One of the core theories that ACM has been operating under these past four years is that the Great Recession was a natural attempt at economic re-adjustment. We believe that monetary policy conducted to “combat” the symptoms of that re-adjustment would ultimately prove to be counterproductive since any disruption of that process would only delay the inevitable.
If we think of the economy in terms of true potential, the growth achieved during the 2003 – 2007 period was far above it. The credit-fuelled housing boom pushed the level of economic activity way beyond what can be rightfully considered as sustainable. That being the case, the contraction that resulted erased some of the unsustainable portion. The lack of real wage growth in the 2000’s should have been the warning sign.
In trying to re-create the “best” days of the housing bubble, monetary policy is doomed to fail because those days were artificial to begin with. There is no way that households and businesses (especially small businesses) can add the kind of debt that would be required to revisit something resembling the housing bubble. On top of that, the banking system no longer has the balance sheet capacity to lend to anyone but zero risk-weighted obligors (see our April 2011 Special Report, Part 2).
In simple terms, economic activity induced by “stimulative” monetary efforts in the wake of the 2007/09 re-adjustment are themselves artificial (though much smaller in scale than the housing bubble) and cannot survive the removal of the money policies that created them. This was the story of 2010.
Despite near-universal optimism that the recovery had turned a corner and was fully sustainable, after the end of the Fed’s first quantitative easing policy (QE 1.0) in April 2010 it all suddenly reversed. Instead of a recovery summer, it was a volatile and worrisome time. Economic activity ground to a halt and there was nearly a double dip recession.
The Fed responded by replacing QE 1.0 with QE 2.0. Rinse and repeat.
In creating money to try to stimulate activity that cannot be stimulated (credit usage), new money only stimulates malinvestment. The visible signs of malinvestment, in our current case, are inflationary.
As we approach the scheduled end of QE 2.0, inflationary pressures are now forcing unwelcome side effects. Prices are squeezing business margins and leading to a deceleration in activity.
The five Federal Reserve regional manufacturing surveys for April 2011 all show the same results:
§ Philadelphia Fed Survey – Current conditions fall from 43.4 to 18.5; new orders down 22 points, first decline in eight months; prices paid down 7 points in April but up 45 points in eight months.
§ Empire State Manufacturing Survey – Current Conditions down 10 to 11.9; new orders fall 5 to 17.2; prices paid up to 69.9, a level only exceeded by mid-2008; respondents experienced an 8.1% increase in actual prices paid in the last 12 months.
§ Dallas Fed Survey – Current conditions down to 8 from 24; new orders down to 4 from 14; 60% of respondents expect raw materials prices to increase in the next six months, only 37% expect finished goods prices to rise.
§ Richmond Fed Survey – Current manufacturing conditions dropped 10 to 10; order backlogs are now contracting slightly, from +8 to –1; prices paid are estimated at a 4.81% increase over March.
§ Kansas City Fed Survey – Current conditions fall from 27 to 14; new orders crash, from 31 to 11; prices paid was down slightly from 72 to 70; prices received was up sharply, but only to 28.
Manufacturing has been the most significant contributor to economic growth since the trough of the contraction. While one month certainly does not make a trend, the magnitude of the deceleration is alarming. It also closely matches the 2010 pattern, particularly with policymakers steadfastly proclaiming the opposite case.
Unfortunately for the recovery, this downshift in economic indications was not limited to manufacturing. The services sector, far larger than the manufacturing sector in terms of GDP, has begun to slow markedly.
According to the ISM Non-manufacturing survey for the entire country, the current conditions diffusion index fell in April to 52.8 from 57.3. This was the lowest level since August 2010. New orders fell all the way to 52.7 from 64.1, while prices paid stayed high at 70.1, down from a near-record 72.1 in March.
All of these surveys still show growth in their individual components but at rates that are much slower than what we should be seeing at this point in a self-sustaining recovery. This broad-based weakness is also matched by the recent upturn in jobless claims and the downturn in industrial production numbers.
At this point what can we expect from the Fed?
If it ends QE in June, the resultant drop in marginal liquidity and rise in interest rates would likely mimic the 2010 collapse. If it continues QE, inflationary pressures due to dollar debasement continue (despite pressure on commodity speculators through the one-way margin increases) to wreak the havoc we saw in March and April 2011.
We have been saying for two years that the Fed is pushing the economy into a trap. If our original thesis is correct, then 2010 was simply another attempt at an economic re-adjustment down toward true potential. These April numbers might point to the beginning of a second attempt (the May numbers will be important at establishing this as a trend). Whether it is accomplished through malinvestment or liquidity withdrawal does not matter, the larger dislocation is still waiting to finish its work.