Bernanke's Big Worry -- Not What You Think

Bernanke's talk in Jackson Hole told us his big concern -- that the current rise in protectionist sentiment, as reflected by the breakdown in the DOHA talks, could end up disrupting the international flow of capital. For this economy, that would be bad news indeed.

Everyone expected Benranke to note the slowdown in housing, believing that this is the bad news for a Fed chairman to address. Recent housing data have quite a few commentators worried that recession is around the corner. These everyones ignore a revived though not booming cap goods sector, the pick up in nonresidential construction, and the general good sense to recognize that the U.S. economy does not run on housing alone. At times, housing is admittedly more important than at other times. This is not one of those times. Speculative overshoot in home building is being hurt, no doubt, and the year-over-year construction and sales numbers will not be pretty for some time. But this is the froth coming off -- while the business side of the economy is doing well (including exports).

The sum of these crosscurrents for growth is not rapid, overheating growth to push the economy to 3% unemployment. The sum is that growth is now self sustaining to a pace that the economy does not need subsidized rates. Fear of a recession is overblown.

Tim Duy, however, seems to have it right. In his August 24 blog he wrote this on housing:

The recent spate of housing data confirms the anecdotal evidence – while there may be some pockets of resistance, the national housing market is quickly reversing course. Still, as I noted earlier this week, the Fed’s reaction to date appears to be muted. How long will they maintain such a complacent posture? In general, I think the answer is: Longer than you might expect.

The key, of course, is to what extent housing undermines the rest of the economy. I think there is little debate that the first impact (outside of residential investment) will be on the consumer, although the Wall Street Journal appears to believe we are still kicking this around:

A key concern, economists say, is whether the softening housing market will hurt consumer spending. In recent years, consumers have used extra cash from mortgage refinancing to fuel extra purchases, and the soaring value of their homes has given them a sense of wealth that could prove ephemeral if the decline in sales accelerates.

I believe it is more accurate to question the extent of the impact, not the impact itself. Two channels leap to mind, the impact of housing related employment and the impact via higher mortgages and reverse wealth effect. Presumably, both will be captured in consumer confidence, which took something of a drop in August, according to the University of Michigan.

He later writes:

Using the complex system of “eyeball” econometrics, the confidence data is pointing to year over year growth in spending of somewhere in the 2-3% range. Not exactly a disaster and necessary if you believe the US economy needs to undergo a rebalancing.

And then he picks up on the capex point I have been making in this blog --

The jump in capital goods shipments should pull the base for investment spending higher, reversing the decline signaled in the second quarter GDP report. In short, the durable goods report will support Moskow’s contention that the underlying trend in investment spending remains healthy, and help him dismiss the Eeyores.

He is kinder than me by calling these people "Eeyores", but then he is brighter than me as well.

Those Eurodollar contracts for 2007, the ones that are forecasting 50/50 of a 100 basis point ease in the funds rate next year seem ripe for disappointment. If you own the 2-year Treasury you are long those Euro contracts. Meaning that unless you think the odds of an ease next year is going to increase, owning this paper makes no sense. If you do think the odds will increase, more profit will come your way. My bias is that the 50/50 odds are too optimistic about the likelihood of an ease, but either way an investor should understand the risk and, hence, where the reward will come from.

Bernanke among the bears of Wyoming, at the base of the beautiful Grand Tetons, laid out his fears.

He starts off by noting:

One of the defining characteristics of the world in which we now live is that, by most economically relevant measures, distances are shrinking rapidly. The shrinking globe has been a major source of the powerful wave of worldwide economic integration and increased economic interdependence that we are currently experiencing.

Towards the end of the speech, he adds:

In the nineteenth century, international portfolio investments were concentrated in the finance of infrastructure projects (such as the American railroads) and in the purchase of government debt. Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors. Flows of foreign direct investment are also much larger relative to output than they were fifty or a hundred years ago.6 As I noted earlier, the increase in capital flows owes much to capital-market liberalization and factors such as the greater standardization of accounting practices as well as to technological advances.

In his concluding paragraph:

Further progress in global economic integration should not be taken for granted, however. Geopolitical concerns, including international tensions and the risks of terrorism, already constrain the pace of worldwide economic integration and may do so even more in the future. And, as in the past, the social and political opposition to openness can be strong.

Then he wraps up with a decidedly non-Republican (my opinion) perscription :

The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared--for example, by helping displaced workers get the necessary training to take advantage of new opportunities--that a consensus for welfare-enhancing change can be obtained. Building such a consensus may be far from easy, at both the national and the global levels. However, the effort is well worth making, as the potential benefits of increased global economic integration are large indeed.

'nuff said.