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Monday, November 03, 2008

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.

An optimist would say that there is a silver lining to last week’s data – it had to get worse before it could get better. With forecasts of a sharp contraction in 4Q becoming the norm, it is reasonable to expect some rebound by the latter part of 2009 (although I still am not optimistic about the strength of that rebound). Fed officials, however, are not likely to view the situation through such an optimistic lens. I tend to think they will focus less on forecasts and more on the here and now. Indeed, they already green-lighted further easing in their last statement, and the likely path of data over the next six weeks almost ensures another policy response in December, as the Fed apparently does not yet see technical issues that preclude another rate cut. From San Francisco Federal Reserve President Janet Yellen, via Bloomberg:

''We would do it because we are concerned about weakness in the economy,'' Yellen said today after a speech, responding to an audience question about the impact on the economy should the Fed reduce the main rate to as low as zero. ''I think we could, potentially, go a little bit lower than'' 1 percent, she said in Berkeley, California.

Note that she does not clear the way to zero; a bit lower may only be to 75bp. Yellen’s whole speech is worth reading, but not exactly heartwarming:

Indeed, recent data on the economy have been deeply worrisome. Data released this morning reveal that the economy contracted slightly in the third quarter. For the fourth quarter, it appears likely that the economy is contracting significantly. Mainly for this reason, inflationary risks have diminished greatly.

Most of the speech is of a similar vein. She identifies a key problem hampering the ability of policy to reverse the credit crunch:

Moreover, investment banks and other entities in the so-called shadow banking sector were very highly leveraged, with the ratio of assets to capital exceeding 30 to 1 in many cases. Such slim equity cushions increase firms’ exposure to insolvency in the face of credit losses or asset write-downs.

The pace of deleveraging is overwhelming policymakers; they can only hope to limit the damages. And as if deleveraging was not enough, declining demand and deteriorating credit quality, both the victim of the deepening downturn, also hamper the growth of lending. These points do not appear to be well understood by members of Congress, who expected that the bailout package would have an immediate impact on lending:

House Financial Services Committee Chairman Barney Frank asserted that a number of financial firms were “distorting” the financial rescue legislation by not using government capital exclusively to boost lending.

“Any use of these funds for any purpose other than lending — for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. — is a violation of the terms of the Act,” Frank (D., Mass.) said in a statement Friday.

Given the immense headwinds facing financial institutions, the first $250 billion of the bailout will likely be a drop in the bucket compared to what would be necessary to push banks into expanding lending significantly. At best, all of the actions by the Fed and Treasury should be viewed as efforts to keep the banking system from collapsing.

The question of whether or not the financial markets can absorb the expected tsunami of Treasury debt coming down the pipeline continues to make the rounds. From Bloomberg:

The next president may find foreign investors, the biggest creditors to the U.S., unable to absorb a growing supply of Treasury bonds as the financial crisis prompts nations to invest in their own banks and currencies. That would drive up yields just as a widening budget deficit pushes borrowing needs to a record $2 trillion, according to estimates by Goldman Sachs Group Inc. and Wrightson ICAP LLC.

Conventional wisdom is that the growing recession will boost savings and reduce investment on a global scale, making an opening for upcoming US debt sales. The counterargument is that if virtually the entire globe is pursuing an aggressive expansionary strategy, there will be less room for US debt than Treasury (or the Fed) anticipates. Moreover, where will Treasuries stand when the current phase of risk aversion and, perhaps more importantly, global deleveraging of Dollar carry trades, comes to an end?

This line of thought, I suspect, would not be popular at the Fed – I doubt they fret much about the possibility that the foreign economies at some point might become less concerned about financing the US and more concerned about boosting their own domestic economies. After all, betting against the Bank of China is a sucker’s bet. Consequently, Bernanke & Co. will remain focused on policies that drive liquidity into the economy; better to remain on the side of too much easing rather than too little. The likely flow of data between now and the December FOMC meeting will argue for a rate cut – not because it will help, but because the Fed will be compelled to do something. The real action will be in the balance sheet, which painted a picture of the crisis as it evolved. And, if the crisis begins to ease, that too should be revealed in the balance sheet, as it would reflect a declining need for the Fed to compensate for the death of liquidity in the financial system.

    Posted by on Monday, November 3, 2008 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (12)


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