Studying the U.S. Economy’s Great Tug-of-War

Federal Reserve

In many ways, central bankers are like physicians (and in some ways, Mr. Market is a hypochondriac, but that’s beside the point). Central bankers are constantly trying to diagnose the condition of the economy and prescribe medication for what ails it in times of trouble. During the financial crisis in the U.S., this looked like the Federal Reserve bringing the economy onto the operating table for open-heart surgery: bailouts, near-zero benchmark interest rates, and unprecedented monetary stimulus.

Whether or not the Fed is treating the symptoms or the causes of slow economic growth is, technically, up for debate. Many policymakers and economists, including those at the Fed, agree that monetary policy is a tool best used to impact economic conditions in the short term. Low interest rates can catalyze business activity, but quantitative easing and the zero-bound are not sustainable.

money-printing-pressIn the post-crisis era, the economy is still very much in recovery and the markets are hooked up intravenously to monetary stimulus. Market participants and investors must make decisions against a backdrop of tediously slow global economic growth and howling fiscal headwinds.

Love them or hate them, the members of the Board of Governors of the Federal Reserve and the presidents of the various regional Federal Reserve banks are not only the people with their fingers on the pulse of this backdrop, but they are largely responsible for both the diagnosis and the treatment. In this spirit, we like to pay close attention to what they have to say.

Where we are now

“Since the end of the Great Recession in mid-2009, we have had 15 consecutive quarters of positive growth of real GDP,” commented Federal Reserve Bank of New York President William Dudley in a speech he delivered on July 2. “However, the average annual growth rate over that period has been just 2.1 percent.”

This sort of fuzzy growth rhetoric has characterized much of the post-recession era. Any statement indicating some sort of growth trend seems to be punctuated with something that undermines it.

jobsHere it is again with employment, also from Dudley’s speech:

“Although the unemployment rate has declined by 2.5 percentage points from its peak of 10 percent in October of 2009, much of this decline is due to the fact that the labor force participation rate has fallen by 1.5 percentage points over this period. Recall that discouraged workers who do not actively look for work are regarded as not participating in the labor force and so are not counted as unemployed even though they are without jobs.”

And, “Job loss rates have fallen, but hiring rates remain depressed at low levels.” At the end of the day, as Dudley says, the labor market can not be seen as healthy despite what seem to be positive indicators. “Numerous indicators, including the behavior of labor compensation and household assessments of labor market conditions, are all consistent with the view that there remains a great deal of slack in the economy,” he says.

But there are some bright spots, despite all the qualifiers. Various measures of household leverage are at their lowest levels in over a decade and household net worth has returned to its average from the previous decade. Banks are (ostensibly) beginning to ease credit standards, which is expected to encourage consumer spending on durable goods (can you say even more car sales?).

house-of-cardsThe great bastion of the recovery to date has been the housing market. “Housing starts and sales are now on a clear upward trend,” commented Dudley, “and a widely followed national home price index is up around 12 percent over the twelve months ending in April. Indeed, anecdotal reports suggest that this higher-than-expected increase in home prices is due to a lack of homes for sale.”

The index he is referring to is from CoreLogic, which at the beginning of June reported that “house price growth continues to surprise to the upside… Increasing demand for new and existing homes, coupled with low inventory, has created a virtuous cycle for price gains, most clearly seen in the Western states with year-over-year gains of 20 percent or more.”

The fiscal drag

It seems like nobody at the Fed can give a speech these days without taking a shot at fiscal policy (and perhaps rightly so). “Estimates from the Congressional Budget Office (CBO) indicate that this fiscal restraint is on the order of 1.75 percentage points of potential GDP this year,” commented Dudley.  ”Thus, I continue to see the economy as being in a tug-of-war between fiscal drag and underlying fundamental improvement, with a great deal of uncertainty over which force will prevail in the near-term.”



Of all the ways to describe the economy, a great game of tug-of-war is certainly one of them. It’s pretty easy to imagine the economy as a limp rope held on one end by the Fed and the other by Congress. From the outside, it’s difficult to determine what the real problem is: either the rope is too heavy, or the players are too weak (in this analogy, it doesn’t look like anyone’s supposed to win, but the rope should at least be taut).

“This tug-of-war is clearly seen in the monthly employment data,” continued Dudley. The recovery of the U.S. labor market has been uneven at best. The private sector added 175,000 service-sector jobs on average in both April and May, but lost 20,000 jobs between manufacturing and the federal government.

What’s more, the National Employment Law Project showed that while low-wage occupations accounted for 21 percent of recession-era job losses, they accounted for 58 percent of recovery job gains — and while mid-wage occupations accounted for 60 percent of recession losses, they accounted for just 22 percent of recovery growth. This is the type of data that undermines the ‘healthiness’ of labor market reports.

“Finally, I believe this tug-of-war analogy is useful in explaining the recent inflation dynamics,” Dudley commented. “As is well known, total inflation, as measured by the personal consumption expenditures deflator, has slowed sharply over the past year and is now running below the FOMC’s expressed goal of 2 percent.”

U.S. Inflation Indicators 3

Dudley explains that you can’t blame low overall inflation on lower energy prices, as some are apt to do. Core measures of price changes, which strip out energy and even food prices, also remain suppressed. “This probably is due in large part to the softening of global demand for goods and the modest appreciation of the dollar that has occurred since mid-2011.”

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