The Burgeoning Expansion and the Quantitative Tightening

The U.S. economy grew at a surprising 5.6% rate during the fourth quarter of 2009 as measured by the gross domestic product (GDP), which measures the total amount of goods and services produced in the country.  This followed a 2.2% increase in the GDP during the third quarter of 2009 and is a welcomed improvement over the reduction in output that occurred during the recession. Although GDP measures output, one should recall that in national income accounting, output is equal to income. Therefore, as GDP fell by 14.4% during the four quarters ending June 30, 2009, it had the impact of reducing the collective income in the United States by that same amount.

Driving approximately two-thirds of the increase in GDP during the quarter was private domestic investment which represents residential building, business investment in plant, equipment, software and other items.  Included in the category would be business inventories, which drove a large portion of the decline in GDP the past several years, but benefitted the most recent quarter's report.  We have watched inventories very closely at Southeast Corporate because it represents an interesting dynamic in terms of interpreting the GDP data.  A reduction in inventory levels in a particular quarter will reduce the current quarter's GDP because the goods being sold during the inventory depletion process were produced during a prior quarter. Although this will reduce GDP for that particular quarter, it bodes well for future quarters as these inventories will likely need to be replenished, increasing production. During the most recent quarter, inventories accounted for a large portion of the gain in GDP, simply because they fell by a lower amount ($24 billion versus $156 billion) than in the prior quarter.  This is extremely encouraging, because while the economy expanded at the fastest pace in over six years, we have yet to see the inventory replenishment begin.

Further demonstrating that the country's inventory level will have to increase is to compare it to the level of sales. The ratio of inventory to sales has declined from a cycle high of 1.46 to 1.25 in January, the second lowest level ever.  This implies that the reduction in inventories has substantially exceeded the decline in retail sales and that businesses have over-adjusted their inventory levels.  This ratio has improved both because of the aforementioned decrease in inventories, but also because of the 3.9% rise in retail sales that has occurred over the course of the last year as the consumer sector emerges from its hiatus.

The final piece of this burgeoning expansion puzzle may have been last Friday's report on the state of the labor markets.  Although the nation's unemployment rate remained static at 9.7%, the economy also generated 162,000 new jobs during the month.  This represented the largest jobs gain in three years. It had been anticipated that the report would be good based on the fact that the prior month's data had been negatively skewed by the snowstorms that enveloped the northeast and therefore, the March report represented a certain amount of catch up in the data. Also benefitting the data was 48,000 jobs that were added by the federal government to conduct the census. This will likely continue as the Government Accountability Office (GAO) estimates that approximately 660,000 workers will be added due to the census. More important though, is that over three-quarters of the March job gains came not from government hiring, but from the private sector, most notably the manufacturing industry.  Given that the inventory replenishment process has not yet begun, we would anticipate that these gains will continue. A final source of positive news was that the January data was revised upward from a loss of 20,000 jobs to a gain of 14,000, implying that the economy has eked out an increase in jobs in three of the last five months.

The fact that it has taken the labor markets so long to rebound is not surprising.  This is typical for the early stages of a recovery as the labor markets are a notoriously lagging indicator. During the onset of a recession, companies will wait to reduce their work force because they do not wish to be at a competitive disadvantage. Similarly during the early stages of a recovery companies will wait until they are certain that demand has increased sufficiently and is sustainable enough to justify re-hiring workers.  In the previous recession, GDP growth became positive beginning in the third quarter of 2001, but nonfarm payrolls did not demonstrate a monthly increase until June 2002 and even then it was sporadic for some time thereafter.  Although the labor markets will have a long way to go in recovering the 8.5 million jobs that were lost in the last 26 months (in fact it will probably take several cycles), the job market is in the process of turning the corner and beginning this arduous process.

Given an expanding economy and a negative real (inflation adjusted) Fed funds rate, we expect that the Federal Open Market Committee (FOMC) will begin to tighten monetary policy by increasing the targeted Fed funds rate by year end.  In fact, we believe that it has already begun this tightening process by removing some of liquidity programs that were put in place during the past several years as part of a quantitative easing process once rates had approached zero. This effort on the part of the Fed was to provide funding and purchase financial assets, and by doing so, expand the money supply.  Therefore, we view the recent efforts to terminate these programs as the opposite of a quantitative easing, essentially a "quantitative tightening." These terminated (or about to be terminated) programs include the Commercial Paper Funding Facility, the Term Securities Lending Facility and the Primary Dealer Funding Facility.  Most notable among the terminated programs were the Treasury and Mortgage Backed Securities purchase program.  The latter of the two expired at the end of March after having purchased $1.25 trillion of mortgage backed securities.  Once all of these programs have ended, the FOMC will begin the final stage of its monetary policy tightening by increasing the targeted Fed funds rate. Given that the high end of the targeted range is currently 25 basis points and the core Personal Consumption Deflator (the Fed's preferred inflation measure) is 1.6%, the Fed funds rate can be increased by 125 basis points and still be negative when adjusted for inflation. Look for the Fed to do at least that over the next twelve months.

Date of writing April 15, 2010