Friday, January 21, 2011

Obama's Budget Guru Orszag Warns of U.S. Debt Crisis

I thought it interesting that he said fiscal sanity can't be restored without tax increases on those who earn LESS than $250,000 per year!

by Peter Orszag in FT:

America is experiencing the hard slog of recovering from the financial crisis. Prospects have turned more positive over the past two months. But a year ago growth was picking up too – and then it stalled, at about the same time Greece’s fiscal problems infected the global economy. The question now is whether a home-grown fiscal crisis could derail this year’s rebound.
Some analysts have reached dramatic conclusions, suggesting the near-certainty of hundreds of billions of dollars in government defaults within the US over the next 12 months. Such predictions will undoubtedly turn out to be substantially overblown. Yet the rejection of one extreme is not the affirmation of the other. International investors would be wise to pay close attention to fiscal trends within the US.
The severity of fiscal risk varies considerably depending on which level of government is under discussion. At the federal level the combination of ongoing weakness in the labour market and large structural budget deficits means that the right policy mix should be more stimulus now and much more deficit reduction, enacted now, to take effect in two to three years. Policymakers have acted on the first part, most prominently through the payroll tax holiday announced in December – one of the factors making the short-term outlook more promising.
They have not, however, undertaken the harder work needed to reduce projected deficits over the next decade. Most fundamentally it is difficult to see how the medium-term federal deficit can be reduced to sustainable levels without additional tax revenues from those earning less than $250,000 a year. And yet it is equally difficult to see the political system embracing that reality without being forced to do so by the bond market.
If policymakers will not act before we have a fiscal crisis at the federal level, a fiscal crisis we will ultimately have. Until then we will see a microcosm of this broader problem arise dur­ing debate about increasing the federal debt limit, later this spring. This will be contentious. We may have to experience some temporary market turbulence before it is resolved.
At the level of state governments, revenue remains more than 10 per cent below pre-recession levels. Public pensions are also significantly underfunded, leading to well-publicised concerns about debt defaults. As a recent paper from the Centre on Budget and Policy Priorities correctly argues, states will have to take immediate and painful action to reduce their operating deficits, while also gradually closing their pension gaps. Outright defaults are not likely, but these fiscal problems require concerted effort and political will, especially in larger states such as California and Illinois. This will impose some macroeconomic drag on the US economy as taxes are raised and spending is cut.
Facile analogies to indebted European countries, or the US mortgage crisis, however, are both misplaced. Although comparisons of debt across different levels of government are fraught with difficulties, US state debt levels are nowhere close to those of Greece. Debt service obligations are similarly much lower.
Unlike in the mortgage crisis, state debt has not generally been repackaged into opaque, complex securities. Furthermore, and contrary to what many pundits suggest, state governments cannot simply declare bankruptcy. Bondholders are also privileged creditors in almost all states. It is thus difficult for states to default: they would generally have to stop paying employees before they stopped making debt payments.
At the local level, however, the situation is different. Many US cities can declare bankruptcy – and given their numbers a severe crisis in at least one major city is both feasible and quite possible. As a thought experiment, take the top 30 or so cities. Assume any one has only a 2 per cent probability of a severe problem. Then the probability that at least one experiences a crisis is almost 50 per cent.
In such a city-level crisis, the state government could help – as has already occurred in Harrisburg, Pennsylvania. States would be wise to consider in advance their options in this kind of crisis scenario. But even if the relevant state government decides not to step in, and a city is forced to default, the direct macroeconomic consequences are unlikely to be substantial – unless that default triggers others to follow. In this scenario the possible contagion effect among investors in the debts of different cities is a crucial consideration.
The bottom line is that there may well be US public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear. I hope it does not ultimately require a crisis to restore fiscal sustainability at the federal level, but I fear it will.
The writer is a vice-chairman of global banking at Citigroup and former director of the US Office of Management and Budget under Barack Obama

Stocks Still Sinking -- Kind of Like California

I'm surprised the bulls have reversed it yet. 

Jerry Brown, California’s governor, declared a state of fiscal emergency on Thursday for the government of the most populous US state to press lawmakers to tackle its $25.4 billion budget gap.
Democrat Brown’s declaration follows a similar one made last month by his predecessor Arnold Schwarzenegger, the former Republican governor.
Democrats who control the legislature declined to act on Schwarzenegger’s declaration, saying they would instead wait to work on budget matters with Brown, who served two terms as California’s governor in the 1970s and 1980s.

Existing Home Sales Hit Lowest of Recession

WASHINGTON (AP) - The number of people who bought previously owned homes last year fell to the lowest level in 13 years, and economists say it will be years before the housing market fully recovers.
High unemployment and a record number of foreclosures are deterring potential buyers who fear home prices haven't reached the bottom. Job growth is expected to pick up this year, but not enough to raise home sales to healthier levels.
"We built too many houses during the boom, and now after the crash, it will take us a long time to get back to normal," said David Wyss, chief economist at Standard & Poor's in New York.
The National Association of Realtors reported Thursday that sales dropped 4.8 percent to 4.91 million units in 2010. That was slightly fewer than in 2008, which had been the weakest year since 1997.
The poor year for sales did end on a stronger note. Buyers snapped up homes at a seasonally adjusted annual rate of 5.28 million units in December, the best sales pace since May and the 12.8 percent rise from November was the biggest one-month surge in 11 years.
Gains in mortgage rates may have spurred some fence-sitters to buy homes in December before rates moved higher, analysts noted.
The increase was an encouraging sign after a dismal year for home sales, said Mark Zandi, chief economist at Moody's Analytics. But he cautioned against raising expectations for a rapid recovery in housing.
"The job market is still very weak, and unemployment is very high. Until we get more jobs, people will be reticent about buying homes," he said.
Zandi said home prices would fall another 5 percent this year. Sales of previously occupied homes would likely exceed 5 million. That's a slight improvement from last year, he said, but it will probably take until 2013 or 2014 for sales to reach a healthy level of 6 million units a year.
Home sales will benefit from an improved hiring market. Many economists predict employers will double the number of jobs added this year compared with 2010. A reason for more optimism is a decline in the number of people applying for unemployment benefits over the past four months.
Last week, applications fell to a seasonally adjusted 404,000, the Labor Department said. That followed a spike in applications in the previous week, which is typical after the holidays end and employers let temporary workers go. Even with the holiday bump and this past week's decline, the latest figures were only slightly higher than the 391,000 level reached last month - the lowest in more than two years.
Fewer than 425,000 people applying for benefits is considered a signal of modest job growth. Economists say applications must fall consistently to 375,000 or fewer to substantially reduce the unemployment rate.
Still, the unemployment rate is not expected to fall much below 9 percent this year. And the housing market cannot fully recover until the glut of foreclosed homes is cleared.
Last year, a record 1 million homes were lost to foreclosures, and foreclosure tracker RealtyTrac Inc. predicts 1.2 million more will be lost this year.
Foreclosures or distressed sales such as short sales - when lenders let homeowners sell for less than they owe on their mortgages - are forcing home prices down in many markets. That has made it difficult for some potential buyers looking to upgrade, because they would have to accept less money to sell their current home.
Even historically low mortgage rates have done little to boost the sales.
The average rate on a 30-year fixed mortgage rose to 4.74 percent this week, Freddie Mac said Thursday. That's up from a 40-year low of 4.17 percent in November. The average rate on the 15-year loan, a popular refinance option, slipped to 4.05 percent last week. That's nearly half a point higher than the 3.57 percent rate in November - a 20-year low.
For December, sales rose in all parts of the country, with the strongest gain a 16.7 percent increase in the West. Sales rose 13 percent in the Northeast, 10.1 percent in the South and 11 percent in the Midwest.
The median price for a home sold in December was $168,800, down 1 percent from a year ago.

Dollar Slash and Burn

Confirmed -- New Dollar Downtrend! No wonder commodity prices are still well supported and moving higher!

Roaring Rally!

It's interesting to me that the futures rose overnight, and initially at the open, but have started to fall now. It will be amusing to see what happens the rest of the day from here.

Thursday, January 20, 2011

World Going Crazy for Cocoa!

Wednesday, January 19, 2011

...And Hurts Some More!

Amazing that the Dow is down only a few points, while the S&P 500 has fallen off a cliff!

Housing Hurts!

We're back down again!

from Bloomberg:

Builders began work on fewer homes than projected in December, a sign the industry that triggered the recession continued to struggle more than a year into the U.S. economic recovery.
Housing starts fell 4.3 percent to a 529,000 annual rate, the lowest level since October 2009, Commerce Department figures showed today in Washington. The median forecast in a Bloomberg News survey called for a 550,000 rate. A jump in building permits, a proxy for future construction, may reflect attempts to get approval before changes in building codes took effect at the beginning of this year.
Companies like KB Homes and Lennar Corp. project demand will be slow to rebound as elevated unemployment and mounting foreclosures discourage buyers. While low borrowing costs and falling prices are helping revive sales from last year’s post tax-credit slump, Federal Reserve policy makers are concerned housing may undermine the economic expansion.
“With sales still near record lows and a lot of unsold properties in the market, there’s very little reason for builders to add more homes to the supply,” said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto, who had forecast starts would drop to a 527,000 rate. “Housing remains a key downside risk to the economy.”

The Daily Shrug Begins

Despite the almost universally-bad news today, the daily shrug-it-off begins!

Corn Plunges Despite Fundamentals

No doubt sympathy with stocks is playing a role!

from Bloomberg:

Corn rose for a fifth day to a 30- month high in Chicago and wheat climbed amid shrinking global stockpiles. Soybeans advanced on speculation that a strengthening yuan may spur imports into China.
World corn supplies will fall 14 percent this year and wheat inventories will drop 9.8 percent, the U.S. Department of Agriculture said last week. Prices also gained as the dollar weakened, making U.S. crops cheaper in terms of other monies. The yuan advanced to a 17-year high against the U.S. currency yesterday.
“The fundamentals are all in place for a very strong rally all of this year,” said Gary Mead, an analyst with VM Group in London. “The USDA figures sent a bolt of lightning through the market because the stocks-to-use ratio is going to be tight indeed through the end of August. And we have a lot of weather uncertainties to get through.”
Corn for March delivery gained 0.9 percent to $6.655 a bushel at 11:27 a.m. London time on the Chicago Board of Trade. The grain touched $6.6625, the highest price since July 17, 2008. March-delivery soybeans added 1.2 percent to $14.3025 a bushel.
Chinese President Hu Jintao met yesterday with U.S. President Barack Obama, boosting hopes that trade relations recently under strain will improve, Chung Yang Ker, an analyst at Phillip Futures Pte, said by phone from Singapore.

More Limit Up Cotton

Back to "Blame the Speculators"!

my post on Zero Hedge this morning:

I guarantee that will cause HIGHER prices, not lower ones. Speculation is not the root cause; it is a symptom of problem, not the root cause. If you hack at the branches (speculators), the root cause (Fed's easy money) remains intact. History shows that by shrinking the size and liquidity of the market, it also shrinks the supply. This eventually results in HIGHER prices. Hugo Chavez has tampered endlessly with attempts to lower food prices in Venezuela, but supplies keep shrinking and prices keep going higher. The antidote to speculative influence is to increase the size and liqudity of the market, not shrink it.
The Hunt Bros' attempt to corner the silver market was a good example. When the market was small, their wealth could easily manipulate the market. But as prices rose, more and more people entered the market. Even housewives were selling their silver at pawn shops. But as the market size and liquidity rose, the Hunts lost control and the market crashed.
History shows that speculators are among the first to perceive an overbougght market and short it. CFTC and other studies have also repeatedly shown that speculators FOLLOW the market, not lead it. CFTC studies have also repeatedly shown that speculators constitute only about 12-18% of total trading volume, even during the commodity boom of 2008. In fact, CFTC studies showed that speculative trading during 2008 was LESS than during 2006, when commodity prices were supressed, as a percentage of total open interest. Studies have also repeatedly shown that non-exchange traded commodity prices rise HIGHER than non-futures traded commodities. If the presence of speculative funds were the real cause, this would not be the case. Those who blame speculators for high prices also forget that by necessity, speculators MUST offset their positions with an opposing position in order to exit the market and take profits. Hedgers don't because they take physical possession. Thus, by definition, speculators negate their effect on the market when they exit their positions. They have no choice! They have to!
The true net cause of high commodity prices is still the Fed's easy money policies that buoy up all risk assets. As long as the Fed is ramping up the stock market, commodity prices will too! Fed policy doesn't just increase the supply of funds. It is also suppressing interest rates that would otherwise give investors a viable alternative and reasonable returns. By denying investors these reasonable returns, it forces them to buy more speculative assets like commodities in order to try to preserve the value of their capital in an inflationary, dollar devaluative environment. Fed policies literally feed the inflationary monster by incentivizing risk assets more than would otherwise be warranted.
By shrinking the size and liquidity of commodities markets, we shoot ourselves in the foot because large investors -- the blue whales of the investment world -- will have GREATER influence on markets, and they will simply move their funds to other commodities exchanges in other countries, where their money is welcome. This thus causes capital flight, thus devaluing the Dollar even more, and thus amplifying the very effect that caused prices to rise in the first place. A blue whale has a lot more influence in a fish pond than the Pacific Ocean. It's the same in the financial markets. The larger and more liquid the market, the less influence the blue whale has. Limiting the market size and participation will drive prices HIGHER, not lower.
These are only a few of the reasons why all attempts to control prices by controlling markets lead to HIGHER prices, not lower ones!

Fed's Money Creation to Have Terrible Consequences

This printing money is going to lead to huge trouble. It’s going to lead to higher interest rates. It’s going to lead to more inflation and at some point there is going to be a train wreck in the currency and the bond market." Market commentator and money manager Bill Fleckenstein

Tuesday, January 18, 2011

Hoisington: Low Growth Ahead

Growth Recession Continues
Factoring in a 4% Q4 growth rate, the U.S. economy expanded by 3% in real terms from the 4th quarter of 2009 through the 4th quarter of 2010. Despite this rise in GDP, the unemployment rate remained stubbornly high at 9.6% in the last quarter of 2010, only slightly lower than the 10% rate it averaged in the same quarter one year ago. Positive real GDP growth with high unemployment is the definition of a growth recession. An even slower growth rate of real GDP should be recorded over the next four quarters, suggesting the unemployment rate will be essentially unchanged a year from now. As we have noted previously, this modest expansion is due to the significant over-indebtedness of the U.S. economy. We see seven main impediments to economic progress in 2011 that will slow real GDP expansion to the 1.5%-2.5% range.
First, fiscal policy actions are neutral for 2011. Second, state and local sectors will continue to be a drag on the economy and labor markets in 2011. Third, Quantitative Easing round 2 (QE2) will likely produce only a slight economic benefit as the Fed continues to encourage additional leverage in an already over-indebted economy. Fourth, while consumers boosted economic growth in the second half of 2010 by sharply reducing their personal saving rate, such actions are not sustainable. Fifth, expanding inventory investment, the main driver of economic growth since the end of the recession in mid-2009, will be absent in 2011. Sixth, housing will continue to be a persistent drag on growth. Seventh, external economic conditions are likely to retard U.S. exports.
Fiscal Policy in Neutral
The recent tax compromise between the President and Congress merely extended existing tax rates for another two years and provided a transitory 2% reduction in social security tax withholding. Personal taxes, including federal and non-federal, rose to 9.44% of personal income in November, up from a low of 9.1% in the second quarter of 2009 (Chart 1). Even with the tax compromise this effective tax rate will continue moving higher as a result of higher state and local taxes. Economic research has documented that temporary changes in tax rates are far less beneficial than permanent ones since consumers spend on the basis of permanent income. Higher outlays for unemployment insurance were also legislated, but these were negated by cuts in other types of spending. Federal spending through early March will mirror its pace in fiscal 2010, and the rest of the 2011 budget will decline slightly in real terms. Therefore, total real federal expenditures are likely to contract in real terms this year.
Chart 1

If fiscal policy becomes focused on long-run considerations (e.g. deficit reduction) economic conditions will improve over time. But, if fiscal policy remains focused on short-term stimulus, the economy's prolonged under-performance will persist since the government expenditure multiplier is less than one, and possibly close to zero.
The recent scientific work on the expenditure multiplier is aligned with the Ricardian equivalence theorem as well as the views of the Austrian economists who continued to follow Ricardo even when the Keynesian revolution was ascendant. Economist Gary Shilling made this point very well in his outstanding new book, The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation.
Dr. Shilling's analysis of the simplified and unsubstantiated Keynesian multiplier (p.216) still taught in many colleges and universities is extremely insightful. ÒBut the Austrian School of economists like Friedrich Hayek and Ludwig von Mises believed that the economy is much more complicatedÉ The Austrian view suggests that the government spending multiplier may be only 1.0 and that there are not any follow-on effects. More recent academic studies indicate that the multiplier is less than 1.0, and perhaps much less.Ó
After recognizing the difficulty of calculating the multiplier, Dr. Shilling writes, ÒAlso, the inherent inefficiencies of government reduce the effects of deficit spending and lower the multiplier.Ó Thus, if steps are taken to reduce deficit spending, the economy's growth rate will recover after the initial transitory negative impact as additional resources are provided to the private sector.
State and Local Governments Drag
Municipal governments face substantial cyclical deficits and significant underfunding of their employee pension plans. In addition, municipal bond yields rose sharply in the second half of 2010, increasing borrowing costs, probably an unintended consequence of QE2. The municipal bond market proceeds are used primarily for funding capital projects, which suggests that such projects will be delayed. State and local governments typically do not undertake capital projects freely when they have large cyclical deficits.
To reign in these financial imbalances, state and local governments have five choices: (1) cut personnel; (2) reduce expenditures including retirement benefits; (3) raise taxes; (4) borrow to fund operating deficits; or (5) declare bankruptcy. All retard economic growth. Any trend toward increased bankruptcy would raise caution in the broader municipal market and add to higher borrowing costs. Raising taxes may give bondholders more confidence, but such actions can fail to raise new revenue as slower economic conditions retard spending. The demographic trends in the decennial census also show that people are increasingly moving to low tax regions, contributing to worsening fiscal imbalances from the exited areas.
QE2's Problems
Clearly, Fed actions have affected stock and commodity prices. The benefits from higher stock prices accrue very slowly, are small, and are slanted to a limited number of households. Conversely, higher commodity prices serve to raise the cost of many basic necessities that play a major role in the budget of virtually all low and moderate income households.
For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income (Chart 2). In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011.
Chart 2

Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy.
Substitution Effects
In a November speech in Frankfurt, Germany, Dr. Bernanke said that the use of the term Òquantitative easingÓ to refer to the Federal Reserve's policies is inappropriate. He stated that quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves. These are channels that the Chairman considers relatively weak, at least in the U.S. context. Dr. Bernanke goes on to argue that securities purchases work by affecting yields on the acquired securities in investors' portfolios, via substitution effects in investors' portfolios on a wider range of assets. This may well be true, but the substitution effects are just as likely to be detrimental (i.e. the adverse implications of increasing commodity prices and rising borrowing costs for some and reducing interest income for others). Importantly, the Fed has no control over these substitution effects.
In his reputation-establishing 2000 book, Essays on the Great Depression, Dr. Bernanke argues that Òsome borrowers (especially households, farmers and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe, but not unprecedented downturn of 1929-30 into a protracted depression.Ó Interestingly, when QE2 drives up borrowing costs for homeowners and municipalities, thereby restricting credit, the Fed is creating (according to Dr. Bernanke's book) the exact same circumstance, albeit on a reduced scale, that helped cause the great depression---rather bizarre!
Liquidity Mistakes
For the past twelve years the Fed's policy response to economic problems has been to pump more liquidity. These problems included: (1) the failure of Long Term Capital Management in 1998; (2) the high tech bust in 2000; (3) the mild recession that began with a decline in real GDP in the fall of 2000; (4) 9/11; (5) the mild deflation of 2002-3; (6) the market crisis and massive recession and housing implosion of 2007-9; and now, (7) the lack of a private-sector, self-sustaining recovery.
The Fed diagnosed each of these events as being caused by insufficient liquidity. Actually, the lack of liquidity was symptomatic of much deeper problems caused by their own previous actions. The liquidity injected during these events led to a series of asset bubbles as the economy utilized the Fed's largesse to increase aggregate indebtedness to record levels. The liquidity problems arose as the asset bubbles burst when debt extensions could not be repaid and generally became unmanageable. Each succeeding calamity or bust reflected reverberations from prior Fed actions.
While governmental directives to Fannie and Freddie to increase home ownership clearly also played a role, the Fed supported this process by providing excessive liquidity to fund the housing bubble as well as other unprecedented forms of leveraging of the U.S. economy. The heavy leveraging and the associated asset bubbles, however, produced only transitory and below trend economic growth. Similarly, like its predecessors, QE2 is designed to cure an over-indebtedness problem by creating more debt.
In addition to failing to revive the economy permanently, major unintended consequences have arisen. The LTCM bankruptcy created a $3 billion loss, a very modest amount in view of the sums required by subsequent bailouts. The Fed's reaction to LTCM served to give market participants a signal that the Fed would back-stop those regardless of whether they engaged in or enabled bad behavior. Also, Fed actions have conditioned Wall Street to seek Fed support whenever stock prices come under downward pressure. In fact, the process of leaking out QE2 began in the midst of a stock market sell off.
Well-intentioned actions to promote growth and fine tune the economy by micromanagement have instead produced failure. Although the Fed had little choice in massively supporting financial markets in 2007/8, no Fed intervention would have been a more long-term productive stance in the previous economic events. QE2 is another example of flawed Fed policy operations.
The Saving Rate Decline
In the second half of 2010, real GDP grew at an estimated 3.3% annual rate (assuming the fourth quarter growth rate was 4%), up from 2.7% in the first half of the year. Transitory developments in two of the most erratic and unpredictable components of the economy---the personal saving rate and inventory investment---accounted for all of this acceleration.
From 6.3% in June 2010, the personal saving fell by a significant 1%, to 5.3% in November (Table 1). Consumer spending is slightly in excess of 70% of real GDP. Without the one percentage point reduction in the personal saving rate, the second half growth rate would have been 2.6%, a shade slower than the first half growth pace, and materially less than the presumed second half growth rate.
Table 1

When job insecurity is high, and defaults, delinquencies and bankruptcies are at or near record levels, a drawdown in the saving rate would seem to be an unlikely event. This development is certainly viewed favorably by retailers but the issue is whether the economy's future is better served by using the funds to make mortgages current, pay other debts and prepare consumers for potential emergency needs. Thus, the lowering of the saving rate is similar to running monetary and fiscal policy to meet short-run needs while ignoring long-term consequences.
Inventory Reversal
Inventory investment was the main driver of economic growth since the recession ended in mid-2009. Based on published data, real GDP grew at a 2.9% annual rate over this span. However, real final sales, which excludes inventory investment from GDP, increased at a paltry 1.1% pace. In the third quarter, inventory investment surged to 3.7% of GDP while preliminary fourth quarter figures on retail, wholesale and manufacturing inventories indicate this figure might have reached 4% (Chart 3). In the final quarter of the recession, inventory investment was -5.1% of GDP. Since 1990, the period of modern inventory control mechanisms, inventory investment averaged only 1.1%. At a minimum, the dominant source of aggregate economic strength will not repeat in 2011.
Chart 3

Housing Drag Persists
Housing will remain a drag on economic activity in 2011. Prices have re-accelerated to the downside over the past four months, as mortgage yields have risen and the housing overhang has increased. The housing overhang, as explained by Laurie Goodman writing in the Amherst Mortgage Insight, "is not caused solely by the number of non-performing loans that exist in the market. The problem also includes the high rates at which re-performing loans are re-defaulting, along with the relatively high rates at which deeply underwater loans that have never been delinquent are running two payments behind for the first time."
Another major problem is that home prices are still too high. An excellent and well-researched study by Danielle DiMartino Booth and David Luttrell in the December 2010 Economic Letter from the Dallas Fed documents this issue very authoritatively. Booth and Luttrell write, "As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85% to their highest level in August 2006. They have since declined 33 percentÉ In fact, home prices still must fall 23% if they are to revert to their long-term mean."
From the standpoint of most households, the home is the main component of wealth, not stock market investments. The continuing drop in housing prices serves to underscore the ill advised and likely temporary drop in the personal saving rate that was so critical to economic performance late last year.
Adverse Global Considerations
The global economy since 2009 may be referred to as a two-speed recovery, with China, India, Brazil, and other emerging economies at the high speed and the U.S. and Europe at the slow speed. That pattern is likely to continue, but with an important difference. China, India, and Brazil are likely to slow adversely affecting the U.S. and Europe. Thus, the two-speed recovery will continue, but with the entire world growing at a much more modest pace. Two major considerations point to this outcome. First, the higher food and fuel prices discussed earlier will serve to significantly depress growth in countries like China, India and Brazil where food and fuel are known to be a much higher percentage of household budgets. Already reports have surfaced from international agencies on the growing adverse consequences of higher food prices, and social unrest has also been witnessed on a limited basis.
Second, Chinese economic policy is designed to slow growth and reduce inflationary pressures. Although the People's Bank of China (PBoC) has already taken several actions to contain surging inflation, more steps may be needed. In China, as elsewhere, inflation is a lagging indicator. It is worth considering that the PBoC has never been able to engineer a soft landing, which suggests that ultimately a downturn in China may be greater than the prevailing consensus.
Thus, changing global conditions should serve to moderate U.S. exports. Ironically, the U.S. current account deficit still may continue to improve. A stabilization of the saving rate will reduce U.S. imports, while a higher saving rate will cut imports significantly. Already this two-speed global economy has resulted in a reduction in the U.S. current account deficit of approximately 3% of GDP (Chart 4). A continuation of this trend will serve to underpin the value of the dollar, which rose in 2010. The firm dollar, in turn, will serve to keep U.S. disinflationary trends intact.
Chart 4

Bond Market Conditions
In spite of the adverse psychological reaction to the QE2, long Treasury bond yields dropped to 4.3% at the end of 2010, down 30 basis points from the close of 2009, producing a total return of slightly more than 10% for a portfolio of long Treasury and zero coupon bonds. The problematic economic environment and its depressive effect on inflation suggests long Treasury bond yields could easily decrease another 30 basis points in 2011, which would produce another double-digit rate of return for a similar portfolio. The probabilities of even lower yields are significant.