The mid-term elections: A new cast faces old problems

November 7, 2014

Our family has a brown thumb: we can’t grow anything successfully. No matter how hardy the plant, no matter whether indoors or out, you can be assured that we’ll mishandle it. There is almost relief when the first frost arrives, because it levels the playing field between our neighbors’ landscaping and ours.

There is, however, one bloom that even we cannot seem to eliminate. Unpleasing to the eye, it comes out only once every other year, and it defies the season by sprouting prolifically in the month of October. It’s the species tabula politica – campaign signs that violate our fields of vision in the weeks leading up to election day.

Balloting is the only effective herbicide for this particular pest. Last Tuesday’s mid-term U.S. elections should, therefore, put an end to this year’s infestation. But those fortunate enough to have earned a seat last Tuesday will nonetheless have to get down into the weeds of economic policy next January in the hope of producing healthy, sustainable growth.

Of immediate concern will be solidifying the 2015 federal budget. The approved discretionary spending level will continue to reduce the drag of austerity on gross domestic product (GDP). Details will need to be filled in; there is hope for a comprehensive outline that covers the full fiscal year (an “omnibus bill”) as opposed to a series of temporary spending resolutions.

Cost-containment remains in place, but the new Congress may want to consider the appropriate level of defense spending. The advancing number of geopolitical uncertainties may warrant additional investments in this area.

The federal debt limit has been suspended until March 2015, but Congress will have to consider a new target (or another suspension) at some point. Given the normal seasonal patterns of federal cash flow, however, we may not run out of room under the updated ceiling until much later next year. We do not expect that government shutdowns or threats of debt default will be used as levers in budget negotiations. Neither proved either effective or popular.

If Congress is able to think beyond the next election cycle (a big “if”), there are three critical long-term areas that would really benefit from some attention.

  • Tax Reform. In the short term, Congress will have to consider the fate of tax preferences that expired earlier this year. These might be extended retrospectively, but broad reform could be stressed over patchwork measures going forward. There is broad agreement that the U.S. tax code is unnecessarily complex and that it produces some economic distortions. Corporate inversions are the most prominent recent example of this. They result from our hybrid system of taxing profits earned in the United States (territorially) and by U.S. companies worldwide (globally).

    The House Ways and Means Committee worked over a two-year period to produce an outline for tax reform that was issued last April. It failed to get much traction in the last Congress but may get a longer look next year. Still, legislators will have to balance the desire for simplification with the fondness Americans have for their favorite deductions.

  • Immigration. U.S. population growth is slowing, and retirements add to the challenge of sustaining vitality in the labor force. Immigration has been rising in compensation, and updating the law in this area seems to have bipartisan support. The proper handling of undocumented entrants has garnered the lion’s share of attention, but raising the country’s quota of visas for skilled workers is an imperative.

  • Entitlements. Long the third rail of American politics, reforming public pensions and medical plans cannot be deferred any longer. At the national level, slower health care inflation has helped the picture, but more needs to be done to put Medicare on sound footing. At the state and local levels, governors and legislatures must face pension shortfalls head on. Failure to do so risks not only solvency but also the stability of the business base.

There is some talk of the new Congress putting additional pressure on the Federal Reserve. We think this would be calamitous. As Dallas Fed President Richard Fisher observed, Congressional management of the nation’s fiscal position does not inspire confidence in its facility with financial affairs. As we observed last July, monetary policy rules have serious limitations. Central bank independence has been one of our strengths and should not be diminished.

With Republicans now in control of the Congress, the dynamic with the White House could go in one of two directions. The two sides could collaborate, as they did in 1999 and 2000. Or they could dig themselves into even deeper opposition, renewing confrontation over financial reform and the Affordable Care Act. This would serve only to build bulletin-board material for the presidential election two years from now.

The latter course would be particularly unfortunate. The American people want more than two further years of gridlock. And having just gotten rid of those ugly clusters of campaign signs, it would be best to wait a while before planting new ones.

Japan Doubles Down

Just as the world was coming to grips with the end of quantitative easing (QE) in the United States, Japan shocked markets with a Halloween surprise.

The Bank of Japan (BOJ) announced the first substantial changes to its QE program since it was expanded in April 2013. Asset purchases will be increased from JPY60 trillion - 70 trillion monthly to approximately JPY80 trillion. In addition to purchasing more Japanese government bonds, (JGBs), the bank will triple its purchases of risk assets like exchange-traded funds and real estate investment trusts.

Unsurprisingly, the bank also dropped its goal of achieving 2% inflation in two years, opting instead for an open-ended timeframe. Recent inflation readings have been pushed upward by this year’s sales tax increase, but that impact will recede over time.

Reaction to the announcements followed a path similar to the one that followed the first QE announcement in 2013, with the Nikkei 225 index racing higher and the yen falling sharply.

Coincident with the BOJ’s action, the Government Pension Invest Fund announced its new asset allocation. The fund will reduce its holdings of domestic bonds from 60% to 35% while raising its allocation for domestic and foreign equities from 25% to 50%. This will accommodate the BOJ’s increasing appetite for government bonds.

Japanese yields spiked in the last week as participants cleared out inventories due to uncertainty. However, after the initial flurry of activity, the JGB yield curve should flatten and stabilize.

Whether it is a result of the failure of QE or external factors – namely the deflationary pressure exerted by low oil prices – the economy was failing to meet the BOJ’s inflation targets. The unexpected move is in line with BOJ Governor Haruhiko Kuroda’s strategy of using speed and size to aid the economy. The central bank split 5-4 on the decision (exact reasons will not be known until minutes are released November 25). The internal opposition makes it unlikely that the bank will add to the program in the near term.

The stated goal of the action is to end the country’s “deflationary mindset.” However, an unstated motive is to give Prime Minister Shinzo Abe the wiggle room needed to implement the second phase of the consumption tax increase. Abe has been waffling a bit on this front, due to lingering sluggishness in the economy caused by the first tax hike in April. The failure of real wages to keep up with inflation, as well as a weaker yen, has put consumers in a gloomy mood.

One camp in Tokyo feels that the second round of tax increases will put undue stress on consumers and risk the economic recovery. Another camp (including Kuroda) sees it as necessary to avoid damaging confidence in the country’s fiscal sustainability.

It is too early to tell if the BOJ has done enough to overcome deflation and put the economy on sound footing. Yet it is telling how quickly the bank moved away from the “mission accomplished” mindset it displayed this summer, replacing it with one of renewed action. Still in question, though, is whether the other phases of Abe’s economic program will be implemented as aggressively. Japan will need all three arrows bound together.

The U.S. Employment Situation: Good but Not Yet Good Enough

The October employment report will be music to the ears of the Federal Open Market Committee (FOMC). But there are aspects of the report that are not entirely in tune.

Hiring continues to advance at a steady pace. October’s unemployment rate of 5.8% is down from 7.2% a year ago. The broad measure of unemployment (U6) declined to 11.5% from 11.7% in September. Payroll employment increased 214,000 in October, and revisions added a further 31,000 to prior months. This puts the 12-month moving average at 219,000, the best since April 2006.

Gains in employment were widespread. In the goods sector, construction employment rose 12,000, and factory employment advanced 15,000. In the service sector, 181,000 new jobs were created, reflecting increase hiring in the retail sector (+27,100); professional and business services (+37,000); leisure and hospitality (+52,000); health care (+24,500); and government (+5,000).

The details of the household survey indicate that part-time unemployment was largely unchanged in October, but there are 1.0 million fewer part-time employees than a year ago (7.0 million versus 8.0 million in October 2013). The share of long-term unemployment (32% of those out of work) is slightly higher than a month ago but also well down from its peak. The labor force participation rate has been mostly steady in the last six months; a flat trend in the near term is likely as discouraged workers return and baby boomers retire.


The main caveat to all this apparent good news is that hourly earnings rose only 3 cents to $24.57, taking the year-to-year change to 2.0%. The trend of hourly earnings has been holding around this range for nearly two years. Other compensation measures such as weekly earnings in today’s report (+2.6%), the Employment Cost Index (+2.2% in 2014:Q3) and hourly compensation from the productivity report (+3.3% in 2014:Q3) are improving, but all remain well below their pre-crisis levels.

Slack in the labor markets is most often captured with measures like the unemployment rate or the level of part-time workers. But there may be a number of Americans working full time who have the capacity to do more and would like to trade upward. This represents a subtle source of labor supply; rising wages will be the signal that it is being absorbed.

Overall, the October employment report does not change our current forecast of monetary policy tightening in September 2015. The Fed will continue to note that underutilization of labor market resources is diminishing but will remain content to watch patiently with inflation still a good distance from the 2.0% target. Progress has certainly been made on the labor front, but the mission of achieving full employment has not yet been accomplished.

© Northern Trust

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