By James Kochan, Chief Fixed-Income Strategist
- Fed Chairman Bernanke and the majority of his Federal Open Market Committee (FOMC) colleagues believe the economy is sufficiently weak that a high degree of stimulus is still needed.
- In each of the past three years, the economic indicators were quite encouraging during the early months but then weakened significantly in the spring and summer months.
- Chairman Bernanke might agree with several other FOMC members to gradually scale down the bond purchase program if the anecdotal observations confirm the economy is stronger now than in the past three years and if the better tone of the economic indicators is sustained through the second quarter.
The basic bargain
After traveling to almost every corner of this nation during the first quarter, I’m struck by how much better the economy is performing compared with this time a year ago. The economy could now be in what former Fed Chairman Greenspan would call a self-sustaining expansion. Yet, Fed Chairman Bernanke and the majority of his FOMC colleagues believe the economy is sufficiently weak that a high degree of stimulus is still needed. If they are misreading the economic tea leaves, they risk staying too long with an overly aggressive bond purchase program and a near-zero fed funds target rate.
The most visible and dramatic improvement in the economic environment is in the now booming oil patch. Along the Gulf Coast, throughout Texas and Oklahoma, and in the upper Midwest, the oil boom is boosting employment, incomes, and spending. Housing construction in those areas is currently so strong that prices of lumber and other construction materials are increasing by 40–50%. Even in formerly depressed areas of Appalachia, natural gas drilling and production are transforming local economies.
The energy boom is also affecting what used to be called the rust belt. Demand for drilling pipe and other equipment has revived steel production. Robust car and light truck sales have allowed auto companies to increase production schedules and employment. The low price of natural gas is an important advantage to U.S. manufacturers versus foreign competitors. Employment in the manufacturing sector is finally increasing, albeit at a modest pace.
In the Pacific Northwest, spending by technology companies is creating labor shortages and a housing boom. In California, even areas hit hardest by the collapse in housing prices, such as Sacramento, are recovering briskly. Houses are apparently selling as soon as they come onto the market. Similar scenarios are happening in Phoenix, which was the epicenter of the real estate collapse. Bidding wars for houses are reappearing.
Home sales are also strong in the Northeast. Bargains have seemingly disappeared in the Boston area, apartments sell quickly in New York City, and home prices are increasing again in the New York/New Jersey suburbs. The manufacturing indexes produced by the Fed banks in New York and Philadelphia have recovered sharply in the past two months.
In the Corn Belt, land prices have doubled in the past five years. High grain prices have pushed farm incomes to record levels in many of the farm states. Regulators are advising banks and other lenders to maintain prudent lending standards in what some fear could become a land price bubble fueled by exceptionally low borrowing costs. The anecdotal reports that comprise the Fed’s Beige Book have also turned more upbeat over the past two months. Yet, the FOMC policy directive and statements by Chairman Bernanke focus almost entirely on the weaker elements in the outlook. The high unemployment rate, the fiscal drag from tax increases and slower growth in federal spending, and recessions in Europe and Japan are all cited as headwinds restraining U.S. growth and reasons to keep policy highly stimulative.
Is this growth sustainable?
At his most recent press conference, Chairman Bernanke acknowledged that recent economic data were healthier, but he wondered if the improvements could be sustained. In each of the past three years, the economic indicators were quite encouraging during the early months but then weakened significantly in the spring and summer months. There is no logical explanation for this pattern. Perhaps Mr. Bernanke and his colleagues want to see whether it is repeated in 2013 before they consider even a modest shift away from current policy.
Chairman Bernanke might agree with several other FOMC members to gradually scale down the bond purchase program if the anecdotal observations confirm the economy is stronger now than in the past three years and if the better tone of the economic indicators is sustained through the second quarter. The announcement of such a decision would probably send yields somewhat higher in the Treasury and mortgage markets. Mortgage rates would likely increase somewhat, prompting fears that the economy would suffer from this policy shift. If, however, the economy is truly on a better growth path, it could absorb such a modest policy shift without faltering.