RBC note: "Is this recession different"?

I see plenty of research each day, but this summary report is very much worth sharing given the insights it provides into the direction of the North American economy. Dr. Mark Gertler, the Henry and Lucy Moses Professor of Economics at New York University, spoke to clients of RBC Capital Markets recently. Below is a summary of Dr. Gertler’s lecture and the Q&A session afterwards:

Is this recession different?

Cumulative output loss is similar to post-war recessions during 1974-75 and 1980-82. In each of these there was a large bounce in growth afterwards. By comparison, after 1982, recessions were milder but bounce back was lower. This time will be the worst of both worlds – large output loss similar to bad recessions, but with slow growth for the foreseeable future. The slow growth will be because of conditions in credit markets.

Unemployment, which recently crept above 10%, on par with two worse recessions, previously began to turn around the trough of the past business cycles because output growth was high. That is not going to be the case, now.

To get unemployment down 1%, you need roughly 2% of growth above trend for a year. Thus, to get unemployment down 1% next year, there would have to be roughly 4-4.5% growth in 2010, which no one is expecting. That means we may not see 8.5% unemployment for 3-4 years.

Gertler on Fed’s balance sheet and unconventional monetary policy
Post Lehman, the Fed effectively went into the investment banking business. It began lending in commercial paper markets and purchasing Agency debt, which is not explicitly guaranteed, and purchasing MBS. In this way, it stepped in to take the place of the shadow banking system.

The Fed funded this lending first by borrowing from the Treasury and then by paying interest on reserves. Once the Fed gained the ability to pay interest on reserves, reserves effectively became riskless assets backed by the full faith and credit of the US government. In that regard, they are not even money.

Bernanke referred to this as credit easing. The goal was not to dump money into the economy, it was to bring down credit spreads and get the flow of credit moving. The balance sheet activities are central bank intermediation. Pre-crisis, intermediation shrunk, which depressed asset values and the Fed stepped in. This is not an expansion of base money.

These measures were largely a success. However, while they succeeded in keeping down credit spreads and stabilizing the economy, they have created moral hazard issues.

As for the risks, luckily the Fed doesn’t have to mark-to-market. It is exposing itself to some credit risk, but currently it is earning an unprecedented amount of money. It is in effect doing a carry trade, buying mortgages and borrowing at very low rates. I tell people the only difference between the Fed and an investment bank is that people at the Fed don’t get bonuses.

Exit Strategies – Inflation is not a concern.

There is hardly any danger of inflation. Balance sheet activities are not money creation, they are financial intermediation. The way that they affect the economy is by decreasing credit costs to stimulate the economy. If the economy picks up, there may be inflationary pressures, but right now the economy is so weak that there are few signs of inflationary pressures. The only way that the Fed’s balance sheet could be inflationary is if the fed took unbelievable losses that had to be financed through money creation, but we are nowhere near that point now. We are a long way from were we would have to worry about overheating.

MRM