Economist's View

Fed Watch: Structural and Cyclical

Tim Duy:

Structural and Cyclical, by Tim Duy: For several months, I have been telling stories that decompose US economic activity into what I think of as cyclical and structural dynamics.  I believe the distinction is very important to firms, markets, and policymakers who need to be aware when one dynamic is clouding their view of the other.

The cyclical dynamics, in my opinion, are the most spectacular, the most visible.  The real cyclical fireworks began in the second half of 2009, as the energy price shock decimated household budgets, quickly followed by a financial shock that triggered an additional pullback in demand.  Firms unexpectedly found they had far too much excess capacity in this environment, and began the process of "rightsizing."  Lob losses mounted even as falling energy costs and lower interest rates for those not credit constrained began to put a floor under spending.

Eventually, firms would realign capacity with the new level of demand, and job losses would taper off.  That would mark the early stages of the cyclical bottom, the point at which growths returns.  The initial growth spurt could be very rapid, as firms restock inventory and pent-up demand comes into play.  The additional of government stimulus will add additional fuel to the fire. 

Once the early stages of recovery are complete, the story shifts from cyclical to structural.  The boost from inventory correction, pent-up demand, and government stimulus fade, and the underlying growth rate, the fundamental rates of activity, becomes evident.  Now your expectations about the nation's economic direction depend on the weight you place on the structural factors.  If you place nearly zero weight on those factors, then growth remains fairly high as the economy rapidly returns to potential.  In effect, cyclical dynamics dominate your story; the Fed is simply flipping a switch that shifts the economy from high to low states and back again, a traditional post-WWII business cycle.  If you place heavy weight on structural stories, you talk about the inability to revert to past patterns of consumer spending growth due to excessive household debt, a reversion to global imbalances that supports outsized import growth, lack of an asset bubble to compensate for these structural problems, etc.  With these stories in your toolkit, you expect a low underlying growth rate - barely at potential growth - in which case the gap between actual and potential output remains distressingly high for possibly years to come.

I tend to view incoming data through both cyclical and structural lenses.  The employment report is a prime example.  Clearly, the steady improvement in the rate of deterioration of nonfarm payrolls since the spring follows the cyclical pattern as firms stop chasing demand down and thus stabilize their workforces.  Moreover, recent increases in temporary help hiring also points to firming labor demand in the months ahead.  It would seem that stronger growth does in fact have the desired impact on labor markets, and that fiscal stimulus helped accelerate recovery in the labor markets. 

At the same time, though, one has to wonder what happens as the stimulus begins to fade?  Will there be sufficient demand from other sectors to compensate for fiscal and monetary withdrawal?  It is worth recalling the patterns of labor market dynamics as we exited from the 2001:

After the post-recession boost  - inventory correction, pent-up demand, etc. - labor markets quickly returned to a period of stagnation that lasted until the housing bubble began to take hold.  What in the next two years can we expect to take the place of that bubble?  Furthermore, if you are worried about a relapse in the pace of growth, the ISM reports last week were not exactly comforting.  Both revealed an overall slowing of activity, and employment signals were not exactly consistent with a strong rebound in hiring anytime soon.  For that matter, the ADP report, while not one of my favorites to begin with, came in far below the actual NFP numbers, suggesting that maybe this employment report was a little stronger than the underlying trend. 

Also worth noting is the dismal reports on retail sales that appear to have largely slipped below the radar last week.  From the Wall Street Journal:

Fed Watch: Ahead of Black Friday

Tim Duy says -- correctly -- "that a significant portion of policymakers are simply clueless":

Ahead of Black Friday, by Tim Duy: We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America. Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event. Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday. We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.

Oooo, how I have come to loathe this exercise. And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list. It is like a car wreck - you don’t want to watch, but you can't take your eyes off it.

Car wreck is something of an appropriate comparison. Recently I have begun using charts of this sort to depict the current economic environment:

 

Not fancy econometrics, I know - most of my audiences are not interested in unit root tests.  The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening. Much, much faster growth is necessary to close that gap. And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits. To be sure, Bloomberg trumpeted today's data:

Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.

How much did the outlook brighten? The story continues:

The Conference Board’s confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board’s index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.

Not much brighter. Indeed, Economix more accurately reports the dismal mood of consumers, noting:

Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.

Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels. This tells us something about the strength of consumer spending. Using the parallel measure from the University of Michigan:

Real year over year growth in the 1% range is not going to bring households back to trend anytime soon. To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending. That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower. Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future. And they will increasingly look for someone to blame. No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke. They are the public faces for an Administration that now owns this economy.

And where are policymakers as we slog through the final month of 2009? The Administration is poised to do virtually nothing:

The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.

There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.

...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.

Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now. Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.

Likewise, monetary policymakers too are caught in the headlights. As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy:

...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Read that carefully and realize this: An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels. Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet. That whole credit channel thing. If not to expand lending during a credit crunch, then what else are they expecting?

I am in shock that this sentence made it into the minutes. One can only conclude that a significant portion of policymakers are simply clueless. Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns.  Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?

At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:

Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."

Maybe if unemployment continues to rise Bullard's vote will matter next year. Maybe.

Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:

New reports Monday didn’t paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.

“Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season,” said Lynn Franco, director of the Conference Board Consumer Research Center.

A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.

Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy: Economic activity is now increasing, something for which we should all be thankful this weekend. The alternative would be very unpleasant. But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation. By all forecasts, it simply falls far short of what is necessary to restore confidence among households. 2.8% just won't cut it.

Fed Watch: The Fed in a Corner

Tim Duy:

The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.

The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.

Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.

To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.

The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.

Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.

Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?

Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.

What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:

It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”

But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.

Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.

I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

Fed Watch: Should the Fed Be Doing More?

Tim Duy:

Should the Fed Be Doing More?, by Tim Duy: Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.

It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could have be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.

The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.

A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero:

Fed Watch: Sustainable Growth?

Tim Duy:

Sustainable Growth?, by Tim Duy: October is becoming my lost month. Between the beginning of Fall term and my annual conference in Portland, the month is a blur, and time to blog becomes a luxury. Now, however, I can see the light at the end of the tunnel. And we can also see the light at the end of the tunnel after this long recession, with a GDP report that confirms what everyone thought - the economy turned the corner in the third quarter of this year. Policymakers undoubtedly breathed a sigh of relief, and rightly so. That said, it is far too early for complacency; I found the underlying details less than comforting, especially in comparison to Wall Street's ebullient reaction to the data.

That the recession would end was never in doubt. Indeed, the timing is almost exactly what one would expected given the steep declines in spending in the first half of 2008 that triggered the flood of job losses later in the year. Spending, consumer spending most importantly, would not fall indefinitely, especially with the benefit of significantly lower energy costs beginning in the second half of last year. Moreover, as the Wall Street Journal notes, rebuilding household balance sheets is not accomplished by just increased savings; a default can do the job much more quickly, quickly adding to household cash flow. Indeed, I admit to being surprised that strategic defaults are not much higher.

The more important question is what will be the durability and sustainability of the recovery in the years ahead? The GDP report raises some significant red flags when considering this question. The consumer spending number was clearly goosed by the Cash for Clunker program and a much slower pace of inventory depletion than expected, which combined to add almost 2 percentage points to the headline figure. But auto sales have slipped back under the 10 million mark in September when the Clunkers program ended, with only a slight gain expected in October. And the slower inventory depletion suggests that firms are further along than expected in realigning stockpiles with demand, and that future improvement will need to stem from more significant improvements in underlying demand (see James Hamilton for a more positive interpretation).

Growth was further boosted by a jump in residential construction, but, as Calculated Risk points out, this sector's future contributions are likely to remain under pressure from high home and rental vacancy rate. Moreover, the impact of fiscal stimulus will fade as we move through next year, and there appears to be little political will to offer up additional stimulus.

Finally, note that net exports subtracted 0.53 percentage points of growth as import growth exceeded import growth. A balanced, sustainable recovery requires, in my opinion, that net exports contribute to growth. This showing reminds us of the ongoing dependence of US consumption on overseas production - stimulating consumption spending flows in part right out of the economy via imports. Recall also Federal Reserve Chairman Ben Bernanke's recent warning:

Fed Watch: Hawkishness Dominates

Continuing with the same theme, but with monetary rather than fiscal policy, Tim Duy is worried about unwarranted hawkishness:

Hawkishness Dominates, by Tim Duy: As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation. To be sure, Bernanke & Co. have shifted direction often during the past two years. But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high.

Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

While Warsh does note that weak economic conditions would defer tightening, the message is clear: we are looking to tighten, and will do so aggressively when economic activity firms. Moreover, we will do so preemptively, which means we are looking for opportunities prior to the emergence of very solid data.

Note one of the concerns identified by Warsh:

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade's debt bubble? Considering the question always draws me back to this chart, which for me epitomizes the difference between the 1990s and the 2000s:

The 1990s saw a remarkable period of sustained, high levels of investment in equipment and software. In contrast, a sustained period of very low interest rates during this decade was barely able to coerce firms to invest in the high single digits. That, in my mind, is a critical problem, reflecting low expected returns to capital investment. In effect, the policy error might not have been low rates. Indeed, rates do not look to have been low enough to stimulate sufficient investment demand to absorb the productive capacity of the nation, the classic Keynesian problem:

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate....

With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.

This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade. In fact, it would lend additional credence to reports that the Fed needs to do much, much more - a massive, unsterilized expansion of the balance sheet - should they even hope to stimulate sufficient investment demand to absorb underutilized labor. Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis. That, however, appears to me to confuse monetary with regulatory policy. The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.

Following the Warsh speech, Vice Chair Donald Kohn looked to tamp down expectations of an imminent rise in rates:

Although economic conditions have apparently begun to improve--partly in response to the extraordinary steps the Federal Reserve and other authorities have taken--resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery. For that reason, as the FOMC stated last week, exceptionally low interest rates are likely to be warranted for an extended period. Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging. Still, we need to be ready to take the necessary actions when the time comes, and we will be.

Still, like Warsh, Kohn looks determined to find an opportunity to remove accommodation. This despite expected high rates of unemployment. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said U.S. economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.

“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate,” Bernanke said in response to questions at a House Financial Services Committee hearing today in Washington. Growth of 3 percent means the rate would “still probably be above 9 percent by the end of 2010,” Bernanke said.

Interesting how the Fed is encouraging expectations of policy withdrawal even though unemployment rates will remain unacceptably high through 2010. And, if above 9 percent at the end of next year, certainly unacceptably high during 2011 as well. Richmond Federal Reserve President Jeffrey Lacker even goes one step further in a Bloomberg interview:

The Federal Reserve will need to raise interest rates when the economic recovery is “firmly” in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.

“I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise,” Lacker said today in a Bloomberg Radio interview. “I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions.”

Seriously, raising rates even if unemployment is 10%? LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y! This redefines the term "hawk."

From where does this fear of inflation emanate? That brings us to perma-hawk Philadelphia Fed President Charles Plosser:

Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed's monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed's credibility to do so came in the form of the 1981-82 recession and was a steep one.

Consequently, just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. The issues of when and the pace at which we unwind the extraordinary measures taken during the financial crisis and recession are ones that are high on my list of priorities and are the subject of ongoing discussions within the Fed.

The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don't exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:

One could at least wait for significant - or any, for that matter - year over year gains in unit labor costs before declaring that we are at the doorstep of the 1970's. Moreover, the seeds of that inflation did not sprout overnight; the signs were evident but ignored in the late 1960's. Only in Plosser's mind exists the need for an imminent withdrawal of policy.

Bottom Line: The data this week has not been supportive of a rapid exit from accommodative policy. Indeed, the opposite could very well be the case. Despite this, Fed officials, albeit to varying degrees, are uniformly signaling that the actions to expand the balance sheet are only temporary and will be reversed absolutely as soon as possible, which only undermines the stimulative potential of those actions. This is definitely not quantitative easing, and uncomfortably harkens back to the fear of inflation that constrained policy at the Bank of Japan. It is interesting that Fed Chairman Ben Bernanke has worked so hard to avoid a repeat of that experience yet appears ready to risk repeating it nonetheless.

Fed Watch: Rushing to the Exits?

Tim Duy is worried that the inflation hawks on the FOMC are gaining too much influence (Update: This was written before the WSJ editorial from Federal Reserve Governor Kevin Warsh saying that the Fed may move faster and more aggressively than people expect, a statement that Tim anticipates in his comments below):

Rushing to the Exits?, by Tim Duy: A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.

The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.

The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of truth behind a rumor that was circulating earlier this month. From Across the Curve:

I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.

Given the FOMC's own forecast, any consideration of tightening seems silly:

While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011. Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:

On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases. Indeed, unit labor costs are giving you the exact opposite story:

And employment compensation for the private sector is likewise trending down:

Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through. That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:

Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world’s largest energy-consuming nation.

Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That’s more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.

“The market has a glut of crude oil and refined products right now,” Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. “If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices.”

And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do? The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth. From Goldman Sachs (no link):

In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.

The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.

So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”

So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.

Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.

Fed Watch: Even With Growth, A Long, Hard Road

Tim Duy looks forward to the Federal Open Market Committee rate setting meeting later this week:

Even With Growth, A Long, Hard Road, by Tim Duy: The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.

Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:

In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:

Fed Watch: Quick Note on Confidence

Should the latest numbers on consumer confidence improve your confidence in the economy? Here's Tim Duy:

Quick Note on Confidence, by Tim Duy: As Calculated Risk noted, the commentary on the August Consumer Sentiment number from the University of Michigan ran along the generally positive tone echoed by the Wall Street Journal:

Main Street is beginning to feel some relief, though, according to the Reuters/University of Michigan preliminary reading of consumer sentiment for September, released Friday.

The index rose to 70.2 in September from to 65.7 in August, the first increase since June. Consumers felt better about current conditions, and about the future.

Looking at a charts, it is tough to see much of a rebound in August; the bounce happened in April, and the index has been moving sideways since:

Still, even moving sideways is better than falling, and it is telling you something about the path of spending, suggesting that consumers are moving toward spending just about what they did last year:

That we are headed to zero year-over-year growth in spending should not come as a surprise. The calendar is now working in the favor of the data as we move past the big declines in spending registered last summer:

When does confidence start pulling higher? For that, we need the job market to improve at a more rapid pace, thereby reversing this pattern of private wage and salary growth:

Beyond that, your forecast for aggregate spending is largely base on your view of a.) jobless recovery or not, b.) the direction of saving rates, and c.) the accessibility of credit in the post-bubble era. Note that the latter alone suggests persistent downward pressure on spending. Returning to the rates of spending growth (and, by association, the confidence numbers) of the pre-Great Recession period looks to be unlikely.

In short, the August "rebound" in confidence isn’t much of a rebound - the rebound happened in April. That said, slowing "improving" labor market conditions argue for a continuing gains in confidence in the months ahead, but I would expect the gains will continue to come slowly.

Fed Watch: Riding The Fed Train

Tim Duy looks at how the Fed is likely to respond to recent data that "continues to point to a turning point in economic activity":

Riding The Fed Train, by Tim Duy: It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issued by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?

The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmaufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month. Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of the freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated into consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:

Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.

All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.

That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded "Cash for Clunkers" program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans. Likewise, housing sales have been supported by the $8,000 tax credit for "first-time" buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer's tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension - and enhancement - is a no brainer:

"Odd WSJ Story on Vermont"

Tim Duy turns from Fed Watcher to Press Watcher. Will more regulation in mortgage markets lead to outcomes like Vermont's?:

Odd WSJ Story on Vermont, by Tim Duy: The Wall Street Journal has an odd piece on the Vermont mortgage market today. Odd in that the thesis appears to be completely unsupported by the rest of the piece. The story begins:

In plenty of other states, Andrea Todd would have been a homeowner years ago. Here, she bought just this month -- a difference that helps explain how Vermont avoided the housing bust, and shows the possible pitfalls in President Barack Obama's plan to tighten mortgage regulation…

...Vermont's strict mortgage-lending laws largely prevented the state's residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S.

It came at a cost. The rules also kept some Vermonters like Ms. Todd from buying homes, keeping this rural corner of New England on the sidelines of the housing boom and the economic bonanza that came with it. Vermont's 10-year growth trails the national average.

The tenor of the article is that Vermont has overregulated the mortgage market preventing…wait for it…the unforgivable error of restricting loans to those who can prove an ability to repay. Worse yet, consumers receive explicit notice of high rates and brokers are held accountable:

In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors', with notices printed on "a colored sheet of paper, chartreuse or passion pink." And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers' fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour.

The insanity. The horror. Encourage personal responsibility? Hold people accountable for their behavior? Unthinkable. While of course such policies would limit defaults, the economic consequences would be disastrous:

Vermont's economy grew 60% in the 10 years ending in 2008, just behind the 63% rate nationally, according to the Commerce Department. Vermont lagged Arizona, Nevada and California over the decade but outpaced most of its New England neighbors.

That's right, Vermont's growth trails the national average by an astounding 3 percentage points over a decade. They truly missed the economic boom. Why surely Vermont would have outpaced Arizona had it not been for the stunningly tight mortgage markets. The snow didn't have anything to do with it.

Of course, homeownership rates in Vermont are dismal. A state of renters, virtual serfs in this medieval land. The author forges bravely ahead:

Vermonters didn't see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting -- and keeping -- a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.

The according to the article, the "pitfalls" amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some "pitfalls" - truly, greater consumer financial protection would spell ruin for us all.

Fed Watch: The Recovery Edges Forward

Tim Duy reviews the state of the economy in anticipation of the Federal Reserve meeting scheduled for Tuesday and Wednesday of this week:

The Recovery Edges Forward, by Tim Duy: Data flow continues to support those who argue that if the recession is not already over as of July, it soon will be. The July jobs report - while not exactly cheery news for those still losing their jobs - is another clear indicator that the employment picture is turning. Still, excitement over the end of the recession aside, the data also reveal that the economy is recovering in fits and starts, with tell-tale signals that the consumer orgy of this decade is not likely to be repeated.

The July employment report in many ways spoke for itself. Possibly most important is the clear improvement in the pace of job losses:

This serves as confirmation of what we already knew from initial claims - the worst damage to the job market is in the rearview mirror. Other positive signs included a rise in manufacturing hours and stability in aggregate hours. To be sure, not all is perfect. The decline in the unemployment rate was driven by an exodus from the labor force - not exactly a sign of improving conditions. And a key leading indicator of employment, temporary help payrolls, continues to decline. If the recession did in fact end in June, and we see evidence of that end in the July industrial production report to be released this week, the decline in temporary help employment is clearly a disappointment. Indeed, coupled with rising production, it would simply reek of jobless recovery.

Other data supported the notion of weak recovery as well. While industrial activity may be close to turning a corner on the back of inventory reduction and the cash for clunkers program, not all is well in the service sector. The ISM read on nonmanufacturing activity actually edged downward for the month, with declines in not only the headline number, but also business activity, new orders, and employment. Better than the freefall of last year, but nothing to suggest that a V-shaped recovery is imminent.

Perhaps the lack of enthusiasm in the service sector is a reflection of what is clearly a subdued consumer. The June personal income and outlays report reveals that consumer spending declined in for the month:

Fed Watch: Is a Jobless Recovery Your Best Friend?

Tim Duy on how the Fed is likely to respond to "the cyclical turn in the US economy":

Is a Jobless Recovery Your Best Friend?, by Tim Duy: Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, and the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic) underwriting conditions. But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

The second quarter GDP report (Jim Hamilton and Menzie Chinn at Econbrowser discuss the details) confirmed what was already well known - the pace of deterioration slowed markedly, setting the stage for a growth rebound in the second half of this year. The game now is upping near term growth forecasts accordingly - not a fool's errand at all, considering the inventory correction is running its course and new residential construction is mostly likely at the bottom (seriously, we were never moving to an economy where zero houses would be built). Moreover, as Calculated Risk reports, it looks like we hit the bottom of car sales, with no small boost being provided by the Cash for Clunkers program.  Say what you like about the economic wisdom of this program or its potential to magnify a double-dip by borrowing from future growth, it will goose the third quarter numbers and advance the pace of inventory correction in the auto industry. And, let's be honest, buying new cars is a whole bunch more fun than just writing massive checks to keep the industry afloat.

The July ISM manufacturing report only adds to the cyclical rebound story. The headline number is flirting with the all important 50 mark, while the new orders component surged into expansion territory. Production, export, and import components all gained. Even the employment reading rose higher, although it continues to signal ongoing job declines. All in all, a report that is predicting recovery in a time frame consistent with the deep cyclical plunges of late last year.

On a more somber note, labor market weakness continues to weigh on paychecks, a phenomenon confirmed by the employment cost index for the second quarter. Wages and salaries for private workers climbed a scant 0.2%. To be sure, this raises concerns about the durability of consumer spending going forward, especially when combined with fears of a jobless recovery. Indeed, I have argued that most if not all of the jobs in the manufacturing sector simply are not coming back. My suspicion is that firms will use the recession to expand overseas supply chains wherever possible. Moreover, firms will not be in a rush to hire back without a clear resurgence of growth, which seems unlikely to occur given precarious household debt burdens.

Now comes the tricky part - what does the evolving economic dynamic imply for financial markets? I am increasingly of the mind that although a jobless recovery will be a dreary fate for the American people, it offers the best outcome for financial markets for one simple reason: The jobless recovery offers the greatest probability that the Fed remains on the sidelines. The jobless recovery is what keeps the Fed goose laying the golden eggs.

True, one should be cautious about reading too much into near-term market action. Macro man puts it succinctly:

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

With the Armageddon trade off the table, market participants need to move the mass of money provided by the Fed somewhere, and it is showing up in all the predictable places. US equities, commodities, oil, and foreign exchange. Indeed, without the Fed threatening to raise rates, there is no rush to exit Treasuries, which could explain the failure of the ten year bond to retake the 4% mark even as equities sure higher.

To be sure, these trades might collapse under their own weight, but the probability of finding a self-sustaining move, like the US housing boom earlier this decade, is higher the longer the Fed keeps rates at a rock bottom level. And the farther that money flows from the US the better for financial market participants; too much money close to home would raise the prospect of stronger growth and tighter monetary policy. Andy Xie (hat tip to Big Picture) believes he has found one such place in China:

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

When will that bubble burst? Possibly 2012, after the Fed can no longer keep interest rates low:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What’s occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index (‘DXY’) has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

However, monetary policy could start a short but powerful bull market for the dollar. In the early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate to contain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak. When inflation starts to accelerate, it would cause panic in financial markets. To calm the markets, the Fed has to tighten aggressively, probably excessively, which would lead to a massive dollar rally. This would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing.

Bottom Line: Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery. The Fed will be in no rush to withdraw that liquidity - especially if a jobless recovery emerges. Indeed, it is easy to tell a story where the Fed holds rates near zero into 2011. That also means the Fed will not rock any boats. Thus, the jobless recovery is almost a dream come true for those trades dependent on easy Fed policy - which seem to be virtually all trades at the moment. Although there has been talk of the Fed acting preemptively to curtail bubbles, I am skeptical that any such action would be taken with US unemployment staring at double-digits. And there certainly would be no rush to react if low US interest rates fueled bubbles outside US borders; that, after all, would be the responsibility of foreign policymakers.

Fed Watch: More Confirmation of Steady Monetary Policy

Tim Duy sees, among other things, the possibility of another bubble:

More Confirmation of Steady Monetary Policy, by Tim Duy: Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve  President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

The Fed continues to expect that low levels of resource utilization will keep a lid on inflation. While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US. Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth. Will the job market improve anytime soon? We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels. That doesn't mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action. But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement? I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.

Fed Watch: The Debate Continues

Tim Duy looks at the shape of things to come:

The Debate Continues, by Tim Duy: The debate over the shape of the  recovery continues unabated.  Equities, at least this week, are voting in favor of the V-shaped recovery, with the Dow pushing past the 9,000 mark for the first time since January.  Never one to accept good news at face value, Nouriel Roubini predictably took the opposite position:

A “perfect storm” of fiscal deficits, rising bond yields, “soaring” oil prices, weak profits and a stagnant labor market could “blow the recovering world economy back into a double-dip recession,” he wrote in a research note today. “It is getting more likely unless a clear exit strategy from the massive monetary and fiscal stimulus is outlined even before it is implemented.”

Roubini, chairman of Roubini Global Economics and a professor at NYU’s Stern School of Business, predicted that the global economy will begin recovering near the end of 2009. The U.S. economy is likely to grow about 1 percent in the next two years, less than the 3 percent “trend,” he said.

Roubini based his short-term outlook on the worsening condition of the U.S. housing and labor markets, which he called “inextricably linked.” He said a “weak” job market will contribute to another 13 percent to 18 percent drop in house prices, bringing total declines nationally to as much as 45 percent from their peak.

I would add to Roubini's pessimism that  bond market investors as of yet do not share the optimism of their brethren in the equity side of the industry.  The run up in yields that brought a 4-handle to the 10 year Treasury appears to have been stopped dead in its tracks, and that maturity has pulled back to the mid threes.  If the run-up in yields foreshadowed a burst of optimism in equities, the pull back would suggest that this rally has nearly run its course.

 The challenge here is two-fold.  The first challenge is to determine how much of the recent equity run is attributable to the weight of evidence that indicates the worst of the downturn is behind us.  With the Armageddon trade off the table, some gains were inevitable, just as was the rise in Treasury yields.  The more difficult challenge is the strength and pattern of the subsequent recovery.  To be sure, one should not ignore the possibility of a blowout quarter here and there, as GDP data can bounce quickly to bounces in underlying data such as a stabilization in auto sales.  But will such a bounce reflect fundamental underlying strength?  A slow, jobless recovery - my dominant scenario - would most likely produce the seesaw trading we saw in the wake of the tech bubble crash, a pattern that held until the housing bubble gained full traction.  Such an outcome looks consistent with the sentiment of Federal Reserve Chairman Ben Bernanke in this weeks Congressional testimony:

Fed Watch: FOMC Forecasts - Reality or Fantasy?

Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:

FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.

I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:

See also consumption data:

Fed Watch: A Tangled Policy Web

Tim Duy:

A Tangled Policy Web, by Tim Duy: Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power. Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years. To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage. That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay down crippling debt loads, effectively turning private debt into public debt. And note that large shifts in consumer behavior are not required to have significant macroeconomic implications. Small changes across households - a little less, percentage wise, spending here and there adds up. From Bloomberg:

Fed Watch: Rate Hike?

Tim Duy responds to talk of a rate hike:

Rate Hike?, by Tim Duy: Seriously, a rate hike in this environment?  Or anytime before the end of 2009?  At the moment, I just can't see it happening.  That said, long rate are higher, and inflation expectations in some corners of the market are rising.  What is going on?  My explanation for recent market action revolves around three themes:

1.)Financial Armageddon appears to have been avoided - at least for the moment.  The "all but explicit" implicit guarantee that no significant US financial institution will be allowed to fail established a return to financial stability.  And with that stability comes an end to the flight to safety that buoyed Treasury prices.  Something off a conundrum for Treasury Secretary Timothy Geithner - cheap financing of the staggering US deficit appears to be dependent on financial instability.

2.)Recent inflation numbers are not exactly what I would call benign.  The trend in core PCE is not  deflationary:

I think deflation fears were always overblown - the current batch of monetary policymakers are simply dead set against such an outcome.  The deflation trade, like the flight to safety, needed to be priced out of Treasury's and TIPS.  The outcome:  Breakeven spreads are up sharply.

3.) The US, in aggregate, is borrowing less from the world than a year ago.  But make no mistake, we still rely on capital inflows to maintain a substantial US current account deficit.  Lacking a flight to safety, it is not clear that private investors are willing to support that deficit at 2.75%.  Or even 4%, for that matter.  That fact that foreign central banks are accumulating Dollars is proof positive that private investors don't want to do the job - and the transition in central bank purchases from the long end to the short end suggest that even they grow weary of this game.   Remember, the argument that "Japan ran a massive budget deficit so we can too" falls apart when you recognize that for decades Japan has been able to rely entirely on internal savings to finance the deficit.  My interpretation: The invisible hand (apologies to Gavin Kennedy) is still pushing for lower US consumption to bring the external accounts into better balance - and that means higher rates to maintain inflows while suppressing the pace of economic growth.  I understand this is in direct conflict with the output gap story; reconciling the two, I believe, requires an admission that the US economy is terribly structurally imbalanced internally.  We may have excess capacity, but not excess capacity to make anything anybody real wants.     

Where do Federal Reserve policymakers stand on recent dynamics?  Turning to Federal Reserve Chairman Ben Bernanke:

Fed Watch: A Return to a Nasty Dynamic?

Tim Duy:

A Return to a Nasty External Dynamic?, by Tim Duy: At the moment, the economic dynamic is exceedingly complicated. An understatement, I fear. The crosscurrents in the data and the markets are treacherous, and I suspect will have Fed officials scratching their heads. Hold steady with existing plans? Step up the liquidity provisions? More actively engage plans to tighten policy? The latter option seems almost inconceivable; for the moment, the debate will focus on the issue of further easing. At this point, I think the Fed will sit tight, allowing further easing to come from the already active TALF program, rather than expanding outright purchases of Treasuries.

The core issue is the steep rise in Treasury yields, which apparently were kept in check only by the expectation that the Fed would continued to gobble up the endless stream of securities issues by the US Treasury. The Fed sank that hypothesis at the last FOMC meeting, and a subsequent statement by Federal Reserve Chairman Ben Bernanke made clear that the Fed does not have a 3% target on 10 year Treasury yields. Since then, yields have climbed as high as 3.75% before prices rebounded today, bringing yields down to 3.61%. Should we be concerned with the gains?

Brad DeLong argued a few weeks ago that the Fed's reluctance to cap rates was a policy error in the making. Indeed, it would seem that rising yields are toxic for debt heavy balance sheets, especially where housing is concerned. Officials repeatedly point to the importance of supporting housing prices, a policy that would be undermined as rising Treasury yields boost mortgage rates higher. And while we have seen some stability in recent months in existing homes sales - of which foreclosures and distressed sales are no small part - the recent Case-Shiller data makes clear that housing markets remains under severe pricing pressure:

Home prices in 20 major metropolitan areas fell in March more than forecast as foreclosures surged, threatening to extend the housing slump.

The S&P/Case-Shiller home-price index decreased 18.7 percent from March 2008, matching the drop in the year ended in February. The measure declined 19 percent in January, the most since data began in 2001.

In contrast is the view that rising yields signal an unambiguously positive environment in future months, a sentiment echoed by US Treasury Secretary Timothy Geithner:

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

Likewise, Alan Blinder is confused by thoughts that the Fed would attempt to control yields at all:

Blinder said he’s “more dubious” about the Treasury purchases themselves. Any reduction in long-term rates makes it more difficult for U.S. banks to generate earnings to make up for what the Fed estimated earlier this month would be $600 billion in losses under adverse economic conditions. “It makes it harder for them to earn their way out,” he said.

So we are stuck with two apparently contrasting views. On one hand, rising long rates and the related steepening of the yield curve should indicate improving economic conditions - after all, rising yields simply imply that market participants are gaining confidence to put their money to work in more risky endeavors. The steeper yield curve should boost bank earnings and, in time, encourage lending. On the other hand, higher yields may undermine support for the housing market, thus extending the downturn. The Wall Street Journal believes the Fed is choosing the positive spin:

Federal Reserve officials believe the recent sharp rise in yields on U.S. Treasury bonds could reflect a mending economy and a receding risk of financial catastrophe, suggesting the central bank won't rush to react -- even though some investors see danger in the government's rising cost of borrowing.

The WSJ is most likely correct. Indeed, I too want to believe the first story; the steep yield curve should be a clear signal that economic activity is poised to soar. Two things are holding me back. First, the 10-2 spread went positive in mid-2007, which should have indicated that the expected Fed easing later that year would catch fire and the economy would be clear of recession territory by mid-2008. Oops - the signal was premature. Something was different (just as I had come to embrace the yield curve's signals). My second concern is that rising yields indicate capital is fleeing the US, and the shape of the yield curve is being influenced significantly by shifts in patterns of foreign central bank purchases. And while the resulting depreciation of the Dollar will support US growth over time, the transition can be very disruptive. Interestingly, the Wall Street Journal story quoted above does not point to this possibility.

Fed Watch: Not So Green Wednesday

Tim Duy says "the green shoots story has been overplayed," and the Fed - despite its worries about inflation - is likely to pursue additional easing:

Not So Green Wednesday, by Tim Duy: Federal Reserve policymakers are working overtime to temper expectations of additional quantitative easing. From Bloomberg:

The Federal Reserve considers the recent jump in Treasury yields more as a reflection of a better economic outlook than a signal it needs to step up purchases of U.S. government debt, according to central bank officials who declined to be identified.

This follows Federal Reserve Chairman Ben Bernanke's efforts to discredit the idea that 3% is a magic number:

The move above 3% isn’t fundamentally important, [Bernanke] suggested. “We are not targeting a particular interest rate” with the long term Treasury note purchase program, he said.

The confusion over the Fed's policy intentions stems from the now familiar conflict between what the Fed defines as "credit easing" and what market participants define as "quantitative easing." The latter requires some quantitative goal, something the Fed acknowledges. But no such target has been defined, nor has the Fed committed to a 3% rate. This is something of a failure of Fed communications - they cannot adequately define their policy intentions to a group of market participants yearning for the simple target rates they have come to expect. But committing to a rate target would rob policymakers of a signal that the economy was improving. Former Fed Governor Lyle Gramley:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley. “The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

And no doubt there is still plenty of smoke. So much, in fact, that practitioners are extremely at odds over what signal we should get from the Taylor Rule. From Bloomberg:

Fed Watch: Turning Which Corner?

Tim Duy:

Turning Which Corner, by Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:

Fed Watch: Despite Green Shoots, Odds Favor More Easing

Tim Duy:

Despite Green Shoots, Odds Favor More Easing, by Tim Duy: The Fed took an interesting risk by holding policy steady on Wednesday.With green shoots all the rage, policymakers are ready to step to the sidelines as they monitor the progress of their many programs.And clearly, they must have known that the 3% level on 10-year Treasuries was dependent on the expectation that policymakers would expand the pace of outright purchases of those assets, but are betting that economic conditions will remain sufficiently weak to prevent a crippling increase in rates. Still, given that policymakers still see the economy in decline, albeit at a slower rate, the odds favor additional easing in the months ahead, especially considering expectations of a widening output gap. Recall that labor markets, and the threat of deflation, kept the Fed easing well past the end of the recession in 2001.

Short of an outbreak of inflation, or a unexpected and unlikely surge of growth, there is little reason to think that the Fed is ready to bring policy to a sustained pause. And an imminent rise in inflation remains an outside risk for the Fed; the focus remains consistently on disinflation or, worse yet, outright deflation.  A key paragraph is:

Fed Watch: TALF Disappointment and the Fed's Balance Sheet

Tim Duy says the Fed is likely to step up its purchases of long-term sucurities:

TALF Disappointment and the Fed's Balance Sheet, by Tim Duy: Mark Thoma directs us to a Washington Post article detailing the slow start-up of the Federal Reserve's much discussed but little used TALF program. At this juncture, a critical constraint appears to be counterparty risk - no one trusts the US government to hold parties to their contractual obligations:

Sources involved in the program said private investors have been reluctant to work with the government, which they view as an unreliable business partner. ... There are restrictions on the business activities of participants in the program. ... But perhaps more significant ... is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. ...

Perhaps TALF will gain traction in the months ahead. For now, however, I imagine that no amount of lipstick is able to conceal what must be official disappointment with the program. The question on my mind is will slow take up on TALF induce the Federal Reserve to step up its purchases of mortgage assets and longer term Treasuries. From the last Fed minutes:

Fed Watch: More on Inflation Expectations

Tim Duy looks at the strength of the Fed's commitment to its inflation target, and its ability to hit the target that it sets:

More on Inflation Expectations, by Tim Duy: Thinking about the issues raised in my piece last week, it is worthwhile to spend more time on actual inflation and inflation expectations within the context of the Fed's policy of "credit easing." Consider as a starting point the recent work by John Williamson at the San Francisco Fed who concludes:

This analysis highlights the central roles of economic slack and inflation expectations in the risk of deflation over the next several years. The evidence indicates that a substantial increase in slack can lead to deflation, but the depth and duration of the deflation depends on how well anchored inflation expectations are. Two policy implications can be drawn from this and other research on deflation. First, a central bank should take appropriate actions to stem the emergence of substantial slack in the economy and thereby reduce the risk of deflation. Second, it should clearly communicate its commitment to low positive rates of inflation. An example of such communication is the Federal Open Market Committee's recently released long-run inflation forecasts. Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral.

Conventional wisdom of the Fed's policy describes quantitative easing as an effort to boost inflation expectations. This flows from the fact that the Fed Funds rate is at zero, therefore a further decrease in the real rate can only be achieved by boosting inflation expectations. To me, however, the Fed has not committed to a program of raising inflation expectations. Instead, they are reiterating their existing commitment to a low, stable rate of inflation. Consider the most recent FOMC statement:

Fed Watch: Johnson and Kwak vs. Bernanke

Tim Duy says that if the Fed is trying to raise inflationary expectations through quantitative easing, they are not doing a very good job:

Johnson and Kwak vs. Bernanke, by Tim Duy: Simon Johnson and James Kwak of the Baseline Scenario argue in today's Washington Post that the Fed risks triggering an inflationary spiral despite the current gaping output gap  (see also Mark Thoma's comments here).  I believe that Johnson and Kwak are perpetuating a misunderstanding about Federal Reserve Chairman Ben Bernanke's policy intentions, namely boosting inflation expectations.  This is an understandable extension of the widely cited policy of quantitative easing.  But despite the widespread use of the term quantitative easing, I still believe this is not Bernanke's understanding of the Fed's policy stance (see also David Altig).  And, I would argue, if this is indeed the Fed's policy, Bernanke is doing a very bad job at implementation.

The key paragraph in Johnson and Kwak that I take issue with is:

Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations.  First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.

Pay close attention to Bernanke's insistence that the Fed's liquidity programs are intended to be unwound.  If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say.  Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply.  Bernanke is making the opposite commitment - a commitment to contract the money supply in the future.  Is this any way to boost inflation expectations?  See also Paul Krugman:

In that case monetary policy can’t get you there: once the interest rate hits zero, people will just hoard any additional cash – we’re in the liquidity trap. The only way to make monetary policy effective once you’re in such a trap, at least in this framework, is to credibly commit to raising future as well as current money supplies.

If Bernanke really intends to raise inflation expectations, he is making an elementary error by reiterating his intention to shrink the Fed's balance sheet in the future.  The current increase in money supply is thus transitory and should not affect future expectations of inflation. I can't see him making such an elementary error, which suggests that Bernanke's word should be taken at face value; he intends policy to be "credit easing," not the oft-cited "quantitative easing."

To be sure, the Fed is setting the stage for inflation if the price for their efforts to stabilize the financial system is monetary independence.  The Fed is very, very aware of this risk; expect policymakers to keep reiterating Bernanke's intention to maintain independence.  Note that he made this point in the quote above, and makes it again later in the same speech:

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Johnson and Kwak also attempt to deal with the central criticism of inflation worries:  How can inflation emerge given the gaping output gap?  They solve this puzzle by analogizing the US to an emerging economy:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

The challenge in my mind is that institutions in the US, primarily the relationship between management and labor, are not conducive to sustained inflation as they are in emerging markets.  Desperation among workers is more likely to take hold.  From today's Wall Street Journal:

Despite what objectives they may have put atop their resumes, when asked to describe the work they really wanted, the job seekers largely had the same goal: "I'll take anything right now."

In many cases, that desperation means that even educated workers must trade down to jobs below their potential and with lower pay. That results in painful, long-term effects, from hurting their own career advancement to displacing those with less education or experience.

Frankly ,I don't see a clear transition mechanism within the US economy to generate sustained inflation in this environment.  I am somewhat more sympathetic to another threat Simon and Kwak identify:

We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

If the US Dollar cracked - a frequent fear of mine during the past year - and commodity prices surge, and the Fed effectively accommodated that price increase by easing policy further to counter the negative demand effect, which would effectively be a permanent increase in the money supply, then I can tell a story about an inflationary spiral.  Such a story did not look ridiculous last year as oil was heading toward $150.  Now, however, it is a lot harder to tell.  Too many "ifs" and "maybes."  A story that hangs together much better after a six-pack than my recent snack of sugar and caffeine.

Bottom line:  I reiterate my concerns that the media and market participants are using the term "quantitative easing" too loosely.  I understand that this complaint falls on largely deaf ears.  If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future.  In other words, they are explicitly committing to a temporary increase in the money supply.  There is no reason to believe this will meaningfully impact inflation expectations.  Such expectations, however, could be generated via a policy error.  The error the Fed fears the most is they lose independence, the increase in money supply becomes permanent, and that political pressures force sustained increases in the money supply.  Consequently, look for officials to consistently repeat their intentions to remain independent.

Fed Watch: The Fed Understands

Tim Duy on the risks to the Fed's independence, and on whether the Fed's insistence that some actions be conducted in secret "damages the democratic process":

The Fed Understands, by Tim Duy: Willem Buiter (via Yves Smith) argues that the Fed's actions over the past eighteen months has placed its independence at risk:

Without a firm guarantee up front that the Federal government will fully re-capitalize the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

Butier's tone suggests that the Fed is not aware of these risks. But I think the opposite is very much the case - the Fed is agonizing over this issue.  See the Fed-Treasury accord that was issued earlier this week; it is a clear effort on the part of the Fed to firmly establish its independence.  Note also that some policymakers have made clear their concerns about mixing monetary and fiscal policy.  Richmond Fed President Jeffrey Lacker hit on the point this week:

Fed Watch: Looking for a Bottom

Are we about to reach bottom? If and when we do, will we bounce back upward and recover, or will we bounce along the bottom in a series of fits and starts as the economy stagnates at a sub-par equilibrium?

Tim Duy:

Looking For a Bottom, by Tim Duy: Given the length and depth of the current recession, it is natural for analysts to start looking for a bottom.  In such an environment, bad news will be ignored while the seemingly good news is overblown.  For example, the most recent initial unemployment claims report indicates that labor markets continue to deteriorate; we have yet to see a turning point consistent with improved conditions.  Likewise, the durable goods report was heralded as a positive sign, but the jump in this volatile series needs to be taken in context of the severe drop the previous month.  The chart of nonair/nondefense new orders is not particularly encouraging: 

That said, things will eventually get less worse, if only because some sectors, such as new residential housing, will hit a bottom.  And that bottom is not likely to be zero, and, I suspect, that bottom will be late this year or, at worst, early next year.  That should not, however, be confused with an optimistic outlook, as the durability and strength of the eventual recovery is in doubt.  I am confident that the economy will not spiral downward endlessly; I am more worried that the we will be left at a suboptimal equilibrium chiefly characterized by low growth and persistently high unemployment.

Fed Watch: Fed-Treasury Accord

Tim Duy on the Fed's efforts to maintain its independence:

Fed Treasury Accord, by Tim Duy: The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Across the Curve).  Clearly, it reveals the concerns of the Federal Reserve that its expansive role in the crisis will eventually threaten monetary independence, and thus wants that right/privilege reasserted:

The Federal Reserve's independence with regard to monetary policy is critical for ensuring that monetary policy decisions are made with regard only to the long-term economic welfare of the nation.

The need for such a statement was heightened by last week's FOMC decision to expand the balance sheet via outright purchases of Treasury securities (in addition to mortgage backed securities).  Considering the massive amount of red ink fiscal authorities are expected to spill for the foreseeable future, the Fed's action could be interpreted as the first salvo in a campaign to monetize deficit spending. I do not believe that this is the interpretation the Fed intends.   Indeed, I believe this is one reason the Fed has shied away from the term "quantitative easing."  Note Bernanke & Co. always place the expansion of the balance sheet in terms of the improving the functioning of private capital markets. See Federal Reserve Chairman Ben Bernanke's speech last Friday:

These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages.

The stated intent is not supporting fiscal stimulus, creating inflationary expectations, nor even fighting deflation.  The Fed expects they will withdraw their extraordinary liquidity operations when financial conditions stabilize (see Monday's Wall Street Journal).  They expect they will have the political freedom to do so; but the deeper they delve into financial markets, the more politicized their activities become. 

The broad points, with my comments:

Fed Watch: When Does Faith in Financial Engineering Wane?

Tim Duy wonders how long it will be until the Fed gives up on the idea that financial engineering can resolve the problems in financial markets:

When Does Faith in Financial Engineering Wane?, by Tim Duy: The data flow is truly horrible, painting a picture of an economy so weakened that it promises to engulf the recently passed stimulus package.  Fiscal authorities will be pushed to do more, and President Barack Obama recognizes the challenges and opportunities presented by this recession.  His recent budget proposal sets the stage for a bitter fight on the magnitude and composition of the government's role in the macroeconomy.  Monetary policy will also be asked to do even more as well, and the question remains the same as last fall when it became clear the Fed was headed to the zero bound - when will Bernanke & Co. shift gears to an overtly inflationary policy direction?  When will the focus of policy shift from the asset side of the balance sheet to the liabilities side?

Fed Watch: Lowering the Bar

One more from Tim:

Lowering the Bar, by Tim Duy: From the terms of the Capital Assistance Program:

As part of the application process, banks must submit a plan for how they intend to use this capital to preserve and strengthen their lending capacity – specifically, to increase lending above levels relative to what would have been possible without government support. The Treasury Department will make these plans public when the bank receives the capital under the CAP. (italics added.)

This is refreshing; unlike the initial TARP program, Treasury is not giving the impression that banks will increase lending - only that lending will contract by less than otherwise expected, all else equal.  Avoidance of a absolute collapse seems to be a reasonable goal.  I would prefer that we moved to avoidance of the Japanese scenario as well, but perhaps I just need to learn to be happy with small steps.

Of course, I can't see that it would be hard for the recipient bank to pick a safe baseline for lending in the absence of Treasury support (like zero).  Nor will it be easy to explain to the taxpayer that they should continue to expect lending to contract.  But at least we can say we were warned. 

Fed Watch: Will TALF Do The Job?

Tim Duy has doubts about how effective TALF will be:

Will TALF Do The Job?, by Tim Duy: The Administration is putting high hopes on TALF, especially now that the program will reach as high as $1 trillion (remember when $1 trillion was a lot of money?).  It has always seemed to me that TALF would fall short of the mark.  The key constraint:

Eligible collateral includes U.S. dollar-denominated cash ABS that are backed by auto loans, credit card loans, student loans, or small business loans that are fully guaranteed by the SBA, and that have a credit rating in the highest investment-grade rating category from two or more nationally recognized statistical rating agencies and do not have a credit rating below the highest investment grade rating category from a major rating agency.

The expansion of TALF to CBMS also requires AAA-ratings.  I suspected that limiting the program to investment grade securities would severely curtail the effectiveness of the program for one simple reason - that, relative to expectations of officials, investment grade borrowers are relatively few, and they have maintained that status by not accumulating excessive debt, so already they are not inclined to borrow.  The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt.  Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction. 

Two recent stories tend to support this point.  First, from the Wall Street Journal:

The government's $200 billion program to revive the market for securities backed by consumer loans may end up providing little help to the very industry that needs it most: U.S. auto makers.

As the Federal Reserve hashes out final terms of its Term Asset-Backed Securities Loan Facility, or TALF, it is becoming clear that securities that help finance auto dealers mightn't meet some criteria. That would block a form of funding that auto companies had hoped would provide immediate relief as they fight for survival.

The problem came to a head because of credit ratings. The Fed has insisted that any deal it helps finance be given a triple-A rating from Moody's Investors Service, Standard & Poor's or Fitch Ratings. Bankers said this kicks out deals backed by loans to auto dealers because S&P and Moody's, in particular, have cut the ratings on such securities over the past several weeks as the industry grapples with potential bankruptcy filings and weaker demand for U.S. cars.

The second is from Bloomberg:

The Fed, through the TALF, could reduce the cost of financing commercial real estate by taking as collateral CMBS already traded in the secondary market rather just new bonds, said RBS analyst Lisa Pendergast in Greenwich, Connecticut.

Accepting bonds from the secondary market would be a “big deal” for reviving credit, said Jan Sternin, a senior vice president at the Mortgage Bankers Association in Washington.

The central bank also should make loans with at least a five-year term against CMBS, Pendergast said. The TALF is now geared to make loans of no more than three years against collateral, a misalignment with the typical five- or 10-year term of commercial mortgages.

“Nobody would buy a 10-year asset with a three-year loan,” she said.

The Fed initially proposed a one-year term for TALF loans it will make before revising to a three-year period in December.

Without TALF support, borrowers would have a tougher time refinancing maturing debt and avoiding delinquency or foreclosure, said Chip Rodgers, senior vice president at the Real Estate Roundtable, a trade group in Washington.

The Fed has said it will only accept newly issued AAA-rated CMBS collateral.  Presumably, newly issued CMBS could be used to refinance maturing debt, assuming the refinanced debt could be rated AAA.  And, I suspect, therein lies the heart of the industry's conundrum.  Given the deterioration in credit quality, we can presume that much of the maturing debt is rated at something less than AAA.  Much less.  Consequently, the TALF would do little to help refinance maturing commercial mortgage debt, at least directly (I would not count on the indirect effect of building confidence in dodgy assets via liquidity programs).  They know it - the article contains a telling quote:

Atlanta Fed President Dennis Lockhart said today that commercial real estate is “the one domestic factor that keeps me up at night.”

“Many banks are pretty heavily exposed to commercial real estate,” he said in Orlando, Florida.

Lockhart must sleep well compared to me; I have a laundry list of economic issues that keeps me up at night. 

If the maturing debt cannot be refinanced at reasonable interest rates, then rising defaults and additional asset markdowns will play further havoc on the banking industry.  The Fed cannot fix this if they limit their loan programs to AAA-rated ABS as the problem debt by definition has a lower rating.   This appears to be the signal the industry is sending, so holders of CBMS want the next best thing - the Fed to absorb the risk of the existing AAA-ABS:

Top-rated commercial mortgage bonds are currently trading at about 10.82 percentage points more than benchmark interest rates, compared with 2.32 percentage points a year ago, Bank of America Corp. data show. In January 2007, the debt traded at 0.22 percentage point.

Seems those "top-rated" bonds are riskier than expected.  Better to sell them off to the Fed (and eat the haircut) while they are still AAA rated.  Of course, it may already be too late; ratings are dropping fast:

Moody's Investors Services downgraded an additional $23.89 billion of commercial mortgage-backed securities amid concerns that losses would grow from increased leverage, reduced reserves to pay debt and loan losses.

The move follows the ratings firm's announcement last week that it would review the ratings of some $300 billion of bonds backed by commercial-real-estate loans. More than a quarter of those securities are vulnerable to multiple-notch credit downgrades.

Last Thursday, Moody's said it will apply new assumptions about falling property cash flows and stressed capitalization rates, which are the ratio of net income to its value, when considering the rating of the bonds. The review is slated to be completed within 60 days.

Including the latest round of downgrades, $62.09 billion of CMBS has been downgraded by Moody's the past week.

The commercial real-estate market had held up better than the residential real-estate market, but it began to deteriorate quickly at the end of 2008 as the recession deepened.

The ratings firm had expected cumulative losses of 2% on commercial bonds issued between 2006 and 2008, but it has increased that to 5%.

Moody's, which on Tuesday downgraded 124 classes and affirmed 69, expects a significant decline in future property cash flows on higher tenant defaults, bankruptcies and a sharp decline in lease-renewal rates. Those cut include 47 tranches valued at $6.6 billion from Wachovia Corp., which was acquired by Wells Fargo Co. five weeks ago, 11 classes valued at $3.8 billion at J.P. Morgan Chase & Co. and 10 classes valued at $2.8 billion at UBS AG.

Existing CMBS might not be rated AAA for long.

Bottom Line:  TALF limitations provide protection for the taxpayer, but curtail the program's effectiveness.  This is not meant to imply that efforts should not be made to support the normal functioning of credit markets; simply to keep expectations about effectiveness in check.

Divergent Unemployment Rates

Tim Duy:

Divergent Unemployment Rates, by Tim Duy: It is common knowledge that educational achievement significantly impacts labor market outcomes.  Still, I was struck by the increase in that disparity as I prepared the following charts for a presentation last week.  Consider the year over year change in unemployment rates by educational achievement since 1993:

Note that the increase in unemployment rates for no high school and high school graduates are increasing at a very rapid rate over the past year (note this also reflects rising labor force participation for the no high school group (Jan. 2008 - Jan. 2009), in contrast to falling participation among other groups).  In contrast, during the 2001 recession, increases in unemployment rates were comparable.  For a closer look at 2001:

And the current recession:

A few thoughts come to mind:

1. Rising structural unemployment.  If the housing/consumer debt dynamic led us into this downturn, and, as I think is reasonable to expect, will not lead us out of the downturn, then we can expect that those persons unemployed as a result will continue to face relatively higher rates of unemployment in the future.  In essence, it is not clear to which sector these labor resources will be reallocated, especially given anticipated lethargic rates of labor growth on the other side of this recession.  I suspect that very strong growth will be required to revitalize a labor market for these individuals (such as that experienced during the information technology boom).  No such growth forecast exists.
2. Hysteresis?  That is a term that has not cross my mind for many years.  Suppose the economy is undergoing a structural adjustment that promises to deliver low growth rates for the next decade, with cycles driven by the start-stop process of fiscal stimulus.  Could each new "boom" end with an unemployment rate higher than the low of the previous boom as structural unemployment edges up? 
3. Stimulus may also have a differential impact on unemployment.  If the jobs generated by fiscal stimulus tend toward workers with higher education levels, then stimulus will not alleviate the problem of rising structural unemployment.  Note - this is NOT an argument against stimulus.  It highlights the importance of proper structure of the stimulus package.
4. Us versus them.  I hate to say this, but certain political partisans could turn this into a morality play...why should your tax dollars be wasted supporting the bottom end of the educational level?  They had their chance.  
5. Inflation risk?  If significant structural issues are in play, perhaps we are fooling ourselves about the low risk of inflation.  Consider Jim Hamilton:

I have in my research instead stressed technological frictions. For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise. More fundamentally, I have suggested that our present situation is as if someone had quite successfully sabotaged the basic functionality of our financial system. Until we once again have a financial sector that can successfully allocate credit to worthy projects, we're not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be. In terms of the textbook Keynesian models that people play with, I'm suggesting that "potential" GDP growth for 2009:Q1-- that growth rate which, if we try to exceed it by stimulating aggregate demand, we primarily just get more inflation-- is in fact a negative number.

I not ready to declare the end of deflation risks.  But I can easily make a story in which structural adjustment combined with misdirected stimulus yielded a higher than expected inflation rate.  As always, it is wise to consider the full range of risks to your outlook.

Bottom Line:  Yet another thing to worry about.

Fed Watch: Waiting For Geithner

Tim Duy:

Waiting For Geithner, by Tim Duy: Treasury Secretary Timothy Geithner is slated to announce the latest financial stabilization plan Monday.  From various press reports and leaks, these are things to be looking for:

1. No bad bank.  The plan appears likely to leave toxic assets in the hands of the financial sector, rather than purging them from the system once and for all.  The bad bank idea is proving to be prohibitively costly if your fundamental goal is to maintain the status quo - one cannot shower the sector with such financial largess and expect to leave existing shareholders and bondholders unharmed.  Instead, there appears to be a move toward guaranteeing losses beyond a certain amount, a "ring fence" approach.

2. More string tied to aid.  Institutions receiving aid will be subject to "limits" on executive pay, requirements that they modify troubled mortgages when possible, and requirements that government money stimulate new lending appear to be among the strings.  The additional strings will likely discourage willing participation.

3. Triage?  From Bloomberg:

The Treasury may increase its stake in lenders that are judged short of capital, the people said on condition of anonymity. Should extra taxpayer funds result in a majority ownership by the government, officials would then decide whether to liquidate the institutions, place them into receivership or retire the companies’ assets over time, they said.

This sounds like Treasury would try to identify those institutions worth saving, and either nationalize or liquidate those with that require federal help on the order of a de facto nationalization.  The Wall Street Journal suggests something different:

The rescue is shaping up to include a second round of capital injections with tougher terms. The government is looking to get money into banks by buying preferred shares that convert into common equity within seven years; that avoids diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that already received capital injections to convert the Treasury's preferred shares to common stock over time.

The Journal version sounds like an effort will be made to protect existing shareholders and avoid nationalization. 

My suspicion is that Treasury will talk tough, but continue a band-aid approach that dribbles out funds at a rate that both avoids the messy issue of nationalization while providing insufficient funds for adequate capitalization, all while trying to keep toxic assets in the banking system.  Clearly, I am not optimistic.

4. Formal acceptance of agency debt.  This one circulated the markets Friday; explicit endorsement of agency debt should render it nearly as good as Treasuries, and bring yield spreads, and mortgages, down dramatically.  

5.  Foreclosure mitigation.  Reports suggest a stepped up effort for foreclosure mitigation to the tune of $100 - $200 billion.  I don't view this as an effort to prop up prices; it is simply not enough the weigh against the literally trillions of lost value.  I also suspect it is very difficult to identify homeowners who can benefit from reasonable modifications that don't require either a substantial and untenable taxpayer contribution or the homeowner becoming a virtual mortgage slave, tied to an unrealistic housing payment.

6.  Support for bankruptcy "cramdowns."

7.  A greater role for the FDIC. Give the FDIC authority to liquidate non-bank firms in an orderly fashion, and extend guarantees of financing bonds issued by banks.  The former would likely require legislation.

8.  Expanded role for the Fed.  The Wall Street Journal describes the evolution of the new TALF facility.  My favorite line:

Some hedge funds, which often use borrowed money to boost returns, are lining up to get in on the Fed program, seeing a chance to make high double-digit-percentage returns with little downside using low-cost loans made on easy terms. Some officials inside the Fed are nervous about relying on unregulated hedge funds. But they see it as a trade-off in order to get capital to consumers.

I can just see how this program evolved.  Fed and Treasury officials meet with Wall Street titans looking for methods to unglue the financial system.  The answer:  Create programs that guarantee risk-free double digit returns for wealthy investors.  In the meantime, I am trying to explain to aging Rotarians nearing retirement that they are simply screwed; the risk free rate for them and the other 99.9% of the population is pushing at zero. 

These appear to be the highlights; I hope I have not missed anything substantial.   We will soon see which leaks were accurate, and what details were not leaked. 

Fed Watch: And Now We Know....

Tim Duy:

And Now We Know…., by Tim Duy: I have been holding off on commenting about the impending, revised financial stabilization plan, content to let those such as Yves Smith express their dismay at the evolving package. I have run the gamut from dismay to anger to my current emotion, supreme disappointment. There were really only two glimmers of hope that the US could avoid a Japan-like multi-year stagnation. One was the offsetting effect of a strong global economy. Of course, we all know how that story ended. Poorly. The other was my certainty that US policymakers like NEC head Lawrence Summers and Treasury Secretary Timothy Geithner had studied the Japanese crisis up and down and realized that you needed to meet a banking crisis head-on, not with halfway measures that left the system crippled.

But today, reading CNBC’s coverage of the plan, it becomes painfully clear that we are headed full speed on a policy bullet train designed to repeat Japan’s errors. From CNBC:

The plan will be "smaller" than originally expected, said the industry source, and centered around government guarantees and insurance of troubled assets, what's called a "ring fence" concept.

Will the ring fence concept work? Consider this paragraph later in the article:

The ring fence concept has already been used with Citigroup ... and Bank of America... It involves government guarantees and insurance provisions for groups of bad assets, but they remain on the balance sheet of the institution. The bad bank concept literally removes them.

Look, just look, at the stock prices, plumbing the depths. From Bloomberg:

Bank of America Corp., the nation’s largest bank, declined to its lowest level in New York trading since 1984 on concern regulators may seize the company after a $138 billion U.S. bailout package failed to halt the slide.

I have got to say, at least from someone on the outside looking in, the US government appears to be headed down a path already proven to be a failure. Is more of a failing policy smart policy? But it gets worse:

The latest round of discussions also appear to have addressed the most controversial aspect of the big bank concept: Pricing.

Under the emerging plan, the government will buy toxic assets below the banks "carrying value," which is basically market value, but not at fire sale levels, the source said.

That approach will likely placate both taxpayer and Congressional concerns about the government over-paying for the assets. But, the source noted, it could "trigger an accounting problem for the banks," presumably because the institutions will have to report a loss on the transactions.

The Obama administration is now working on ideas to address that, which might entail a temporary suspension of certain accounting rules.

Classic. Absolutely classic. Is this really addressing the problem of pricing? Are we not in the same boat of “if we pay too little, the bank is undercapitalized, but if we pay too much, the taxpayer holds the bag and therefore we need to nationalize”? Obviously we are in the same boat, because the new plan may cause an “accounting problem.” Like insolvency. That is, in fact, a problem, no argument from me. Apparently, though, the Administration’s solution is a suspension of accounting rules. Translation – we are going to try to hide the problem.

As if investors won’t see through that mirage because all of you traders are clearly slow witted. Again, Bank of America already plumbing the depths…

Why are we here? Why, months after TARP, are we still not willing to dig down in the balance sheets of troubled banks and disgorge the questionable assets once and for all? Why, with a new Administration, supposedly unfettered from the ideological positions of the last Administration? More from CNBC:

The latest developments come as Congressional support for the bad bank concept and additional financial support for the financial sector is fading.

In a news conference Wednesday afternoon, House Speaker Nancy Pelosi (D.-Calif.) said she was "not so sure" that another bailout request from the Obama administration is inevitable, reversing an a previously-held assumption.

Sen. Charles Schumer (D-NY), a senior member of the Senate Banking Committee, Tuesday joined the bad-bank skeptics, telling CNBC the approach would be "hugely expensive" and added he prefers government guarantees of such assets.

Congressional Democrats, led by House Financial Services Committee Chairman Barney Frank (D.-Mass.)  have shared with the new administration their anger and disappointment over former Treasury Secretary Henry Paulson’s administration of the TARP program, which was seen as too generous to and too lenient on Wall Street firms.

The financial crisis has been so mismanaged that the public will not support package with a high price tag, a price tag that could climb into the trillions. And there is no way to even bring the issue to the public unless taxpayers effectively buy troubled banks, which can only be justified after first wiping out shareholders and bondholders. Then the bad assets could be rooted out once and for all. But this Administration appears no more willing than the last to consider temporary nationalization. They either do not want to own banks (I don’t blame them), or they are in too deep with Wall Street interests to upend the status quo.

We used to wonder aloud at the intransigence of Japanese policymakers. How could they allow their banking system to deteriorate? Why not take decisive action? Now we know: Fettered to an adherence to the status quo and an aversion to the concept of nationalization, the political will to attack the problem head-on is overwhelmed by the enormity of the financial crisis.

On a final note, the Administration still appears to selling the package with this line:

Both approaches are meant to spur new lending by banks.

And more from Bloomberg:

Earlier today, Senate Banking Committee Chairman Christopher Dodd urged the Obama administration to redesign the financial-rescue program to ensure that banks receiving aid increase lending and restrict salaries.

In the current environment, I can only imagine this is a pipe dream. The survey of loan officers shows clearly that while standards are tightening, loan demand is dropping off. Moreover, as the recession deepens and job losses mount, credit quality is deteriorating and loan losses increasing. Balance sheets are only coming under more pressure from rising credit card delinquency and expected downgrades of CMBS. Administration officials may find this hard to believe, but you cannot fix the banking system by encouraging banks to make more bad loans. And the number of opportunities to make good loans is rapidly drying up. If we sell this to the public – again – as the fix that will increase lending, there will be either massive disappointment or an effort to obfuscate balance sheets (since we are apparently ready to suspend accounting rules anyway) so that it appears government funds are being used for new lending (as if money was not fungible).

Geithner is slated to announce the new plan next Monday, February 9. Perhaps the final plan will be bolder than early reports suggest. And I can always hope that I am dead wrong and the “ring fence” concept is a spectacular success. But at this point, I am not optimistic...the Japan scenario is looming larger in my mind every day.

Fed Watch: More Will They or Won’t They or When Will They

Tim Duy:

More Will They or Won’t They or When Will They, by Tim Duy: Thursday’s action in the Treasury market – which saw the yield on the 10-year bond leap 18 basis points – has triggered another debate of when will the Fed begin wholesale purchase of Treasuries to hold yields close to zero and openly expand the monetary base. John Jansen thinks it is only a matter of time:

One trader noted, and I concur, that traders are now engaged in a game of financial chicken with Federal Reserve as traders attempt to force the Fed’s hand. The Fed has no desire for higher rates and the higher rates defeats the intent of the myriad of plans it has implemented to fight the financial crisis. I do not know what level on 5 year or 10 year notes would invite Federal Reserve coupon purchases. However, in this fragile environment such a level does exist and I think that the street will now probe to discern that level.

And more:

The Federal Reserve has purchased several hundred billion mortgages and is significantly underwater for all its efforts. They have bought big chunks of FNMA 4s between 100 and 101. Those bonds currently trade around 99.

I mentioned in the preceding post that I thought that the street would force the Fed’s hand regarding purchases of Treasuries. The debacle in the Treasury market has erased the gains in the mortgage market. The Fed will not wait long to buy Treasuries as dilatory action will only lead to higher mortgage rates.

Earlier I wrote that the Fed’s last statement, however, appears to say that the Fed is not yet targeting the level of long rates. Instead, the Fed, using the asset side approach to balance sheet policy, is only interested in outright Treasury purchases if deemed supportive of maintaining normal credit market functioning. On this point, CR revives his series on credit crisis indicators, and concludes that we have already seen significant improvement. Moreover, his chart of the yields on the 10-year Treasury reminds us that Treasuries remain at historically LOW levels, and could rise quite a bit and still be “low.” Another sign of normality:

The difference between 10-year Treasury Inflation Protected Securities and nominal Treasuries rose to one percent for the first time in more than three months as traders brace for government-induced inflation.

As markets heal, we would expect investors to move out of low-yield risk-free assets and into other, higher yielding assets, thereby improving yield spreads. A rise in the 10-year Treasury back to 4%, in such an environment, should be seen as a welcome indication of improving financial health. But that might entail rate increases in some consumer loans as well, including all important mortgages. Therein lays the conundrum – if markets conditions normalize, will the Fed breath sigh of relief, pat themselves on the back, and walk away? Or will Fed Chairman Ben Bernanke climb aboard his helicopter?

Moreover, we have been working on the assumption that governments around the world can turn the fiscal faucets on full blast because there are endless amounts of excess saving that can be sucked up and put to productive use. I would not throw away that story just yet; I think in a normalizing financial environment rates could back up to 4% without cause for alarm. But the US government alone is asking markets to absorb an ever rising amount of debt. And the US still runs a current account deficit, meaning we still need external financing resources. So I would not be surprised to see rates start to rise; I have said before that the key to getting fiscal stimulus right is listening to the market signals; if rates start moving steadily upward beyond 4%, authorities should carefully consider the possibility that they have gone overboard.

If rates are rising simply due to financial healing or obvious strains on the capacity of the debt markets to absorb endless trillions of US debt (which, by the way, would be something of a surprise given the steady willingness to absorb seemingly endless debt since the Reagan Administration), the room for policy error is great. If the Federal Reserve chooses to lean against the market and start effectively monetizing fiscal spending, I think we could all agree that we would be moving into an inflationary environment. Sell the Dollar, buy commodities. On the upside, some serious inflation would reduce the debt overhang in real terms.

Note that I am not saying we are at this point; it is just one risk in a range of possibilities. A fresh bout of financial fever could send rates back toward the 2% mark, and that would end this story entirely.

In short, the Fed opened something of a can of worms by offering up Treasury purchases as an option in the monetary policy arsenal – they left open the question of what would trigger them to use that weapon. Only if necessary for the smooth functioning of financial markets? Or to hold rates artificially low? By my read, the most recent statement suggests the former. But I will also be the first to admit that Bernanke has tended to error on the side of more policy is better.

Fed Watch: Quick Note on the FOMC Statement

Tim Duy reacts to today's statement from the FOMC:

Quick Note on the FOMC Statement, by Tim Duy: Many will parse today’s FOMC statement; I will keep my comments focused on the sentence:

The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

Conventional wisdom has that any Fed action to purchase longer-term Treasuries would be done with the intent of holding interest rates low, thereby stimulating economic activity. That, however, is not the implication of this sentence. Instead, the Fed views Treasury purchases only as a mechanism to support effective functioning of credit markets, which suggest that the Fed is not worried about controlling the level of longer term interest rates, but the spread between Treasuries and other assets.

This also suggests that the Fed is not particularly interested in expanding the balance sheet further via Treasury purchases. They may be willing to, but I am not sure how Treasury purchases will improve market functioning. To date, improving credit market efficiency has meant purchasing or holding as collateral risky assets, or even safe assets that the market currently shuns, not riskless Treasuries. What factors would cause a reversal of that position?

Moreover, one should also question the willingness of the Fed to fight against rising interest rates if those rising rates were the result of a shift to riskier assets and credit spreads fell to more normal levels. Presumably, this would correspond to a loosening of credit conditions, which in and of itself would be stimulative even if rates edged upward.

In short, as long as the Fed is focused on the issue of improving credit markets – what they view as the asset side of the balance sheet – they are not likely to engage in Treasury purchases that effectively shift policy to the liabilities side of the balance sheet. This shift, however, is what Richmond Fed President Jeffery Lacker wants to see:

Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

Lacker views the Fed’s adherence to its asset side approach as an encroachment on the role of the fiscal authorities (not to mention a power grab by the Board). He would prefer the Fed conduct straightforward monetary policy – drive up the monetary base, effectively monetizing deficit spending. His colleagues are not there yet.

Fed Watch: Passing the Baton

Tim Duy:

Passing the Baton, by Tim Duy: The Federal Reserve will offer up the results of its two day meeting this afternoon. It is hard to find much to argue with Rebecca Wilder’s conclusion that not much has changed in the past six weeks, and hence we should expect little from today’s statement. CR opines on the possibility that Bernanke & Co. might update us on their evaluation of the potential benefit of purchasing longer dated Treasuries. Economists at Merrill Lynch suggested earlier this week the Fed may be forced to pursue that option sooner rather than later if yields keep rising (although some think that bonds are about to make a technical turn in direction anyway).

It seems, however, that outright purchases of Treasuries to hold rates lower would shift the Fed’s attention from the asset side of the balance sheet to the liabilities side, which would put them in the realm of their definition of quantitative easing. It doesn’t seem like they are quite ready to go there; just six weeks ago they made an effort to differentiate between their policy and Japanese style quantitative easing. Seems too quick for a reversal given the relative calm of credit markets since the December meeting. Given the lack of Fed preconditioning to expect a significant policy shift, today’s statement is not expected to move markets, and will be carefully dissected to see how, if any, the Fed’s view of the economy or credit markets have changed.

So what now is the ultimate intention of policymakers? What do they hope to accomplish?

Fed Watch: Short Takes for January 11, 2009

Tim Duy:

Short Takes for January 11, 2009, by Tim Duy: I am running low on time these first few weeks of the term. Bits and pieces of things I am worried about:

On the employment situation report: Mark catalogued links to a host of insightful commentary that pours over the details of this decidedly negative report. The headline figures tell a brutal story, with ongoing steep declines in payrolls and aggregate hours worked pointing to a sharp contraction in economic activity in the fourth quarter. Internal details are even more painful, with the number of part time for economic reasons skyrocketing, one factor pushing the U-6 measure of unemployment up almost a full percentage point to 13.5%. Moreover, the diffusion indexes (for one month, 25.4 in December for all industries, just 11.3 for manufacturing) reveal the staggering breadth of this downturn; outside of health care, virtually no sector is spared some pain. Finally, further declines in the temporary employment sector point to more reports like this one in the months ahead.

On consumers: Wednesday, we see retail sales numbers for December. It is not expected to be pretty; the holiday season is widely believed to have been the final straw for an array of retailers – see the WSJ story here. A rough estimate based on confidence numbers suggests to me that real PCE continued to run at a rate of negative 1% or so in December, a swing of roughly 4 percentage points from spending growth prior to the recession. The positive impact of lower energy prices ran up against the forces of joblessness and increased saving rates (household deleveraging). The latter two dynamics remain in play in the months ahead, whereas energy prices might not have much further to fall. To some extent, an increase in refinance activity should step up to compensate for any stagnation in energy prices, but I am not expecting any miracles, especially since, at least as of the third quarter, households had yet to significantly deleverage their balance sheets significantly:

While tracking at a sustained 1% decline in real spending is bad enough, odds are for further deceleration – I suspect that household deleveraging in the years ahead will amount to more than a trillion dollars of foregone consumption. Business models that relied on consumer spending, particularly luxury spending (from RVs to $600 pairs of shoes) are going to suffer greatly in this environment.

On international trade: The sustained weakness in consumer spending points to a massive amount of import contraction, a supposition supported by Brad Setser’s article today on Asian export growth (or non-growth). This, however, might not yet show up significantly in tomorrow’s release of the US monthly trade accounts for November. Of course, if you were concerned that the trade deficit would eventually need to correct, you were likely looking for import compression as one mechanism supporting that correction. And the faster the adjustment, the greater the degree of import compression. Unfortunately, the fastest way to get people to stop spending on imports is to put them out of work – which is where we are now. The dynamics have not played out as I expected, but the end result appears to be the same: There is no way out of this mess without a reduction in the standard of living for US households. Making the situation even worse is the inability of the world to break with the US dynamic, which means that rather than cushioning declining domestic growth, exports are likely aggravating domestic conditions. And the export decline is complicating predictions concerning the one potential silver lining – that at the end of this mess the US external accounts would be closer to balanced.

On fiscal stimulus: Lots of commentary on the incoming Administration’s spending plans; once again, Mark is keeping tabs. Given growing estimates of the output gap, there is substantial concern that the early numbers are woefully insufficient to meet the economic needs of the nation. The concern is accentuated by the large tax cut component of the package, which is widely expected to have little bang for the buck. Menzie Chen argues that, contrary to concerns about enough shovel ready projects, there is plenty of room for infrastructure stimulus given the depth and duration of the expected output gap. And Nate Silver suggests that the early numbers are lowballing the expected final figure to gain a strategic negotiating advantage. My take is that the current numbers, especially with a large tax cut component, are likely to pop the data in the second half of the year relative to the baseline. It is a lot of money. Behind that pop, however, the size of the package, and the timeline, are woefully insufficient to fix the economy. It took us almost three decades to get into this mess; it will take decades to get out. While Menzie is right, there is plenty of scope for infrastructure projects, they need time and planning; if the Obama administration tries to rush such projects, they will be vulnerable to charges of waste, fraud, etc. But they need to do something to get a floor under the economy now to provide hope that they can get the job done over the long haul. Hence, we get a policy that is more of the same – tax cuts. Quick to implement with bipartisan support, but with, I suspect, few lasting effects – especially given the newfound predilection for saving. Why we don’t get more safety net expansions, however, is still a mystery to me. Seems like an easy way to use existing program to quickly get money to those in need – and those who will spend.

On what should the little guy invest do with their 401(k)s. According to the Wall Street Journal, Americans are losing faith in the 401(k) system of retirement savings. I count myself in that group – the draw has not been good this decade for those following the rules:

Even if workers follow the golden rules of 401(k) investing -- saving early and diligently, holding a broadly diversified investment mix, never tapping their savings until retirement -- their success can still depend largely on the luck of the stock-market draw.

I would be willing to bet that the average person would sacrifice liquidity (money trapped in retirement accounts) to simply earn something like a 6% nominal return (assuming a real return closer to 4% or so) and avoid the headaches and stress of managing their own retirement portfolios. For the foreseeable future, however, if the Fed sees such a yield, they will want to snuff it out. So what are your ideas? What should I tell people who ask this question? Assuming you stick with a base 401(k) contribution for the tax benefits, where do you put extra retirement money? My recent answer – feel free to offer alternatives – is to pay off your mortgage, which earns a guaranteed return (admittedly, there are some tax considerations, as well as the issue of walking away if you are seriously underwater). An interesting question – does a low interest rate environment really encourage taking on debt and spending, or the opposite? I recall in the 1980s people would take out high interest mortgages (the cost of housing was much lower, and as such still affordable), but then work to pay off the mortgage as quickly as possible. Under what conditions could a low interest rate environment create similar behavior?

Enjoy your week – good luck.

Fed Watch: Starting on an Ugly Note

Will the economic recovery package will be too "fleeting":

Starting on an Ugly Note, by Tim Duy: The only certainty for the New Year is that policymakers will continue to pull out all the stops to keep a floor under the US economy. And recent data highlights the difficulty they will face. Hope is high that the incoming Obama Administration can provide the stimulus necessary to generate economic growth by the second half of 2009. The numbers being floated look sufficient to do the job. But will the package provide little more than short term relief or a lasting fix?

The last two weeks were not pleasant. Working backwards, we were greeted on the first trading day of the New Year with a truly terrible report on manufacturing. Across the Curve has the details; my eyes were pulled to the decline in the export orders component. The external accounts should be cushioning the US downturn. Instead, it looks increasingly likely the opposite will happen – another sign that the global economy is hopelessly imbalanced.

Earlier in the week, the Case-Shiller index confirmed the expected ongoing decline in housing prices. Efforts to support this sector have proven insufficient to stem the pain. This should not be a surprise, as government efforts have focused on maintaining a market for mortgages made under conditional underwriting standards. Such standards limit home financing to that which is prudent for the borrower and lender, but well below that necessary to maintain housing prices. Moreover, lending for home purchases (and consumer credit in general) is now fighting against a deteriorating labor market. I don’t care how much money has been spent on TARP, you can’t reasonably expect banks extend fresh credit to the jobless. And there is no mistake that the floor is falling out from under workers. Look at the employment component of the ISM report. Or the recent trend in initial employment claims, with a four week average of 552k; discount the seasonally affected drop last week. This Friday is likely to see another blowout employment report.

New orders in durable goods report were better than expected, although I take little comfort in the improvement. The numbers tend to be volatile, and the ISM release noted above strongly suggests this indicator will trend lower in the months ahead. The personal income and outlays report was also better than expected as falling gas prices provided a significant boost to real incomes. But the downside in oil prices is likely limited at this juncture, and, consequently, gas is not likely to provide as much of a boost in future months. Moreover, the declining energy costs are fighting against rising joblessness and increasing saving rates. The latter two forces are likely to prove overwhelming.

Given the rising sense of despair, policymakers will continue to fall over themselves in a mad rush to pump massive amounts of stimulus into the economy. On the monetary side of the equation, traditional policy is obviously at its end. We are left with efforts to sustain lending activity that are asset-side directed expansion of the Fed’s balance sheet while waiting for economic conditions to deteriorate enough that the Fed officials switches to quantitative easing, or policy directed toward the liability side. Yes, I know, two sides of the same coin, but the Fed appears to view those sides differently.

Until the Fed shifts gears again, fiscal policy will be the main event. And quite an event it is likely to be, with estimates that the final package will be as high as $1 trillion. That is real money that will soon start flowing into the economy, and it is difficult to see how it does not have a measurable impact. We can all respectively debate the long term effectiveness, the impact on job growth, the ultimate cost, etc., while still acknowledging it should provide significant support to the economy. The near-term risk, I think, to bonds is that it is enough support that Federal Chairman Ben Bernanke does not leap into outright purchases of Treasuries (a liability side maneuver). This does not imply that the stimulus “fixes” the US economy, just that at a minimum it should delay the most bearish day of reckoning.

The structure of the upcoming fiscal stimulus will determine whether this is money wasted trying to sustain a broken consumer/debt driven economic model or on investments that foster future economic growth. I was heartened two weeks ago by incoming head of the National Economic Council Larry Summers:

Fed Watch: Zero, But Not Quite Quantitative Easing

Can the Fed's current policy be described as quantitative easing?:

Zero, But Not Quite Quantitative Easing, by Tim Duy: On the surface, the Fed’s recent statement should not have been much of a surprise. It was remarkably consistent with Fed Chairman Ben Bernanke’s recent policy speech. And it leaves little illusion that the US economy is mired in anything but the worst recession since the Great Depression.

My takeaways from the statement were straightforward:

1.) Since the effective funds rate was trading well below the Fed’s target, and it was economically unimportant in any event, just take the target to a range near zero. I assume that given the instability of financial markets, they thought it best not to prescribe a specific target, but a range instead.

2.) The Fed committed to low rates indefinitely, giving market participants faith that they can extend Treasury purchases further out along the yield curve without fear of a sharp policy reversion in the near future. (Does the Fed’s commitment to low rates leave Treasuries as the last one way bet?)

3.) Not surprisingly, economic weakness, not inflation, is the primary concern. There is no reason for near term optimism.

4.) Policy will focus on the tools that reveal themselves in the Fed’s balance sheet. Those tools may be expanded to include outright purchases of longer dated Treasuries.

The final point is worth considering further, especially since the Fed brought forth a “senior Fed official” to elaborate on the statement. I don’t quite understand the need for secrecy – why not have Bernanke himself just step up to the plate? In any event, the secret official took pains to explain that this policy did not constitute quantitative easing. First, the statement:

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.

What struck me on the first read was the commitment to maintain the balance sheet at a high “level.” I think the use of the word “level” was deliberate – quantitative easing implies a commitment to a steady expansion, or rate of change, in the balance sheet. The Fed is offering no such commitment at this time. Is this the proper interpretation? From the senior official:

The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing — effectively expanding the money supply once interest rates cannot be eased further — as Japan did during its economic turmoil.

But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did.

What, stop….the arrogance of Fed officials never ceases to amaze me! Note that this official accuses “[S]ome analysts” as misinterpreting the Fed’s policy stance. I have written on this in the past:

…What we have now is an expansion of the balance sheet to accommodate liquidity measures. This may pave the way to quantitative easing, but still maintains the Fed Funds rate as the primary target.

But then why do they keep saying they have a policy of quantitative easing? This first crossed my radar when reviewing a recent interview with Dallas Federal Reserve President Richard Fisher. I discounted his reference to quantitative easing as Fisher is something of a colorful character who often talks before he thinks. But subsequent policymakers repeated the term. Earlier this week New York Fed President Gary Stern was quoted by Stephen Beckner:

Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement. I think the world is a little more complicated than that, but I don't think that's a bad statement."

So, just to be clear, it is not just “some analysts” who are confused by the Fed’s policy – the confusion spills over to Fed policymakers as well. Maybe analysts would not be confused if Fed officials would simply stick to one set of talking points.

According to the official, we are not in the realm of quantitative easing. What is the distinction?

The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.

Fed policy has been directed at improving credit market functioning, thereby acquiring assets, of which the expansion of liabilities is simply a side affect of the policy, not the policy itself. The Fed apparently views deliberate expansion of liabilities – a commitment of x% percent growth in some monetary aggregate via Treasury purchases – as quantitative easing. A commitment to increase the balance sheet at a steady pace (the first derivative) rather than maintain a high level. We are not there yet.

Is this distinction important? Or just semantics? I believe it is important, as the latter, a move to target the liabilities side of the balance sheet, would imply that the Fed is deliberately trying to stoke an inflationary fire. This may become the future policy, but for now the Fed is simply trying to keep the financial system from collapsing. Inflation would be an accident, not a deliberate policy effort, at least from the Fed’s point of view. For the moment, the policy remains insufficient to ward off deflationary pressures long as the rest of the world refuses to accept the burden of global adjustment.

The problem, in my mind, is that the rest of the world either refuses or is simply incapable of shouldering some of the burden of global adjustment. This inability to adjust appears to be the end result of almost thirty years of global acceptance and US indifference to external imbalances. Global consumption and production patterns, both spacially and intertemporally, are so misaligned that it looks like we are all now in a race to the bottom together. An amazing global policy failure. So, so depressing.

So when does Fed policy truly become inflationary? Currently, I am thinking it becomes inflationary when policymakers become desperate enough to attempt to use monetary policy to entirely offset the headwinds blowing against economic activity. When they truly attempt to target asset prices to “fix” the housing market. When they decide the easiest answer to the excessive build up of debt is to inflate it away. At that point, policy will shift from the asset side of the balance sheet to the liability side. That is when Treasury and the Fed will risk a disorderly adjustment of the Dollar. Hopefully we will not get there. But I suspect that is when the tide will turn for the Fed.

Fed Watch: What If the Analogy is Wrong?

Tim Duy is worried that "the Fed the Fed and Treasury are setting the stage for a disorderly adjustment of the Dollar":

What If the Analogy is Wrong?, by Tim Duy: I say this with no exaggeration: The picture painted by the data flow of the past two weeks is deep into the left tail of any of my reasonable distribution of probable economic outcomes. The die is now cast – fiscal stimulus will be too late to prevent the snowballing that will occur throughout the first half of next year. In this environment, policymaking will become increasingly desperate.

The free fall in economic activity reported by the ISM in both the manufacturing and nonmanufacturing sectors yielded the worst for the labor market. There is no way to candy coat the November employment report. It was simply dismal; downward revisions to the previous month boosted the sense of dread that emanated from the BLS release. And the damage to labor markets appears to be accelerating, with the rise in initial jobless claims last week pointing toward a December job loss of 600k or more. Expectations of rising headline unemployment rates can be tempered only by defections from the labor force; I would not be surprised to see the broad U-6 measure of unemployment coast through 15% before the first quarter is over.

With the labor market in disarray, the Fed will feel compelled to do more, as only they can deliver stimulus in the near term. The FOMC begins a two day meeting tomorrow, with a further 50bp of rate cutting almost certain. Also almost certain is that no one believes that the last 100bp has much stimulative power to offer. The rate cut itself, thus, is largely irrelevant. What is relevant is the statement – will the Fed more explicitly define their apparent policy of quantitative easing? Federal Reserve Chairman Ben Bernanke’s recent speech set up expectations that such a shift was coming. Failure to follow through would be yet another communication failure.

I am torn on the wisdom of this move. On one hand, using the Great Depression as a guide, the appropriate policy direction appears clear – flood the markets with liquidity, coupled with massive fiscal stimulus. This is the track the policy train is on. I completely understand this policy in a closed economy suffering from insufficient demand relative to supply. But when faced with a large open economy with a substantial current account deficit, the back of my mind screams “caution.” It is an itch I can’t scratch.

In my view, policymakers tend to see the current account deficit as almost an unimportant residual, something that just falls out of the global economy, but tells you little about the economy itself. I tend to view it as representing a fundamental imbalance. I believed that as part of the adjustment of the past year, a combination of import compression and export expansion would eliminate the imbalance, and that the appropriate role of policy was to facilitate and cushion that imbalance.

Fed Watch: Potentially Very Bad Policy

Tim Duy does his best to shoot down the trial balloon Treasury floated yesterday:

Potentially Very Bad Policy, by Tim Duy: Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week. ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. TheBeige Book provided grim anecdotal evidence consistent with the data.

Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.

In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, US Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant. Quietly watching while the US current account deficit expanded validated the global perception of the US as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s off-balance sheet entities have raised more questions?

In all honesty, I hold Geithner and Summers less to blame for the aftermath of the Asian Financial Crisis than the Federal Reserve. Arguably, they never had the chance to offset the negative outcomes of their crisis management efforts; the stage was soon taken over by the Bush Administration, which set about eviscerating Treasury. And it is to Geithner’s credit that while at the helm of the New York Federal Reserve he tried to get ahead of the challenges in the CDS market. Overall leadership at the Federal Reserve, however, should have worked to correct the moral hazard they infused into the financial system.

This is not to deny the importance of crisis management, but to point out that when the crisis is over, you need to be able to correct for the excesses of your actions. With that in mind, crisis managers need to be wary of taking actions that they cannot revoke when necessary.

Which brings me to the trial balloon Treasury floated today; leaking plans to stem the decline in the housing market:

The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency. Once the federal government defines a right to low rate mortgages, they will find it very hard to reverse their position. (The Treasury may think they can make an arbitrage profit now, but just see what happens when the relative yields flip.) Why? Because at some point in the future, revoking the right will create classes of winners and losers, especially if it results in a steep rise in mortgage rates. And the losers will fight tooth and nail to prevent that rise; just imagine the army of lobbyists from home builders and realtors that will descent on Washington. (Separately, Calculated Risk questions whether or not the Treasury can meaningfully impact housing prices via the rate mechanism.) Moreover, it seems difficult to imagine that this program can be limited to those buying a home; why should those seeking to refinance be excluded? Wanting to stay in your own home is something the government should discourage?

The Fed has already stepped onto this dangerous ground by announcing plans to bring down mortgage rates by buying agency debt in large quantities. A reversal would threaten their political independence (which perhaps was lost long ago). To be sure, the Fed has always altered interest rates as a tool of monetary policy, and rate increases have always drawn the ire of politicians. But the Fed could always argue that the impact on home mortgages was simply an indirect consequence of their efforts to stem inflation in the economy as a whole. Now their actions are directly targeted at housing itself; they have announced they have the power to set mortgage rates. Politically, this is very different. At some point in the future, interest rates will need to rise, and I worry at that time the Fed will learn just how hard it is to taken away what Americans view as a God given right – government support for the housing market. Just think about trying to take away the home mortgage deduction.

Perhaps I worry too much. Perhaps it really will be temporary. Consider, however, who is behind this proposal:

The Treasury plan is similar to ideas previously floated by the National Association of Realtors and the lobby group for home builders...

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many). The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.

Final thought: Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the US government. Then when mortgage rates needed to rise at some point in the future, neither agency would have to take responsibility for the resulting damage to the housing market. Simple versus complicated.

Fed Watch: A Step Towards Explicit Quantitative Easing

Tim Duy thinks about where the Fed is headed next:

A Step Towards Explicit Quantitative Easing, by Tim Duy: Dull times these are not – Monday was another whirlwind that culminated with another steep drop in equity markets, despite clear indications that Bernanke & Co. are ready for a broader campaign of quantitative easing.

The day brought more recession news, of the official variety as the NBER declared the recession began in December 2007. My own estimation was closer to the middle of this year, consistent with the research of our colleague Jeremy Piger, but differing with the NBER is pointless. Typically, I would take an odd comfort in the NBER’s declaration, thinking that it would presage an end to the recession in the near future. In the current environment, such comfort is lacking as data that we typically see closer to the beginning of recession is just emerging. Case in point – the steep drop over the past three months in the ISM index. As expected, the low headline reading of 36.2 for November pretty well summarizes the sad state of US manufacturing. Moreover, the details were weaker almost across the board. About the only good take away is that it can’t get much worse. Maybe. Hopefully.

The early news provided an appropriately sanguine backdrop for the speech delivered by Federal Reserve Chairman Ben Bernanke. The Fed chief summarized the near term outlook with a simple paragraph:

The likely duration of the financial turmoil is difficult to judge, and thus the uncertainty surrounding the economic outlook is unusually large. But even if the functioning of financial markets continues to improve, economic conditions will probably remain weak for a time. In particular, household spending likely will continue to be depressed by the declines to date in household wealth, cumulating job losses, weak consumer confidence, and a lack of credit availability.

This is an outlook that calls for additional easing, but of what variety? Bernanke admits what all realized long ago:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.

With traditional policy at an end, Bernanke provides a glimpse of his next moves:

Fed Watch: New Month, New Data, Same Story

Tim Duy says the Fed needs to be more definitive about the type of policy rule it is following:

New Month, New Data, Same Story, by Tim Duy: The new month brings forth fresh data to gauge the health of the US economy. But no one expects the patient to wake from his coma just yet. Indeed, the deluge of depressing data will likely prompt the Fed to cut the Fed Funds target at least 50bp, although it is not obvious that anyone believes further cuts will have any practical impact at this point. As the Fed repeatedly proves, the action is on the balance sheet side of policy. And even there, monetary policymakers are now fighting a rearguard action, simply trying to prevent the financial tailspin from taking the economy further into the abyss.

The data flow during the last two weeks of November was nothing but bleak; the numbers speak clearly of a deepening recession. If you had any doubt that the credit crunch is causing firms to shelve capital expenditure plans, you had only to look at the durable goods release. New orders of nondefence, nonair capital goods slid 4% in October, extending what is now a three month decline. This number also likely reflects slowing export activity as the global slowdown pulls one of the last rugs out from under the US economy. Not surprisingly, regional surveys suggest manufacturing weakness extended into November, a hypothesis that is likely to be confirmed by this morning’s ISM report. The question is not whether the report will be bad; it is how bad it will be.

The underpinnings of consumer spending continued to deteriorate as well. Via the Case-Shiller numbers, we learned what most suspected - housing prices continue to decline seemingly unabated in September, a decline that likely reflects only the early stages of the most recent phase of the credit crunch. The Fed made an attempt to lean against this trend, announcing a plan to purchase agency debt in an effort to pull down mortgage rates. This will provide some marginal support to housing, if at a minimum by raising affordability slightly, but I doubt anyone expects it to work miracles. A larger impact is likely to come through the reported wave of refinancing the Fed’s action triggered – support for those who are not underwater on their mortgages.

Still, any refinancing gains, which extend the boost from lower gas prices, will be fighting against rising joblessness. Indeed, jumping initial claims in November foreshadow a dismal employment report Friday. The weight of the deteriorating labor market is revealed by the October Personal income and Outlays report; revised figures on private wage and salary disbursements revealed stagnant income growth. The multiple weights on consumers – housing markets, inflation in the first half of the year, declining equity markets, higher unemployment, and reduced access to credit – finally broke the fabled US consumer, with personal consumption expenditures now down for five consecutive months.

As household balance sheets deleverage, saving rates are edging up, rising from 0.6% in August to 2.4% in October. Ultimately, a sustained rise in household saving rates works to the benefits of households, providing an economic cushion, etc. In the short run, however, it plays havoc with the economy, especially if firms too are postponing spending. A simple, yet powerful argument for fiscal stimulus – the credit crunch in the second half of the year has opened a gap in activity that the federal government can reasonably fill. Being a deficit hawk is unproductive now; if the stimulus is too much, financial markets will send the appropriate signal via higher interest rates. Policymakers just need to listen; in theory, policy should be able to pull back if necessary.

Fed Watch: Policy Adrift

Tim Duy lets loose:

Policy Adrift, by Tim Duy: I understand the Federal Reserve Chairman Ben Bernanke is considered something of a sacred cow, our one point of light in an uncertain world. An academic who cannot be questioned by other academics. A smart person who has mastered the Great Depression and therefore “knows” what to do, and is providing the leadership to do it.

I am beginning to question all of these assumptions.

I am hoping Bernanke can step forward and clarify the direction of policy. At this moment, he has the best perch from which to guide policy between administrations. He has the opportunity to show leadership. But for now, I see a distinct lack of leadership from the Federal Reserve, and it suggests that Bernanke has used up his bag of tricks. And I don’t think that he knows what to do next. Indeed, Fedspeak is now littered with confusing statements that leave the true policy of the Federal Reserve in question.

First, policymakers appear uncertain about what to do with the Fed Funds target. The minutes of the most recent meeting tell the story:

Fed Watch: Misguided Policies

Tim Duy:

Misguided Policies, by Tim Duy: From the wires:

15:30 *PAULSON SAYS MARKET TURMOIL WON'T ABATE UNTIL HOUSING REBOUNDS

Such comments always leave me with a sick feeling in my stomach – if policymakers are waiting for the housing market to rebound, they had better be prepared for a long wait. Sort of liking waiting for the NASDAQ to revisit the 5,000 mark. I think the biggest potential for policy error lies in maintaining the delusion that preventing housing, and by extension, consumer spending, from adjusting is central to fixing the nation’s economy. Policy would be best focused on supporting the inevitable transition away from debt-supported consumer dependent growth dynamic.

Housing prices are falling because fundamentally the price of housing became unaffordable. The stream of expected household income necessary to repay the loans exceeded the capacity of household budgets. It is that simple – there is no sense in paying $3,000 a month in mortgage payments on property with the rental equivalent of $1,000. To be sure, a homeowner could justify such a purchase as long as they thought they were guaranteed a 15% annual risk free return. But who, other than realtors and mortgage brokers, remain under that delusion?

Similarly, I find programs that purport to “help” homeowners by reducing their mortgage payments of questionable value. Lowering your mortgage payment to 38% of income might sound like a good deal – but if you have no equity, you do not really own anything. You are just a renter by another name. So if your final mortgage payment significantly exceeds the rental equivalent, has the government really made you better off? And if, as I suspect, homeowner bailouts will not stem price declines, the program recipient could soon find themselves with negative equity again in a matter of months. If you really wanted to help underwater homeowners, you would bring their payments in line with the rental equivalent. I suspect this would be extremely costly.

That housing prices will ultimately return to some conventional relationship with incomes does NOT imply that the government has no role in supporting the housing market. The government’s role is simple: to take actions that ensure that persons who can afford a mortgage remain able to do so. The Federal Reserve and Treasury need programs that allow creditworthy borrowers access to credit. This justifies the takeover of the GSEs, and even justifies pouring billions of dollars into them to ensure that the family earning $60k a year is able to get the mortgage for a $200k home.

The problem for housing prices, of course, is that two years ago that same family could purchase a $400k home. Unless policy is expanded to encourage such loans, then the supply of funds is no longer available to support $400k homes. If policy is redirected toward such a goal, then the government, and ultimately the taxpayer, will take on additional credit risk in one form or another. There will be pressure to use the GSEs in this fashion. Consider this proposal, via the WSJ:

As part of an industry proposal called "Fix Housing First," builders are asking Congress for a tax credit of up to $22,000 on houses bought over the next year and an interest rate buy-down that would reduce rates on new, 30-year fixed mortgages to 2.99% for houses bought through June 30, 2009. The proposal could cost up to $268 billion, according to the National Association of Home Builders, though the group may scale it back.

Thirty year money costs the US Treasury 4.2%, so obviously the taxpayers is expected to make up the difference. I suspect this proposal would cost vastly more than $268 billion, as it would ultimately be expanded to refinancing as well. Why shouldn’t those of us who want to stay in our homes be on the same terms? Moreover, can anyone imagine that the government could end such a program? Might as well hope for the mortgage interest tax deduction to be eliminated. I can see that a guarantee of ultra-low interest rates would support the housing market, but I don’t see how the resulting massive unfunded liability could be supported with anything less than outright monetization of deficit spending.

In a similar vein, we are seeing increasing interest in support consumer access to credit. Treasury Secretary Henry Paulson today announced that TARP is no longer about troubled assets:

Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit.

Again, policy should rightfully focus on maintaining credit to the creditworthy. But we should draw the line at encouraging lenders to make risky loans. The Federal Reserve has the right idea:

At this critical time, it is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met. As discussed below, to support this objective, consistent with safety and soundness principles and existing supervisory standards, each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention, and reassess the incentive implications of its compensation policies.

Unfortunately, I suspect such jawboning will have little impact. With consumers already overextended, the room for rapid credit growth is simply limited. Moreover, with economic activity deteriorating and unemployment rising, the number of creditworthy borrowers is falling. This comes on top of the deleveraging already underway in the financial sector. The Fed and Treasury are able to do little but prevent the banking system from outright collapse.

Simply put, policies focused on housing and consumer spending are a black hole for spending – this summer’s short-lived stimulus package is a case in point. Policymakers need to come clean with the American public: Future patterns of growth will simply be less dependent on consumer spending. We are entering a period of structural adjustment, and it will be painful. We spent decades pretending that the relentless focus on producing nontradable goods and relying on a ballooning current account deficit to hide our lack of productive capacity was an appropriate policy approach. But ultimately, those policies have failed us, with stagnant income growth for median income families and the deepest recession since the 1980’s (or even worse).

This admission, however, in no way, shape, or form means policy options are limited. The admission simply defines your policy. In the short term, policy can cushion the transition by expanding the social safety net. In the medium term, if consumption is falling, and private investment is unable to compensate, then the federal authority should fill the gap. There is no shortage of sectors of the economy that offer opportunities for investment. In so many ways, we are running on the fumes of the infrastructure investment made by the last generation. Roads, bridges, channels, etc. – you name it, there is an opportunity. Or human capital, via education? Should the federal government finally step up and fund unfunded mandates? And by all means, continue efforts to reform health care, including the development of nationwide, portable medical records tracking. Reasonable policymakers free from ideological constraints can develop a host of potential projects without relying on bridges to nowhere. You can even extend the argument to supporting Detroit – if current management and boards are swept clean.

Can we afford these policies? For the moment, yes. I did not believe this in the first half of the year, as I though the global economy was running too hot to support substantial stimulus without an inflationary offset. That is no longer the case. If we reach a point we can’t finance the spending, financial markets will tell us. All policymakers have to do is listen and adapt. And I think it is much more likely that we can afford investment spending that yields productive assets rather than taking on the risk of refinancing the housing market at less than the cost of funds. Indeed, I think relentless focus on housing prices will lead to rash policies that could only be inflationary in the long run. After all, the key to supporting housing prices is simply to inflate nominal incomes.

In short, policymakers need to envision an economy in the future that is distinctly different from the past. Relying on the housing market to propel growth is a failed policy. Relentless upward leveraging to support consumer spending was not sustainable. Accept the failure, and move on.

Fed Watch: Bad to Worse

Tim Duy looks at monetary and fiscal policy options in light of an economy that continues to slide downhill:

Bad to Worse, by Tim Duy: From bad to worse is about the only way to describe the flow of data last week. With each new data point, the case for additional stimulus grows. But does the Fed have much room to maneuver before pursuing a significant shift in policy? And should we listen to those nagging concerns that the limits to US deficit spending are soon approaching?

Adding to the dismal manufacturing report early in the week, the ISM nonmanufacturing numbers confirmed what most suspected – the downturn has moved solidly into the service sector. The details were as weak as the headline, including a fresh drop in the employment measure. The latter set the stage for the weekly initial claims release, which unsurprisingly pointed to further deterioration in the labor market even as the jobless total climbed to the highest level in 25 years. The all important employment report only added to the gloom – a solid analysis from HBSC is available via Across the Curve, with more to read from Jim Hamilton. I would shy away from analysis that focuses on the relatively small percentage loss of employment, or minimize the consequences. From Justin Fox (hat tip Menzie Chinn):

The vast majority of workers remain employed--and will remain employed even if the recession deepens. Barring an unraveling of the financial system, they will eventually get back to spending at a healthier pace than in the scary month of October.

Justin Fox is apparently not worried about the economic consequences of having the U-6 broad measure of unemployment at 11.8%.

If the economy was still shedding jobs at less than 100k a month, and the losses were most sector specific, you could say that a relatively mild restructuring process was underway. That is no longer the case – the breadth and depth of payroll declines scream something much worse. Note also that these numbers are appearing closer to the beginning of the recession than at the end. It could and will get a lot worse before it gets better.

Fed Watch: Ugly Numbers

Tim Duy responds to the latest set of "ugly numbers":

Ugly Numbers, by Tim Duy: For many months, this was the recession that wasn’t, as many key cyclical indicators refused to roll over as expected. That is no longer the case, as virtually all data is headed down at an almost blinding pace. Today’s ISM release is a perfect example; the headline number made a key move well below 50 in September, and extended that decline to 38.9 in October to the lowest level since 1983.

The details were even worse.

The new order index plunged; only 13% of surveyed firms experienced an increase. Production and employment figures collapsed, the latter further evidence of what most expect – we can anticipate a series of very weak employment reports. The export machine that has sustained US manufacturing throughout the past year has also collapsed, victim of the widening global crisis. And while prices paid fell sharply again, the drop does not provide much confidence. It is a reflection in the same shift in global demand that is weighing on exports.

Changing fortunes in the auto industry no doubt contributed to the pain in manufacturing overall. Hit with a double whammy – an overextended consumer and credit crunch that walls out some of those remaining in the market – automakers reported a devastating October:

When adjusted for increases in the U.S. population, last month was "the worst month in the post-World War II era," Michael DiGiovanni, GM's top sales analyst, said in a conference call. "This is clearly a severe, severe recession."

Just last week Ford announced plans to expand production of its newly designed F150 pickup. Good luck with that. This move seems like a leap of faith, but perhaps Ford sees only upside at this point, believing that pent-up demand and collapsing gas prices will save the day. I am not so confident…this year’s spike in gas prices was scary for many, and the memory of $100 fill ups will linger. (Jim Hamilton has more on auto sales).

Also today we saw more evidence that the credit crunch is extending its grip in traditional bank lending. The Fed’s Survey of Professional Loan Officers points to an ongoing tightening of lending standards for commercial and industrial loans, a key source of working capital for firms. Not surprising data, but notable in its implications for growth over the next several months.

The path of data suggests a steady stream of dovish rhetoric from Fed officials; even once arch-hawk Dallas Fed President Richard Fisher offered a sanguine outlook on Bloomberg TV:

''My forecast is I don't see any economic growth through 2009,'' Fisher said in a Bloomberg Television interview. ''The credit crisis reached up and grabbed the throat of the global economy and choked off economic growth.''

Colorful, as always – clearly willing to ease policy further, but thinks that fiscal policy will play a more important role in the months ahead. He expects the balance sheet to rise to $3 trillion by year end, and interestingly, explicitly claims the Fed is already engaged in quantitative easing. I would be wary of using this term so loosely, as the Fed has not announced specific quantitative targets for bank reserves, monetary aggregates, etc. The expansion of the balance sheet is the result of specific policy actions intended to boost liquidity, not an end in and of itself. A minor point perhaps – but I think an explicit shift to quantitative targeting represents a critical policy change that we have not yet seen. To be sure, all of the tools are in place for the Fed to move to this next level…but with the explicit use of paying interest on reserves to sterilize the expansion of the balance sheet, they are not there yet.

On the international front, we saw more reports that the Chinese economy is on the ropes. Calculated Risk delivers a link on collapsing manufacturing activity in China, while the WSJ reports that Hong Kong is slowing signs of weakness. With global activity on the ropes, we can expect plenty of official stimulus in the months ahead. See for example efforts in China and India and Pakistan to encourage more lending. Fisher also pointed to global stimulus as a reason for long-term optimism. A key question is that with their domestic economies teetering, with China and others focus on policies that support their own consumption or, via export growth, US production. The answer to that question has important implications for the long end of the yield curve, especially as the Treasury prepares to issue a record amount of debt and expectations grow of another, sizable stimulus package next year. If nothing else, it will be interesting.

Bottom Line: Incoming data are dismal, and will keep the Fed on the road to additional easing. There is room to cut rates further, at least another 25bp, and ongoing liquidity injections point to further swelling of the Fed’s balance sheet. But supporting growth in the near term is no longer within the Fed’s ability – the baton will be passed back to fiscal stimulus early next year. The ability to support that stimulus without triggering a rise in long-term interest rates is still in question. A rise in rates should serve as a warning sign to policymakers – but would they listen to the inflationary implications? Or see it as reason to move explicitly to quantitative easing to bring down long term rates?

Fed Watch: The Great Recession

Tim Duy looks at the Fed's likely reaction to a weakening economy:

The Great Recession, by Tim Duy: Economic weakness that in many ways did not qualify as recessionary turned for the worse in the third quarter. Incoming data continues to paint a picture of an economy that clearly slipped into recession. Indeed, the worst financial crisis since the Great Depression will likely prove to yield the worst recession since the 1980’s. It seems fitting to describe the unfolding scenario as the Great Recession.

While the advanced GDP report revealed only minor headline contraction in the third quarter, the underlying details were undoubtedly distressing. Household budgets, under fire from all quarters, lost the spending battle, and the resulting 3.1% decline in consumption was the worst since 1980. Investment spending is poised to trend even lower in the future – the credit crunch will weigh heavily on equipment and software spending and the remaining bright spot, nonresidential investment. Growth was bolstered by an inventory accumulation, but that will almost certainly be reversed fourth quarter given the drop off in activity in September. Export expansion is threatened by the global slowdown, leaving only the offshoring of domestic weakness – import compression – to support net exports. And the support offer from government spending does not look sustainable (without fiscal stimulus, of course), as it was goosed by a burst of defense spending.

In short, there was not much to like about the GDP report. And, as if to add insult to injury, the early reads on the October data leave one feeling queasy. The Chicago Purchasing Managers report came in well below expectations, suggesting that Monday’s ISM release will be ugly. Consumer confidence tumbled, heading back toward lows recorded earlier this year. And firms are lining up to deliver layoff announcements; better now before the holiday season is in full swing. Some retailers, seeing the writing on the wall, don’t even hold out hope that Christmas shoppers will save them.

And with that special season approaching, I think it is only right to give thanks to Felix Salmon, who directs us to heartfelt and poignant stories of families struggling in these troubled economic times on only $500,000 a year. Take note that these families are not rich – as the article makes clear, they do not have their own private jets. And personal hovercrafts are out of the question.

Fed Watch: More Easing Expected

Today, the Fed lowered the target interest rate to 1%. Will the Fed lower the target rate even further if things don't improve?:

More Easing Expected, by Tim Duy: The FOMC performed as expected today, delivering a 50bp cut that returns rates to their lows of the Greenspan era. More importantly, Bernanke & Co. made clear that further policy easing remains on the table.

The FOMC statement describes an economy in recession without actually using the “R” word:

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Any other assessment would have been surprising; by all measures, economic activity fell off a cliff as we entered the second half of this year. Today’s durable goods report is no exception, with nondefense, nonair capital goods declining 1.4% in September, extending a 2.2% decline the previous month. The intensification of the credit crunch (yes, Virginia, it is a crunch), increased hesitation to expand capital outlays in the current environment, and slowing global growth suggest that investment activity will show even greater declines in the months ahead.

Consistent with the darkening outlook, the incoming flow of data is likely to be horrid, especially during the next two quarters. In particular, the employment report will soon reveal the big declines in nonfarm payrolls consistent with a recession. An increased pace of job losses will sap aggregate household budgets of the real gains afforded by falling energy prices. Consequently, spending data will remain weak. Overall, the data will argue for additional policy response, and the Fed’s statement makes clear that they are prepared to ease policy further as required.

But will that easing come in the form of lower rates? And how far would the Fed go?