Economist's View

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?

Fed Watch: Only the Timing is in Doubt

Tim Duy:

Only the Timing is in Doubt, by Tim Duy: Yesterday I opined on the Fed’s hesitation to cut rates when such a call should be a slam dunk. Why not step forward with the intermeeting cut? Could possibly the Fed have given up hope on rate cuts, and instead intend to focus on other policy measures? Fed Chairman Ben Bernanke today made clear that given the deterioration in the real economy, a rate cut was on the table:

Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.

Moreover, the minutes from the last FOMC meeting indicated that there was already some thought to a rate cut “way back” in September:

Some members emphasized that if intensifying financial strains led to a significant worsening of the growth outlook, a policy response could be required; however, such a response was not called for at this meeting.

Wall Street, however, was unimpressed by confirmation of an imminent rate cut. There appears to be no shock value in such news. Indeed, equity markets plunged even as expectations grew that a global coordinated rate cut is likely as early as Thursday, and if not then, this weekend. The Fed can only disappoint, it appears. Or perhaps market participants simply feel that lacking a functioning credit channel, rate cuts are now simply a sideshow to the financial crisis.

I would not disagree. The Fed can provide infinite amounts of liquidity, but if it does not get into the hands of someone who will spend it, then it is just worthless paper.

One argument against a rate cut is that it risks upsetting a very nice little equilibrium the Dollar has shifted into as global deleveraging in the financial sector looks to be forcing a rapid unwind of Dollar based carry trades. The more stable Dollar, and the subsequent downward pressure on commodity prices (with the exception of gold), eases the US inflation outlook, which in turn gives the Fed room to cut rates. The pressure to ease, coupled with pressure to sustain the Dollar, thus argues for a coordinated cut, as 50bp across the board would leave interest rate differentials unchanged. In theory, this would allow the Dollar to hold it ground while delivering the easing that everyone expects and expects to be meaningless (although it provides grist for bond traders).

Of course, 50bp is all the Bank of Japan has to give, so it takes something of a leap of faith to see them go along with such a plan.

Current Dollar supportive dynamics notwithstanding, the path of monetary policy is placing the Dollar in an increasingly perilous position – if credit channels refuse to loosen, the Fed will be driven inexorably toward policies that attempt to place cash directly in the hands of those that will spend – such as today’s leap into the world of commercial paper. And as the Fed draws more and more risk onto its balance sheet (as well as the US government, via TARP), its credible commitment to price stability will be increasingly in doubt. Will outright monetization soon be the only remaining option if the Fed is under pressure to restore spending power to the US economy?

Is outright monetization really off the table at this point? Consider that Bernanke is widely thought to be determined not to make the same mistakes of the Fed of the 1930’s. Consequently, he has pulled out all the stops, cutting rates quickly and lending freely on a wide range of collateral. But the credit crunch continues unabated, as this is not simply a panic, but a massive deleveraging brought about by fundamental insolvency. Recession is now unavoidable, and the length of the downturn grows longer with each day the credit markets are constricted. Short term interest rates are headed toward zero, suggesting a liquidity trap. What options are left? Bernanke must have at the back of his mind the incident that many believe ended the Great Depression – the 1933 devaluation of the Dollar as the US left the gold standard. Certainly outright monetization would bring such an end; and going back to the Great Depression has been a good way to look for Bernanke’s next move.

Maybe this is getting ahead of ourselves; maybe not. I think it is important to remember that as we head into next year with a profoundly weakened consumer, the calls to “do something” will be increasingly louder. Actions to date have centered on fixing the financial system; the billions in debt soon to be issued for TARP are not likely to flow into the hands of ultimate demanders. And if credit channels remain broken even after these efforts, near-term options to support growth are limited. Monetization of deficit spending is one such option.

Bottom Line: The stage is set for a rate cut; only the timing is at issue. If a rate cut does not come via coordinated fashion by next Monday, it is safe to assume that the Fed intends to move rate policy back to its regularly scheduled meetings. The Fed’s apparent hesitation to cut in the midst of a significant equity sell-off (13% on the Dow in five days) and credit collapse is puzzling given their past behavior.

Fed Watch: Where Is The Rate Cut?

Tim Duy says the Fed may not cut the target interest rate at its next rate setting meeting:

Where Is The Rate Cut?, by Tim Duy: On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.

If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.

Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed President James Bullard and Richmond Fed President Jeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.

It is arguable that rate cuts have done little to stem the tide of deleveraging that is ravaging the banking system. Indeed, despite a policy path that appears determined not to remake the Fed’s mistake during the 1930’s by taking rates down quickly and flooding the financial markets with liquidity, the crisis continues unabated, as if the more the Fed does, the more financial markets need done. To be sure, perhaps the situation would be worse if not for the Fed’s actions, but those actions failed to produce anything remotely near the quick fix I think was originally envisioned by Fed Chairman Ben Bernanke. Some even think the Fed is making the situation worse via their liquidity provisions, prolonging the lack of interbank lending by providing an escape valve. Why try to reduce counterparty risk when the Fed stands ready to be the riskless partner?

The lack of a rate cut at this juncture suggests the Fed is readying a new bag of tricks. They let us sneak a peek at that bag today, using the new powers granted by TARP to pay interest on deposits, thereby setting a lower bound on the Fed Funds rate that should nearly reduce the Fed’s need to sterilize their liquidity provisions via term auction facilities. At the same time, they extended the size of the TAF. These are clear efforts to fix broken credit channels, and this is likely the Fed’s focus, not interest rates.

But, as noted above, will an expansion of the existing liquidity provisions, or additional rate cuts, have any impact? Or are they simply more of already failed policies? The Fed is likely preparing for a significant new initiative, consistent with reports that the Fed, with the cooperation of Treasury, is preparing a program to purchase a broader class of assets than simply troubled mortgage backed securities. Outright purchases of commercial paper appears to be on the table – not surprising as the growing credit crunch in this market threatens working capital, the lifeblood of daily commerce.

Would outright purchases be inflationary? Here is where the Fed would believe that the ability to pay interest on deposits is important – short term interest rates cannot fall much below the Fed Funds rate, as any excess money would simply flow into reserves at the Fed. The ability to pay deposits should automatically sterilize any excess money creation. This might also explain why the Fed would be hesitant to cut rates at this point; policymakers would want to see if the new system worked as expected before changing policy rates. We are in uncharted territory here, but if excess money created simply flows automatically back into the Fed’s coffers, inflation should not be a concern (assuming that outright purchases are equivalent to term lending). If credit channels suddenly loosen up, then interest rates may prove to be too low and inflationary, but the Fed hopefully, could react quickly by raising the Fed Funds rate and the interest rates they pay depositors.

Bottom Line: It is impossible to rule out a rate cut, and it seems like a cut should be the baseline case. Indeed, the case for a rate cut should be a slam dunk, expect for a.) rates are already low and b.) we haven’t seen a rate cut yet. The latter point, especially given the intensity of the crisis over the last two weeks, suggests that looking for a rate cut is simply a case of barking up the wrong tree. It is what we have been conditioned to look for, and hence we are expecting it. But there is nothing like an inconvenient fact to undermine a perfectly good theory. The Fed may simply have already moved well beyond rate cuts in searching for solutions to the current crisis. And outright asset purchases is looking like that next move.

Fed Watch: Rate Cuts Increasingly Likely

Tim Duy says "the Federal Reserve is inching closer to lower interest rates":

Rate Cuts Increasingly Likely, by Tim Duy: This week’s data flow only confirms what was apparent last week – the US economy deteriorated as we headed into the third quarter. By now, there should be no doubt that the US consumer is devoid of resources to further propel spending. And without an active consumer, the US economy will undoubtedly stagnate, especially since the rest of the world appears equally reliant on the US consumer. Such persistent weakness would traditionally prompt additional rate cuts on the part of the Federal Reserve, but I suspect interest rate policy has largely lost effectiveness. Starting with the mortgage meltdown that began last year, credit channels have become increasingly impaired despite aggressive rate cuts. The credit explosion of this decade has proven unsustainable; you cannot borrow your way to prosperity. The US economy is undergoing a structural adjustment that the Fed can only cushion, not stop.

Monday brought the personal income and expenditure report for August, which indicated that consumption expenditures will be negative in Q3 for the first time since 1991, a point pounced upon by commentators (here and here). Interestingly, private wage and salary growth continued to defy gravity:

Fed Watch: Regardless of Bailout, US Economy Decelerating

Tim Duy:

Regardless of Bailout, US Economy Decelerating, by Tim Duy: The US economy is limping through the second half of the year as the impact of this summer’s stimulus checks fades. The continued weakness, I suspect, will come as a shock to the public, who have now been essentially promised that their problems will be solved with a bailout package they really don’t understand to begin with for the financial sector they view as arrogant aggregators of wealth. But any bailout will only prevent a financial meltdown that threatens to deepen the credit crunch and worsen the ongoing slowdown, not reverse the current weakness. I doubt, however, the general public sees that distinction. And they are not likely to be convinced; this Administration sacrificed its credibility long ago. Instead, the public will see billions channeled into Wall Street as the unemployment rate climbs. And climb it will.

The flow of data this week, for those paying attention, is decidedly negative in tone. The housing market continues to deteriorate, with a precipitous decline in new home sales reported today. By definition, we must be closer to a bottom on new construction – but, to say the least, that bottom remains elusive. Initial unemployment claims, reached nearly 500,000 last week, although the Department of Labor attributes roughly 50k to the impact of recent hurricanes. Still, initial claims hovering around 450k foreshadows another weak employment report next week. Perhaps the most discouraging report this week was the advance durable goods release, which revealed a 2% decline in new orders for nondefence, nonaircraft capital goods. As Spencer at Angry Bear notes, the report is a negative for third quarter GDP.

Fed Watch: The Beginning of Another Wild Ride

Tim Duy is "less than enthusiastic" about the Paulson plan:

The Beginning of Another Wild Ride, by Tim Duy: The sheer amount of commentary over the weekend regarding US Treasury Secretary Hank Paulson’s first pass at an ultimate solution to the credit crisis is simply overwhelming. The response is, justifiably, less than enthusiastic. I can be counted among that group.

No one should expect that taxpayers will come away unharmed by a comprehensive solution. That said, the Paulson plan is a virtual giveaway to the financial industry. As commentators noted early on, the objective of any rescue effort needed to be the recapitalization of the financial community. This could not be done by acquiring weak assets at what was initially claimed to be “steep discounts.” The weakness was publicly revealed over the weekend, via an amazing transcript delivered by Yves Smith:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

Paulson is trying to swap $700 billion of US Treasury assets in return for $700 billion of assets valued what I suspect effectively amounts to their original value when the asset was created. Presumably, once this swap was complete and the questionable assets were purged from the system, financial institutions could raise any additional new capital needed via private sources. Such a swap would make sense if the assets the Treasury was purchasing could be sold back into the market at some future date at their purchase price. But no one actually believes this is possible; those assets will undoubtedly fetch less than their $700 billion purchase price, and the taxpayer will eat the difference.

Now, as I said earlier, the taxpayer should not expect to remain unharmed, but should expect to be compensated as much as possible (Mark Thoma notes that even if taxpayers were expected to break even, they still need to be compensated for the risk of harm). And it is on this point that the plan is woefully insufficient. See Steve Waldman at Interfluidity for a very nice, concise reaction to the deficiencies of the plan, with a variety of links. I don’t see how any plan can commence that does not include substantial equity dilution for existing shareholders of firms that transfer their bad assets to the government.

Perhaps, in the name of expediency, you are willing to accept the taxpayer burden implicit in the Paulson Plan. A rational justification can be made for quick action when faced with a complete collapse of the US financial sector. Indeed, the consequences for the taxpayer from inaction may greatly exceed that of even a poorly structured rescue effort that nonetheless begins the important task of recapitalizing the financial sector. But what cannot be accepted, under any circumstances, is this clause:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

That Paulson should even propose that he be given authority that supersedes all other should be grounds for demanding his resignation. I am not prepared to anoint Paulson or Federal Reserve Chairman Ben Bernanke or anyone to the position of economic dictator, regardless of the danger to the economy. How ironic would it be if the unbridled push toward free market capitalism brought about the same dictatorship via economic chaos that a worried Frederick Hayek opined would be the end result of socialism in The Road to Serfdom?

Congress is still mulling over the Paulson proposal. We can only hope that less economic dictatorship and more taxpayer upside emerge in the final document. The only sure thing is that the range of assets to be purchased will only increase. From Bloomberg:

Officials now propose buying what they term troubled assets, without specifying the type, according to a document obtained by Bloomberg News and confirmed by a congressional aide.

The change suggests the inclusion of instruments such as car and student loans, credit-card debt and any other troubled asset. That may force an eventual increase in the size of the package as Democrats and Republicans in Congress negotiate the final legislation with the Bush administration, analysts said.

Yes, Virginia, $700 billion is only the beginning. Will markets be willing to finance this debt? That remains the elephant in the room…if our foreign creditors finally balk at the never ending stream of debt they are expected to absorb, the consequences for Treasuries and the Dollar will be devastating as the financial crisis evolves into a balance of payments crisis. If, however, global policymakers maintain the current arrangements of Bretton Woods II, they will absorb the debt via an expansion of foreign central bank balance sheets – raising the specter of inflation at a time when all eyes are on deflation again. What a tangled web…one that I will be taking up later in the week.

The only thing to expect this week is the unexpected. Indeed, the surprises are already starting – tonight the Fed agreed to convert Morgan Stanley and Goldman Sachs to traditional bank holding companies. Wall Street as we knew it for generations is officially gone. I anticipate another rollercoaster week; time to buckle your seat belt and get ready for the ride.

Fed Watch: Friday Can’t Come Soon Enough

Tim Duy says policymakers need to be honest that a solution to the financial crisis will not be painless:

Friday Can’t Come Soon Enough, by Tim Duy: A wild week is coming to an end, with news that US policymakers are preparing a comprehensive approach the financial crisis – see the prophetic Mark Thoma below. Details are thin at this point, although the central feature is expected to be a mechanism that will extract the bad assets from Wall Street’s balance sheets. The devil, of course, is in the details. A critical element, as described by the Wall Street Journal:

A big question still to be answered is how the government will value the assets it takes onto its books. One possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. Financial companies would likely take big losses.

But Calculated Risk makes an important point about this approach – it appears to deal with only one side of the balance sheet:

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

So even after the bad assets are removed, the affected firms still need to be recapitalized, presumably via taxpayer infusions. What exactly will the taxpayer receive in return? Preferred stock? Since we are already moving toward an overarching solution, maybe we should just follow the example of Sweden. Via Yves Smith:

Fed Watch: What Was He Thinking?

Next, Tim thinks stress maybe taking its toll on Bernanke:

What Was He Thinking?, by Tim Duy: There are two stories about Federal Reserve Chairman Ben Bernanke that are rather disturbing. The first is reported via Yves Smith. Apparently, Bernanke told a private economist David Hale:

"We have lost control," said Hale, quoting Bernanke. "We cannot stabilize the dollar. We cannot control commodity prices."

To be sure, if Bernanke actually believed he had policy independence in an economy driven by the financing of foreign central banks, we should all be a bit concerned. And why would he tell anybody this? How do I get such a private meeting?

I am hoping the quote was taken out of context.

Fed Watch: Quite a Day

Tim Duy assesses the day's events:

Quite a Day, by Tim Duy: I am in Portland tonight, taking a breath to assess the day’s events as I mentally prepared for a three hour presentation on the economy for a friend’s business group. A spectacular harvest moon was hanging over the Cascades as I approved the city; the deepest orange moon I have ever seen.

That can’t be a good omen.

To say the least, this was an interesting 24 hours. My son took his first swimming lessons. A forest fire is raging within spitting distance of the family cabin. I understand the local bar has burned to the ground; I can’t see how that is going to be good for property values. And the Fed bought an insurance company.

I seem to remember that the US owned at least one “gentlemen’s club” in the wake of the S&L crisis, so what’s the big deal with an insurance company?

But I get ahead of myself – consider first the Fed’s interest rate decision. It was the logical choice one would have expected at the end of last week. The Fed Funds rate was held steady at 2%, risks are equally balanced between inflation and growth, and it was acknowledged that commodity prices have moved significantly lower. That the Fed did not cut interest rates in the face of arguably the most treacherous period of the financial crisis says little about moral hazard concerns, in my opinion. Instead, it indicates the Fed sees little that lower interest rates can do to alleviate the crisis. Policy is directed to the real economy, and by virtually every measure, rates are already lower than one would expect given the flow of data. That is not to say that the state of the real economy is healthy. Anything but, to be sure. But, while one can say that the Fed has been behind the curve with respect to the financial market turmoil, we have seen in the past a considerably slower reaction to real economic data.

More interesting is the AIG loan/purchase/bailout. I have to imagine the employees of Bear Sterns and Lehman Brothers are currently thinking that they clearly did not take on enough risk over the past several years. Lehman employees, in particular, were fed into the moral hazard grinder that was operational for a scant two days. How unfortunate. Which leads me to my most significant concern about Fed policy over the past year – the inconsistency. Facilitate the liquidation of Bear Sterns by backstopping $29 billion of questionable assets. Then, recognizing the moral hazard created by that move, let Lehman collapse. Then, recognizing the consequences of vanquishing moral hazard, effectively purchasing AIG. At this point, the endgame should be clear to policymakers – a taxpayer bailout. The bad assets need to be consolidated and eliminated. Congress needs to be working on a mechanism to make this happen, a new RTC. Any Congressional action needs to include a reevaluation of the state of financial regulation. Perhaps, just a thought here, insurance agencies need to be separate from investment banks. And if, as is often threatened, the shadow banking industry just moves offshore, maybe we should just let it do so.

Fed Watch: End Game:

Tim Duy assesses the financial crisis, and what the Fed is likely to do at its next rate-setting meeting:

Endgame?, by Tim Duy: News is flowing in faster than the ability to process the implications.  When I went to bed Saturday night, the only sure thing looked like the liquidation of Lehman Monday morning.  A scant 24 hours later, to that liquidation is added the sale of Merrill Lynch to Bank of America and, later the possibility of a collapse of AIG by midweek.  The Fed and Treasury suddenly play hardball, and the floodgates break open.

Mark Thoma is working overtime to keep readers informed. 

Fed officials likely now understand the can of worms they opened with the Bear Sterns bailout.  At that point, Wall Street realized that attempting to solve their own problems was a sucker’s bet – better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain.  Arguably, this is one reason the Lehman issue was allowed to fester for another six months.  Moral hazard.  With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk).  It is looking like the endgame is finally here.

To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event.  Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost.  By now, however, officials probably realize this is a solvency crisis.  Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable. 

A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis).  Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around.  Instead, the questionable assets need to be eliminated, and some agent needs to accept the loss.  Who will that agent be?  Wall Street obviously prefers that the taxpayer ultimately absorbs that loss; the Bear Sterns bailout provides the precedence for such an outcome via the Fed’s financial backstop. 

Repeated Bear Sterns type bailouts would eventually force taxpayers to absorb the losses of the entire crisis and, more importantly, do so without legislative approval.  We can cordially debate the appropriateness of taxpayer support, but we should all be clear that that decision needs to be made in a democratic fashion.  It is too big an issue for an “ends justify the means argument,” a justification that Bernanke & Co. need to do whatever is necessary to make the trains run on time.  Bernanke & Co. likely understand this now, encouraging their hesitation to continue down that road.  Of course, if Lehman is forced to liquidate assets, that too has obvious consequences, such as setting prices for those assets that further destabilizes the investment banking community, pushing financial markets to an end game in the crisis.  Still, even with that crisis in the making, the Fed has already pushed their legal boundaries; some would argue they have stepped well beyond those boundaries.  And it hasn’t stopped – the Fed expanded the collateral it will accept in repo operations, putting taxpayer dollars at risk in a less explicit manner (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?).  Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector.  Some version of the Resolution Trust Corporation is the most likely outcome.  I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation.  But to what extend will Congress be willing to perform a hard look as an industry that has brought the illusion of wealth that hides gaping and undeniable equity flaws in the US?

The FOMC is gathering this week for a decision on interest rates.  I imagine all bets are off regarding the outcome; indeed, we may get an emergency rate cut by the time I get to the office.   As of Friday, policymakers were widely expected to keep rates steady; only the language of the statement is in doubt.  Specifically, market participants will be looking to validate growing expectations of a rate cut later this year.  At issue is the use of the term “significant” to qualify the inflation threat.  Given the collapse of commodity prices, there appears to be room to remove that qualifier.  I suspected they would be wary, however, of giving hints that a rate cut is in the making – they are probably just now breathing signs of relief that Dollar/commodity dynamic is no longer working against them.  They do not need to trigger a fresh run on the Dollar; moreover, Chinese policymakers likely are happy that they foreign currency value of their Dollar assets is on the rise, and do not want a reversal of that situation.  After last week’s nationalization of Freddie and Fannie, we can no longer hew to the illusion that policy is based only on domestic considerations. 

Cutting interest rates, I suspect, will make little if any difference at this juncture.  That said, the Fed has delivered a rate cut at each critical juncture of the past year.  I am at a loss to convincingly explain why this week is any different.

Fed Watch: Get Shovel, Dig Deeper

Tim Duy says it is an "illusion that the US is like Japan," and the differences between the two cases matter for the conduct of monetary and fiscal policy:

Get Shovel, Dig Deeper, by Tim Duy: The US is not Japan.

I realize, however, that whenever I suggest this, I am viewed as downplaying the seriousness of the economic situation. That is not my intention – I simply think you need to break with the Japan framework to interpret the seemingly discordant nature of the data flow. Japan’s travails could be understood in terms of a simple closed-economy Keynesian framework, with an excess of domestic savings over investment. The current US situation requires a more comprehensive framework that includes analysis of massive capital inflows.

Indeed, in my opinion, the US can only wish it were Japan. This idea was driven home to me in the wake of the Fannie/Freddie bailout/nationalization. From the Wall Street Journal:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Brad Setser adds:

I suspect this is the first case where foreign central banks exercised their leverage as creditors to push the US government to make a policy decision that protected their interests. The need for ongoing central bank financing certainly weren’t the only reason why the US government acted. US banks hold a lot of Agency debt too. But the need to maintain the confidence of the world’s central banks — and the attractiveness of Agencies as a reserve asset — was certainly a factor in the Treasury’s decision.

Take note of this milestone; US authorities effectively are ceding policy independence. To be sure, just a bit – a bailout of the mortgage behemoths was inevitable given the implicit Federal guarantee. Still, for all the humiliation heaped upon Japanese policymakers over the past decade by their American counterparts, who confidently and smugly offered economic “advice,” I never recall Japan’s officials having to bow to the will of their external creditors. This of course, is the benefit of being a creditor nation – Japan ran a current account surplus throughout the lost decade, leaving policymakers able to finance spending entirely from domestic resources. Arguably they could have done more, faster, as the resources were available, but that is their lesson, not ours.

No, the US is not Japan. But there is a list of nations that have had to go, hat in hands, to their creditors – Indonesia, South Korea, Thailand, Russia, Brazil, etc. The US had already implicitly joined that list, but now joins explicitly. Do the implications resonate in Washington DC? I don’t know to what extent US policymakers realize the importance of the external financing issues in defining the current turmoil. And, even if they do realize it, would they be willing to admit that the accumulation of US assets abroad has finally left the US vulnerable to external pressure?

I suspect US policymakers, from both sides of the aisle, would be loathe to make such an admission. Indeed, such an admission greatly complicates policy making. By ignoring the fact of America’s dependence on foreign capital flows (or, specifically, foreign official inflows), one can look to the lessons of the Great Depression, and have confidence that a scholar of that episode, such as Federal Reserve Chairman Ben Bernanke, is well-positioned to address the current crisis. But when a nation is dependent upon foreign inflows for survival, cutting short term rates to zero – the ultimate destination of the Bank of Japan – is not an option. Indeed, the limits of monetary policy may already have been reached. From Larry Summers via the Wall Street Journal:

Fed Watch: Short Takes

Tim Duy on bailouts, media problems with export data, data inconsistency, inflation damage, the employment report, and, of course, the Fed:

Short Takes, by Tim Duy: One of my goals for this school year is to concentrate on writing shorter posts rather than lengthy analysis. With that in mind:

On Bailouts:

The Freddie/Fannie bailout was inevitable. There was never really an implicit guarantee of a taxpayer backstop for these institutions; in practice, the guarantee has always been explicit. Moreover, they evolved into institutions that are too big to fail. Cutting them loose at this juncture would be an unacceptably risky strategy. Teaching lessons in moral hazard (beyond that of the substantial losses likely to be borne by shareholders) is interesting coffee table talk, but not practical policy when the potential downside broadly impacts the public. True, there may be a consequence for future taxpayers, but they too will be spared the ramifications of letting these mortgage giants collapse today.

Moreover, the bailout provides an important policy lesson – nothing truly bad can happen as long as the US Treasury is willing and easily able to float debt onto the global financial markets. Presumably, Treasury will finance any cash injections into Fannie and Freddie by issuing debt that will be forced fed to foreign central banks, the same way Treasury financed the now forgotten stimulus package. The US can always inflate away the real value of that debt at a later time. As long as foreigners are willing to continue to take that risk, let them.

To arrive at a truly bad outcome, the US needs to be cut off from foreign financing. Otherwise, the economy will muddle along at anemic growth rates until a broad restructuring away from consumer dependent growth is complete.

On Exports:

There is a consistent mischaracterization in the media regarding the contribution of exports to 2Q GDP growth. Take, for example, the Wall Street Journal:

Fed Watch: The Knife Edge Cuts Deep

Tim Duy says "the economy will need to shift clearly in one direction or another – deflation or inflation – to drive any change in rate policy":

The Knife Edge Cuts Deep, by Tim Duy: The sharp decline in commodity prices has turned the tables on the inflation crowd, at least for the moment. To be sure, the most recent inflation report was none too encouraging, but as Jim Hamilton notes, it is largely old news. Indeed, bond markets appeared to react more strongly to higher than expected initial jobless claims. Headline inflation was a foregone conclusion, with rising core inflation an inevitable result of the spike in oil prices; while demand has been weak in the US, the depth of the downturn has so far been insufficient to forestall the pass through.

The Fed is powerless to prevent what will likely be a series of uncomfortably high core inflation readings in the month ahead. Expect little but lip service about “carefully watching inflation expectations” for now. Simply put, the case for a rate hike rested entirely on high oil and a weak dollar. Trends in these factors are cutting in the Fed’s direction in the last month, so much so that Across the Curve can posit the possibility that the next rate change will not be a hike:

Prices of treasury coupon securities posted solid gains today in a lackadaisical and lackluster trading session. The dollar continues to trade with new vigor and its strength debilitates commodities. I think that there is a bit of a slow and delayed reaction as participants realize that if the lower energy prices should stick that the Fed will eventually have room to lower rates…

The Fed is not there yet. They have been blindsided so many times over the past year that they will be hesitant to move dramatically on the basis of what could quickly reveal itself to be a temporary turn in commodity prices. More to the point, Bernanke & Co. view the economy as trapped somewhere between inflation and deflation, a knife edge that cuts deep into their policy options. The last FOMC statement was caught between these two outcomes, with the growth outlook diminished somewhat despite heightened inflation expectations. Interestingly, Federal Reserve Bank of Chicago President Charles Evans defines the current stance of policy similarly, stuck between the credit crunch and inflation:

Fed Watch: The Rapid Reversal

Tim Duy:

The Rapid Reversal, by Tim Duy: The rapid shift in financial markets over the past month caught me off guard. I have long been of the view the US economy was undergoing a fundamental adjustment to an unsustainable external imbalance. That adjustment required a lengthy period of relatively slow domestic demand growth to bring US consumption in line with productive capacities – a process that should reduce the magnitude of the US current account balance. Effectively, the US economy would ease into some new equilibrium characterized by a fresh constellation of exchange rates, interest rates, and prices.

The exact constellation of these nominal variables, however, was not predetermined and likely to be impacted by policy decisions. Excessive monetary and fiscal stimulus would interfere with this adjustment, overstimulating real activity and thus forcing prices higher and the value of the Dollar lower than would otherwise be the case (of course, the tradeoff would be lower unemployment). In essence, if the policy refused to allow the adjustment to occur, financial markets would force the adjusted via alternative channels. One consequence was the sharp rise in commodity prices, particularly energy.

I did not expect that oil would choke off US demand until prices closed in on $175 or higher, sending gas prices north of $5/gallon. As it turned out, $145 and $4 were the magic numbers at which households were forced to take as cold, hard look at their finances and start cutting expenses that would result in the least real reduction in living standards. Not surprisingly, Detroit suffered a grievous blow in the process, experiencing a sharp fall in sales:

Fed Watch: Anemic

Tim Duy reviews the economy and the Fed's likely response to current and expected future economic conditions at its rate-setting meeting this week:

Anemic, by Tim Duy: Two weeks away from the blog. The first was spent dealing with a crashed computer – the technician said “your machine is sick,” which is a euphemism for “you’re screwed.” The second was spent advising incoming freshman. Still, two weeks later, the economy looks pretty much the same, and best characterized as “anemic.” Not as bad as might be expected, but clearly weak, with few signs of strength. I suspect that is what the FOMC will feel Tuesday, and consequently will find themselves with little reason to change policy or signal that a change will occur in the near future.

Working backwards through recent data brings us to the July employment report with a headline nonfarm payrolls decline of 51k, a tepid number to be sure, but not the triple digit declines normally associated with a recession. Still, this better than expected number masked a considerable array of general weakness. Teen unemployment is skyrocketing, total hours worked decline sharply, temporary employment decreased, real wages are declining, and the number of part time for economic reasons continued to climb. The latter is helping to drive up the broadest measure of unemployment, U-6, to 10.3%, up a whopping 2 percent points from last July and within striking range of the recent 10.4% high reached in 2003. It is difficult to envision Bernanke & Co. seriously entertaining the notion of a rate hike in this environment, despite the hawkish rhetoric of a few regional policymakers such as Philadelphia Fed President Charles Plosser. Such hawkishness, however, was not likely to go very far after the recent close call for Freddie and Fannie revealed the still precarious state of US financial markets.

Brad DeLong cites the U-6 unemployment rate as decisive evidence that the US economy has slipped into a recession. That sounds right from an employment perspective, but would be the oddest recession in memory. This point was driven home last Thursday with the release of the 2Q08 GDP report. I admit it is tough for me to accept a recession call when aggregate activity is growing at 1.9%, and the only quarter of negative growth was just barely negative. The recession case becomes clearer after stripping out the impact of external adjustment and turning to the persistent weakness in real gross domestic purchases:

Aggregate activity is evolving very close to my expectations, as growing exports and import compression maintain overall growth despite a contraction in domestic demand, thereby minimizing the impact of the slowdown on labor markets. The result is a recession that is not quite a recession as the overall economy continues to expand; growth that doesn’t feel quite like growth. In my mind, the current dynamic reflects a downward shift in the standard of living that Americans are enduring after a long period of debt-supported growth; it certainly feels like a recession to many, even if not technically a recession.

In a similar vein, the ISM report of manufacturing was also released last Thursday, with a headline number that continues to however around the 50 mark, a weak reading that remains well above recessionary levels. Overall, “anemic” sounds like a good description. Others might prefer the term “Purgatory.”

Is there much hope of a decisive change in the economic climate in the second half of this year? I tend to think the economy will experience more of the same; the lurch downward experienced at the end of 2007 looks likely to be followed by an extended period of persistent weakness. The ongoing impact of fiscal stimulus trickling through the economy, a stimulative monetary environment (resulting in a yield curve that has been relatively steep for months now), and rising new orders for nondefence, nonair capital goods (a bright spot in last week’s data) are all suggestive of a stabilizing economic environment. But with Detroit reeling from the impact of the oil shock and signals that global growth has eased back in recent weeks, it is difficult to see that stabilization evolving into a more dynamic pattern of growth this year.

Such a tepid outlook for growth suggests stable monetary policy. The wildcard is the inflation outlook. To be sure, recent headline and core numbers have not been inspiring (today we get the PCE report). And the ISM revealed that manufacturers remain under intense pricing pressure, with no commodities reported down in price. But, more importantly, nominal wage growth continues to fall short of consumer price inflation. And without stronger nominal wage growth, it is difficult to argue that inflation expectations can truly become embedded, regardless of the pricing pressures clearly in evidence. Moreover, the Fed will take comfort in recent significant drop in oil prices (a drop that caught me by surprise) and the stronger Dollar, the primary factors driving the case for a rate hike by the end of the year.

Still, should we entirely discount the possibility of a rate hike this year? Market participants still see a small probability of a rate hike this year; attention has to be turned in this direction as the Fed is almost certainly done cutting rates. At this point, the best bet for a rate hike hinges on a return to stronger growth abroad that fuels a reversal of recent trading patterns in oil and the Dollar and sustains the US economic growth derived from exports. Brad Setser reminds us that one of the forces propelling global growth, Dollar pegs in the Gulf, remain in play. But the bigger question is whether or not China stumbles in the quarters following the Olympics. I tend to believe that the Chinese government will act decisively in an effort to forestall a slowdown, redirecting spending toward investment and rebuilding and loosening monetary policy regardless of the inflation risk. Still, even steady, strong growth in China may be insufficient to sustain global growth given signs of slowing economies such as in Europe and Japan. In short, the case for a rate hike appears tied to continued decoupling of the US and global economies; recoupling argues for stable monetary policy.

Bottom Line: I suspect the Fed will stick with a statement that is largely neutral, indicating that there remains enough economic stimulus in play to sustain growth while showing concern about elevated inflation rates. Falling energy prices and a weak job market should be sufficient to keep the hawks largely at bay, with more than one dissent unlikely. Lacking the justification of skyrocketing energy costs, a plummeting Dollar, or clear signals that growth is set to rebound this year, it seems unlikely that the Fed will signal a rate hike is imminent.

Tim Duy: Not So Bad?

Tim Duy gives and answer to Brad DeLong's question:

Not So Bad?, by Tim Duy: Brad DeLong is puzzled. Earlier this week, defending Greenspan-era monetary policy,

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

Today Delong adds:

I still do not understand why the real side of the economy is doing so well in relative terms. The worst financial distress since the Great Depression ought to trigger the worst downturn in demand, production, and employment since the Great Depression. It hasn't--at least not so far.

Good questions; I think economic activity has surpassed most peoples’ expectations. My answer to DeLong’s question comes in three parts:

1. The nature of the expansion defines the nature of the following contraction. The post-tech bubble expansion was anemic by most measures, and never gained much traction until the housing bubble arose. The primary channel through which housing supported the economy was via consumer spending, generating a tepid growth dynamic compared to the equipment and software investment boom of the 1990’s. The tepid upside suggests a tepid downside. I would be more worried if the chart for equipment and software:

looked like the chart for residential investment:

And given trends in new orders, I am hoping it won’t:

2. The impact of the consumer slowdown is partially offshored, a point which I think deserves greater attention. This shifts job destruction to an overseas producer. In fact, as spencer at Anger Bear shows, the recent improvement in the real trade balance has less to do with rising exports, which continue to follow recent trends, than the sharp slowdown in real import growth. Note too that exports are not falling as they were in the 2001 recession as the global economy has held up better than expected.

3. Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).

Ideally, the slowdown remains moderate, allowing for a rebalancing as we expand export and import competing industries domestically, narrowing the current account deficit and eliminating the necessity of foreign official financing. This means accepting a period of time with suboptimal domestic demand growth and structural adjustment. Excessive fiscal stimulus risks testing the willingness of foreign CBs to continue to accumulate US assets. Moreover, I believe that excessive stimulus will eventually foster a more damaging inflationary dynamic, but such a process would likely build over a long period of time – the seeds for the 1970s were planted in the 1960s.

In short: External dynamics play a significant role in explaining the relatively mild US downturn. As long as foreign CBs are willing to accumulate US debt, the US government is willing to issue debt, the Federal Reserve is willing to accommodate the debt with low interest rates, we will avoid the most dire deflationary predictions.