Have We Run Out of Options?

On Saturday I attended the monthly meeting of the American Association of Individual Investors in Baltimore featuring  Senior Economist Russell T. Price of Ameriprise Financial. The presentation was wide-ranging and covered the broad areas of the macroeconomy. The focus was on the consumer, and the conclusion was consumer spending would do fine despite higher gasoline and food prices. Automobile sales was one indication of consumer confidence. Along with the usual caveats, the U.S. economy should continue to progress in 2011. First quarter GDP is expected to be revised higher, and the remaining 3 quarters to see growth of 3.5% and higher. Early 2012 is expected to see growth below 3%.

One intriguing chart showed crude oil prices (West Texas Intermediate) rising in tandem with dollar flows into commodity funds since 2003. This chart was used to theorize that commodity prices are heavily influenced by exchange traded fund participation. Mr. Price pointed out that ETFs enable individual investors to participate in the commodity markets without being part of the "price discovery" process. After all, he pointed out, individuals don't take delivery of the commodities and don't produce products using the commodities. They are using ETFs to "bet" on commodity prices. Commodity prices, therefore, are heavily influenced by individual investor speculation - not just by professional hedge fund activity.

Overall, the charts supported his contention that the economy is slowly improving and that the odds of a new contraction are slim.

One point bothered me, however. He pointed out that, when the economy hits a bump, we have have two broad macroeconomic policy responses:  fiscal policy and monetary policy. The fiscal policy response to a slowdown is to lower taxes and increase government spending.  The U.S. has done that in spades. The deficit is estimated at $1.4 trillion, and the payroll taxes have been cut 2%. The Bush tax cuts have been extended. On the monetary policy front, Bernanke has pushed short-term rates to 0% and engaged in two massive bond buying programs known as quantitative easing.

What  bothers me is that I wonder if we are at the end of our policy response choices.  Are we out of dry powder?  Just a few years ago, we were wringing our hands over $600 billion deficits. Now we pretty much accept a $1.4 trillion deficit. We readily accept quantitative easing (the stock market actually embraces it!) even though we know it is printing money and blowing up the Fed's balance sheet to heretofore unimaginable levels. As a matter of fact, political correctness prevents polite people from calling it what it really is - monetizing the debt.

All of this is reminiscent to me of the frog-in-the-frying-pan metaphor. If a frog jumps into a hot pan, it will jump right out. Put a frog in a cold frying pan and slowly turn up the heat, however, and it will stay in the pan until it's fried. My concern, as I listen to economists present economic forecasts, is that they are missing the turning up of the heat.