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Three rounds of quantitative easing by the Federal Reserve have produced record-high stock prices, but real economic growth still remains below the levels expected in an economic recovery. An encouraging uptick in housing prices and the gradual decline of the unemployment rate have helped bolster household wealth and consumer spending, but with fiscal tightening weighing on economic growth, inflation falling, and corporate earnings flat, the current rise in stock prices is unsustainable. The US economy might be headed for another midyear “swoon,” and after three doses of easy money from the Fed, it is unclear whether another round of quantitative easing would help produce the sort of robust growth policymakers and consumers seek.
Key points in this Outlook:
Paul Samuelson once famously quipped that the stock market had predicted 10 of the last 5 recessions. That was before the advent of quantitative easing (QE), the Federal Reserve’s zero-interest–rate-bound monetary policy experiment aimed at boosting the economy by purchasing large quantities (about $2.4 trillion worth to date, since March 2009) of government and mortgage notes and bonds.
Since the 2008 financial crisis, Samuelson’s apt dictum has been reversed. The stock market has predicted three of the last zero sustainable economic expansions at various times during 2010, 2011, 2012, and now, it appears, again in 2013. (See figure 1.) The gap between the GDP growth rate and the rate of increase in the Standard & Poor’s (S&P) 500 index has always been volatile. (See figure 2.) During the first quarter of 2013, the annualized GDP growth rate was 2.5 percent, while the annualized rise in the S&P 500 was 46 percent, a gap of 43.5 percent, or just over one standard deviation above the average gap of about 5 percent. To date, the gap for the second quarter looks to be larger. And even larger gaps have appeared during five quarters of the last four years (2009–12). In all, 6 of 17 quarters from the first quarter of 2009 through the first quarter of 2013 have seen the S&P rise much faster than the current or subsequent growth of GDP.
Stocks Outperforming the Economy Again in 2013
The pattern that appears to be playing out again this year has become so familiar that the term “annual swoon” has entered the vernacular of daily news market commentary to describe the outlook for stocks if the economy underperforms. US first-quarter 2013 growth of 2.5 percent was below expectations and could be revised up or down. Yet, the strong 46 percent annualized first-quarter growth rate of the S&P essentially repeated the pattern of the last four years: Stocks rise sharply, seemingly predicting the advent of a strong recovery. But then at midyear, during the second or third quarter (or both), growth slows sharply and stocks fall sharply only to be revived by a new round of QE, either announced or hinted at by Fed Chairman Ben Bernanke at the annual August Jackson Hole, Wyoming, conference of central bankers. During 2009 to 2012, expansionary fiscal policy measures of varying sizes (between $75 billion and $858 billion, averaging about 3 percent of GDP) were also in place, but their presence did not obviate the need for Chairman Bernanke to introduce the annual extra boost from a new round of QE.
Each time, this QE has served only to start the cycle all over again. The stock market rises strongly in response to a new dose of QE. Economic growth, however, does not keep rising, and resulting disappointment leads to a weaker stock market. The Fed announces more QE, and stocks rise again but growth does not. (See figure 3.)
Core inflation kept falling from the second quarter of 2008 to the third quarter of 2010, then rose modestly for two years to a peak 2.3 rate early in 2012 and has since fallen steadily back to 1.7 percent through April of this year. (See figure 4.) The impotence of monetary policy strongly suggests a liquidity trap wherein banks, households, and firms end up hoarding much of the cash being injected into the economy through the Fed’s QE.
Somewhat ominously, the requisite doses of expected QE have grown larger. By the December 2012 update to the third round of QE, the Fed had committed to purchasing $85 billion per month—over $1 trillion per year—of government and mortgage-backed securities until and perhaps after the rate of unemployment, now at 7.5 percent, reaches 6.5 percent or lower. The initial round of QE, enacted in March 2009, amounted to $600 billion, and, as already noted, QE rounds to date have amounted to $2.4 trillion, a quadrupling of the Fed’s balance sheet in just four years.
The percent annualized rise in the S&P during this year’s first quarter and the subsequent rise during early May have been among the largest since 2009 and have taken the index to a record high above 1,650, surpassing the pre–Lehman Brothers collapse high in October 2007 of 1,550. The rise in stock prices is partly attributable to aggressive buybacks of stock by cash-rich companies. Yet, earnings, while good, are on average flat relative to a year ago. (See figure 5.) Although market expectations for the second-quarter growth rate are about 2.5 percent, the same as the first quarter, there are sound reasons to believe that the stock market may be predicting the fourth sustainable recovery in the last four years of failed sustainable recoveries.
Is This Time Different?
Will the 2013 rise in the stock market to date, at well over a 50 percent annual rate, finally portend a sustainable US recovery? “Sustainable” would mean steady growth over the coming year at the rate of 2.5 to 3 percent currently predicted by the Fed without a growth scare in which growth falls to below 1 percent and again makes the stock market a poor predictor of expansions.
The main positive signs arise from the booming stock market, as noted, a heretofore unreliable predictor, and the rising housing market. The 9 percent year-over-year rise in home prices reported by the widely followed S&P Case-Shiller Home Price Index is encouraging and has substantially added to household wealth. Higher wealth from rises in stock prices and the value of homes should support consumption growth. Another area of support tied to the housing recovery would be the contribution to GDP growth from more investment in residential housing.
Over the past year, real household net worth, including home prices and stock prices, has risen by about $4 trillion, about 7 percent of household net worth. (See figure 6.) On average, about 4 percent of wealth increases are converted into consumption spending over a period of a year or more, so the 2012 rise in wealth could have boosted consumption by about $160 billion, or about 1 percent of GDP. The further rise in wealth during Q1 2013 could sustain that contribution. (The latest data are available only through Q4 2012).
The other contribution of housing to GDP growth comes largely through increases in residential construction. This category amounts to about 5 percent of overall GDP and, on average, contributes just a tiny 0.06 percentage points to GDP growth. (See figure 7.) During 2012, however, residential investment contributed 0.27 percentage points to growth. Although the housing sector can certainly help the recovery by virtue of positive wealth effects that encourage consumption and increased residential construction, it is unlikely that these alone can boost the economy to a growth rate of 2.5 to 3 percent.
The extra boost to household wealth from higher home prices and higher stock prices is probably being offset by the high level of fiscal drag that has appeared during 2013. Recall that between 2009 and 2012, fiscal expansion contributed about 3 percentage points to US growth. During 2013, fiscal drag has appeared that could subtract, other things equal, about 2 percentage points from growth. The possible contribution of about 1.3 percentage points to growth during 2012 from the combined impact of higher residential construction and positive wealth effects, if it is sustained throughout 2013, will not offset the 2 percentage point drag from tighter fiscal policy. The negative net impact of fiscal drag, wealth effects, and home building at 0.7 percent would, given an underlying growth rate of 1.9 percent, leave 2013 growth at about a 1.2 percent pace.
It is difficult to see how the Fed, along with many forecasters, is expecting a 2.5 to 3 percent growth rate for 2013. Given a 2.5 percent Q1 growth rate, a Q2–Q4 growth rate of about 0.8 percent per quarter would leave the growth rate at the estimated 1.2 percent for all of 2013. The Fed’s ability to reboost growth with another round of QE in response to a midyear drop to a growth rate of 1 percent or less can surely be questioned in view of the tepid response of GDP growth to repeated rounds of QE, along with fiscal stimulus since 2008.
Sustained stronger consumption growth would provide encouraging evidence that positive wealth effects are boosting household spending. Over the last three years, consumption growth has accounted for about 70 percent of overall GDP growth, about the expected boost, excluding wealth effects, since consumption accounts for two-thirds of GDP. But consumption growth has in part been supported by a steady drop in the household saving rate from 5.1 percent of disposable personal income in 2010 to 4.2 percent in 2011 and 3.9 percent in 2012. During the first quarter of 2013, the saving rate dropped sharply to 2.6 percent, evidence that households are betting on wealth gains from stocks and housing to persist. The consumption boost tied to wealth gains is ominously reminiscent of consumer behavior during the run-up to the financial crisis, when many, including the Fed, believed that house prices would never fall.
The most recent data on consumption suggest that it may be slowing. The mid-May report on April retail sales growth—the earliest available hint about second-quarter consumption—was, oddly, taken as an encouraging sign of higher consumption. That interpretation looks like wishful thinking. The year-over-year retail sales growth as of April was just above 3 percent, well below the average growth rate since 1980 of 5.5 percent. (See figure 8.) If positive wealth effects from higher home and stock prices are really boosting consumption, we should be seeing a year-over-year increase in retail sales of about 6 percent, twice the current rate, especially during a real economic recovery.
Another sign of weak growth and excess capacity arises from the falling inflation rate in the United States and worldwide. Year-over-year US overall and core inflation have dropped to 1.1 and 1.7 percent, respectively, as of April. (See figure 4.) Slower inflation and tepid wage growth suggest that demand growth is still weak, notwithstanding the wealth support from higher stock and home prices. The last deflation scare, in mid-2010, resulted in Bernanke’s announcement of QE2 at the Jackson Hole conference. This year, Bernanke has already announced that he will not attend the Jackson Hole conference, perhaps portending his decision not to continue as Federal Reserve chairman when his current term ends in January 2014.
Although it is not yet a consensus view, considerable evidence is pointing toward a midyear growth slowdown, notwithstanding the sharp rise in the stock market during the first four and a half months of the year. The fiscal drag during 2013, amounting to about 2 percent of GDP, even given an offset from positive wealth effects and more home building, is not likely to be offset by ongoing Fed QE purchases of $85 billion per month because much of this monetary injection is simply being held on bank balance sheets as excess reserves rise steadily.
This is perhaps no surprise because the Fed is paying banks 25 basis points, or an average of about $4.5 billion per year, on their current $1.8 trillion in excess reserves. Households earning zero returns on their liquid balances, another impediment to spending, may be unhappy to learn of the Fed’s generosity to banks, but that financial repression story is well known and need not be pursued further here.
There is one bright spot in the economy. Employment growth has increased during 2013 to a pace of about 200,000 per month, enough to reduce the unemployment rate from the 7.8 percent level at the start of the year to 7.5 percent during April. The employment increase is concentrated within large firms, particularly those with substantial international exposure. However, along with a rise in employment has come stagnant growth in wages and hours worked, both signs that the improvement in the labor picture, while encouraging, is not decisive enough to ensure sustained growth going forward.
It is likely that the sharp 18-plus percent rise in the stock market this year to date has fully discounted the consensus for 2.5 to 3 percent growth in 2013. Optimists, of course, hope that the higher stock market will have a further boosting effect on the economy whereby higher stock prices boost wealth, which in turn boosts consumption and growth and stocks rise still further. That virtuous circle is what the Fed is hoping to initiate by using QE.
Should the pace of growth slow below 1 percent, as we expect, the stock market will likely sell off as it has done over the past three years when growth has slowed. The Fed will probably respond with QE4, another round of monetary easing that boosts stock prices without improving growth.
The hope will be that the Fed will get lucky on its fourth try. But with Europe in recession, China slowing, and tighter fiscal policy, there is little reason to believe that having the Fed buy another $1 trillion–plus of bonds from banks will increase growth or reduce unemployment further. Whether or not a new round of QE boosts stocks again remains to be seen. I wouldn’t bet on it.
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