While cautiously optimistic about the chances of a global recovery, State Street Global Advisors chief economist Dr Christopher Probyn says last week’s speech by US Federal Reserve Governor Ben Bernanke was disappointing.
“It was a disappointment to many who expected a lot and a disappointment even to those who expected a little, and we were in the camp of expecting a little,” Probyn says.
“Even for those expecting so little it was a disappointment because he basically said that the Fed has some more options to help the economy but there was no degree of specificity about what form those measures might take.”
Bernanke, in his annual speech to a Fed gathering in Jackson Hole, Wyoming, hinted that the Federal Reserve would do more to support the US economy if it continued to lag.
But it was far from the emphatic language he had used in a similar speech last year. His lack of discussion about any of the Fed’s easing options was widely seen as making a third round of so-called quantitative easing unlikely.
Bernanke did say that the Fed’s September meeting would be extended to further discuss what further measures might be necessary to bolster the US economy if economic data continued to indicate the US economy was in the doldrums.
“The Federal Reserve has a range of tools that could be used to provide additional monetary stimulus,” Bernanke said in his speech on Friday.
“We discussed the relative merits and costs of such tools at our August meeting.”
Probyn speculates that Bernanke was limited in what he could say in this speech, due to disagreement created in the Federal Reserve over the recent decision to issue guidance that short-term interest rates would stay at exceptionally low levels through to 2013.
There were three regional members – so-called “inflation hawks”, of the Fed’s committee – who dissented over that decision.
“The slow-down earlier this year is really horrible and there are certainly grounds for taking stock of where we are and asking questions about what we can do,” Probyn says.
“It just may be that he couldn’t get there yet just by the amount of dissent he created by stating that interest rates would be kept low for about two years.”
Despite Bernanke saying the Fed still has some bullets left in the chamber, Probyn says the Federal Reserve is fast running out of ammunition to tackle any potential future economic shocks.
“The consensus view is there is going to be some improvement, [but] we are not going to shoot the lights out, that is for sure,” Probyn says.
“But there will be some improvement and further Fed action will be quite limited. But risks are skewed to the downside – you have got problems in Europe, fiscal consolidation everywhere and very limited policy ammunition left. If anything does go wrong it will be a real mess.”
Markets have since rallied on the back of the speech, but Probyn says the release of a range of economic data will be crucial to whether the Fed decides to take more drastic action at its next meeting in September.
Markets are looking to President Barack Obama’s speech, scheduled for September 5, to provide more indication of what Washington intends to do about the economic malaise facing the US. But Probyn says the Fed may be forced to act if growth stays stubbornly flat.
“If we see an improvement in the economy in the second half of the year I don’t think the Fed is going to do anything more,” Probyn says.
“If, however, the data deteriorates – and here I am talking about growth in the first half of the year – if growth stays at current levels they will have to move, because unemployment will start going back up again.”
Probyn says the Fed has limited options at its disposal but could give guidance on setting a higher level of targeted inflation, which may act as a stimulus to spending.
If the Fed stated what might trigger it to act, this could also provide the market with confidence that there was a policy response to any potential sharp downturn in the economic outlook, Probyn says.
But Probyn notes that the normal effectiveness of the Fed to stimulate demand through monetary policy has been severely hampered due to the wealth destruction caused to households in the wake of the financial crisis.
More than $14 trillion was wiped off the wealth of households through a mixture of falling house prices and hits taken to stock portfolios, and indirectly through losses incurred by their pension funds.
“The problem for the Fed is when they lower interest rates under normal conditions, then people go out and borrow money in order to accumulate assets; and when we talk about assets we really focus on cars and houses,” he says.
“This time around people are not going out and borrowing money to buy or accumulate assets. The Fed normally doesn’t have a problem stoking demand, but in this case it isn’t working. The reason we think this isn’t working is that so much wealth was destroyed during the global financial crisis.”
The lack of consumer demand in the economy is also having an effect on US corporations, says Probyn.
“The cost of money is cheap, they [US companies] have done a great job of cutting costs and they have cash up the wazoo,” he says.
“But in order to increase capacity you have to see a steady increase in demand for your product… If no-one places orders for equipment or goods then they will not put in place the capacity to produce it.”
Probyn says he expects the US economy to “grind higher” in the second half of the year. But he notes there is still a risk the US may share a similar fate to Japan, which suffered a “lost decade” of economic growth after its asset bubble burst in the early 1990s.
“Investors really have to make up their mind about the state of the global economy,” he says.
“Personally, I think we will grind higher but we are not going to shoot the lights out. The recovery is sustainable and I am cautiously and guardedly optimistic about the outlook for risky assets.”