In this business, predictions are made all the time, but how often do folks look back and see how well the predictions have panned out? Well, here is a snippet from my June 2009 Strategy Report:
"This will not be a V shaped recovery. At best we are looking at a U, and there is a very real possibility that we are looking at an L. After both of the last two recessions, unemployment remained high (and even rose) for a very long time after the recession formally ended.
"That is likely to be the case this time around as well. The ‘green shoots’ that everyone has been talking about really mean that we are moving from the vertical portion of the U or the L to the horizontal. They do not say if there will be a right-side vertical (forming the U), let alone when it will come.
"For the time being, deflation remains a much bigger threat than inflation. This is mostly because the velocity of money has slowed dramatically. Remember the monetary equation for GDP: Money (M) x Velocity (V) = Price (P) x Quantity (Q). V has plunged, resulting in both Price (inflation) and Quantity (production) going down.
"The Fed has been desperately fighting this by increasing M. It does this by expanding its balance sheet. Historically, the Fed only had short-term T-bills on the asset side of its balance sheet. This made it relatively easy to shrink the money supply by letting those bills roll off.
"Now not only do the Fed assets hold more credit risk, they are also have a much longer duration. By the end of the year, the Fed will own almost 25% of all the Fannie/Freddie-backed paper in existence. If the Fed has to drain money from the system because V picks up, it will have to actually sell those securities, dramatically driving up mortgage rates. So through 2010, the danger is deflation; longer term, inflation remains a very significant threat."
I would say that events have largely borne out what I was saying almost two years ago. As far as the recovery is concerned, it has been somewhere between a U and an L shape (check-mark shape?). The Fed has had to not only complete the first round of quantitative easing discussed, but move on to QE2, which is now just about completed.
Still, inflation — especially at the core level — is not a major problem. QE2 did manage to remove deflation as a major threat. The Fed now plans to hold tight, and simply reinvest the coupons and roll over those securities that mature.
With unemployment still at 9.0% and the economy well below potential, frankly I would prefer to the Fed move on to QE3, but I don’t think that is likely to happen. Raising the Fed Funds rate, or selling off the accumulated securities (i.e. tightening policy) would be a major mistake right now. I would also favor more fiscal stimulus, in the form of infrastructure investment/repair especially. However, in the current political environment that also is not likely to happen.
My prediction/analysis later in the same document on business investment was a bit too pessimistic:
"Spending on equipment and software has collapsed for a very good reason — namely, that the existing capacity is not being used. Why should a company buy a new lathe when they have ten of them sitting and gathering dust on the shop floor?
"Investment is always a much more volatile part of GDP than consumer or government spending. When it starts to go up, it could go up very significantly. However, I do not expect that to happen any time soon. At the very least we need to see capacity utilization get back up over 75% from the current 69.3% before we start to see any real pick up on business spending on equipment and software. Even 75% is a level that has historically indicated a very deep recession. Normal is about 80%."
In reality, in the 8 quarters since the prediction was made (including the 2Q of 2009, that was not released at that point) growth in investment in equipment and software has averaged 12.4%, and the average contribution to GDP growth has been 0.80 points, while overall growth has averaged 2.35%. In other words, equipment and software investment has been responsible for 34% of the overall growth over the last two years.
In the process, it has grown to be just 7.38% of the overall economy. Capacity utilization has increased to 76.8%, but spending picked up while the number was rising, not after it rose to what would normally be considered an anemic level (from a just-plain-awful level).
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