Dr Lacy Hunt, executive vice president of Hoisington Investment Management (which has $US5.6 billion in assets under management), was one of the first leading US economists to highlight the problems associated with the Fed’s quantitative easing programs.
In an wide-ranging interview with Business Spectator, Hunt, who was previously the senior economist for the Federal Reserve Bank of Dallas and the chief US economist for HSBC, explains why the US central bank will be reluctant to embark on a new bond-buying program even though optimism about US economic growth is about to be dashed.
Lacy, many economists are getting excited that the US economy could finally be on track for a sustainable recovery. Is this optimism misplaced?
The main obstacle to a resumption of normal economic growth is the excessive indebtedness of the US economy. Policy measures are trying to cure the indebtedness problem by an easy monetary policy that is encouraging private indebtedness to rise, and by stimulatory fiscal policy that increases government indebtedness. Both these are counterproductive in the longer-term sense. Whenever monetary or fiscal authorities resort to increasing indebtedness, they can produce transitory periods of growth. But these episodes of better growth dry up quickly, and then the economy is saddled with even more debt. Indebtedness will not be cured by more debt.
The other prevailing belief is that extra debt can buy gains in GDP, production and employment. But the extra debt does not generate extra income, and that’s a really important distinction. GDP measures spending, income determines prosperity. Median household income adjusted for inflation, the key measure of our standard of living, has fallen back to where we were in the mid-1990s, even though our debt to GDP ratio is 100 percentage points higher. Similarly, real disposable income per capita has basically been bouncing on either side of zero for the past two years and in the latest three months it has declined slightly. Thus, in spite of gains in GDP and employment, income has continued to weaken, as higher paying jobs have been substituted for lower paying ones.
If debt is increased without generating income, the consumers, businesses and government are not in a position to service the higher debt, and so debt quickly becomes destabilising.
However, US growth did appear to pick up in the final three months of 2011.
People became optimistic after the GDP gains in the fourth quarter of 2011. But most of that gain – over 60 per cent – was due to higher inventories. My tracking of the US economy suggests that we’re not getting much growth in the first quarter of 2012, and that much of the growth reflects a further acceleration of inventory investment as well as a sharp drop in the personal saving rate, neither of which suggests sustainability. At present, firms are optimistic, stock prices are higher, and people are taking on more debt, including in the consumer sector. Instalment debt relative to disposable personal incomes has risen by 0.75 per cent in the last three months, which helps retailers in the short-term but ultimately represents more of a burden for the household sector.
The personal income tax receipts of the US Treasury confirm the disconcerting income situation. For the first five months of the US government’s fiscal year, which starts on October 1, the US Bureau of Labor Statistics says there were 1.8 million more people with jobs. That’s not really a robust increase, but it’s better than we’d been getting and would seem to indicate there’s some degree of revival taking place. With 1.8 million more people with jobs it might be presumed that personal income tax receipts would be higher than they were in the comparable period the previous year. Instead they were down by 0.2 per cent per day. In the midst of job creation overall, higher paying and full-time jobs were replaced with lower-paying part-time jobs. So the gains in economic activity and employment fuelled by recent debt increase in my opinion are no more sustainable than they have been in the past because they didn’t generate the income to make the debt more sustainable.
Still, the US unemployment rate has fallen quite sharply.
The unemployment rate measures the number of those people who are jobless as a percentage of those who are in the labour force. But it’s hard to measure the labour force precisely. The unemployment rate has declined as the labour force participation rate has dropped to a three decade low. A lot of people are not really looking for work anymore, and I’d argue that it’s because they’ve become discouraged. A cleaner measure of the labour market is the ratio of those employed compared to the population. And it’s still sitting very close to the lows to the lows reached near the end of the recession 11 quarters ago. It’s basically been stagnant in the 11 quarters since the US economy technically emerged from recession. So the employment ratio paints the same picture as real disposable income per capita – that there is no major improvement taking place.
You were also one of the first economists to highlight the negative effects of the US central bank’s quantitative easing strategies, QE1 and QE2.
Yes, as a matter of fact, since early December we’ve had an additional stealth QE. In early December, the Fed expanded its balance sheet at one point by $105 billion in order to make loans to the European Central Bank. Although not as large as QE1 and QE2, such an amount is still very sizeable. Whenever the US Fed engages in radical balance sheet expansion, an initial liquidity effect on markets is evident. Domestic and global stocks rise. But also some of this liquidity goes into commodities, because the Fed has no control over the process once the balance sheet has been expanded.
As a result of QE2 and the stealth QE since early December, wholesale gasoline prices have risen by more than the increase in domestic or global stocks, and big increases occurred in other commodities that are important elements in the cost of living. So the Fed, through QE1 and 2, and the recent stealth QE, has increased the inflation rate, at least temporarily. It’s now at 3 per cent. At the same time, wages are continuing to decline in real terms. Year on year, wages only rose 1.9 per cent in nominal dollars. Thus, the Fed undermined the living standards of millions of modest and medium households. In the twelve month periods ending in February 2012, real disposable income per capita dropped 0.4 per cent, but in the latest three months, the annualised rate of decline was a sharper 0.7 per cent. In essence, through its policies, the US central bank exacerbated the income and wealth divide. The high end benefited from higher stock prices while the position of the broad middle worsened.
Until recently, many economists had been tipping that the US central bank would embark on a new round of quantitative easing – QE3 – before the US presidential election, but the latest minutes suggest that the bank is not in any hurry to do so. What’s your view?
I think they’re now aware that balance sheet expansion has had counter-productive effects, and so they may be more interested in a sterilised approach. They recently floated a trial balloon for an approach that would not increase the size of their balance sheet – they’d borrow funds from the market place in order to fund any additional purchases. This different approach is not going to produce the short-term liquidity and inflation effects that were evident in QE1 and QE2, and the stealth QE.
Do you think that US bond yields are likely to keep rising?
We had a steep rise in bond yields during QE1 and QE2. The stealth QE has also pushed bond yields higher due to higher inflation. But, the upturn in inflation in QE1 and 2 were temporary, and I’d argue that current rise is also transitory. I think we’re going to follow a pattern we have seen before. The market is overly optimistic about the economy’s prospects. I expect growth to be much less than is generally anticipated. Thus, inflationary pressures will recede and so will bond yields.
Firms are optimistic that sales are going to be robust and they are boosting production. But revving up production to build inventories is not the same as increasing production to meet final demand. We don’t have a lot of information yet on the first quarter of 2012, but some outside reality check indicators are consistent with a much more sluggish picture of the economy. According to the American Trucking Association, trucking volumes were down a net 4.1 per cent in the first two months of the year. From another source, US railcar loadings are tracking below the levels of 2011 and 2010, and not much higher than in 2009. Such indicators do not provide conformation that a robust surge in economic activity is taking place.
And at the same time, US housing prices are continuing to fall.
The thing to remember here is that residential construction only accounts for 2.4 per cent of the economy. So even with, say, a 5 per cent gain in residential construction in the first quarter, this would only add 0.1 per cent to the GDP growth rate. The capital goods sector, which is 7.5 per cent of the economy, activity contracted by a 3 per cent annual rate in the January and February versus the fourth quarter. That’s not surprising because the special 100 per cent depreciation allowance on capital goods ended on December 31. Non-residential construction – which accounts for 10 per cent of GDP – saw broad based weakness in January and February, declining at a 1.8 per cent annual rate. That is also not surprising since plant modifications have typically occurred when new equipment was purchased. Thus, for the first two months of the quarter, total construction expenditures fell as weakness in nonresidential more than offset the gain in residential. This decline is against a backdrop of one of the mildest winters in many decades that should have boosted outdoor activity.
State and local governments are facing a cumulative deficit of almost $50 billion for their next fiscal year that starts in July. The states, particularly the big states like California and New York, are experiencing weaker income tax collections. The state and local sector is more likely to detract than add to economic growth this year.
Finally, although the federal government is on the path to $1.25 trillion deficit in fiscal 2012, government expenditures for goods and services adjusted for inflation are in negative territory. So the government sector is not a positive for growth. At the same time, a recession in Europe and severe slowdowns in China and other parts of Asia are resulting in a higher international deficit. Although only one month of data is currently available, the deficit on the international goods and services account is paring 1 per cent growth from GDP. So the main area of strength is inventories, unlikely a sustainable pattern. Consumer spending is positive but only because the saving rate has dropped to a paltry 3.7 per cent, or the same level as January 2008. People are expecting US economic growth of 3 per cent. I don’t think growth is anywhere near 3 per cent. I think growth will decline and become less balanced – tipping more towards inventories and less towards final demand – unless income growth stops contracting and there is no indication such a reversal is at hand.