Economic Commentary

“Like it or not, the 800-pound gorilla usually sets the standard.”
- Daya Nadamuni

While the Federal Reserve’s latest announced round of monetary stimulus, in the form of quantitative easing, has been affectionately dubbed “QE2,” it is viewed by some as something more akin to a turbulent trans-Atlantic voyage. The fixed-income markets seem to be wondering whether the Fed’s purchase of up to $600 billion in securities will result in lower long-term yields. Some view the Fed’s purchases of longer-term securities as constricting the supply and, therefore, the price; others view the action as sending a message that the central bank of the U.S. has abandoned monetary discipline in favor of a debased currency and higher inflationary prospects down the line.

This month’s release of hard choices from the non-partisan deficit reduction commission spelled out multiple recommendations for reducing government debt by $4 trillion by 2020, including a phase-in of higher taxes, cuts to social programs such as Social Security and Medicare, and a decline in military expenditures. Indeed, former Fed Chairman Alan Greenspan summed up the situation by stating, “something equivalent to the (commission recommendations) is going to be approved by Congress. But the only question is whether it is before or after a crisis in the bond market.”

For now, the Fed is erring against the probability of inflation occurring anytime soon. To underscore this point, it revised its projections from June—forecasting that the current unemployment rate of 9.6% would only fall to a rate of 9.0% by the end of 2011. The employment picture is not expected to improve due to a hint of only modest growth. Indeed, the latest revised GDP figure for the third quarter showed 2.5% annual growth. Additionally, such economic variables as leading indicators, new unemployment claims, and manufacturing activity have shown healthy readings in recent weeks. The latest Fed forecast even shows an increase in GDP growth next year, to between 3.0% and 3.6%. Still, that’s hardly enough to cover the increasing eligible members of the workforce and those eight million workers that remain jobless.

This month, the world saw the possible consequences of carrying a budget deficit of 12% relative to GDP. In exchange for an € 85-billion aid package from the International Monetary Union and the European Union, the Republic of Ireland must commit to cutting its spending by 20% and impose significant tax increases over the next four years to reach a budget deficit goal of 3% of GDP by 2014. Some examples of the tough choices: 10% pay reductions for new entrants into the government workforce and similar reductions in the minimum wage. Also, the introduction of a new property tax and an increase in the national sales tax will be imposed.

The New York Times November 13, 2010 article, “Budget Puzzle: You Fix the Budget,” summarized the U.S. budget puzzle in an interest fashion—displaying the relative impact of each of the major spending and tax issues on the future budget deficit. It’s a great reminder of the old Fram Oil Filter commercials. The commercial was set in a junkyard, with a mechanic displaying a Fram premium filter against an inferior line. The memorable tagline: “You can pay me now, or you can pay me later (when your engine breaks down).” Perhaps today’s respective appropriate analogy is the choice of taking concrete action, versus the choice of doing nothing.

John P. Biestman, CFA, is director of business development at the Federal Home Loan Bank of Seattle.