I don’t know about you but if I hear Larry Kudlow say “mustard seed” one more time, my head may explode. Mustard seeds and green shoots - what’s with all the gardening metaphors? There has been a recent trend to home gardening - even Michelle Obama planted one - but we better hope that the economy fares better than my last tomato crop. I suspect a lot of new home gardeners are finding their dreams of home grown salad a bit tougher to turn into reality than they thought when they optimistically bought their potting soil and seeds. The same may turn out to be true for those who have bought the more optimistic view of the economy.

For the short-term, I actually think the mustard seed/green shoot crowd has a point. The economic indicators with the most credibility when it comes to calling the bottom do appear to be signaling that the worst is over. Robert Gordon recently published a research paper at Vox that uses jobless claims to pinpoint the trough of the recession:

If we refine the NBER weekly trough date to be the third week in the NBER trough month, then in four of the past five recessions the new claims peak leads the NBER weekly trough by a range of only four to six weeks, and in the fifth recession the new claims peak lags the NBER weekly trough by two weeks. Since new claims have recently reached a peak in the week ending 4 April 2009, it is tempting to conclude that the monthly trough of the US recession could come as early as the middle of May 2009 – a date earlier than most analysts appear to expect.

Of course, for this to be accurate, jobless claims will have to continue their recent trend, but for now this can be counted as a good sign.

The ISM indices give us more reason for optimism. The manufacturing version of that index is now up four months in a row.

The index now stands at 40.1 and while that is quite a ways from signaling an expansion of the manufacturing sector, the ISM tells us that a reading in excess of 41.2, over a period of time, indicates an expansion of the overall economy. The new orders component of the index is also up considerably from its low at 47.2, not far from the 48.8 that is consistent with an increase in manufacturing orders.

The non-manufacturing index has also been rising:

While these indicators are improving, it should be remembered that at this point, they are just telling us that the rate of decline has slowed. They are not indicating expansion - yet.

The housing market is another source of encouragement. Residential investment has been a major drag on GDP over the last 2+ years, but it has fallen so far now that even if things don’t improve, the likelihood of it falling further and remaining a drag are minimal. And if housing starts follow a pattern similar to past housing recessions, it could provide some upside surprise:

In the past, housing starts have tended to have V-shaped recoveries. With the current inventory of homes, that might seem unlikely, but with sales rising rapidly in some areas, it isn’t out of the question. The hardest hit areas in the housing crash are now seeing sales rise at very high rates. Sales in California, Nevada, Arizona and Florida are all rising rapidly. In California, the inventory is down to 5 months of supply at the recent sales pace. Florida, particularly South Florida, still has a severe inventory overhang, but other areas are working off inventory fairly rapidly. The unknown in the housing equation is the number of future foreclosures. If foreclosures continue at the recent elevated rate, it will just continue to add to inventory and delay the recovery in building.

Home prices also seem to be stabilizing. While the oft-cited Case Shiller index continues to show steep declines, the OFHEO index has risen for two straight months. There are problems with both indexes. The Case Shiller index is dominated by the bubble states and cities and I think overstated both the rise in prices as well as the fall. The OFHEO index only includes houses with government-backed mortgages and therefore excludes a lot of sales. No matter which index one uses though, house price declines are at least moderating.

The first quarter GDP report also contained some positive signs. Consumer spending was up 2.2% in the quarter and real disposable incomes were up 6.2%. The savings rate rose to 4% and while the Keynesians lament this as lost consumption, it makes more sense to look at it as future investment. The mainstream economists and commentators seem to think that the key to growth is consumption, but that gets things backwards. Consumption can only be the result of past investment and production and real savings are the only source of real investment. A rising savings rate is good news. Inventories also fell in the quarter which should mean increased production in the future as inventories are replenished.

The source of these mustard seeds and green shoots tentative signs of recovery is the Federal Reserve. The Fed has expanded its balance sheet dramatically and the liquidity created is starting to have an effect. Those who believe in the liquidity trap are about to be proved wrong. The Fed can always create more money and when they do, it creates economic activity. It may not be efficient or even desirable activity (see housing bubble) but it is activity. The “stimulus” plan enacted by Congress has barely had time to get off the ground so any indications of recovery at this point have to be credited to the Fed. Like most past stimulus spending plans, this one will likely kick in after the recovery has already started. When it does, it will only exacerbate inflationary pressures. (The core price index in the GDP report was up 1.5% in the first quarter; we do not have deflation.)

Monetary policy is powerful stuff and I have never doubted that the Fed could create enough money to generate a recovery. There was a question back in the Fall as to whether they would, but there should have never been any doubt that they could. But the Fed’s powers are limited and there are always consequences to their monetary manipulations. There is no free lunch and if printing money was all that was required to have a healthy economy, places like Argentina and Zimbabwe would be models of success.

While the Fed can generate a recovery in the short-term, and seems to be doing so now, it takes real investment to generate long-term growth. Real investment requires capital which can only come from savings. The paucity of such savings in the US would seem to indicate that our economic problems will not be solved in a short period of time. The rise in government spending (and the taxes or borrowing to pay for it) will only prolong the time it takes to get a real recovery.

We are now seeing a recovery from the worst of the recession and it seems possible (likely?) that an economic expansion is just around the corner. Between the Fed and government spending it is possible to foresee a rapid V recovery in the short term, but what happens when the Fed needs to remove some of the liquidity? What happens when the government spending fades? We won’t be able to run budget deficits of the size envisioned for this year indefinitely. At some point, we will have to face the fact that we need to live within our means.

The recovery that seems to be forming now could last for quite a while and it will certainly feel better than the recent past, but it will be no more real than the last expansion built on Fed easy money policies. This is nothing more than inflation and it isn’t real. There is a lot of debate among economists about whether we face deflation or inflation, but the outcome of that debate will depend on how the Fed reacts in the future. If they are unable to remove the excess liquidity, we will get inflation. If they are successful, we’ll avoid inflation but at the expense of another recession and potential deflation. This is similar to what the Fed faced in the 70’s and we know how that turned out. The political pressure to continue inflating will be enormous and I have no expectation that the Fed will be able to resist it.