Is something heating up under the blanket of snow?

As you may know, both real and nominal GDP growth were a bit disappointing in the fourth quarter, especially nominal growth.  On the other hand real final sales rose at the fastest rates in more than 20 years.  This led David Beckworth, Bill Woolsey and Marcus Nunes to suggest QE2 was already working (recall it started strongly raising stock prices and reducing the value of the dollar as early as September.)

I was a bit skeptical about the final sales numbers, partly due to issues raised by Jim Hamilton and his commenter “rootless” (at 3:49pm.)  I see the optimists as making an implied prediction that production would rise strongly in 2011:1, as firms restock depleted inventory.  And now we have the first indication that the optimists may be right:

WASHINGTON (AP) — Factory activity expanded in January at the fastest pace in nearly seven years, as manufacturers reported a sharp jump in new orders.

Still, builders spent less on projects in December, pushing annual construction spending down to a decade low.

The Institute for Supply Management, a private trade group, said Tuesday that its index of manufacturing activity rose last month to 60.8, from 58.5 in December. The sector has expanded for 18 straight months, and January’s reading was the highest since May 2004. Any reading above 50 indicates expansion.

People who have brains that are “wired Keynesian” often ask me where will the extra demand (from QE2) come from.  Businesses have lots of slack and don’t need to invest, and without more investment how will cash-strapped consumers have enough income to spend?

They are essentially arguing an economy can’t be raised up by its bootstraps.  This is because they don’t understand how nominal shocks can have real effects.  There’s an old movie line “build it and they will come.”  In this case it’s more like “provide the extra NGDP, and the RGDP will come” (when there’s lots of slack.)  The transmission mechanism is asset prices.  Here’s some more info from the article, which explains where the demand is coming from:

Consumers are spending more on autos, appliances and other goods, while businesses have invested in more industrial machinery and computers. Those trends boosted economic growth to a 3.2 percent pace in the October-December quarter, the Commerce Department said last week.

Duesterberg said orders for mining and drilling equipment and for airplanes and airplane parts are also rising.

Factories’ healthy pace of expansion is likely to continue in the coming months. Manufacturing firms surveyed by ISM said their backlog of orders jumped in January, pushing an index measuring that activity to 58 from 47.

U.S. factories are also benefiting from rising overseas sales. The index of export orders jumped to 62 in January, from 54.5 the previous month. That matches a recent peak reached in May and is otherwise the highest level for that index since December 1988.

The employment index rose to its highest level since 1973, a sign that manufacturing companies are hiring more workers. But Duesterberg cautioned that the ongoing boom in productivity in manufacturing would likely limit hiring.

We’ll need a few months more data, but so far it looks like the recovery is going from almost nonexistent during May through August, to moderate.  That’s progress.

PS.  Does anyone know how meaningful this index is?  That phrase “highest level since 1973” certainly caught my eye.  And it also seems to have caught Wall Street’s eye.



16 Responses to “Is something heating up under the blanket of snow?”

  1. Gravatar of Keith Keith
    1. February 2011 at 10:49

    “The Transmission mechanism is asset prices.”

    Well, yes, via the rise in asset prices that can motivate investment and the shift in income toward assets that can motivate investment. But the key is investment, is it not.

    But isn’t there a potential problem too? Price is the great communicator between supply and demand. Informing producers where demand is growing or falling via price movements and informing consumers where supply it abundant or tight. However, with QE2 price is not sending a clear signal; prices, especially commodity and asset prices, are heavily affected by the value of the dollar.

    No one on this planet can separate the QE2 component from the supply and demand component of current/recent price movements. Won’t the fog of QE2 present significant risk that some, perhaps a lot, of current investment will come to naught: i.e., be wasted.

  2. Gravatar of scott sumner scott sumner
    1. February 2011 at 11:43

    Keith, Of course investment is more procycical than consumption, but asset price increases also boost consumption. And monetary stimulus can lower the dollar, and boost exports. It can also increase commodity prices, which boosts America’s farmers, oil and gas drillers, miners, etc.

    Regarding the “fog,” that’s what the policy has been since 2008, when they allowed NGDP to fall sharply below trend. You minimize the “fog” by having NGDP grow at a steady rate. QE2 is trying to do undo the previous damage of ultra-tight monetary policy. Get it back closer to normalcy. That makes investment decisions more transparent.

  3. Gravatar of Gregor Bush Gregor Bush
    1. February 2011 at 11:56

    To give you an idea, the correlation between Q/Q RGDP growth and the level of the headline ISM index is 0.65 since 1947 and 0.71 over the last 10 years.

    The correlation between the employment component of ISM survey (which was at its highest level since 1973) and the % change in monthly manufacturing payroll employment is 0.68 since 1947 and 0.88 over the last 10 years.

    The ISM is huge for the markets because it’s highly correlated to growth and employment and it’s released earlier than other major reports.

  4. Gravatar of Bryan Willman Bryan Willman
    1. February 2011 at 12:26

    Can’t it be a little simpler.

    Given there is a lot of slack, and presuming that most consumers have unmet needs and wants, then anything that actually gives people (consumers) the ability and the confidence to buy existing products will run up AD and RGDP, until the slack is gone. It’s hard to say whether spending is up because people think we’ve seen the bottom, or spending is up because people have an easier time finding money. But until the slack is gone, AD and RGDP for existing products can grow together without particular long term investment, no?

  5. Gravatar of marcus nunes marcus nunes
    1. February 2011 at 12:57

    Scott: I always take issue with the “contribution to RGDP” from different components, especially with the “drag from imports” as put forth by Jim Hamilton:
    “But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There’s a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories). So although inventories shouldn’t be the same drag on GDP in 2011, I expect imports to go back up and exert a drag of their own”.
    When someone´s asked “Why were imports so “robust”, the usual answer is “Because growth was strong”, and in the next setence you typically read: “If it weren´t for the “drag” from imports growth would have been stronger still”!!!
    Fantastic: Let´s ban imports and growth will soar!!!

  6. Gravatar of Master of None Master of None
    1. February 2011 at 16:04

    The one thing that worried me in the ISM report was that input prices rose SHARPLY in the month, virtually across the board. In fact, the last time we saw input prices rise that fast was in March/April 2008.

    Let’s hope that oil prices moderate a bit in the coming weeks, so as not to put a dent in our 6% GDP growth party.

  7. Gravatar of Master of None Master of None
    1. February 2011 at 16:10

    “PS. Does anyone know how meaningful this index is?”

    Very meaningful, as Paul Krugman notes here:

    He must have skipped the body of the report, which actually states the implied GDP growth number:

    “The past relationship between the PMI and the overall economy indicates that the PMI for January (60.8 percent) corresponds to a 6.4 percent increase in real gross domestic product (GDP) on an annual basis.”

  8. Gravatar of scott sumner scott sumner
    1. February 2011 at 19:10

    Gregor, Thanks for the info. Krugman has something similar.

    Bryan, Yes, I did mention consumption could go up without more investment, due to higher asset prices. But I think investment also usually rises in recoveries.

    Marcus, I agree, but if you read Hamilton, and then his commenter rootless, it’s pretty clear to me that there is a major flaw in final sales. Because the government doesn’t handle inventories properly, it gives a very misleading indication. An imported Toyota sold from inventory is a “final sale of domestic goods” yet that’s not at all what most people visualize by the term.

    Master of None, Yes, if oil rises too rapidly, and for reasons other than stronger growth in the US, it could put a dent into the recovery. But remember, a stronger world economy also boosts US exports.

    Thanks for the Krugman link.

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. February 2011 at 19:54

    I’m tired of economic depression. It’s been 3 years now. Yes I know the GD was longer, but I’m ready for the Spring:

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. February 2011 at 19:56

    “As long as the roots are not severed all is well, and all will be well, in the Garden.”

  11. Gravatar of James in London James in London
    2. February 2011 at 02:58

    ISM employment is not reliable. Survivor bias distorts ISM and PMI surveys. Just last month, the ISM and Chicago PMI not only showed great strength but also surging employment. Analysts forecast a great NFP. But they were wrong. Survivor bias is a huge problem in all commercial surveys.

  12. Gravatar of W. Peden W. Peden
    2. February 2011 at 06:18

    Good. Since 2008, we’ve been running with only half of the global economy’s wheels (China) going. We need both the US and China to be growing steadily if Europe can have a real recovery.

  13. Gravatar of scott sumner scott sumner
    2. February 2011 at 09:09

    Mark, I’m also ready for spring.

    James, Maybe, but the NFP number is also questionable. The household survey was very strong.

    W, Peden, I agree.

  14. Gravatar of “Appropriate Monetary Policy” « Historinhas “Appropriate Monetary Policy” « Historinhas
    2. February 2011 at 11:32

    […] economy faces an uphill battle to regain what could be termed a “new adequate trend level path” Scott Sumner writes that there are some optimists out there (me included). Hope that comes to […]

  15. Gravatar of Rien Huizer Rien Huizer
    4. February 2011 at 01:57

    In the early stages of the GFC I thought that the US gvt should intervene in the housing market (for instance by offering to bona fide homeowners or buyers of existing homes (not developers or lenders) the option to buy high cover mortgage insurance at a very low premium, with 10 years of slow appreciation) rather than in the financial markets. That would have hurt the housing industry but probably have had more positive effects than the various bailouts we’ve had at lower cost and there would have been less of a need to shift so much mortgage debt onto federal and quasi federal balance sheets. Targeting that key asset price would have done wonders for sentiment as well.

  16. Gravatar of scott sumner scott sumner
    4. February 2011 at 19:07

    Rien, In principle that might work (I am not expert) but it’s a moot point, as our government does not have the capability to implement that sort of policy. A government like Denmark might be able to (although they have a much better mortgage system, so they probably wouldn’t need to.)

    We did try to implement a program to help people with mortgages, but the attempt failed. The US government is too big and bureaucratic to figure out who is a bona fide homeowner.

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