National Economic Trends – November 2010

Economic policymaking is reaching a crucial turning point due both to the results of the recent mid-
term elections and to the decision by the Federal Reserve Board to open wide the monetary spigots.
The two events might well work to cancel each other out, but financial markets are clearly reacting
more right now to the implications of loose money than they are to the possibility of a return to fiscal
rectitude and smaller government. While everybody in Washington was contemplating these vast
and momentous issues of state, meanwhile, the economy has gradually shown signs of renewed vigor
without anybody much noticing. Which kind of what worries us, as pouring a whole bunch of cash
into an economy that’s already starting to heat up is akin to using a flamethrower to light a campfire –
it probably will work, but you might end up burning down the forest.

After playing coy and hinting around for a couple of months, the Fed has now firmly committed to a
second round of quantitative $2,500,000
easing, or QE II. As you doubtless $2,300,000
recall from last month’s discussion $2,100,000
$1,900,000
(assuming you made it all the way $1,700,000
through without slipping into a $1,500,000
coma) the Federal Reserve, in an $1,300,000
attempt to get the economy $1,100,000
growing fast enough to provide $900,000
$700,000
employment for the victims of the $500,000
recession, will be injecting massive 2005‐01‐05 2005‐12‐21 2006‐12‐06 2007‐11‐21 2008‐11‐05 2009‐10‐21 2010‐10‐06

amounts of cash into the economy Permanent Assets Term Asset‐Backed Sec Loan Facility

by purchasing government debt Comm Money/MM Central Bank Liquidity Swaps

Bearn Stearns/AIG Mortgage‐Backed Securities
securities from financial Fed Agency Debt Securities
institutions. The intent is to drive
down interest rates even further from where they are now, and to encourage banks to use some of
their cash to lend instead of parking it in bonds. The first round of QE, which expanded the Fed’s
balance sheet from about $900 billion to over $2 trillion, was initially targeted at emergency lending
facilities during the height of the financial crisis in the autumn of 2008, but that quickly was followed
by a program of buying mostly mortgage backed securities to support housing. This second round of
QE will take the balance sheet up by another $600 billion over the next eight months and will be
exclusively targeted at purchasing U.S. Treasuries.

What this amounts to is a doubling down by Riverboat Ben Bernanke and his posse at the Fed Open
Market Committee, who are positing that there isn’t anything wrong with the economy that can’t be
cured by more liquidity. Bernanke’s academic research has focused on central bank policymaking
during the Great Depression, and he has long been convinced that the key policymaking mistake was
that the Federal Reserve was too tight for too long once the economy slipped into chronic deflation.
So it’s more than a little ironic that this dude is in charge of monetary policy right now, because
we’re pretty sure that wasn’t on George W. Bush’s mind when he nominated him to succeed Alan
Greenspan. At any rate, there are three big risks to this strategy: 1) it is deliberately slightly
inflationary – they’d like inflation to be a little higher and interest rates a little lower, so that real
interest rates (the difference between the two) are lower, which will theoretically stimulate
investment. If you think that threading the fine line between a little inflation and a lot of inflation is a
bit much for a bunch of academic economists to manage, we’re right with you, 2) it assumes that
Economic Trends November 2010.doc 1
bond traders will behave exactly as expected and bid real interest rates lower. In fact, if bond traders
suspect that the Fed is letting inflation get out of hand and/or that they don’t have an effective exit
strategy for shrinking the balance sheet once the economy gets cooking then they are likely to bid real
rates higher, not lower, and the whole thing will be a colossal waste of time and money, and 3) it is
uniting the rest of the world – rich countries and poor, allies and enemies alike – in the conviction
that we are out of our freakin’ minds. Now it is possible that we’re right and everybody else is wrong
but, in the meantime, it isn’t doing our global standing much good.

At least part of the reason that the Fed is moving on the monetary side so strongly is that they are
disappointed that there hasn’t been more fiscal stimulus from Congress. The voters sent a strong
message in the elections they don’t much like the recent leftwards tilt in policy and would prefer a
smaller government and lower taxes and deficits. The problem is that these are not mutually
congruent goals, at least in the short term. For example, one thing that is likely to happen either in
the lame duck session or early in the next Congress is an extension of the Bush tax cuts, currently set
to expire at the end of this year. If these tax breaks are extended without a parallel plan to cut
spending then the result will be higher deficits, which we don’t think is exactly what the voters had in
mind. But the prospect of the split Congress agreeing to any set of substantial spending cuts,
especially those that might roll back programs so recently enacted, isn’t great. It’s shaping up to be
an interesting 2011.

There have been signs of the economy accelerating lately, but they have been subtle. We’ve all been
waiting expectantly for signs of life in the labor market, for example, and we finally sort of got some
in the October employment report. The economy added jobs for the first time since May, 151,000 of
them, with private sector employment surging by an unexpected 159,000. We use the term “surging”
loosely, because back in the olden days of the bubble years 159,000 private sector jobs would have
been a bad month. And it’s not nearly enough to get the unemployment rate, currently stuck at 9.6%,
to start declining. So far this year we’ve added 874,000 jobs, which leaves us down about 7.5 million
from the peak prior to the recession. Labor Market Indicators
As mediocre as this report was, we (in 000's) Source: U.S. Dept. of Labor
(in %)
may look back at October as the 600 12.0

month were employers finally 400

10.0
decided that they’ve squeezed as 200
8.0
much productivity out of the worker -

bees as they could and finally started (200) 6.0

adding headcount. Seasonal hiring (400)

4.0
plans for retailers are generally much (600)
2.0
better than either of the two prior (800)

holiday seasons, for example. We (1,000) 0.0

don’t want to get you too excited just Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

yet, but it is entirely possible that, as Change in Non-farm Payrolls Unemployment Rate

you wander about the mall looking

for gifts this holiday season you may just be able to find someone to help you purchase them.

Speaking of which, expectations are guardedly optimistic that holiday season retail sales will be
strong despite the weak job market and the lack of a “killer app” to rival last year’s Zhou Zhou pet
hamsters of death. The Zhou Zhous are still around and presumably still chock full of toxic
chemicals, but you should be able to purchase one this year without participating in a bidding war on

Economic Trends November 2010.doc 2

EBay. The early buzz for this year’s hot toy is something called a Zooble, which is a stuffed animal
that comes as a rolled up ball, then magically pops open into a cute as a button alien-like being when
placed upon a magnetic stand (which we presume is sold separately.) As far as we can tell, that’s all
they do. We could sort of understand the appeal of the Zhou Zhous but we’re stumped on the
Zooble. Our advice is to only buy them for a very young child, at the age where they are fascinated
by a bright light bulb, for example, or possibly if you have an NFL receiver on your gift list who has
taken one too many helmet to helmet hits. There is also a special “premier wooden edition” of
Scrabble that will cost $119 and will only be available on line, presumably because nobody wants to
risk being seen in a store spending $119 on a Scrabble set.

The Q3 gross product report provides support for the concept that consumers are gradually crawling
out of their shells. The initial
Sector Contributions to Growth
estimate was for overall growth of Source: U.S. Department of Commerce
% of GDP Growth
2.0% during the quarter, which was 6.0
about what most economists 4.0
expected. Personal consumption 2.0
contributed 1.8% to the total growth, 0.0
which was just a little better than the -2.0

previous quarter for the fourth -4.0

consecutive time. It’s good that -6.0

-8.0
consumers are starting to pick things
up because business investment, -10.0 Q3'08 Q4'08 Q1'09 Q2'09 Q3'09 Q4'09 Q1'10 Q2'10 Q3'10
which has been a strong point during
Net Exports & Gvt. Spending Private Investment Personal Consumption
this weak recovery, was dialed back
to a 1.5% contribution, about half
that of the prior quarter, due to moderating growth in spending on equipment and software and a
dreadful quarter for residential construction. Net exports took a sizable 2.0% out of quarterly growth,
but that was significantly better than the prior quarter’s 3.5% negative impact. Import growth
moderated considerably, which was expected after an unsustainable surge in Q2 caused by retailers
stocking up on Zoobles in
Automobile Sales
anticipation of a cheerier Yule. We’ll Thousands of Units, Seasonally Adjusted Annual Rate
Source: U.S. Dept. of Commerce
make the usual disclaimer that next
15,000
month’s revisions could change this
story completely but, because the 14,000
initial numbers are so close to
13,000
expectations, we’re thinking the
revisions won’t be drastic this time 12,000
around.
11,000

Of course the holidays have recently 10,000

become an important season for car 9,000

sales, which have generally been Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10
stronger than expected recently.
Once again, don’t confuse “stronger than expected” with good, but the trend is headed in the right
direction. This holiday season we also have the bonus of two exciting new product introductions
with the all electric Nissan Leaf and the partly electric Chevy Volt. Neither will be available in large
enough numbers to move the sales needle noticeably this year, but they are the first two of what will

Economic Trends November 2010.doc 3

be a substantial wave of plug-in vehicles coming soon to a utility grid near you. The big question
from a grid planning perspective is, naturally, how big a chunk of market share will these vehicles
garner and how fast. Based on the specs for the Leaf and Volt, our guess is not that much after the
initial demand from early adopters is satiated.

No matter what you hear about all the wonderful things going on with advanced battery technologies,
the fact is that range is still a huge issue. Because Houston will be one of the roll-out markets for the
Volt, Chevy recently allowed journalists in the city to participate in a test drive of the car from
Houston to Baton Rouge. The testers were generally impressed with the car and with the ability to
drive it all the way on one charge. The catch is that only about 40 of those miles were on the original
battery charge – the rest came from the small gasoline engine that kicks in and drives the electric
motor which makes the wheels go round and round. The Leaf is a different animal – its electric
motor will go for about 100 miles on a charge. But it does not have a back-up gasoline engine, so
after 100 miles you’d better find a plug. If this was 1923 and we were comparing the Leaf to a
Stanley Steamer then we probably would be impressed with a car that could get you all the way from
Houston to Lake Charles in one shot. But we just don’t think that most modern consumers are going
to spend $41,000 (for the Volt) and $33,000 (Leaf) for cars that have such limitations, even with the
$7,500 federal tax credit. And we seriously doubt that the aforementioned grumpy voters are going
to want to subsidize these cars at that level for very much longer.

One sad note to report – Paul the prognosticating octopus from Germany has passed along to a better
ocean. Turns out that he was a rather elderly octopus when he stunned the world by correctly picking
eight out of eight world cup soccer matches earlier this year. We have the consolation of knowing
that he went out on top. Word is that there was a lovely memorial service followed by a tasteful
seafood buffet luncheon. No internment was necessary.

Economic Trends November 2010.doc 4