Why Canadians should be praying for the US stimulus package to work

I had some free time this weekend so I ran a pessimistic scenario for US recovery through my small-scale Canadian economic model. This scenario assumes that the US recession continues to 2009-Q4 and is followed by a very weak recovery in 2010. The implications for the Canadian economy are pictured below as deviations of Real GDP from its peak in 2008-Q3.



Lets hope it works!

More proof that things are really, really bad

Canadian job losses reached 129,000 in January, sending the National unemployment rate to 7.2% from 6.6% in December. Over 100,000 of the job losses were in manufacturing and 71,000 were lost in Ontario alone. My home Province of BC lost 35,000 jobs and the unemployment rate here now stands at 6.1% - up almost two full points from the end of 2007. Alberta continues to hang on to its jobs - I'm not sure how long that can last.

Payroll employment showed employment fell by close to 600,000 - unemployment now stands at 7.6%. Job losses since the start of the recession in December 2007 total 3.6 million. Wow.

Perhaps now that strange breed of creatures known as "Republicans" will feel a little more urgency to pass the stimulus package - that is, if , you know, they can get past the bizarro land logic that "spending" is mutually exclusive with "stimulus".

-0.7% Real GDP in November

Ouch. Before the November release I had Q4 2008 coming in at around -2.4%. I think that forecast is probably still going to be about in line with the actual Q4, though maybe more reflective of the low-end of a range of -2.4% to -3.0%.

I was surprised by the better than expected Q4 GDP in the US (if you can put a positive spin on the biggest contraction since 1982). Real GDP came in at -3.8% vs expectations of -5.8%. Barry Ritholtz points out that much of the upside surprise came from higher than expected inventories. Higher inventories in Q4 should mean production cuts shifting into 2009 and therefore even weaker growth in Q1.

Not good times - bad times.

I'm hoping to post a revised Canadian forecast later today to reflect the released budget and incoming Q4 data. Stay tuned.

US Credit Expansion?

Following yesterday's post regarding Canadian bank lending, a commenter directs me to the following chart of total bank credit for all US banks. He notes that lending is still increasing in spite of the credit crisis.


It is interesting that lending, in aggregate, always increases - even through severe recessions (early 70's and 80s). However, the most interesting thing to me is the anomalous behaviour of credit in the current recession. The data shows a dramatic flattening of credit followed by a sudden spike. What could explain the behaviour of this data?

In response to the "credit crisis is a myth" hypothesis, researchers at the Boston Federal Reserve note (convincingly) that the recent changes in aggregate loan data can in part be explained by the fact that banks used to securitize loans but are now increasingly being forced to bring loans onto their balance sheets:

During crises, bank balance sheets expand for a number of reasons. First, one consequence of the credit crisis is that loan "securitization," the business of packaging various loans (home, business, auto and other) into assets for investors, has become more difficult. Accordingly, banks have had to keep the loans.

The authors further note that weak financial conditions mean more companies tapping existing lines of credit:

Second, during this and other times of financial weakening, companies increasingly rely on their existing loan commitments and lines of credit. This is because general liquidity dries up and commercial paper markets become strained.

This could explain why we are currently seeing increased loan volume in spite of bank failures and a massive build-up of reserves. The entire article is worth reading: http://www.bos.frb.org/bankinfo/qau/wp/2008/qau0805.pdf

Welcome to the Liquidity Trap

I guess its time to put our traditional monetary models on the shelf for awhile as we are now in the world of quantitative easing.

Somehow markets view a historically low fed-funds rate, and a dramatic shift in the primary monetary policy instrument as a sign to celebrate rather than as a signal that the economy is in a very bad place and will be there for long time- Dow up 360; S&P up 45; TSX up 262.

Firing Blanks

The US Federal Reserve convenes its two-day meeting today to deliberate on the direction of monetary policy. Expectations are for a cut of 50bps, which would bring the fed-funds rate to a historical low of 0.5%.

Given that most of the normal channels through which monetary policy works (eg. housing, credit, investment) are either severely jammed or completely broken - there will likely be no material stimulative impact from a rate cut. Moreover, the effective funds rate has been trading at below 50bps for quite some time, and it is still unclear how the decision to pay interest on reserves has impacted the usefulness of the fed-funds rate as a policy instrument (see here for an excellent discussion).




There also may be significant risks to cutting rates , most prominent, (as Tim Duy notes) of which is a disorderly adjustment in the US dollar. A falling dollar, along with massive borrowing associated with bailouts and a coming stimulus package, could send interest rates higher as countries demand higher compensation on US government debt (though this hasn't happened in the past couple of years, despite a weaker dollar and massive borrowing). Moreover, as global trade deteriorates, there may be none of the typical stimulative trade effects normally associated with currency depreciation.

What are the risks if they don't cut? Who knows. Uncertainty is scary and markets are too fragile not to deliver on expectations which is why the Fed will continue towards the zero bound with their hands firmly gripping the monetary spigot.