Tag Archives: economic growth

(Revised) A Constantly Changing Landscape

The landscape in which financial institutions operate is very different now than it was before the financial crisis of 2008. Mergers and acquisitions between healthy firms and failing firms allowed the strong to get stronger and subsequently gain market share. As the market has grown more concentrated, it has also grown less competitive. Although competition is a corner stone of capitalism, maybe large banks help promote financial stability. Whether or not this is true, new government regulations have been enacted with the sole purpose of reducing risk taking by financial institutions.

Unable to put as much capital at risk as before, banks are shedding operations that were once major profit centers. For example, the Volker Rule bans propriety trading and limits commercial banks to hedging and market making. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and I believe this is representative of increased regulation. Higher capital requirements mandates that a significant portion of cash is set aside. Essentially, cash must be tied up as an unproductive asset (rather than being put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in commercial lending (i.e. lending to businesses). According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred riskier operations in order to earn a higher return, more lending to businesses is certainly better for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is a vital source of credit that promotes booming business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this businesses might be indicating a positive outlook for economic growth. On the other hand, banks very much want to lend the cash as evidenced by lower lending standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. As long as commercial lending is monitored correctly, then the risk should be manageable.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for homebuyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although the housing market seemed to heat up last year, it slowed down in the fourth quarter and the first quarter of this year. Although one factor contributing to the slowdown might have been the winter weather, rising interest rates also certainly played a role. Higher interest rates decrease affordability for homebuyers.

Changes in interest rates have significant implications for both borrowers and lenders. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”.  Rising interest rates make lending more appealing for a few reasons. First, creditors get to collect higher interest payments. At the expense of debtors, banks earn increased revenue from lending activities. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities. Banks can hedge interest rate risk and realign asset and liability maturity structures through commercial lending.

I cannot help but be concerned when I hear banks are lowering their lending standards because I am reminded of bank conduct during the housing bubble. I can only hope that regulators are watching more closely this time.

Commercial Lending on the Rise

Since the financial crisis, the climate has been constantly changing for financial institutions. Bankruptcies allowed banks to grow in size as healthy banks absorbed failing banks. Since then new regulations have been imposed on the largest financial institutions changing (and in some cases eliminating) many of their most profitable operations. For example, the Volker Rule bans   propriety trading by commercial banks. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and this is representative of increased regulation. For example, higher capital requirements mandates that a significant portion of a bank’s capital is tied up being unproductive rather than being put to use (i.e. put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in their lending to businesses. According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred to continue running certain risky operations such as proprietary trading, I think the increase in lending is is more beneficial for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is an vital source of credit that can promote booms in business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this might indicate a positive outlook for economic growth. On the other hand, part of the jump in lending is due to banks lowering their standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. I agree that we are far from the dangerous lending that occurred prior to the financial crisis, however, I hope a minimum level of lending standards can be maintained so that we avoid another financial disaster.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for home buyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although we had a nice pop last year, the housing market slowed down in the fourth quarter and the first quarter of this year. Part of the slowdown might have been due to weather as well as the rising interest rates.

Rising interest rates making lending more appealing for a few reasons. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”. First, higher interest rates help creditors and hurt debtors. Although debtors must make higher interest payments, creditors get to collect higher interest payments. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities because longer duration securities are more sensitive to changes in interest rates. Making more commercial loans enables banks to realign asset and liability maturity structures.

The Dangers of Low Volatility

On Monday, I discussed March retail sales and that its strength might be a positive sign economic growth. Today, there is more good news for the U.S. economy. According to the Wall Street Journal, “U.S. industrial production rose in March, moving beyond a lackluster winter and showing potential to gain strength in coming months”. Industrial production gauges the output of U.S. mines, manufacturers, electric and gas utilities. The manufacturing sector is only a fraction of domestic economic activity since the U.S. has transitioned to a service oriented economy. Nonetheless, many economists consider it to be an indicator of future demand.

In fact, economic activity across the United States is picking up steam. According to the Wall Street Journal, “Overall, the latest beige book, which describes economic conditions across the central bank’s 12 districts, pointed to an economy that was getting back on track after growth slowed earlier in the year”. This report, which is two weeks before the Fed’s April policy meeting, will likely have an impact on monetary policy. As the Fed continues to reduce asset purchases, the prospect of rising interest rates becomes more of a reality.

However, the Fed must watch the level of inflation when making its decision about interest rates. Even though economic activity is picking up, inflation is remaining stubbornly low and is a source of concern for the Fed. According to the Wall Street Journal,

Price gains could provide some comfort to Fed policy makers as they debate whether to keep pulling back on their easy-money policies meant to spur growth. Consumer inflation has run below the Fed’s 2% annual target for nearly two years, but price gains have accelerated a bit recently. Some central-bank officials have been concerned that low inflation—which discourages businesses and consumers from spending—could persist and weigh on growth.

Low levels of inflation are being experienced around the world. For example, the Bank of Japan is conducting asset purchases with the sole purpose of creating inflation. For this reason, the Fed can continue tapering at a slow pace as this should help push up inflation.

The problem with low inflation is it might be a symptom of something larger. We are starting to see the United States as well as other countries enter a stable path of growth. In addition, volatility is at very low levels. The last time we had a similar situation was during the Great Moderation. Starting in the mid-1980s, major economic variables such as gross domestic product (GDP) growth began to decline in volatility. In economics, the  “Great Moderation” refers to how stable the business cycle was at that time. We are again seeing that stable path of growth and global inflation, which is coinciding with an approaching of all-time lows again on volatility. However, this situation is easily disturbed. The first time around it masked a bubble in the housing market and that ended in a financial crisis. I am not sure what it is masking this time.

Retail Sales and Producer Prices Go Up

Following three slow months, retail sales jumped 1.1% in March. According to the Wall Street Journal, “Retail sales increased 1.1% last month… the reading was the best monthly gain since September 2012”. Strong retail sales, which are an important piece of U.S. consumer spending, could be an indication of accelerating economic growth. The healthy pickup in consumer spending suggests that weaker spending in recent months was an outlier likely due to severe winter weather.

The automotive component of retail sales led the rise with an increase of 3.1%, which reflects a significant jump in new vehicle sales. According to the Wall Street Journal, “March auto sales, as measured in dollars, rose 3.1% from the prior month. That was the best gain in a year and a half”. Purchasing a new vehicle can be a big investment. Thus, many households make use of auto loans. As a result, the increase in auto sales might also reflect improvements in private credit markets. The availability of credit plays a central role in the booms and busts of business cycles.

In addition to auto sales, other components of retail sales were also solid. According to the Wall Street Journal, “Spending also improved at general merchandise stores, restaurants and nonstore retailers, which includes online shopping… Excluding automotive purchases, sales advanced 0.7% in March, above the forecast 0.4% gain”. Retail sales beat expectations even without including the large contribution by auto sales. I think it is good that the surge in retail sales were well distributed among several different areas rather than being highly concentrated in one (i.e. auto sales). The strong retail sales in March helped restore my confidence in the economic recovery following the weaker data in December and January. The severe winter weather seems to have caused December and January to be outliers among the stronger overall trend in consumer spending.

Retail sales are meaningful component of consumer spending, which is a significant piece of gross domestic product (GDP). According to the Wall Street Journal, “Consumer spending accounts for more than two-thirds of U.S. economic output. As such, expectations for stronger economic growth this year are largely pinned to shoppers’ wallets”. Due to strong retail sales in March, some economists have raised their projections for GDP growth in the second quarter. Consumer spending is a pro-cyclical component of GDP, which means it is positively correlated with GDP. If consumer spending picks up, then we should expect GDP to follow.

Another good sign for the U.S. economy is that producer prices increased 0.5% in March, which might predict a rise in U.S. inflation. According to the Wall Street Journal, “The producer-price index for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% from February”. Although the producer-price index (PPI) is not the Federal Reserve’s preferred measure of inflation, the PPI is still a useful gauge of U.S. inflation. Considering the prolonged period of low inflation, I welcome the increase in the PPI and believe it might be a good sign for the U.S. economy. Furthermore, the 0.5% increase is a noticeable change as it is the largest gain in a single month since January 2010.

Not only does rising prices indicate inflation, it also reflects increasing demand. The increase in demand can also be seen in the strong March retail sales. I think the March employment report, which showed a hiring rebound after the winter slowdown, contributed to the rise in the PPI and the jump in retail sales. When you have a job you are able to spend more and increase your demand, which pushes up prices. The labor market is incredibly important and I completely agree with Janet Yellen’s emphasis on promoting job growth. A healthy labor market is an indispensable component of economic growth.

Inflection Point for U.S. Economy: And Perhaps the World

The United States economy seems to be at an inflection point in which growth will either accelerate above the trend or remain below. The March Employment report had some very positive signs, which showed that more people are finding jobs. According to the Wall Street Journal, “All of the gains came from private companies, which added 192,000 jobs. The March gain means the private sector has regained all the positions lost in the recession”. Although the 192,000 jobs added was just below forecasts, I think it is a strong number that proves the December and January employment reports were outliers that were negatively impacted by severe winter weather. The recovery has been painfully slow in the labor market, but the March employment report was a significant step in the right direction. The better level of hiring, as evidenced by the March employment report, will hopefully give a boost to consumer confidence and in turn support consumption expenditures.

According to Ray Dalio, credit expansion and credit contraction essentially determine booms and busts in economic business cycles. Following many years of expansion, the credit market collapsed in the recent financial crisis. Thus, the health of private credit markets is central to the current inflection point of the U.S. economy.

fredgraph_credit

As seen above, the year over year percent change in private credit has recently turned in the right direction. If credit markets continue to strengthen, households will be able to take on more leverage. An improvement in private credit conditions is indispensable to supporting the positive signs in the March employment report.

If the March employment report was so lovely and credit conditions are improving, then why the recent dip in financial markets? I believe changing expectations about future interest rates played a significant role. Expectations about interest rate increases are mid-2015 (i.e. 6 months following the end of quantitative easing) and there are concerns surrounding what the impact will be on each sector of the U.S. economy. On the one hand, financial stocks moved up on the news as they stand to earn more interest revenue from loans. On the other hand, sectors sensitive to interest rates (ex. Housing) will likely suffer when rates move up at first. For example, higher interest rates decrease affordability in the housing market and could potentially lead to decreased residential investment. A key rate to watch is the ten-year Treasury yield, which is usually considered the risk-free rate for long-term debt and is thus intertwined with many other rates.

fredgraph_10yr

The yield on the ten-year Treasury has tested 3%, but has remained below it. I believe it is only a matter of time before the 3% level is breached. As mid-2015 approaches, expectations about future rates will need to be fully priced in. As a result, a first test for the inflection point will be whether sectors that are sensitive to interest rates can handle higher rates. If all of this goes smoothly, then the United States economy could reach escape velocity and grow above the cyclical trend of 2.5%. Wonderful! Not so fast… According to the Wall Street Journal,

If the U.S. grows a half-percentage point faster than expected, it would force the Federal Reserve to raise interest rates at a quicker clip. That would boost borrowing costs for emerging markets more than many governments and investors planned, raising serious questions about the ability of countries, households and corporations to pay off their debts.

Although I am hoping for stronger economic growth in the United States, I was unaware that it might cause problems for the rest of the world. To be clear, the IMF is expecting the U.S. economy to expand at 2.8% this year and 3% in 2015. I am not sure how likely the U.S. is to grow above these levels, but I am very pleased by the signs in the labor and credit markets. Hypothetically, if U.S. economic growth takes off, then the Fed must respond quickly and effectively with higher rates despite a negative impact on the rest of the world. As the Fed demonstrated during the major sell off in emerging markets this year, the Fed’s mandate is the U.S. economy and so it must keep its focus here.

Immigration Reform: A Spark for the Economic Recovery

Although immigration reform in the United States can be extremely controversial, I believe  successful reform will greatly benefit the economy. A successful overhaul of America’s immigration policy would benefit our economy by opening our borders to highly skilled noncitizens. According to the Wall Street Journal, “The most important reason to reform immigration laws is to promote economic growth and prosperity. The U.S. has long had a generous immigration system, but it has been skewed to family unification rather than U.S. economic interests”. Considering the slow recovery from the financial crisis of 2008, I believe immigration reform could be an effective way to give the economy a meaningful push forward. The current immigration system seems outdated and reform seems in the best interest of the economy.

Attracting and keeping highly skilled workers would be a positive step toward economic growth. Highly skilled workers would provide a boost to productivity, which in turn would help increase gross domestic product (GDP). According to the Wall Street Journal, “In today’s global economy, with many rising nations, the U.S. is in an increasingly competitive contest for human capital. Yet often today the U.S. educates talented foreigners in our schools only to deny them visas to stay and work in America. The companies they create will be in China and India rather than Austin or Minneapolis”. I have always thought that it was silly for foreign students to come to the United States for a fantastic education, but not be able to stay after graduation and contribute to long run economic growth. During high school (boarding school), I lived with a foreign student who expressed the challenges he would face if he wished to work in the United States after college. Although some foreign students might (understandably) wish to return home, I think it is clearly in the best (economic) interest for the United States to retain these trained workers.

On the one hand, some see immigration reform as a boost for the economy. On the other hand, some claim that immigrants steal American jobs and depress wages. According to the Wall Street Journal, “The populist wing of the [right] wing party has talked itself into believing the zero-sum economics that immigrants steal jobs from U.S. citizens and reduce American living standards”. However, in the long run this will likely not be the case. The concern that immigrants “steal” American jobs operates under the assumption that immigrants only impact the labor supply and not labor demand. The key is that immigrants would not be substituting for American workers – instead, immigrants would complement the natural-born American labor force. Although adding more workers to the labor force in isolation would lower wages and add to the unemployment rate, this ignores the fact that new workers will also add to demand by spending the money they earn.

Successful immigration reform would provide increased productivity and higher wages once businesses expand to absorb the larger labor force and meet increased demand from a larger population. Unfortunately, promoting the benefits of long run policy can be a challenge since the long run is so intangible. As Keynes said, “In the long run we are all dead”. In the short run, the increase in demand for labor might lag behind the increase in demand for goods and services causing unemployment rate rise in the few years following the implementation of immigration reform. However, I am confident that the long run is not that far off. Ultimately, adding immigrants to the labor force should benefit the United States economy. The political landscape can be extremely challenging, but the Senate has a bill that might solve these issues. According to the Wall Street Journal, “This is why the Senate bill wisely opens the gates wider for foreign graduates and high-tech (H1-B) visas“. I am hopeful that the Senate bill will get passed and implement successful immigration reform.

Japanese economic growth – now time to stimulate export

In my previous blog posting on Abenomics (Japan’s (Domestic) Economic Recovery – is this an urgent problem?), I pointed out that Japan’s struggle in exports should not be the greatest concern as Japanese economy showed other signs of recovery. However, was it my hasty judgment? Recently, Wall Street Journal posted several articles that are concerned about Japanese economic growth and its recovery.

According to Wall Street Journal article (Japan Export Growth Stalls as Economy Picks Up), Japan’s export grew just 1.7% in the fourth quarter of 2013 after a 2.7% annualized fall in the third quarter. It is said that Japan needs 5% growth in exports in order to meet 2.6% growth projected for the fiscal year ending in March. The major reason for Japanese export struggle is due to the fact that Japanese manufacturing sector has been moving overseas over the past years. Japanese electronics are now assembled in China, and car makers also increased production overseas. Furthermore, Japanese auto exports fall by 7% in last December, which could hurt export as well. The article suggested several solutions, such as reducing corporate tax and be on board for Trans-Pacific Partnership led by U.S, in order to remove trade barrier of rapid growing markets in emerging Asia.

So how “severe” is Japanese economy at the moment? Wall street journal article (Japan Growth Figures Disappoint) analyzed growth numbers of Japanese economy well. In October to December quarter, Japan’s annualized growth rate was 1%, a rather disappointing figure after Abe’s strong policies.  The picture below shows growth in Japanese economy after Abe’s regime. Although Japan has achieved four consecutive quarter of positive growth rate after Abe’s regime, the growth rate has been low (near 1%) for past two terms. Furthermore, private consumption index continued to increase but net export continued to decrease, as imports increase continuously while exports are struggling.

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One thing I did not consider during my previous blog post was the fact that Japan will be raising sales tax from 5% to 8% in upcoming April. During my previous blog post, I wrote that struggle in export is not a huge deal as Japan’s domestic consumption is large enough to boost the economy. However, now I feel like too much dependency on domestic consumption could be dangerous for growth of Japanese economy. I think Japanese government needs to act fast in order to stimulate the economy; reducing corporate tax to stimulate more domestic production for Japanese auto companies might be a solution for this problem.

The Recovering Signs from 2013

After four years of recovery, the U.S. economy is working on a right direction. However, the speed of renewal might not as fast as previous economic crises. In last year, we saw the obvious growth in consumer spending and business investment and trade and housing market. Although the influence from global markets especially from Asian market increases the risk for economy recovery, there were clear signs of economic recovery.

The greatest growth came from consumer spending.  In the fourth quarter it grew 3.3%, which was the fasters pace in three years. There were some worries about the potential week in holiday season, but in fact the purchases increased 0.5 percent after a 0.4 percent gain in October.  68 percent of the consumers thought the economy is already out of the recession and 71 percent of them would spend more in holiday season. Big retailer companies such as Wal-Mart and J&J Snack Foods Corp and manufacturer Leggett & Platt saw the increase in sales. The positive figures of consumer spending indicate the increase of consumer confidence and family wages. Although the inflation rate did not increase as much as economist expected, but the boost in consumer spending definitely contribute the growth of economy.

Moreover, trade in becoming a new factor driving the economic growth. The export increased greatly at the beginning of 2013. The gap between exports and imports shrank to 43 billion dollars in February and kept a steading growth after that. The increase encouraged the manufacturers to invest more in the global markets and push the economy up. This increase in trade could also be supported by the recovering economy. Recently, the news about banks’ plan on easing limits for lending could help these manufactures by providing them more capital for extend business.

Also, the hosing market kept a healthy growth. This year the home price increased 12% and still in a safe range without causing another bubble. Jed Kolko, the chief economist at Trulia, said the price is about 4 percent undervalued in the fourth quarter of 2013, which is far from the danger of housing bubble. Compared to the 39 percent overvalued price in 2006, we don’t need to worry about the current growth of home price. This recovery in price helped real estate companies and increased their asset value.

In sum, in 2013 the economy had many driving factors bringing it back to the right track. It seems that these factors will still have a positive effects because of some beneficial policies like the ease on loan standard.