Bernanke Testimony Translated

When the Chairman of the Fed testifies before Congress, it is always a good idea to pay attention. Even if you do not agree with his assessment of the economy, it is an important insight into what the Fed is likely to be doing in the near future. Below are excerpts from his prepared testimony, with my interpretation and commentary interspersed.
 
"The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market -- the number of new and continuing claims for unemployment insurance through late May -- suggests that sizable job losses and further increases in unemployment are likely over the next few months."

Hard to disagree with mostly factual statements here, although I would say the next few quarters would be a more accurate statement than the next few months. In both of the last two recessions, unemployment continued to get worse long after the economy bottomed. The dynamics of this recession make it likely that it will be even more the case this time around.

"However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions."

Not going down is not the same thing as going up. He is correct that the stimulus program is helping out, and that if it were not put in place things would have been much worse. It was an attempt to prime the pump. The question is, are we just pumping back out the water we put in, or are we drawing out additional water? Have we ignited a self-sustaining basis for economic activity after the stimulus has worn off? Only time will tell.

"Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline--a precondition for any recovery in homebuilding."
   
True that existing home sales have been fairly stable, however an increasing percentage of them have been distressed sales, either short sales or sales of previously foreclosed homes (about half now). In a normal housing market, a sale at the low end generates a chain reaction of three or four additional move up sales. With distressed sales, this does not happen.

The rebound in mortgage rates will not help going forward. It is a good thing that starts have declined faster than new home sales have, allowing for inventories to decline, but there is still a huge overhang of excess inventories, both new and used.

"Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production."

True, but the entire improvement in the first quarter between the inital read and the second read, which moved the estimate from -6.1% to -5.7%, was due to less of an inventory drawdown than had originally been estimated. The most recent inventory-to-sales ratio we have is from March, when it was at 1.44 -- flat with February and down ever so slightly from 1.46 in both January and December. A year ago it was at 1.28. We probably still have some work to do on the inventory front.

"We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast."

I generally agree here -- the pace of inventory liquidation will slow but not stop, let alone seeing a rebuilding of inventories anytime soon. Residential investiment is already at its lowest share of GDP on record in the first quarter and is not going to zero. This is more a case of an absence of a negative being a positive, rather than an absolute positive.

"Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes."
    
I fully agree that this is NOT going to be a V shaped recovery -- the big question is will it be a U or an L? Eventually, consumer balance sheets will be restored and pent-up demand will be released, but this will be a very long process.

Historically, the drivers to get us out of a recession have been housing and consumer durables, most notably Autos. While auto sales were the highest for the year in May, and both Ford (F - Analyst Report) and General Motors (GM) gained market share, it is hard to get excited about sales that are still below a 10 million annual rate.

For years we were at an annual rate of about 17 million. Those days are probably gone forever, and I would expect it will be 2011 before we get up to the 13 million level, which was the scrappage rate during the good years.