Published April 13, 2009

The stock market has jumped by more than 20% in the past couple of weeks, and some housing and orders data have surprised to the upside. Are these early indications that the recession is coming to an end? Absolutely. Having said that, do not expect the economic turnaround to occur much before year’s end. And when it does occur, it is likely to be anemic.

The reason for this relative optimism is primarily the tools by which we regulate our economy — monetary policy and fiscal policy. Policymakers have ignited the afterburners on both.

Monetary policy
The Federal Reserve sets monetary policy via its control of interest rates. Specifically, it controls the “federal funds” rate, which is an overnight rate that banks charge each other for borrowing and lending reserves. But that rate effectively determines all other short-term interest rates: the prime rate, the Treasury bill rate and CD rates.

Monetary policy is neutral if the funds rate is about two percentage points higher than the rate of inflation. Because most inflation measures today are between 1.5% and 2.0%, Fed policy would be “neutral” if the funds rate were between 3.5% and 4.0%. It is not. Indeed, the Fed is targeting a funds rate of 0.0%. Conventional Fed policy is wildly stimulative.

If that were not enough, in an unprecedented move last month, the Fed decided to buy long-dated Treasury securities. Once the decision was announced, 30-year bond and mortgage rates instantly fell by a half percentage point. At a minimum, that will trigger a refinancing boom, which will put more money into homeowners’ pockets. It could induce others to buy a house.

A couple of things should be kept in mind: First, there are lags of six to nine months before the economy responds to changes in interest rates. The Fed adopted its 0% target in the fourth quarter of last year and began to purchase long-dated Treasuries in March. Thus, Fed policy changes are consistent with a turnaround in the economy — but not until fall.

Second, consumers typically respond to lower interest rates by boosting spending, and by borrowing to do so. But consumers are scared. Their stock portfolios have been cut in half, the value of their homes has dropped by 25%, and they are worried about whether they will have a job by year’s end. They are more interested in paying down debt and boosting savings. In fact, the savings rate, which was about 0% a couple of years ago, has climbed to the 5% mark.

The situation is exacerbated by the difficulty in obtaining credit. Banks have tightened their lending standards — for good reason.

This combination of banks’ unwillingness to lend and consumers’ desire to save could delay the onset of recovery.

Fiscal policy
President Barack Obama just signed a $787 billion fiscal stimulus bill, which comes on top of all the other ”bailout” bills that have been adopted for banks, AIG, automobile manufacturers and the housing industry. This degree of fiscal stimulus is unprecedented; it is going to help.

Unfortunately, the Congressional Budget Office estimates that only about 40% of this government spending will occur in 2009. The remainder will occur in 2010 and beyond. Economic pessimists suggest that the recession will be over by spring 2010. Thus, the bulk of the stimulus will occur after the recession has ended.

But this is characteristic of fiscal policy: It takes awhile for Congress to recognize the problem and decide to act; there is a bidding process before any spending project can begin; and, once a contractor has been selected, there are further delays before construction gets under way.

Despite these caveats, there is an unprecedented amount of monetary and fiscal stimulus in the pipeline.

One of the first signs of recovery will come from the stock market. A stock market gain bolsters confidence, and the economy will not recover without it. Many stock market analysts suggest that the recent run-up is merely a bear market rally. That is possible; but this time the rally is accompanied by gains in some economic indicators that typically lead economic activity — home sales, auto sales and orders data. More about them next time.

Meanwhile, watch the various measures of consumer confidence. A significant gain would be the next crucial step on the road to recovery. 

Stephen D. Slifer, a former economist for the Board of Governors in Washington, D.C., served as chief U.S. economist for Lehman Brothers from 1980 until his retirement in 2003. He lives on Daniel Island.