“Fixing” the Payroll Problem
With the US Fed’s third quantitative easing program since 2009 announced in latter 2012, QE3, we know the Fed is explicitly targeting two key hoped for outcomes. First, Mr. Bernanke has told us he wants to see higher stock prices. So far, so good. The thinking being that if stock prices rise, households will “feel” wealthier and be motivated to increase their consumption – the so-called “wealth effect”. Secondly, Mr. Bernanke tells us that the Fed intends to keep interest rates at zero and will continue to print money (at a current annual rate equal to 6.5% of GDP, well above actual GDP growth) until the US unemployment rate at least reaches 6.5%. But are these two key Federal Reserve endpoint goals actually at odds with each other? I do not see this question being asked, but believe it is very deserving of consideration. Could it really be that the Fed’s own worst enemy in this grand and unprecedented monetary experiment is…the Fed itself? And if indeed the Fed may in part be working against itself, what does that mean for the markets and economy?
Let’s start with some backdrop. In the past I have written about my own perception that in the current environment the “wealth effect” is an academic fallacy. At the heart of the Fed’s wealth effect assumption is that households will have something to spend. Wage growth in the current economic cycle has been tepid, to be charitable, so growth in wages will not be meaningful fuel for additional consumption at the margin. If stock and real estate prices rise, as the Fed wishes, again, what will households spend? Will they sell their stocks and real estate, and use the proceeds for short term consumption?
From the early 1980’s to the middle part of the last decade, the US savings rate dropped from a high of 12% to a low of 1%. Over that period where stock and real estate prices ascended in generational fashion, households spent down their savings – that was the wealth effect in action. Bottom line being, the precursor of a positive wealth effect is a substantial household savings rate. In the current cycle, households have not been able to rebuild their savings due primarily to ongoing deleveraging and lack of wage growth. The character and magnitude of household savings are key not only to the Fed’s desired wealth effect (a primary rationale for QE), but also play an important secondary role in the broad economy that ultimately impacts payroll employment (the latest Fed target rationale for QE3).
If you’ll bear with me for a minute, let’s review the academic definition of GDP. Although perhaps painful, you may remember that in your Econ 101 class of yesteryear, GDP, or output, was defined as the sum of consumption, Government spending and investment (simplistically this definition ignores imports and exports). Whatever is not consumed by households or the Government is available as savings, or investment. It’s in this basic equation that we see the importance of savings as the fuel for future investment in productive economic assets. Now to the potential conundrum in Fed policy of the moment.
One fingerprint character point of the current economic cycle has been the unprecedented weakness in business fixed investment. Very important in that investment in productive capacity (think manufacturing plant and equipment) provides any economy a basis for future growth in trade, and by definition jobs. What could be more important in the increasingly globalized and competitive economy of the present? It’s not wildly surprising in that businesses invest when they foresee expansion in aggregate demand. We know this has been a very slow growth environment.
The top portion of the chart below shows us the history of US business fixed investment as a percentage of GDP. Experience in the current cycle reveals the lowest non-recessionary level on record. And in the current economic cycle, this has been accompanied by some of the lowest historical US savings rate levels ever seen. As your economics teacher would remind you, savings equals investment.
One more important historical economic data point correlation that ties the importance of business fixed investment to payroll growth. The chart below shows us the year over year change in US business fixed investment alongside the annual change in US payrolls. The key observation is that historically, the year over year change in fixed investment has led the year over year change in US payroll growth in each economic cycle of the last half century. As stated above, fixed investment is the cornerstone of longer term growth in productive capacity and jobs.
So back to the original question – is current Fed policy focused on both the wealth effect (the stock market) and lower unemployment competing agendas? IF the Fed is successful in sparking a wealth effect via higher stock prices, already low US savings will be further drawn down for consumption. But as per the very academic definition of GDP, increased savings are crucial for the expansion of business fixed investment. Importantly, we know from the historical chart above that increased US business fixed investment is directly tied to US payroll expansion. Increased savings equals increased investment, which in turn increases job growth.
So for the Fed to see a lower unemployment rate, it makes sense that US savings (and investment) need to rise. But if US savings rise, it will be at the expense of present consumption, negating the supposed positive wealth effect of driving stock prices higher. At least to me, it’s a very confusing Federal Reserve agenda. I have heard Mr. Bernanke give many a speech espousing the benefits of money printing in terms of levitating stock and real estate prices. But I’m still waiting for a speech that has never been given. A speech that directly links the Fed’s money printing and purchasing of US Treasuries and mortgage backed securities to actual job creation. I would think for an academician such as Mr. Bernanke and many of his Federal Reserve cohorts, there must at least be an equation similar to the exercise I walked through above regarding such a linkage between Fed bond buying and jobs, shouldn’t there? I guess for now it’s a secret.
Current business fixed investment remains subdued in terms of growth. That tells us payroll growth will come, but it will be slow. Not surprising within the context of a still relatively slow growth economy compared to historical experience. Near term, Fed money printing will continue to support asset price reflation. In the absence of accelerating fixed investment, corporate cash flows are being used for dividend increases and stock buybacks, likewise acting to underpin stock prices. Given this set of circumstances, we do have an environment where financial assets prices may diverge from underlying macroeconomic fundamentals. It’s into such divergence potential where risk management in the investment process takes on heightened importance.
About Brian Pretti CFA
Brian Pretti CFA Archive
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