Recovery Missing Normal Expectations

By Christine Benz| 2-23-2012 3:00 PM (article that appeared on Morningstar Research)

Christine Benz: I am Christine Benz for Morningstar. I am here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with William Strauss. He is a senior economist at the Federal Reserve Bank of Chicago, and he shared his views on the economy and what he sees as the potential headwinds and tailwinds to an economic recovery.

Christine Benz: Bill, thank you so much for being here.

William Strauss: Happy to join you.

Benz: You are here to talk about the state of the economy, and I am hoping you can kind of summarize what you will discuss in your presentation. I think there is a general consensus that there is some strengthening in the economy, maybe not as much as one would hope, but still strengthening. Is that your general view?

Strauss: Yes. We certainly saw some improvement for the U.S. economy as the year came to a close, and that has continued into the early part of this year. That being said, the expectation is for growth this year to be roughly around trend rate of growth next year, perhaps a bit better than that, but still not the type of recovery/expansion period that you would typically expect given that we went through one of the deepest drops in economic activity that we've seen since the Great Depression.

Benz: What do you think have been the key impediments to the economy not strengthening at the pace one would hope?

Strauss: So, I think in large part it's really the whole financial crisis. Carmen Reinhart and Ken Rogoff went ahead and wrote the book, This Time Is Different. What they were basically highlighting is that, unlike any other recession that we've had since the Great Depression, this one has been associated with a financial crisis. What we've seen is that recovery periods that are associated with financial issues tend to be far more muted than a typical type of recovery. There is very little pent-up demand. In fact, leading us into this was just probably an overconsumption in particular of housing. So, this time around we are seeing absolutely no contribution to the recovery coming from the housing sector, which is very unusual.

Benz: You noted that still-tight credit is another headwind here.

Strauss: So you look at the banks' balance sheets, and these firms are sitting on a lot of deposits. The question is why is that the case because historically banks have these excess reserves. It has been much more profitable for banks to lend that cash out, charging an interest rate higher than what they are paying the depositors, and that--on a risk-adjusted basis--is how they make their money. They are not doing it at this point, and I think that's occurring for a number of reasons. Some of it has to do with supply. You look at the number of underperforming assets that are out there. We mentioned the housing sector, and there's probably still a year's worth or more of an excess amount of homes out there. So, if you are looking at a marketplace where there is excess supply of homes, you can't imagine there is great willingness on the part of a lender to lend to a builder that plans to build an extra 200 homes in a development.

So, I think for those kinds of risky issues at this point, there is some hesitancy there. In addition, with commercial real estate, we see similar things with the vacancy rates still being quite high. Then on the demand side, we have an economy which is expanding but not setting the world on fire. Since the recovery expansion began in the middle of 2009, growth has been roughly at trend rate of growth. This is, again, well below what we would typically expect. For example, during the mid-1970s and the early '80s, growth for a three-and-a-half-year period was well north of 5% for that entire period, significantly above what we thought of as trend.

With the fact that the economy is not taking off like a skyrocket, companies are really being very hesitant to want to expand capacity, wanting to push their businesses, and wanting to take on debt. I think when you look at those companies that put themselves in an overleveraged position, they got themselves in trouble. So, I think that we are in a state right now where there is this preference for being very cautious with regard to debt.

Benz: How about consumers?

Strauss: I think in a similar vein there. We have an unemployment rate that is above 8%; incomes are rising but not very rapidly. Consumers similarly were put into a position of having too much debt, and some of their main assets have really taken a hit on values, such as their homes, which are down about 30% nationally, and in certain markets they are down by more than 50%. Down here in Florida, this is one of the key states that has seen tremendous loss of value of homes. And the stock market is another factor. Granted we've been on this great bull market run since March 2009. But unless you put your money in the market in March '09, unless you've been riding this horse all the way through, we're still well below the levels where we were back in 2007. So, investors look at their 401(k)s and their other assets that they have perhaps invested in the stock market, and they are just not feeling all that wealthy relative to 2007.

Benz: Bill, I know a big focus for you at the Chicago Fed is the manufacturing sector. There has been a lot of excitement about what's been going on in Detroit, and I'd like your take on that area and the strength of manufacturing overall?

Strauss: So, here I can be a lot more positive. Manufacturing output was at a record-high level in December 2007. This persisting view that we no longer make things in this country is totally false. We were producing more than ever, more than China back in December '07. Then we had the Great Recession. Although we saw of drop of 5% in economic output nationally for gross domestic product measurement, it fell much more significantly for manufacturing with a loss of more than 20%. One fifth of the business gone.

This was quite dramatic, but I should also highlight, when you decompose it, the industry that really took the biggest hit was, as you mentioned, the automotive sector. So, Michigan was severely affected, in particular. In addition, the primary- metals market took a hit. You need steel and aluminum to go with the vehicles, so it kind of goes hand-in-hand. But the two industries that are now really recovering much more rapidly than the others are automobiles as well as primary metals--steel and aluminum. So, we are getting that kind of tennis-ball bounce by sector.

That being said, for overall manufacturing, it is really doing quite well. Rather than growing at trend as we're seeing for the overall economy, it's growing at more than twice its historical trend rate of growth. It has been expanding now for 31 months. It has seen an average annualized growth rate of 6.3%, recovering nearly 70% of the lost output.

The pace is probably going to slow. It probably won't be growing at 6% during the next couple of years, but my personal view is that it might be closer to 4%. But with the rapid kind of pace continuing, probably sometime next year we'll begin to see, once again, an all-time record-high level for manufacturing output in this country.

That being said, this rebound that we're seeing in manufacturing has allowed the economy to actually add jobs for the first time in a long time. But we're adding jobs to a degree because with that 20% drop, we cut 2.3 million workers out of manufacturing. One in every four jobs that were cut was in manufacturing. This is an industry that represents less than 10% of the workforce. So, they have the lion's share of the hit for those unemployed workers.

At this point in time, they've only added back 400,000 workers, so there are still roughly 2 million workers in manufacturing who lost their jobs who have not gotten them back. So, we've got 70% of the output back, only adding less than 20% of the workers. It's a story of productivity, and this is something that has gone on for decades in manufacturing and one of the reasons why the number of people as a share of the economy employed in manufacturing has continued to fall during the last 60 years.

Benz: So it's good news for the manufacturing sector in general, but bad news for people who work?

Strauss: Just in terms of the numbers. It is interesting though. You talk to the manufacturers who say they would like to hire more, and that 400,000 level would probably be a better number than it currently is. I don't think we are talking job growth in the millions by any stretch of the imagination, but employers say that they have difficulty finding the skilled workers to fit the skills that they are desiring in this

21st century-type of manufacturing environment. So, you begin to wonder what about these remaining 2 million workers; why aren't they fitting the bill? It's not an easy thing to answer. Probably some of them do not have the kind of computer- numerical-control knowledge because the companies that they were working at-- maybe they were the ones that went out of business--were maybe not the most sophisticated and not the most productive. So, those people might have a difficult time.

In addition, whenever you visit any manufacturing plant, one observation I've made is just the fact that it tends to be an older workforce. Typically, a lot of people are in their 50s. It could very well be that during this downturn, many of them just said, "I am just going to retire. I am not even going to bother trying to look for another opportunity." It could be a bit of that kind of activity taking place.

Estimates are--and I don't know how good these are, these are just from people who throw these numbers out--that there could be as many as 600,000 unfilled positions. Even if you can fill every one of those, and assuming that's correct, that would still only represent 1 million workers when factoring in the other 400,000. This is still a shortfall from the 2.3 million that we had lost during the downturn.

I am optimistic for manufacturing rising and probably with that, some employment opportunities in manufacturing. But as we have seen over the decade, since it's being driven by productivity, the manufacturing sector is not going to be a major employer for the U.S. economy.

Benz: Right. So, we're seeing a human cost there. Last question for you, Bill, I'd like to talk about one or two of your favorite economic indicators. You always hear about Warren Buffett looking at railcar volume. Do you have some favorite statistics that you look at to gauge the economic health?

Strauss: I think in terms of looking at the overall economy and how it's doing, I actually really enjoy--and it's not just because it has the Chicago Fed moniker attached to it--an indicator known as the Chicago Fed National Activity Index. Even though it's called Chicago Fed, it's not a regional indicator. It's an indicator for how the nation is doing as a whole.

Its advantages are that it comes out monthly, so we just recently got the January release this past week. The way the indicator works is that we are taking a whole host of different economic series and put it into a black box model. They kind of fight amongst themselves to determine how the economy is doing vis-a-vis trend.

Manufacturing still plays a major role within that because manufacturing largely does a large job explaining volatility in the economy, as that one example I gave about the 5% versus 20% drop.

This National Activity Index, when it has a reading of zero, it means that the economy is growing near its roughly trend rate of growth, which is something in which we're interested. When it's below zero, it doesn't mean that the economy is declining, but it means we're underperforming what we're capable of doing. Now, if it slips down too far below zero, typically around a minus 0.7 to a minus 1.3 that has historically been associated with a recession, meaning that the growth has now slowed to become actually negative growth.

Now, what's the most recent reading on this? In January, actually it popped slightly above zero, so we're hopeful that, as we talked about at the very beginning, the strength that we're seeing in the economy is being reflected in this indicator. So, I do believe it's real. Hopefully it can be sustained as we move into 2012, and maybe we can have an output that might be better than trend.

Benz: Bill, thank you so much for sharing these insights. We very much appreciate you taking the time to be here.

Strauss: Wonderful. Thank you.