21 June 2009

Fed to keep 0% rates for another year...

The US Federal Reserve will keep rates close to zero until 2011 to continue providing monetary stimulus to an economy that will slow down again next year after the current bounce, analysts said.

"We are changing our forecasts to indicate stronger GDP growth overall for both 2009 and 2010. But this stronger growth is caused by a temporary spurt in output during Q4 2009 and Q1 2010, when we see annualised growth reaching three per cent," said John Calverley, Standard Chartered bank's (SCB) Head of Research for North America.

"Later in 2010, as the fiscal stimulus reverses out and the inventory bounce comes to an end, economic growth will slow again, as the economy works through the aftermath of the financial crisis. Inflation will continue to fall back throughout 2009 and 2010, at least, and we expect the Fed to keep the Funds rate at the current near-zero level until 2011," Calverley wrote in a research note.

Stimulus boost

The first effects of the $1 trillion-plus (Dh3.67trn) US stimulus package have shown up in income growth in recent months via tax cuts. Starting this summer, SCB expects to see some of the infrastructure spending begin to kick in.

"The effects of the stimulus will add to GDP for three or four quarters and then, as the spending rate slows, there will be a negative effect on GDP, sometime later in 2010," Calverley said.

"A few months ago US lawmakers promised there would be more stimulus packages next year if necessary. Probably some Congressmen had hopes they would have the chance to legislate for more spending just ahead of the November 2010 mid-term elections!

"But the bond market, reinforced by the view of several foreign governments, has already squashed those hopes. Even if unemployment is still very high next year [as we anticipate], there will be no room for a major new stimulus. Indeed the Administration and Congress will need to demonstrate how they plan to reduce the deficit over time," he said.

State and local governments are struggling to deal with reduced revenues and some have already made or announced large cuts in spending, while others are finding ways to temporarily avoid them. Further cuts will be necessary in 2010-2011, the analyst said, "as opportunities for creative accounting and prevarication dwindle".

Hence, 2010-2011 overall is likely to see the first stages of a substantial tightening of fiscal policy. Markets have recently begun to price in a rise in the Fed Funds rate over the winter. "Our forecast of a recovery starting in Q3 and with some relatively robust GDP numbers over the winter would, at first sight, seem to support that view. Moreover, we have long argued that the Fed will not want to leave interest rates at ultra-low levels for too long for fear of inflating a new bubble and creating new imbalances," Calverley said.

"However, we believe that the Fed will remain on hold during this period for two reasons. First, we expect core inflation to continue to decline over the next year, with fears shifting again towards deflation. An inflation-targeting central bank – as the Fed is in all but name – should keep rates below 'neutral' as long as inflation is below target.

"Secondly, we expect that the Fed will be focusing closely on private final demand, along with unemployment. We expect private final demand to continue to show clear signs of weakness since the recovery will mostly be due to the inventory bounce and government spending, both of which are strictly temporary," he said.

"Meanwhile, unemployment will peak at more than 10 per cent next year, leaving substantial slack in the economy and making it uncomfortable for the Fed to raise interest rates. Instead they will more likely tighten liquidity by reducing the size of the Fed's balance sheet, selling securities into the market. Our guess is that they will not rush to sell back the Treasuries and mortgage securities being acquired this year but instead will sell short-term securities into the market to mop up the liquidity.

"By the middle of next year the Fed might be ready to think about rate increases but, by then, we expect the bounce in growth to be fading. Only in 2011 do we expect a stronger outlook for growth, allowing the Fed to finally push up rates. Even then we expect the new norm for Federal Funds rate, at least initially to be around 2-2.5 per cent rather than the 4-5 per cent of the last two economic cycles," Calverley said.

Inventories will provide lift

Economic recoveries in the US historically have been driven by a combination of an inventory rebound, a surge in house-building and a jump in car and other big-ticket purchases. The inventory rebound is almost a mechanical process, Calverley said.

"During a recession, business cuts output below sales to pull inventories lower and then, once inventories are on a downward path, production picks up again, generating the economic recovery. After the severe recessions of 1974 and 1982, this bounce gave a lift to GDP of around two to three per cent over the subsequent year.

"We expect a boost in the one to three per cent range this time, because inventories are a smaller share of GDP than in the past. The exact timing of this rebound is hard to predict, though as usual it will have a considerable impact on the quarterly path of GDP.

"It could start as early as Q3 but given the still very high level of inventories in relation to sales currently, inventory liquidation may stay very high during the summer so we forecast it starting Q4," Calverley said.

House-building recovery

The outlook for house-building in the near term is less promising. Recent levels of starts, at around 500,000 annually, are well below the rate of growth of household formation based on demographic and immigration trends. "So, at some point, we can expect house-building to move back up to around 1.5 million annually, an adjustment which will provide a boost to GDP of around two per cent," SCB said.

But any significant upward move is unlikely for some time, it added, given the overhang of unsold homes and continuing high foreclosures. "Housing starts exceeded the 1.5 million level throughout 2002-06 and we estimate that there is a surplus now of perhaps two million homes. Absorbing this surplus will take around two years at the current level of starts.

"House-building likely will creep up gradually, starting later this year but not fast enough to add a whole lot to GDP growth. That will probably have to wait until 2011-12. Still, Q4 this year may be the first quarter since 2005 that residential construction has not subtracted from GDP. "Unfortunately, the better news here will be offset by declining commercial construction as buildings are completed and few new ones are started, unless they are part of the government's fiscal stimulus package," Calverley said.

Car sales and production

There is a good chance that car sales will pick up from their current very depressed levels, the bank said. In 2006-07, sales were running at an annual rate of 16-17 million units, whereas recently the figure has been below 10 million. Sales have been depressed partly by the uncertain economic outlook and rising unemployment and partly by the difficulty of obtaining credit.

"As unemployment starts to top out, (in our view between 10-11 per cent), and auto financing becomes easier with the help of government programmes such as the TALF, sales should pick up. However, we would not expect a quick rebound to 2007 levels. For one thing, Americans probably bought too many cars during the last boom, with the help of surging wealth from real estate and stocks as well as zero-rate credit.

"So, despite recent low sales, it is much too early to talk of pent-up demand, as was often an important factor after past recessions. Still, over time, a recovery in car sales and production, perhaps initially into the 12-13 million range annually, will help boost the economy," Calverley said.

Consumer demand

All this implies that consumer demand is expected to remain sluggish, and that is bad news for an economy in which this accounts for 70 per cent of GDP. "The two key variables are real income growth and the savings rate, but it is hard to be optimistic on either," Calverley said. Income is being squeezed by rising unemployment, slowing wage growth and rising gas prices. There are reports from across the US of pay freezes and even pay cuts. Benefits are being shaved too.

"Of course we expect price inflation to moderate as well so real income growth will not slow as much as nominal income but companies are determined to raise margins so real income will still be squeezed. Consumers will not have much extra money to spend, nor will they be able easily to borrow.

"Banks continue to cut back on credit lines, while the fall in home prices is undermining wealth and collateral. Weak income growth due to rising unemployment is a particular problem right now and will restrain spending in Q2 and Q3," the bank said.

"Payroll losses should come to an end and, depending on oil price trends, real income growth should resume, though slowly. Then much will depend on the savings rate. It has already moved up to 5.7 per cent but we expect consumers to continue to push the savings rate higher," it said.

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