There are two boxers “duking” it out in America. On the one hand, the Federal Reserve Bank and Congress are trying to stimulate the economy, but on the other hand, the States are cutting their budgets and raising taxes. That might be the very reason the economy is getting nowhere fast.
In This Corner
Corporations shed jobs faster than you can spell “recession” in 2008 and 2009; however, now it’s the public sector’s turn. While a low Fed Funds rate and bond purchases by the Federal Reserve Bank have helped to try and re-inflate the economy, state budget cuts are working against those measures.
"At least 46 states plus the District of Columbia have enacted budget cuts that will affect services for children, the elderly, the disabled, and families, as well as the quality of education and access to higher education." - Center on Budget Policy Priorities (CBPP)
The budget cuts come as a result of previous and projected budget shortfalls from 2009 to 2012 to the tune of $500 billion according to the CBPP from 46 states. Revenues have drastically fallen as a result of near 10% unemployment (understated) for the country. In the last recession, unemployment peaked at 6.3%. The shortfalls, this go-around, are much larger than in the last recession, and represent the steepest decline in tax revenue on record.
What does this mean for the economy? It means higher taxes. Despite heavy Federal Aid, roughly 0 billion over a two-and-a-half year period from the American Recovery and Reinvestment Act, 30 states have already raised taxes in some form.
"Since the recession began, over 30 states have raised taxes, sometimes quite significantly. Increases have been enacted or are under consideration in personal income, business, sales, and excise taxes. Major state revenue packages have been enacted in California, Colorado, Connecticut, Delaware, Hawaii, Nevada, New York, North Carolina, Washington and Wisconsin, among other states." – CBPP
On top of higher taxes, states are cutting services to close the budget gaps. As stated above, these cuts include health care, services to the elderly and disabled, K-12 education, higher education, infrastructure services, safety services, and more. Cuts to these areas hurt the economic recovery because they continue to keep our unemployment level elevated. Just as the state government got smaller, the recession created greater demand for these services as more and more families now face economic difficulty. The prospects of higher taxes and more unemployed are working together to dampen the economic recovery.
And In This Corner
To put their collective "dukes up", Congress and the Federal Reserve Bank are taking the inflationary approach rather than an austerity approach. Stimulus packages have been created and interest rates remain low. Recent news suggests that the Federal Reserve Bank may even enact Quantitative Easing (QE) 2.0. This came from a report by a self-proclaimed inflation hawk, James Bullard, the President of the Federal Reserve Bank St. Louis, that has rippled through the streets of Wall Street. The "Seven Faces of 'The Peril'" details the possibility of a Japanese-style deflationary outcome in which massive quantitative easing is the doctor prescribed medication. His thesis is as follows:
"Pledging to keep the policy rate near zero for such a long time would also be consistent with the low nominal interest rate steady state (like Japan) in which inflation does not return to target but instead both actual and expected inflation turn negative and remain there."
And the inherent problem therein:
"The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense (long after policy becomes passive), creating a second steady state for the economy."
And his solution:
"A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities (underlined for emphasis)."
The difference between QE and a possible QE2.0 is the keyword: Treasuries. QE in March 2009 was announced as a purchase of mortgage-backed securities. It was done so without any measuring stick to add flexibility to the policy to accelerate or decelerate in response to economic conditions. Bullard believes that the U.K. style of Treasury debt purchases had a more "state-contingent character than the U.S. program". As I agree with Bullard, the most important component to either the U.K. or U.S. program is the change in the private sector’s inflation expectations. It is commonly believed that QE represents monetization of debt, which is considered inflationary. Let’s now consider the reaction the market has taken towards Bullard’s "Seven Faces of 'The Peril'" on the 29th of July.
When someone talks about inflation expectations, there are a couple places we can look: the first of which is gold. Since July 29th, a December contract of Gold is up , rising seven out of the last eight days traded (including today). Gold seems to be currently struggling with the 50-day moving average as it did in July.
Another measure we can look at is the price of securities that bond investors hedge their bond portfolio with, namely: Treasury Inflation Protected Instruments, a.k.a. TIPS. Since Bullard’s article, iShares Lehman TIPS Bond Fund (TIP) has risen to a new 52-week high.
On the flip side, the yield on the 10-year Treasury note has reached a recent low. If inflation expectations are rising, then the yield on the Treasury note should be rising. Could it be that investors are already bidding up the price in expectation that QE 2.0 will be directed here? It could be.
Conclusion
The state of the States is horrible. Budgets have been cut and future cuts have been scheduled. The employment numbers last Friday were down, largely due to the public sector. State powers are limited to taxation and budget cuts. The Federal Reserve Bank, however, can use the “government technology, called the printing press” as Ben Bernanke so coined it in 2002.
James Bullard’s article was a likely trial balloon to leak information on a policy change under consideration, a.k.a. QE 2.0. Recently, market participants have largely turned the risk-trade back on with rising stock and rising commodity prices. The question will be whether the Fed continues to talk QE 2.0 or enact QE 2.0. The idea of QE 2.0 is of critical importance to the stock market because economic indicators and state budgets would rather steer the U.S. economy towards deflation. Let’s find out more in tomorrow’s FOMC meeting announcement. Put up your dukes, Bernanke, because this economic boxing match still has a few rounds.
