Third Quarter 2012
by Nicholas S. Perna, PhD
The Doldrums
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Doldrums noun plural (dol-dr mz). A part of the ocean near the equator abounding in calms, squalls, and light shifting
winds. A spell of listlessness or despondency. A state or period of inactivity, stagnation or slump.
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Slump? The Not-So-Great-Recovery from the Great Recession seems to be slowing further. Some big names have even
gone so far as to say that we’re about to re-enter recession, well before we’re fully recovered from the last one.
Job growth has shrunk to a trickle, causing nervous consumers to be tightfisted with spending. All of the gain in car
sales occurred during the first few months of the year. True, housing is looking a bit better. Prices are stabilizing and
maybe even creeping up but they are still 20-30 percent below the peaks hit five years ago. There also seems to be
some modest improvement in sales and construction activity but from very low levels.
Why the doldrums? It takes a long time for the wounds from a large-scale financial crisis to heal. Cities and states are
still tightening their belts in the wake of anemic tax revenues and spending commitments made during the good times.
Most European economies are in trouble. Budget austerity is being used as the cure for everything, but the result is
spreading recession and high unemployment. There’s now even some concern that some European nations could be at
the brink of deflation. A sustained decline in the overall level of prices would make the situation even worse, as people
postpone purchases to wait for lower prices later. Deflation wreaks havoc on the financial system as the value of loan
collateral falls and the ability of borrowers to service loans weakens.
The U.S. legislative and executive branches are stalemated as the elections near. Failure to pass legislation during the
past year means massive budget tightening as tax cuts expire and spending cuts hit on January 1. I find this hard to
believe: during his July briefing, Fed Chairman Bernanke was asked by some members of Congress to refrain from
taking further monetary action! “If con is the opposite of pro, is Congress the opposite of progress?”
Early in July, accusations that the important LIBOR rate was being rigged to benefit some of the big banks increased
skepticism about the functioning of the financial system and its regulators. And if that’s not enough, the very hot weather
and drought are pushing farm prices up just when we’ve been getting a little relief from gas prices.
Where do we go from here? I think the odds are fairly high, maybe 30 percent, that we could slip back into recession.
At this point, the downside risks far outweigh any upside potential. If we escape recession, which seems to be the
consensus of major forecasters, growth will be slow, with the unemployment rate still around 8 percent by year-end.
Reactions. I’m pretty sure that the Federal Reserve will ignore those Congressional requests to refrain from further
action. However, there really isn’t a lot the Fed can do. Short-term interest rates were reduced to zero back in 2008.
Long-term rates have been brought down to incredibly low levels by a combination of factors, including Quantitative
Easing (QE) and, most recently, the “Twist.” It’s hard to see yields going much lower. Twist is the label given by the
financial press when the Fed sells short-term bills to buy longer-term notes and bonds. The idea is to bring down
long-term yields without increasing the size of the Fed’s portfolio to calm the critics. One risk is that it will put upward
pressure on short-term rates.
So far, the Fed has implemented two Quantitative Easing programs. Over the past three years, more than two trillion
dollars in Treasury debt and mortgage backed securities have been purchased from financial
institutions. The proceeds from the sales mostly sit as idle reserves at the banks where they
earn 25 basis points. The Fed could try cutting this rate below 25 basis points to see if it
continued
stimulates lending. However, that could hurt the money market mutual funds by driving earnings below their costs of
doing business.
So I guess that leaves a third bout of Quantitative Easing. When I was asked in a recent Wall Street Journal survey about
how large QE3 would be, my response was $500 billion because anything smaller would be dismissed as trivial. The
problem is going to be how much impact this will have on long-term yields when they are already so low.
Implications for credit unions. Those falling long-term interest rates make it hard to earn a buck on securities and
loans. This increases the temptation to “reach for yield” by taking on additional credit risk through lower quality loans, or
assuming more interest rate risk by extending bond maturities. Both are dangerous.
The other area to be concerned about is the general level of credit quality. Even without a recession, slower economic
growth undermines the ability of households and businesses to service their debts.
Finally, while recession is not the most likely outcome, it is not too early to start thinking about how you would adjust
your business plans to cope with one.
Stay cool this summer!
Nick Perna is Resident Economist, Alloya Corporate. He specializes in economic analysis,
forecasting and strategy. Dr. Perna has served as an economist for the Federal Reserve
Bank of New York, General Electric and a number of major banking institutions. The
Wall Street Journal and BusinessWeek have each twice cited Dr. Perna as one of the top
economic forecasters in the United States. He has served as an economics professor at
Williams College and New York University, and currently teaches an economics course
at Yale University. In addition, he has also appeared on The NewsHour with Jim Lehrer,
CNN, CNBC, the NBC Nightly News, ABC Radio and NPR’s All Things Considered.