Back to Basics

Oct 16, 2013

U.S. Chamber of Commerce Chief Economist Dr. Marty Regalia.

With the government shutdown and debt ceiling crisis behind us, at least temporarily, I thought it may be a good time to take a closer look at the underlying economy and the role of the Federal Reserve in stimulating the recovery.

A Slow Recovery. The economy entered the recovery over four years ago. But the recovery has been very slow by historical standards, with economic growth averaging only 2.2 % since that time. This rate of growth is virtually identical to our long-term potential rate of growth and, as such, has been barely enough to provide jobs for new entrants into the workforce and far too slow to reemploy those workers displaced during the downturn.

The unemployment rate has fallen to about 7.3% as unprecedented numbers of people have dropped out of the labor force. During the last recovery in 2001 when it took almost 39 months to regain the prerecession peak in employment, the press labeled it “the jobless recovery.” We are now 50 months into our current recovery and are yet to regain our prerecession level of employment.

While there are many explanations for the slow, subpar recovery, including the accompanying financial crisis, the tsunami and the nuclear meltdown in Japan, the European debt crisis, and the housing collapse here at home, much of the blame must fall on poor public policies. Policymakers overreacted to the downturn with excessive and poorly defined financial regulations, expensive environmental and labor market regulations, ineffective housing and tax policies, and an unpopular and ill-defined health care law. Together with rhetoric from the administration, these policies have created a paralysis that even today is impeding growth.

We are now 50 months into our current recovery and are yet to regain our prerecession level of employment.

A Faster Pace. The struggling economy is beginning to gain some momentum. The housing market has finally started to rebound both in terms of new construction and prices. Another positive factor in the outlook has been the recent developments in exploration and extraction of fossil fuels in the upper Midwest and east into Pennsylvania. These developments have led to significant job and income creation, and if fully utilized and expanded to federal lands, they could lead to energy independence and a major source of exports.

Europe has so far avoided a collapse of the monetary union and may be growing again, Japan shows signs of improvement, and the Federal Reserve has chosen to maintain an unabashedly aggressive “loose” monetary policy. So it may be informative to take a look at a few of the positives.

Going forward, the most important of these factors may be the continuing improvement in the housing sector but not for the reasons most people focus on. The explanation may require a bit of a digression.

Consumption represents over two thirds of our economy and is driven primarily by income and wealth. As is customary during economic cycles, real disposable income fell during the downturn but turned positive early in the recovery. Granted, the growth was slow by historical standards, owing to weak job creation and slow real wage growth, but positive nonetheless. This income growth, together with the Fed policy of keeping interest rates near zero, has lowered debt servicing costs and has increased spendable income.

Household net worth, however, has behaved quite differently. Household wealth uncharacteristically fell by over $15 trillion during the recession and was very slow to recover. Financial wealth returned as the equity and bond markets recovered and is currently well above its prerecession level. But the total value of housing assets did not recover quickly and is still below prerecession levels.

Total housing assets were almost $22.5 trillion (over 27% of household wealth) before the recession. This figure fell to below $16 trillion, losing over $6.5 trillion, as the recession deepened. Housing wealth has recently begun to recover; however, at only about $18.5 trillion, it is still well below the prerecession peak. Thus, improving existing home prices and recovering home values are paramount to underpinning consumption and getting the economy back on track. And, obviously, a few more jobs in the homebuilding sector wouldn’t hurt either.

The Fed’s Growth Steroids. Perhaps the second most important of the aforementioned factors pointing toward stronger growth is the aggressive stance of monetary policy. Fed policy has taken two forms—the first is maintaining short-term interest rates at close to zero.

While the main thrust of the interest rate policy may be to encourage borrowing by keeping borrowing costs low, the biggest benefactor of this policy may be consumers. American households currently have about $13.5 trillion in liabilities, an amount down only about a trillion dollars from its prerecession peak. But because interest rates on many of these liabilities are tied to the shorter end of the yield curve, Fed policy has lowered the service costs of this debt by about $220 billion a year. This has an effect similar to a tax cut of the same magnitude.

The second part of the Fed’s program is the asset purchase program known as quantitative easing. In the dark days of 2008, Fed Chairman Ben Bernanke, then-secretary of the Treasury Hank Paulsen, and the president of the New York Fed proposed a program to buy troubled assets from the financial markets. The program, known as the Troubled Asset Relief Program (TARP), was never implemented as advertised. Instead, it morphed into a $700 billion program for injecting capital primarily into banks and other financial institutions.  

When TARP expired in October 2010, rather than pushing to have the program renewed, the Fed invoked a never before used clause in the Federal Reserve Act. This enabled the Fed to buy assets, primarily U.S. Treasury bonds but also other high-quality instruments such as AAA-rated mortgage-backed securities, directly from  financial markets. Over the next couple of years, the Fed purchased almost $3 trillion of these assets with varying maturities from the banking system. This injection of reserves made the banking system more liquid and ostensibly better able to lend.

At the same time, the Fed didn’t seem to want the banks to lend these newly acquired reserves and by so doing increase the money supply and possibly cause inflation to accelerate. So the Fed encouraged the banks to redeposit the proceeds back into the Fed by offering to pay the banks a 25 basis point premium. As a result, over $2 trillion of the reserves that the Fed provided through this program were redeposited at the Fed. While not immediately obvious, this program reliquefied the banking system at a time of stress and provided a fairly riskless income stream to help build capital. In short, the greater purpose of quantitative easing has been to strengthen a banking system deeply wounded by the financial crisis.

Recently, the Fed announced that it would like to begin to unwind this program and return to a more normal policy stance, presuming, of course, that the economy is strong enough to handle the withdrawal. This announcement has understandably led to some increased angst in equity and bond markets, but the Fed has, as yet, refrained from initiating any tapering. And both Fed interest rate policy and quantitative easing remain very accommodative.

The bottom line is that some positive factors at work in our economy should help accelerate growth toward the 3% range as we near year-end and look into 2014. Now, if we can just avoid shooting ourselves in the foot … again!

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