This is a follow up on Q2 from Cumberland dvisors.

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis@cumber.com.

At the start of this year, we argued that the Fed would keep interest rates low at least through the end of this year, and at quarter’s end little has happened to change this view at this time.  There were several key arguments to support this view, which reflect an assessment of how the Fed views the economy and will guide its approach to policy.  Briefly, the FOMC relies primarily upon what is know as the Phillips curve framework, which, in a simplistic form, posits that as unemployment declines, labor markets become tight, employers bid up wages, capacity utilization decreases, and to maintain profits companies increase prices.  In other words, there is a tradeoff between employment and prices, with inflation increasing when unemployment reaches a critical low rate.  The Fed’s job is to strike a balance so that sustainable economic growth that maintains full employment doesn’t trigger an outbreak in inflation.  Using this framework, the FOMC has provided us a window into its views as to the likely evolution of the economy.  The current picture is mildly optimistic but supportive of this view.  For example, while the FOMC in its most recent February projections suggested that it sees real year-over-year economic growth above 3 percent in 2010 and hovering around 4 percent for both 2011 and 2012, with personal-consumption inflation below 2%, unemployment is expected to be relatively stable through 2010 in the 9.5-9.7 percent range.  Most of us, and policy makers too, regard that rate of unemployment as unacceptably high.  The FOMC sees only a slight improvement in employment, with the unemployment rate moving to about 8 percent by the end of 2012 and to only around 7 percent at the end of 2012.

With the current substantial slack in the economy, a stagnant housing market with prices still not completely stabilized, few signs of impending inflation, and a continuing problem in the commercial real estate market, the FOMC can focus on jobs and keep interest rates low to support growth in the real economy as it gradually recovers.  But what will lead the rebound?  We don’t look for the consumer to lead this recovery.  Unemployment is high, incomes have not been improving as of the most recent data releases, consumer credit is constrained, and consumers have been rebuilding their balance sheets.  Credit for businesses and consumers will contine to be restricted for several reasons.  Large banks still need to rebuild their capital positions and won’t return to the previous high-leverage days before the financial crisis.  And credit standards have been tightened by both small and larger institutions.  With heightened regulatory scrutiny, credit is likely to be a tight for some while.  Business have recently been replenishing diminished inventories, but that is not likely to sustain economic growth.  On the other hand, corporate profits have rebounded the last three quarters, and history suggests that profits are the main source of funding for investment.  With the eventual pickup in investment as aggregate demand gradually increases, employment should slowly recover.

Some forecasters have been recently suggesting that employment growth will not only turn around from its continued contraction the past many months but will turn significantly positive.  Our estimates suggest that it will take a minimum of 4 years to recover the 8.4 million jobs that have been lost during the recession to date, if the economy grows at near the rates the FOMC has forecast; and this does not include the need to employ new entrants into the labor force.  The risks to this forecast are to the downside, given the structural changes that have taken place in the labor market, the changing demographics of the labor force, and the huge productivity gains that businesses have made.

For the many reasons just enumerated, it appears that the FOMC will keep its foot on the gas as it contemplates and then gradually begins to wind down its quantitative easing program.  We think this will take some time and that the continued weakness in the job market, no impending signs of inflation, and a fall election will keep policy interest rates at approximately their same level through this year.