,000 jobs jump in professional & business services with temp help jumping 47,000. Temp hiring tends to be a leading indicator for overall payrolls.

Employers seemed to have misjudged the strength of holiday consumer spending. For about three dozen of the country’s biggest chains, sales at established stores actually increased an average of 2.8 percent in December from a year ago, according to the International Council of Shopping Centers (ICSC), a trade group.

Sales for the last two months of the year jumped 1.8 percent, compared with a record 5.6 percent drop in 2008 — marking the strongest holiday performance in three years. This tallies with the recent increases in wages and salaries that are enabling consumers to both pay down their debts and begin to spend again.

This could mean a 4 percent jump in Q4 Gross Domestic Product growth. But debt hawks shouldn’t call for early tightening and removal of stimulus spending, until the unemployment rate declines to a tolerable level.

In fact, historically, there is no real inflation danger with high unemployment. Inflation only rose during the last cycle when the unemployment rate fell below 6 percent. And the severity of this downturn means that won’t happen for years.

Harlan Green © 2009

The Mortgage Corner

Nationwide housing affordability, bolstered by affordable interest rates and low house prices, hovered for the third consecutive quarter near its highest level since the series was first compiled 18 years ago, according to the National Association of Home Builders.

The NAHB’s Housing Opportunity Index (HOI) is just one of several that show rising housing affordability at a time of declining incomes and housing values. What makes buying opportunities so special this time, as opposed to past downturns, is the record low interest rates. The various government stimulus plans have been buying down conforming and ‘high balance” conforming 30-year fixed interest rates to below 5 percent.

The HOI showed that 70.1 percent of all new and existing homes sold in the third quarter of 2009 were affordable to families earning the national median income of $64,000, down slightly from a near-record 72.3 percent during the previous quarter and up from 56.1 percent during the third quarter of 2008.

"At a time when housing is at its most affordable, we applaud the recent actions taken by Congress and President Obama to stimulate housing by extending the federal tax credit beyond its Nov. 30 deadline and expanding it to a wider group of eligible home buyers," said NAHB Chairman Joe Robson. "With interest rates now lower than last quarter, the tax credit will encourage even more home buyers to enter the market and help stabilize housing and the economy by creating new jobs, stimulating home sales, reducing foreclosures, cutting excess inventories and stabilizing home prices."

Indianapolis was the most affordable major housing market in the country during the third quarter, a position the metro area now has held for 17 consecutive quarters. Almost 95 percent of all homes sold were affordable to households earning the area’s median family income of $68,100.

Housing inventories continue to decline, so prices are firming in most areas of the country. Existing-home inventories have just declined to 7 months, and are now below 2007 and 2008 levels. This probably means that housing affordability is at its high point, as household incomes are declining at the moment and interest rates cannot go much lower. The September S&P Case-Shiller index for existing, same-home sales showed California cities San Francisco, Los Angeles, and San Diego with 3 of the top 4 price increases.

Due to the increased affordability, first-time homebuyers accounted for 47 percent of purchases and were mostly buying using FHA insured loans. Investors bought 15 percent of homes in October, according to a recent Campbell Communications survey. About 72 percent of these purchases were cash. Current homeowners bought 38 percent of homes sold in October and used a mix of financing.

The key to continued affordability will be maintaining the record low interest rates. This should continue until at least March 2010, when the Federal Reserve has said it will discontinue purchasing Mortgage Backed Securities that set the price of fixed rate mortgages. The Fed has bought almost $1 billion to date, but it is the private financial sector that must replace the Fed’s purchases next year. That will happen when we see a decline in default and foreclosure rates, which are dependent on an improving jobs market. Stay tuned.

Harlan Green © 2009

Popular Economics Weekly

The recession has ended with the large increase in Gross Domestic Product for the third quarter just ended. So positive signs are accumulating that the economic recovery will be sustainable. That means it will continue to grow even when the various government stimulus plans cease sometime next year. I am even more optimistic than the New York Times’ Paul Krugman in seeing a sustainable recovery. He believes another stimulus package will be needed if we want to bring back the 7 million jobs already lost in this recession.

The main reason for such optimism? A weak dollar is causing soaring exports, consumers have decided to increase their spending, and labor productivity has soared, meaning much more is being produced even with a reduced work force.  Employers will have to begin hiring soon, however, as workers are again closer to the 40 hour week, and it is cheaper to hire than pay more overtime to existing workers.

Since consumers make up 70 percent of economic activity, they must be the main driver of any recovery. And consumers have shown they will dig into their pocket books when they feel confident that their situation is improving. But we should not be looking at comparisons to the bubble years to know what kind of recovery this will be. Those years were an anomaly that won’t be repeated anytime soon.

The most positive sign was the 3.5 percent increase in third quarter Gross Domestic Product. It expanded in all areas, including an increase in residential construction. But consumers and businesses also increased their spending. Exports (read manufacturing mostly) in Q3 increased 14.7 percent, vs. 4.1 percent in Q2, while imports increased even more—16.4 percent vs. a decrease of 14.7 percent in Q2.

This is why personal consumption contributed 2.36 percent to Q3 growth, the highest percentage since Q1 2007. Residential construction contributed the most in 3 years. (Construction spending as a percentage of GDP had begun to decline in 2005—just when subprime loans became widely available.)

But because our economy is so dependent on consumers, it will be job creation that determines how much consumers will spend. With labor productivity soaring upwards of 6 percent (via more technology investment), employers have the luxury of increasing production up to a certain point without increased hiring.

The big surprise was the rise in private residential construction. It rose 0.8 percent in September, but is still 12 percent below last year’s total to date–another sign of a real estate recovery. Residential investment grew 23.4 percent in the Q3 GDP report, reversing the 23.3 percent decline in Q2, and contributed 0.53 percent to Q3 GDP.

The Calculated Risk Blog has broken down the components of residential investment, and single family construction tops the list. So it will also be one of the largest components of any sustainable recovery. Its historical contribution looks to be around 2 percent, which means 4 times the current production of approximately 460,000 units annually. During the bubble years 2004-06 it regularly exceeded 2 million units annually, hence the current oversupply.

The Federal Open Market Committee also reaffirmed its commitment to keep interest rates low and credit markets flowing. It said, “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The Fed’s statement highlights how necessary is continued fiscal and monetary policy to keep interest rates low and support this recovery. For example, more than 80 percent of all mortgage originations are sold to the government GSEs—Fannie, Freddie, FHA/VA. Confidence has not yet returned to private sector business, unfortunately, the reason for such high unemployment. So confidence has to return to the private business sector, as well as consumers, before we see any substantial job creation.

Harlan Green © 2009

Popular Economics Weekly

Nobelist and New York Times columnist Paul Krugman recently wrote about “zombie” economics coming back from the grave to haunt us. By that, he meant a version of Adam Smith’s classical, free market economics that advocated less regulation and lower taxes that was in vogue in the 1980s. Their mantra was “Government is the problem”.

It was labeled ‘trickle-down’ economics as the ticket to greater prosperity for all because it advocated tax breaks to the wealthiest while allowing financial markets to regulate themselves.

Dr. Krugman lamented the fact that even though its principles had long since been discredited—only a few prospered, while it meant greater debt for government, and the majority whose incomes didn’t rise—its proponents were using its arguments to attempt to discredit the various stimulus plans, as well as health care reform.

The zombie economists maintained that cutting taxes always created jobs, forgetting that it depended on whose taxes were cut. When it was the investor class, then it usually resulted in an oversupply of goods and services that tended to create the various asset bubbles–such as housing. Unless the majority of consumers’ incomes were also boosted, there would be no one to buy the products.

That is why the various stimulus plans accentuate direct job creation more than tax cuts and cash rebates. Tax rebates provide a temporary stimulus but peter out when the money is gone. Putting the stimulus monies into various public projects-such as high-speed rail transport—creates not only jobs, but new industries in the better-paying high tech sector for the longer term.

The Cash for Clunkers is another example. By encouraging consumers to buy high-mileage cars, it nudges the auto industry and its affiliates towards energy conservation and lower pollution, as well as creating more jobs.

The stimulus monies were designed to feed into the economy over the next 2 years, once the financial markets stabilized. And so the just released minutes of the Federal Reserve’s latest Open Market Committee meeting point to continued concern that economic growth will take at least 2 years to recover. They are in no hurry to increase interest rates for that reason.

That’s a good thing for real estate values, in particular, not to speak of consumer debt loads, which have now fallen to 2005 levels. Low rates are spurring the real estate recovery, with fixed interest rates up to $729,750 now at or below 5 percent with a 1 point origination fee. The June Case-Shiller home price index increased for the first time in a year.

What about the federal debt? It is currently $9 trillion and on track to become $12 trillion by the end of 2009. That is approximately 80 percent of our Gross Domestic Product. That is high but nowhere near the record of 120 percent set in WWII, and it took that amount of government spending to get us out of the Great Depression.

This is important, because without the government stimulus spending we could be in a full-blown recession. Interest rates would not be this low and job losses would be much more serious. So though the government debt is troublesome, we won’t be able to pay any of it back without a sustained economic recovery, which means when the private sector is willing again to expand.

Harlan Green © 2009

Popular Economics Weekly

Why do we say that this could be a ‘V’ shaped recovery, instead of ‘U’, ‘L’, or ‘W’ shaped? Last week’s column included a graph that portrayed the history of recoveries from 1980, the last ‘W’ shaped recover. The W was because it was really 2 recessions—in 1981 and 1983, as the economy recovered from double-digit inflation and job losses.

In contrast, a ‘V’ shaped recovery means that because output, jobs and housing prices “fell off a cliff” last fall, to use Warren Buffet’s term—the down leg of the V—panicked investors and consumers over reacted. Some pundits predicted another Great Depression, after all. The stock market is one example of a more ‘V’ shaped recovery. The stock market became oversold and so investors jumped back in when the credit markets recovered, which caused the very sharp rise in the various stock indexes from March—the up leg of the ‘V’.

The labor markets are another example. The loss of more than 6.5 million jobs in just one year is unprecedented, the result of panicked business owners who didn’t know what the future would bring. They therefore dropped workers while selling off their inventories, which means their shelves are now relatively bare.

But second quarter GDP figures show that demand is picking up. In particular, real estate, manufacturing and service sector activity is increasing, so businesses will have to over correct in the other direction to replace their inventories—the up leg of a V-shaped recovery again.

The Federal Reserve Open Market Committee met again, and decided to keep their low rates for an “extended period”, as before. But they are also anticipating a recovery. Their release said:

“Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

The Fed also said they might have spent all of the $300 billion set aside to buyTreasury securities by October, and then no more. What will it do to interest rates is the question? They have already bought more the $250 billion. Here is their statement on the matter.

“To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.”

There is no question that the massive amounts of Federal Reserve stimulus—mainly in aid to banks, but also to the credit markets—have kept rates at historic lows for this extended period. The Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency (Fannie Mae and Freddie Mac) debt by the end of the year, as well.

But there is no way real estate values will even begin to recover until 2010 and beyond. So the Fed will have to continue their stimulus efforts in keeping rates down into 2010, at least. Since only when real estate recovers will the rest of the economy (and consumers) follow.

Harlan Green © 2009

Popular Economics Weekly

Don’t take the White House word for it. The huge amount of stimulus injected into the U.S. economy is working. Not only is second quarter gross Domestic Product (GDP) growth showing improvement—it contracted just 1 percent in the initial estimate, vs. 6.1 percent in Q1—but the unemployment rate actually fell to 9.3 percent from 9.4 percent.

Economists and analysts polled by the New York Times said that President Obama’s $787 billion stimulus plan had already added 1 percentage point to second quarter growth. As more of its job-creation spending kicks in, it could add as much as 3 percent to growth by the end of this year.

Direct government spending has worked the best. There is general agreement that tax rebates and tax cuts have done less, mainly being used to pay down debt. The latest Federal Reserve report on consumer credit showed that consumer debt decreased another 5 percent in June, and a total of 5.4 percent in the second quarter. This has put consumer debt totals back to 2007 levels. Consumers have been holding on to their wallets and purses until they see better times coming, in other words.

Chief of Staff Rahn Emmanuel said, "If you think about it, the first six months were spent rescuing the economy. Now the president is laying the groundwork for rebuilding the economy."

Non-farm payrolls decreased just 247,000 and have been decreasing at a 330,000 per month rate in Q2, compared to an average 645,000 per month decrease over the prior 6 months. Average hourly earnings have been rising 2.5 percent, but average hours worked is stuck at 33 hours per week, the smallest work week since World War II.

Even so, the credit markets are working so that auto and home sales are beginning to recover. The Cash for Clunkers program is but one example of the pent-up demand. Car sales rose to an 11 million unit annual rate just in July, where it has been languishing at 9-10 million over the past months.

Another sign of recovery was the June rise in factor orders. Orders for core capital goods, which are used by businesses to expand or update their productive capacity, rose for the second consecutive month by 2.6 percent. This is confirmed by the Institute for Supply Management July manufacturing report. The ISM survey reported that overall manufacturing activity jumped 4.1 points with most its components—including employment, new orders and prices—now above 50 percent, signaling manufacturing businesses are once again expanding.

The unemployment report is one of 4 indicators used to call the end of a recession. It probably confirms that the recession ended in July. In fact, this could turn into what is called a ‘V’ shaped recovery if past recoveries are a guide. Only the 1990 and 2001 recessions—under administrations that did not believe in government stimulus spending—had more prolonged and jobless recoveries. If the stimulus plan continues to perform as expected, we could see jobs as well as overall economic growth expanding by the end of the year.

Harlan Green © 2009

POPULAR ECONOMICS WEEKLY

The expectations we hold illustrate how important confidence is to an economic recovery. And because the latest unemployment report wasn’t what the pundits expected, stock prices tanked, causing interest rates to decline back to historic lows. (It helps that the Fed is also buying Treasury Bonds, driving down rates further, of course.)

It’s hard to say what is driving the disappointment in expectations. It has in part to be the Obama Administration’s overoptimistic growth projections. But there also has to be alarm over the growing deflationary wage spiral that affects so many consumers. Yet after 30 years of supply-side economic policies—that depressed wage and salary growth that make up 80 percent of personal incomes—it will take more than a few years for consumers to spend again.

In fact, one reason that consumers are now saving more than they are spending (savings rate is up 5.7 percent vs. just a 2 percent annual spending increase) is their expectation that incomes will not improve very soon.

And expectations affect the general level of consumer confidence which in turn helps to determine when general economic conditions will improve. The optimists hope the recession will end this year, including President Obama’s Council of Economic Advisors, while many reputable economists say we will have to wait at least another year.

Yet expectations are notoriously hard to measure, since they are based on feelings more than facts. And feelings cannot really be measured, yet we have no other way to assess our futures. That is why economist Robert Shilling has focused so much research on the importance of the components that instill—or deflate–confidence, including trust in our financial institutions that was broken with the subprime debacle.

We know a consumer expectations survey by the Conference Board has risen more than 16 points since November 2008. But it cannot rise much more without an improvement in wages and salaries. Such wage deflation last happened during the Great Depression, as a result of very similar policies that saw a massive redistribution of wealth in the 1920s. President Roosevelt’s Federal Reserve Chairman Martin Eccles said at the time:

“… a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”

That is why so much of the Obama stimulus plan is devoted to creating jobs over the next 2.5 years. But it will be a slow process, since it has to reverse 30 years’ of policies that choked off wage growth.

What happens if the Federal Reserve worries so much about inflation that it begins to soak up all the excess liquidity before sufficient economic growth returns? A historical look at the 1937 recession (the Great Depression was actually 2 depressions, from 1929-33 and 1937-38) illustrates what happens when government tries prematurely to balance its budget.

The civilian unemployment rate had dropped from 25 percent to 10 percent by 1937, but quickly shot back up to 20 percent by 1938, prolonging the depression until the start of World War II.

The Obama Administration must therefore create more realistic expectations of future growth, a hard thing to do. One can only look at the various indicators that do the best job of measuring business sectors—whether in the service or industrial areas. Both have been improving of late. June business activity in the service industries shot up 7 points, for instance, and is on the verge of expanding after 2 years of contraction. Consumers (and so real estate) will be sure to follow.

Harlan Green © 2009

WASHINGTON (MarketWatch) – “Five of the Federal Reserve’s 12 district banks reported that the downward trend in the economy is showing signs of moderating, according to the central bank’s latest Beige Book report on economic activity. Contacts for several Fed districts said their expectations had improved, but none saw growth returning this year.”

This headline tells us that there is no recovery on the horizon yet—incipient or otherwise, as the inflation hawks would have us believe. Once we do begin to see a resumption of economic growth—maybe this fall at the earliest—then inflation would need at least another year to pick up any steam. Retail inflation as measured by the Consumer Price Index has in fact been negative over the past 12 months, after peaking at 5.8 percent in 2008. See the enclosed graph.

The main inflation worry has been about the enormous amount of government debt. But the U.S. ran twice that amount of debt as a percentage of GDP during World War II that got us out of the Great Depression. Japan’s debt load is even higher.

And we cannot have inflation without rising wages and salaries—which make up more than 80 percent of incomes. Not only have wages and salaries barely kept up with the inflation rate for more than 30 years, but the jobless rate of this recession will reduce incomes even more. The average work week has now dropped to 33 hours—when it was 40 + hours during boom years.

A recent Elliot Wave newsletter (usually hawkish on inflation) by writer Bill Rice also maintains that looming fears of inflation are unfounded:

“The Federal Reserve’s balance sheet has exploded, with total reserve bank assets now standing at $2.079 trillion. This same time last year, total assets stood at $1.181 trillion. Inflation? Yes, the balance sheet is significantly inflated — but is it inflationary? Not necessarily”, says Mr. Fox.

“Such a huge reserve certainly has the potential to catalyze inflation (indeed a hyperinflation), but only if the Fed Chairman Bernanke liquidates the assets that make up the reserve accounts. Simply put, there is no inflation if the Federal Reserve refuses to turn those assets into cash (i.e., buys them back) and dump that cash into the economy.”

Consumer-driven inflation is not there, in a word. Consumers have to have cash (or credit) in hand to create demand upon products, services and raw materials — and thus drive up their prices. When rising home prices and easy-to-get credit cards financed consumer purchases, demand was strong. But now the housing equity is gone, millions are out of work, average wages are stagnant and lending standards have returned to the world of reality. "Inflationary pressures" are not here.

Therefore, the talk of inflation is essentially a head fake, which means it is based on fears of repeating past history, rather than facts. It is another form of the irrational pessimism permeating markets during this recession. And it is contagious, just as the infectious greed of the Greenspan era spawned irrational exuberance.

Nobel laureate Paul Krugman’s recent New York Times column sums up where we are: “A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual,” said Krugman. “Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss.”

The one and only sure sign of an economic recovery is when the real estate markets begin to recover, period. And that will take time—even more time if the inflation alarmists have their way and cause interest rates to climb further.

Harlan Green © 2009