Tim Duy's Fed Watch

Rushing to the Exits?

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

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

 

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

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

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

 

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

 

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

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

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

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

 

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

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

 

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

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

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

 

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

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

On the G20 Agenda

Simon Johnson at the Baseline Scenario has anice piece bemoaning the US pursuit of a rebalancing agenda at the upcoming G20 meeting.  I largely agree with Johnson's tone.  Something that sounds nice, but that to which no parties, particularly China and the US, can make a credible commitment.  It is, however, keeping some poor staffer at the US Treasury busy 24-7.  Johnson's third point, however, misses some important points:

Where is the evidence that this kind of “imbalance” had even a tangential effect on the build up of vulnerabilities that led to the global financial crisis of 2008-09?  I understand the theoretical argument that current account imbalances could play a role in a US-based/dollar crisis, but remember: interest rates were low 2002-2006 because of Alan Greenspan (who controlled short-term dollar interest rates); the international capital flows that sought out crazy investments came from Western Europe, which was not a significant net exporter of capital (i.e., a balanced current account is consistent with destabilizing gross flows of capital); and the crisis, when it came, was associated with appreciation – not depreciation – of the dollar.

I believe Johnson underestimates just how close we came to a destabilizing collapse of the Dollar in 2008.  That avoidance of that near collapse was well documented by Brad Setser in his legendary "quiet bailout" series:

...The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.

 

So far that hasn’t been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.

Later analysis can be found here.  Had it not been for the supporting role that China and other central banks played in financing the US current account deficit, we would have seen a full blown currency crisis, well before the financial crisis of September 2008.

 

As an aside, the intervention to support the Dollar was also the key event that allowed the US recession to evolve in the pattern envisions by domestic-focused economists, as opposed to those seeped in the traditions of international finance.  Brad Delong has a fantastic piece on this issue, including the key assumption failed the internationalists:

Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future…

 

...The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.

I have no doubt that the willingness of central banks to flood the global economy with money in an effort to hold currency pegs contributed greatly to the great commodity price bubble that ultimately sent US real consumption into a tail spin well before the events in the fall of 2008.

 

As to the G20 proposal itself - easier said than done.  Back on the real side of the economy, I believe the US economy is very structurally misaligned, to a disturbing degree.  We simply do not make many of the products we want to buy, and have the capacity to make many products - like expensive housing - that no one wants to buy.   Moreover, these structural misalignments have been building for at least 15 years, at least partly the consequence of the US strong Dollar policy that gave license for wholesale currency manipulation to support mercantilistic policy objectives.  Reversing 15 years of policy in which deep structural shifts occurred will not happen overnight.

 

Nor do I think the Chinese are interested in making that transition happen.  Thomas Freidman has a point here:

China now understands that. It no longer believes it can pollute its way to prosperity because it would choke to death. That is the most important shift in the world in the last 18 months. China has decided that clean-tech is going to be the next great global industry and is now creating a massive domestic market for solar and wind, which will give it a great export platform….So, if you like importing oil from Saudi Arabia, you’re going to love importing solar panels from China.

This restructuring, not so much the financial restructuring, is what I suspect the Administration really wants to address. 

 

Good luck with that.

Even With Growth, A Long, Hard Road

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

 

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

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

All of that is well and good.  The FOMC, however, will look at this data flow and ask "what's next?"  An inventory correction in the wake of the 2001 recession provided little lasting support, leaving the economy struggling until the housing bubble gained force in 2003-04.  The clunkers program and the homebuyers credit likely borrowed some spending from the future. And even if the homebuyers credit is extended, the marginal impact is likely to decline as it increasingly benefits those looking to buy anyway.  Moreover, there is growing concern that this summer's buying binge - such that it is was - can be partly attributed to a slowing in foreclosure activity earlier this week.  Now that the pace of foreclosures looks to be picking up, and the threat of the option-ARM lending comes more clearly into the view, the sustainability of this summer's housing gains comes into question.  On top of all that housing concern, the possibility that the FHA might need a bailout indicates that the risk of loaning into an overpriced housing market has simply been shifted from the private sector to the taxpayer.  Consequently, the FHA - the current housing lender of last resort - is poised to tighten credit standards.  And even the surprisingly strong retail sales numbers are somewhat suspect, as they don't appear to comport with the anecdotal reports of retailers.  A reasonable midpoint analysis, via the Wall Street Journal:

The July/August average for “core” retail sales is still not much stronger than the [second-quarter] average, but after a string of contractions, these data suggest that consumer demand is, at a minimum, stabilizing. Core retail sales may even be starting to firm slightly (up in 2 of the past 3 months), but we will need to see another month or two of positive data to have confidence in that view. –Stephen Stanley, RBS

In addition, financial markets remain glued up by many metrics.  Importantly, consumer credit growth is still significantly restrained, as is bank lending for commercial and industrial loans:

Given the steady anecdotal buzz surrounding the deterioration of the commercial real estate market, it is difficult to expect a rapid reversal of these trends.  In short, if you think credit markets are still under stress, as the Fed certainly does, and are worried about the availability of credit to support future spending, also among Fed concerns, then shifting rhetorically to signal a tighter policy stance irrational.  Moreover, it would seem inconsistent with plans to continue expanding the balance sheet via purchases of mortgage backed securities and TALF assets.

 

Now, the above are among the reasons many expect a relatively tepid recovery to emerge in the years ahead.  Suppose instead that you, logically, believe that the economy is set to come roaring back on the straightforward hypothesis that deep recessions are always followed by strong recoveries.  James Grant makes just such an argument in this past weekend's Wall Street Journal:

"At the business trough in 1933," Mr. Darda points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.

One would have to wonder if Grant has ever seriously considered a different analysis of the path of the business cycle.  After all,  I have never heard it argued by the more pessimistic forecasters that the  fundamentally reason for their concerns is that private enterprise is no longer practiced in the US.  That this should be his line of argument seems silly.  That aside, the post-1933 rebound is illustrated by the industrial production series:

What one could add to this story, however, is that despite the rapid growth of 1933-1937, unemployment remained unacceptably high and inflation remained sufficiently contained such that the price level never came close to regaining the ground lost during the depression:

And - critically for divining the path of policy - the growth in the 1933-1937 period was not sufficient to allow for policy tightening, as evidenced from the 1937 recession.  One does not have to deny that the recession is over - and can even expect nontrivial growth - while still expecting a sufficiently weak outcome that prevents a significant reversal of the Fed's monetary stance.  Or further fiscal stimulus, for that matter.  Which is to say that those who see rapid growth as a reason for an imminent Fed reversal are looking in the wrong direction.  Even rapid growth could leave the Fed on the sidelines for much, much longer than many anticipate - and they know it.  Bernanke has schooled policymakers well on the lasting damage that typically follows the collapse of a debt-driven bubble.

 

Bottom Line:  Economic activity is clearly on the upswing - but the durability and sustainability of the recovery remains in doubt.  The FOMC statement will certainly take notice of strengthening economic data.  But a resumption of growth is not the only issue that factors into policymaking.  At this juncture, the focus to resource utilization - how long will persistently weak labor marks sustain downward pressure on wages and thus make a wage-price inflation spiral simply unattainable?   For now, a seemingly long period of time.  Indeed, I find it virtually impossible that Fed officials will dare shift from "sure, we can withdraw stimulus when needed" to "it is not necessary to aggressively withdraw stimulus" until the unemployment rate begins a sustained march downward.  And for now, we are still waiting for the upward march to end.

Quick Note on Confidence

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

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

 

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

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

 

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

 

 

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

 

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

 

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

 

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

Trade Activity Up, But Rebalancing Stalled

I was somewhat distressed this morning when I realized that, with the absence of Brad Setser, I would have to do my own analysis of the trade data - data Brad taught me how to analyze over a decade ago.  I may be a little rusty.

 

The good news in the data was the widely touted revival of global trade, an indication of economic healing.  The bad news in the data was the return of an old enemy, a pattern of unbalanced trade.  To be sure, I would not focus too intently on a single data point, but the July numbers raise the possibility that the external sector will weigh on US GDP growth in the third quarter.  That, of course, is the price to be paid for attempting to revive growth via household spending as a portion of that spending flows overseas in the form of increased imports.

 

The trade deficit rose to $32 billion in July on the back of rising import growth that easily swamped export growth.  Note to that higher oil prices were not the primary culprit; goods imports drove the trend:

 

 

The firming of the US economy is thus having the expected impact, as efforts to sustain consumer spending combined with stabilizing business investment plans have combined to drive import growth in the expected sectors - capital, consumer, and automotive goods.  Similarly, with oil prices having little impact, real goods imports gained sharply, rising 5.3%:

 

 

Exports got a boost from reviving global growth, but, in contrast imports, real goods exports gained a smaller (although still respectable) 3.7%:

 

On net, the real goods deficit increased 8.5% compared to June to $38,811.  Moreover, the July figure compares to a second quarter average of $38,500.  If this trend continues, trade will likely be a net drag on growth, something of a disappointment for those looking for continued rebalancing to help support the US economy. 

 

Again, a single data point does not make a trend.  Indeed, it is a trend that should not return.  Perhaps the US economy stumbles while the rest of the world remains strong, the long-awaiting decoupling.  Moreover, the falling Dollar should help support rebalancing, driving export growth in excess of import growth.  But perhaps with each new recession the  structural nature of global imbalances becomes more entrenched as manufacturing capacity that is lost in the US during recessions is revived overseas, particularly China, thus explaining why durable goods manufacturing employment failed to recover from the 2001 recession and is not likely to recover after this recession.  And clearly nondurable goods manufacturing is simply dying in the US, as employment is in virtual freefall with the advent of the strong Dollar policy.  It may simply be that as the US emerges from the recession, sustained rebalancing cannot continue without a very significant depreciation of the Dollar that justifies the more rapid expansion of export and import-competing industries in the US, a depreciation that appears in excess of what Chinese policymakers are willing to tolerate (or other nations are willing to tolerate on their behalf).   Or a more significant relative compression of US consumer spending than US policymakers are willing to endure.

 

And, of course, if rebalancing does not resume while labor markets remain anemic, expect trade tensions with China to continue to rise.  Never a dull moment on the international policy front.

Riding The Fed Train

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

 

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

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

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

 

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

“There will be some payback, particularly late this year and early next and that’s one of the reason house prices are going to begin weakening,” Mr. Zandi says.

 

Mr. Zandi’s reasoning could provide fuel to those in Congress and the administration who want to extend the tax credit. While some in the administration think it should be extended, concerns about the mounting deficit may make such an argument politically tricky.

 

For his part, Mr. Zandi says the tax credit should be extended and possibly expanded to all home buyers — not just those purchasing for the first time. He says the credit could have a bigger impact once the job market recovers and fewer people are out of work and able to buy homes

Leaving aside the issue of whether or not it is wise to create a fresh entitlement for housing purchases (not), the likely all-out push for an extension points to the current vulnerability of the recovery.  It looks neither durable nor sustainable at this juncture; moreover, once again the recovery falls short of providing a significant boost to the labor market.  Yes, the pace of deterioration in nonfarm payrolls is clearly improving, and a turning point has been reached.  But payrolls data continues to deteriorate nonetheless, with only the health care and social assistance sector proving a significant supporting role during the month of August.  Moreover, unemployment is staring at the 10% mark while underemployment is just shy of 16%.  The pace of improvement in initial claims has become anemic, and soon claimants will begin dropping off the roles, another headwind for consumption spending (let alone the human cost) if hiring intentions don't soon head significantly higher.

 

The weak labor market is clearly weighing on inflationary pressures.  From the Beige Book:

Wage pressures remained low across all Districts. Several Districts noted businesses and local governments imposing wage freezes or even reducing employee compensation in some instances. Boston noted that several manufacturers who have cut wage rates do not expect to restore pay levels until next year. Kansas City, Philadelphia, Chicago, Minneapolis, San Francisco, Dallas, and Richmond noted an increase in the cost of some raw materials, including fuel, metals, and steel. Chicago and Dallas mentioned that excess supply was putting substantial downward pressure on natural gas prices. Retail prices were described as generally steady in most Districts, although Kansas City and San Francisco noted continued discounting and downward pressure on consumer prices. 

From the Fed's perspective, the flow of data and anecdotal evidence points to an economy that is definitely improving but not so much as to generate inflationary pressures.  Moreover, the profound and persistent weakness in the job market leaves open the question the sustainability of an external inflation pressures (from commodity prices, for example).  If high prices do not trigger higher wages, the much feared inflationary spiral cannot take hold.   And thus is why Fed officials keep warning that a rate rise is not in the cards in the near term; Chicago Federal Reserve President Charles Evans reiterated this position Wednesday:

Evans also said that when it comes to rate hikes and major unwinding of other emergency support programs now, a shift lies “some time down the road.” In reaching a determination of whether rate hikes are needed, Evans said that “we are going to be looking very carefully at how the economic recovery is preceding,” and will be watching inflation and unemployment measures.

 

“As the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively,” Evans said. When the time does come to raise rates, “we could have a pretty reasonable withdrawal of accommodation.”

Remember, in the last jobless recovery the Fed was still cutting rates well after the official end of the recession.  Of course, the Fed could very well move faster when the signs of sustainable recovery emerge - but if sustainability and inflation potential are based on the labor market, that recovery is easily a long way off.  Moreover, the Fed will not be keen on risking a premature reversal of policy; such reversals never did the Japanese economy any favors.   Speaking of Japan, another prime example of start-stop "recovery":

Japanese machinery orders fell more than economists forecast in July, signaling companies are wary that a rebound in sales abroad will last.

 

Orders, an indicator of capital spending in the next three to six months, declined 9.3 percent from June, when they jumped 9.7 percent, the Cabinet Office said today in Tokyo. Economists surveyed by Bloomberg News predicted a 3.5 percent decline...

 

...“There’s been an enormous wave of confidence in the stock markets but that hasn’t been shared by business leaders,” said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. “Producers know that lots of the improvement in exports and in the overall outlook has been on the back of government programs and they’re still troubled by the outlook.”

It is not easier to pull one over on Japanese business leaders; they have been living this dynamic for nearly two decades.

 

To be sure, there will be consequences of the Fed's extended ZIRP policy; pump enough money in the economy, and it has to show up somewhere.  Pump enough of a reserve currency into the global economy, and things can get interesting fast.  From Bloomberg today:

“Over the next few months, we see the yen strengthening against the dollar and European currencies,” Greg Gibbs, a foreign-exchange strategist at RBS in Sydney, wrote today in a report. “We expect the yen to continue to be replaced by the dollar, and even possibly European currencies, as the preferred funding vehicle for higher-risk, higher-yielding assets and currencies.”

Consider what has occurred - the principle reserve currency, that which is supposed to be an effective facilitator of exchange and a store of wealth, is threatening to overtake the yen and become the primary financing vehicle of hot money gambling.  Under such circumstances, the current market dynamic should come as little surprise - commodities stronger (Gold again breached the $1,000 mark before retreating) while the Dollar is substantially weaker and US equities get a lift.  Seriously, can this really end well?

 

The game is on.  And we all know it.  According to China Investment Corporation Chairman Lou Jiwei (ht Baseline Scenario):

"It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we're just taking advantage of that. So we can't lose," he said

When will it come crashing  down, as all free money pyramids eventually do?  As always, when some aspect of policy or economic activity makes a fundamental shift.  We need to be on the watch those changes.  Renewed financial crisis that sparks a flight to safety, assuming the Dollar is still considered safe?  But what is the likelihood of true counterparty risk when US policymakers have effectively implemented a too-big-to-fail policy that will soon evolve into a too-big-to-regulate policy - even as, according to the Wall Street Journal, the appetite for risk of the top five banks has risen to record levels.  Sure, if your counterparty is Podunk Bank in Nowhere, North Dakota, you have risk.  But Bank of America or Morgan Stanley?  Get real - they have tighter security than President Obama.  Domestic policy change?  The Fed is trying to get credit flowing to consumers, but the data is saying that just is not happening.  Would the situation improve by raising rates?  No, and assuming the jobless recovery scenario emerges, there will be no pressing domestic reason to rush to tighten.  And if markets stumble as the Fed winds down its purchases of Treasuries and mortgage securities, the best bet is that the Fed would reverse course and expand the balance sheet further.  Lack of political will to maintain US stimulus?  Goodness knows that when push comes to shove, the US Congress loves to spend as much as any drunken sailor.  External changes?  China becomes unwilling to hold its Dollar portfolio in response to rising protectionism and makes a bid for the Renminbi to supplant the Dollar as the global reserve currency?  Or rising commodity prices foster foreign inflation, which in turn prompt foreign central banks to raise rates and choke off growth? 

 

The Fed is fueling a nice little train of trading, if not economic, activity.  The Fed will fuel the ride until inflation pressures truly emerge, a ride that can last for a long time given the current state of the labor market.  Everyone should join in for that ride.  But train rides fueled by cheap money always end the same - we pretend the ride can continue indefinitely, but eventually the train moves on to a track that policymakers can not tolerate.   We need to be watching for that track.  The risk:  That track could be a ways off, and we will become complacent before we get to it.