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Economic Notes-Animal Spirits

 
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PostPosted: Sat Oct 27, 2007 5:06 pm    Post subject: Economic Notes-Animal Spirits Reply with quote

Bill Gross Jan '07 (partial) interview is below:

Bloomberg's Tom Keene: "Bill [Gross], your note every month is always interesting. This last one is one of my favorites. As you know, I'm a big fan of nominal GDP - this, folks, is real GDP plus inflation. It's the 'animal spirits' that's out there. You say be careful, Bill Gross. It looks real good to me, Bill. I see 6% year-over-year nominal. You say that's going to end?"

Pimco's Bill Gross: "I think almost assuredly, because of oil prices. I'm not suggesting it end because of real growth going down - that's the Goldilocks scenario in which we have 2% plus or minus real growth. With oil prices doing what they're doing - if they hold in the $55 range - gosh, we're going to see CPI prints y-o-y over the next three or four months of 0.5% or 1.0% and that means nominal GDP is down in the 3% range. "Ultimately, the inflation component affects the real growth component. To the extend that you have nominal GDP - in my forecast 3 to 3.5%, that's really not enough growth in terms of the economy itself to support asset prices at existing levels. And so, declining assets prices ultimately factor into eventually lower real growth. But that's not for mid-2007 but perhaps for later in the year."

Tom Keene: "When we look at six months of low nominal GDP, is that enough to link directly into the 'animal spirits" of the business investment component of GDP - the "animal spirits" of business men and women?"

Bill Gross: "Well sure it is. When you realize that the average cost of debt in the bond market - and therefore in the economy and this includes mortgages - it is about 5.5%. If you can only grow your wealth and service that debt at 3.5% rate, then that has serious implications. When you go back to 1965, Merrill [Lynch] did this study - in terms of asset prices during periods of time when nominal growth grew less than 4%. Risk assets have been negative in terms of their appreciation and actually bonds have done pretty well. The question becomes why hasn't that happened yet, and I think we're simply in a period of time where there are leads and lags that are much like the leads and lags of Federal Reserve policy."

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So, based on the Bill Gross interview, if the Fed doesn't ease further, the (benchmark) 10-year bond yield may fall below 4%, further inverting the yield curve (below the 4.75% short-term Fed Funds Rate), because of expected slower economic growth.

Also, Gross states: "The average cost of debt in the bond market, and therefore in the economy and this includes mortgages, is about 5.5%." So, if economic growth accelerates (to close the output gap) and/or inflation accelerates (e.g. wage growth rising faster than profit growth), then households will be in a stronger position to pay-down debt and build-up saving.

Most of the debt acquired in recent years were by U.S. households, not U.S. firms (which had 18 consecutive quarters of double-digit earnings growth) or U.S. government (where the budget deficit shrunk to $150 billion in 2007).

Moreover, it's important to note that income growth is exponential growth, while debt often declines at roughly a steady rate, e.g. paying-down the principal of a mortgage helps increase equity and decrease debt, while both housing prices and income rise geometrically. Consequently, U.S. household debt can fall, at least relatively, somewhat quickly.
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