Market Commentary

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The lame duck session of Congress will receive more than the usual amount of attention for a variety of reasons, not the least of which some important decisions have to be made. One key decision has already come and gone, at least temporarily, as the House failed to extend jobless benefits for about 2 million long-term unemployed workers. The bill will likely be taken up again, but passage before the end of the year looks quite dim at this point. Then there is the Bush-era tax cuts that are set to expire on December 31. Keep your fingers crossed that some reasonable compromise will be forged between President Obama's wish to extend the cuts just for those earning under $250 thousand a year and the Republicans' (with some Democrats on board) desire to extend them for everyone - but don't bet the house on it, unless it was foreclosed.
If a resolution on these two key issues is not reached in the lame duck session of Congress, things won't get any easier when the newly-elected version takes office in January. The point of this diatribe against gridlock is that the economy could be in for some rough sledding if politics trumps compromise in coming months. Admittedly, fiscal austerity is the mantra of the day, and deficit hawks are emboldened by the midterm elections. But the potential for higher taxes in the near term coming on top of a struggling economy is a pretty daunting prospect, to say the least. What's more, absent a sudden about-face in the House, the aforementioned two million unemployed workers who will become ineligible to receive benefits after November 30 will almost surely curtail spending.
Simply put, with the deficit-cutting bias firmly ensconced in Washington, the task of pump-priming the economy out of its lethargy rests solely with the Federal Reserve. Yet the Fed is under attack from several sources for its latest effort to stimulate growth with the implementation of QE2. As we discussed last week, foreign officials are leading the charge, asserting that the Fed is striving to engineer a weaker dollar to strengthen exports, thus promoting U.S. growth at the expense of other nations. That criticism, as we noted, lacks credibility for a number of reasons, including the fact that faster U.S. growth would not only lead to a stronger dollar but would also result in a greater demand for imports, which would benefit our trading partners.
But an equally misdirected concern is coming from domestic quarters, particularly from critics who assert that the heavy dose of monetary stimulus will inevitably lead to higher inflation or, at least, another asset bubble. The Fed, of course, is highly sensitive to this criticism, given its history of overstaying the course and widespread suspicion that it is now more concerned with promoting jobs than containing inflation. However, while it is fair to question the Fed's handling of recent asset bubbles, it has done a commendable job of keeping inflation in check over the past two decades; there is no valid reason to expect otherwise in the period ahead.
Indeed, there are more compelling reasons to fear a pernicious onset of deflation, given the huge amount of slack in the labor force, the lackluster demand for goods and services and persistent efforts by businesses to increase productivity. Chairman Bernanke can certainly draw on incoming data to back up his oft-stated contention that inflation is running too low for comfort. This week, for example, the government came out with its consumer price index, and the picture is hardly that of pending runaway inflation. In October, the underlying inflation rate, as measured by the year over year increase in the core CPI that excludes volatile food and energy prices, slipped to an annual rate of 0.6. That was the lowest since at least as far back as 1957, when data for this metric was first compiled.

The headline CPI, which embraces the entire basket of goods and services including food and energy, stood more comfortably above the zero threshold, coming in at an annual rate of 1.2 percent. However, this merely returned the price index back to its July 2008 level when it registered 219.1; the October index actually stood a tad lower, at a seasonally adjusted 218.9. Keep in mind though that households are less equipped to afford the cost of goods and services than they were then. The unemployment rate, at 9.6 percent, is 4 percentage points higher than it was in mid-2008, households have suffered a devastating $7 trillion shrinkage in net worth, and more than one in five homeowners owe more than their homes are worth.
From our lens, it is hard to see how the Fed's $600 billion bond purchase program will ignite an inflation outbreak in the foreseeable future. Instead, the risk is that the QE2 strategy won't provide the oomph needed to close the gap between the economy's actual and potential output capacity, nor the job growth needed to narrow the intolerably high unemployment rate. Underpinning this concern is the notion of a liquidity trap, which may short-circuit the transmission of the Fed's ambitious asset-purchase plan. What this notion says is that the Fed's liquidity injection is winding up as excess reserves in the banking system, rather than as loans to households and businesses. Simply put, the Fed's operation is akin to pushing on a string. No matter how much liquidity is available to lend out, and no matter how low interest rates fall, households and businesses will not step up the demand for loans in the current uncertain economic environment.
That said, it has to be remembered that monetary policy works with lags, and the additional stimulus provided now should eventually work through the economy in time-honored fashion. Even if the Fed's actions do not impart an immediate spending boost, they do influence financial conditions - both positively and negatively. Despite some harsh criticism of quantitative easing, there is no denying that it has had a positive effect on the financial markets. True, bond yields have not declined much but stock prices have moved solidly higher since August, when the Fed chairman indicated that QE2 was coming. That has a positive influence on confidence and wealth, both of which encourage increased spending behavior.
Indeed, there are glimmers of hope that the economy is emerging from the soft patch it sank into over the spring and summer months. The upbeat jobs report for October was perhaps the most telling piece of evidence that things are looking up. Without faster job creation and income growth, the spark needed to launch the economy out of the aforementioned liquidity trap will not be lit. To be sure, a one-month spike in payrolls is not convincing evidence of a trend, and all eyes will be focused on the November jobs report due on December 3. But consumers seem to be behaving with more confidence in job prospects.
That was clearly evident in this week's retail sales report. In October, total retail sales jumped 1.2 percent, well above expectations and the biggest increase since March. True, the major thrust came from the volatile auto sector, where sales surged by 5 percent. But the sales gains were broadly based and have to be viewed as an encouraging omen for the upcoming holiday shopping season. Excluding autos and the price-driven sales at gasoline stations, retailers enjoyed a solid 0.4 percent increase in revenues, lifting the total 5.2 percent above the level of a year ago. That is the strongest annual gain since December 2006, a full year before the onset of the recession. Of course, the October increase is measured against a weak base of twelve months earlier, when the economy was in the early stage of the recovery.

But it's the momentum that matters, and it does appear that consumers are reopening their purse strings, portending the first respectable holiday shopping season in three years. That bodes well for manufacturers, as new orders should pick up and spur production, something that may already be underway. Industrial output was unchanged in October, but only because mild weather cut utility output. Manufacturers increased production by a solid 0.5 percent during the month, lifting the annual increase to 6.1 percent. That's much weaker than the 9 percent year-over-year increase posted last May, when inventory rebuilding was in full swing and having a major impact on industrial activity. But the setback that was expected after the completion of the inventory cycle is turning out to be much milder than thought. What's more, if consumer demand continues to hold up in the months ahead, retailers may well decide to add to their stock of merchandise, leading to more orders and a second wind in industrial activity.

What recent data tell us is that the threat of a double-dip recession has faded considerably compared to the fears being expressed over the summer months. But it's a far cry from avoiding a recessionary relapse to an outbreak of inflation, which should not be used as an argument against the Fed's $600 billion asset purchase program. There are risks to what the Fed is doing; the massive expansion of its portfolio will at some point be a problem when the time for a tighter monetary policy comes into play. Just how this is handled will require a lot of thought and luck, as the prospect of unwinding a $3 trillion portfolio of bonds could have a highly disruptive effect on market psychology, not to mention interest rates. But that's an issue for down the road; the challenge now is to make sure the recovery stays on track.