Goldman Sees "Disturbing Signs" If Government Does Not Bow Down To Krugman, Reflate Monetary And Fiscal Bubbles

1. Friday’s jobs numbers were disturbing. At best, they show an economy that is growing only quickly enough to keep the unemployment rate flat near 10%. At worst, they suggest that the labor market is once again turning down. Both the manufacturing workweek (the only part of the employment report included in the index of leading indicators) and the employment/population ratio (the broadest job market measure in the household survey) dropped significantly in June. Given the noise in these series and—in the case of the workweek—the potential for substantial revisions, both fortunately fall short of a clear-cut signal that another labor market downturn has begun. But we will need to see at least a partial reversal of these declines next month.

2. This comes at a time when the end of the inventory cycle has triggered the inevitable slowdown in the manufacturing sector. With inventory investment now again close to a normal rate, GDP growth is likely to converge to final demand growth, which has averaged only 1½% since mid-2009 and is unlikely to accelerate given the various headwinds facing the economy. The resulting slowdown in GDP growth is likely to be concentrated in the goods-producing sector, which previously received the largest boost from the inventory cycle. Hence, further declines in the ISM index following last Thursday’s drop to 56.2 are likely; our GDP forecast implies a decline to around 50 by early 2011. 3. The weak labor market implies not only a great deal of hardship for workers, but also a growing risk of deflation. Although the last couple of core CPI/PCE releases were a bit higher than those earlier in 2010, the trend still seems to be downward and other measures such as wage growth and inflation expectations have been declining. In particular, the 5-year 5-year forward breakeven inflation rate in the TIPS market has fallen 75bp since April and now stands at 2% for on-the-run securities, the lowest level since mid-2009.

4. Our recently released Global Economics Paper No. 200 entitled “No Rush for the Exit” argues that policymakers should react to the combination of a sluggish recovery and declining inflation with additional policy easing, either via a return to unconventional monetary policy or via further fiscal stimulus. The obvious counterargument is that monetary and fiscal easing carries long-term costs in the form of, respectively, a risk of a renewed asset bubble and a higher public debt burden. But our study shows that these costs look far from prohibitive at present. On the monetary side, US financial markets are nowhere close to bubble territory. On the fiscal side, it is difficult to argue that the US government has reached the limits of its debt capacity when long-term bond yields are low and falling, and when federal interest payments stand at just 1½% of GDP. When compared with the risk of a renewed economic downturn and/or a descent into deflation, the cost of additional stimulus seems to be well worth paying.

5. So what is to be done? On the monetary side, the possibilities include additional purchases of Treasuries and mortgage-backed securities, as well as TALF-like structures—i.e., special purpose vehicles that lend to nonbanks using equity provided by the Treasury and debt provided by the Fed. Whether these will happen anytime soon is another matter. Additional purchases of Treasuries and/or MBS mortgages do not yet seem to command a sufficient majority on the FOMC. This might change if growth and/or inflation ease further. But even then it is unclear just how effective they would be. After all, Treasury purchases did not seem to have much impact in 2009, and MBS spreads are already quite compressed, limiting the potential for further narrowing. A TALF-like structure could be more powerful, but it would need the Treasury’s cooperation and the Fed’s authorization under article 13.3 of the Federal Reserve Act, i.e. the Fed would need to invoke “unusual and exigent circumstances.” This is a very high hurdle. [TD: please Jan, have you met the criminals who run this country? The "very high hurdle" is about $100,000 per fat, bald and corrupt politician]

6. On the fiscal side, we hope that Congress passes the extension of emergency unemployment insurance, continued aid to state and local governments, and at least a temporary extension of the bulk of the 2001/2003 tax cuts beyond the end of 2010. If some of the tax cuts are left to expire, then this should be offset by temporary fiscal easing elsewhere. The point is that a tightening of the overall fiscal stance at a time when the economy is already struggling to maintain the current, unacceptably low level of resource utilization is a bad idea. In fact, we favor additional deficit-financed stimulus, coupled with a commitment to cut the longer-term deficit more aggressively than currently envisaged in the administration’s 10-year plan. The consolidation could include cuts in discretionary expenditures, slower growth in entitlement spending, and gradual hikes in both direct and indirect taxes. The precise mix is a matter of political preferences, and reasonable people can disagree about the pros and cons of different measures. But the need for long-term budget restraint should not stand in the way of a near-term boost when the economy clearly needs it.

7. A failure to enact additional stimulus—at a minimum, extended unemployment benefits, state fiscal assistance, and extension of the bulk of the 2001/2003 tax cuts—would imply a downside risk to our GDP and employment forecasts, specifically for 2011. Right now, we are showing a gradual reacceleration to 3% on a Q4/Q4 basis in 2011, but we worry that this might end up being too optimistic. We will evaluate developments both on the policy front and in the US economic data closely over the next few weeks to see whether any adjustments are warranted.