Tim Duy's Fed Watch

Obsidian Hunting

The view from Little Glass Butte - listening to a herd of cattle walking by the tent at night.

Brothers, Oregon

East of Bend - not all of Oregon gets lots of rain.

Brief Hiatus

I remained under the radar for the past two weeks. Summer finally got the best of me, perhaps just as well, as I did not have the opportunity to backtrack from my last assessment of Fed policy:

All in all, this is pretty weak medicine given the condition of the patient. I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight. But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth. Their tools are more effective against deflation. And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

As was widely noted, Federal Reserve Chairman Ben Bernanke emphasized the Fed’s “wait-and-see” position, offering only an extended September meeting to consider the available options. Nothing specific to hang our hats on, no clear guidance as to the next move – suggesting the next "move" is likely to be more of the same, especially if financial markets stabilize and growth lifts off the first and second quarter floors. I believe we need to see even weaker growth, coupled with a steeper drop in long-term inflation expectations to prompt additional action.

The failure of Bernanke to push for more aggressive action is even more puzzling in the wake of this speech. According to the Fed chair, the situation is becoming urgent:

Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.

I suppose I should be happy that someone in Washington considers unemployment to be a crisis, both near and long term. That said, Bernanke follows up with this:

Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank. We have heard a great deal lately about federal fiscal policy in the United States, so I will close with some thoughts on that topic, focusing on the role of fiscal policy in promoting stability and growth.

So he passes the ball to fiscal policy. With good reason, to be sure. Congress and the Administration are failing miserably at macroeconomic policy. The debt debate was an unnecessary, destabilizing, pointless disaster. Does this mean the Fed should be let off the hook? Consider that question in the context of Bernanke’s speech on February 3 of this year:

Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways…By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy, thereby supporting the economic recovery.

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions. For example, since August, when we announced our policy of reinvesting maturing securities and signaled we were considering more purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen from low to more normal levels…Interestingly, these developments are also remarkably similar to those that occurred during the earlier episode of policy easing, notably in the months following our March 2009 announcement of a significant expansion in securities purchases. The fact that financial markets responded in very similar ways to each of these policy actions lends credence to the view that these actions had the expected effects on markets and are thereby providing significant support to job creation and the economy.

Funny that additional quantitative easing yielded “significant support to job creation” in February, when Bernanke wanted to justify QE2, yet now “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” Sometimes I think the only person who doesn’t read Bernanke’s past speeches is Bernanke himself. In any event, it seems the key difference between then and now, from the perspective of the Federal Reserve, is that the recent burst of inflation spooked them badly, raising in their minds the possibility of any central banker’s worse fear, an inflation spiral.

The bottom line: We are playing a data game as we approach the next FOMC meeting – lacking a more extensive collapse of growth forecasts and or inflation expectations, the Fed looks likely to stay the course.

As to my absence alluded to earlier, this summer finally caught up with me. My son being out of school was no small issue – parents are well aware with the requirements of summer camps. New schedule, new location each week. A bit different than I recall of my summers growing up, which were much more of the “go away and try not to wind up in the hospital” variety.

In addition, my wife was in trial in late July. For those of you married to a litigator, you understand what happened to July, and by my recollection, half of June (although I am confident the latter claim will be subject to family debate for years). Household production shifted to my corner.

Most importantly, my father passed away ten days ago after a sixteen-month battle with leukemia. I feel compelled to put a something in words, but none of you should feel compelled to keep reading (the Fed Watch part is obviously done for the day). The battle began at the end of winter term 2010 when I drove him to OHSU for an initial diagnosis and ended on August 18 at his home with his immediate family (my mother, my sister, and myself). As I am sure any of you who have faced the illness of a family member understand, the process is draining. I surely have a greater appreciation of both the possibilities and limitations of modern medicine. We were sure we lost him last September, when he fell into a coma during the first round of treatment. It is tough to forget my mother and I trying to understand the difference between “life-supporting” and “life-extending” treatments when one doctor wants to push forward yet another, just before moving onto dialysis, assured us that no one ever walks away at that point.

As it turns out, at least one person walked away, and my Dad recovered to dictate his own treatment for the next year, right up to the point when he knew he ran out of options and the end was near. We were lucky that my family moved to Eugene after my first child was born, giving us the opportunity to support each other through this ordeal. Still, throughout the year, my mother and sister were the real heroes. It was a year of sorrow, pain, uncertainty, and unexpected opportunities. My father passed on his woodworking skills to my sister as they completed projects such as a beautiful maple coffee table:

Moreover, there was a furious effort to produce a large quantity of end-grain cutting boards as “goodbye presents” to friends and family:

We had some very good times even during the last week. That week he managed to convince me to take a trip to introduce his friend and former business associate to cask conditioned ale (you do need to have your priorities straight). An unambiguously fun night regardless of the circumstances. Another night with just the two of us. And a final trip to the family cabin. Good memories to add to a long list.

In short, more nights with family left fewer nights for blogging. And I will most likely sink below the radar again for the next week. My calendar tells me I am supposed to be walleye fishing in Canada – a trip planned by my father after he recovered from the coma – but instead we will be taking our traditional summer-end vacation near home. For the next few days we will disappear into Central and Eastern Oregon where, much to my wife’s dismay, I have planned a rock-hunting trip in the desert. Moreover, not one of her carefully planned (and almost certainly successful) trips; more one of my “vague, have-car-will-travel, sort of know where the campgrounds are, hope I can get 3G reception as a backup” kind of trip. This is really for my son, who became interested in rocks after a presentation in his kindergarten class. Supporting that interest is a small price to pay given the teacher managed to get him reading at a third grade level after just nine months. Any attempt by his parents to accomplish the same were worse than pulling teeth. That and Oregon is a vast and diverse state, and I want to get to a few places I have yet to see.

Enjoy the end of summer, and look forward to all the possibilities of the next year.

Weak Medicine

The Federal Reserve pronounced on the state of the economy, and the assessment wasn't pretty.  I think this was pretty much the only good news:

However, business investment in equipment and software continues to expand.

We'll see if that holds up given the downdraft in the economy. Speaking of that downdraft, the growth outlook pushes back the return to full employment:

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.  Moreover, downside risks to the economic outlook have increased.

And that hawkish inflation story is falling apart:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.

In response to these clear and present dangers to the economy, policymakers offered this:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Not exactly shock and awe.  And this takes some of the fun out of Fed watching.  What will become of us if the Fed starts telling everyone the policy path for the next two years?  I imagine we will preoccupy ourselves with this:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

We can do more, but we won't.  And why not?  I think the answer was back up in the first paragraph:

Longer-term inflation expectations have remained stable.

The story from the Treasury rally is more of a low growth than a deflation story.  In what world would anyone foresee that real 5 year yields would be negative, real 10 year yields would be zero, and the real 30 year yield just 1.06 percent?  If this really represents annual potential growth over the long run, the next few decades are going to be no fun at all.  

Now, I think it is perfectly reasonable to argue that low growth will eventually work its way into substantially lower inflation expectations, and it would be better to get ahead of that curve.  The Fed doesn't see it that way.  They will need to see inflation expectation numbers turn more solidly south to bring out another round of QE3.  I think that takes some additional weakness on top of what we are currently experiencing.

As far as the expectation of near zero rates for two years, is this weak or strong medicine?  My initial reaction was similar Paul Krugman's:

The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh...

The Fed did not actually promise to keep rates low (whether market participants caught that nuance is another matter).  They only said that based on what they see now, they would anticipate zero rates for another two years. And so what?  We were going to figure that out sooner than later.  The expected date of the first rate hike of the cycle has been repeatedly pushed back "another six months."  And, sure, with mere words the Fed can flatten the near term portion of the yield curve to nearly zero, but there wasn't a lot of room to play around there to begin with. 

Still, upon reflection, I see some additional upside from this psuedo-commitment.  In effect, the FOMC publicly marginalized the hawks.  You know who I am taking about:

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

Awfully convenient to have a block of three dissenters - the names "Larry, Moe, and Curly" come to mind.  But I digress.  One complaint over the past two years is that Fedspeak turns prematurely hawkish.  The instant one good month of data rolls through the door, the more hawkish policymakers rush to let market participants know the end of easy money is near, talk that induces a tightening as agents hedge their dovish bets.  Now we know not to be distracted by such talk, that while the bar to QE3 might be high, so too is the bar to actually raising rates.  In other words, while not a promise, the Fed's outlook  works to entrench expectations against any misunderstandings caused by Fed hawks.  

Bottom Line: All in all, this is pretty weak medicine given the condition of the patient.  I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight.  But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth.  Their tools are more effective against deflation.  And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

The Unpleasantness Continues

Lots of moving pieces tonight as financial centers around the world prepare for the impact of the S&P downgrade of US debt and the ongoing Eurozone debt crisis.  The list:

ECB Finally Ready to Come to the Table.  The ECB is signaling they are prepared to buy up massive quantities of Italian and Spanish debt, hoping to put a firewall around the European debt crisis.  Of course, this isn’t the first firewall European leaders have set, to no avail.  Perhaps this time will be different.  Paul Krugman argues, I think correctly, that at least for Italy the issue is seemingly a liquidity crisis, not an insolvency crisis.  The ECB could effectively act as a lender of last resort in such a case, and bring about stability with only minor fiscal adjustment.  My concern is that if this was just a liquidity crisis, then why did the ECB posture that significant fiscal adjustments were necessary?  Just to look tough?  As to whether or not the ECB is actually prepared to follow through with big bond purchases, I refer you to Yves Smith:

My readers of European press tell me that the signals this weekend was that the ECB wants to nibble only and is trying to prevent panic sales. If this reading is correct, this is a variant on the Paulson “bazooka” strategy of July 2008 with Fannie and Freddie, that if the markets knew he had a bazooka in his pocket, he would not have to use it. We know how that one turned out.

The G7 Communiqué.  The G7 finances ministers and central bankers met over the weekend and more or less confirmed their commitment to fiscal austerity:

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

Whether the US has adopted a credible medium term plan for fiscal reform is debatable, even more so given ongoing economic weakness likely to be exacerbated by near-term fiscal austerity.  What the US needs is near-term stimulus and long-term consolidation, or at least a political system capable of producing this.

Regarding the rapid implementation of the EFSF, I think this means the someone in Europe is going to have to cut their vacation short and actually get on this before the end of the month. A key paragraph:

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

I think this gives the Fed cover to move this morning; more later.  I like this part:

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation.

On one hand, nothing warrants the pressure on Spain and Italy – just a liquidity crisis.  On the other hand, they welcome additional policy measures.  Less reassuring, has the feel of a solvency problem.  Honestly, I think I would be more confident if the ECB had just stepped up to the plate and not demanded a quid pro quo.  Finally:

The Euro Area Leaders have stated clearly that the involvement of the private sector in Greece is an extraordinary measure due to unique circumstances that will not be applied to any other member states of the euro area.

This is a clear line in the sand.  Expect more fiscal austerity.

The Federal Reserve.  As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift.  An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level.  This should give the Fed a green light to act.  I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries.  Just get ahead of this.  The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.

The S&P Downgrade.  Lot’s of speculation on the competence of S&P.  They obviously messed up on the math.  And let’s not forget the role they played during the financial crisis – aren’t any mortgage backed assets investment grade?  They are if you want to keep earning your fees.  But Ezra Klein and Felix Salmon argue that the circus of US politics warrants a debt downgrade.  After all, a small but apparently vocal contingent thinks the debt-ceiling is no big deal, and is actually willing to press the button to prove their point. 

Should the downgrade have significant economic consequences?  I fear the answer is yes.  First, if you believe confidence is important, that confidence has surely been shaken, as evidenced by wild ride of financial markets.  Second, the political response could be a full-court press for more fiscal austerity.  Finally, we don’t completely know the knock-off effects on the rest of the financial system.  From the Wall Street Journal:

The downgrade late Friday had implications for a range of entities with links to the U.S. government or holdings of its debt, running the gamut from mortgage giants Fannie Mae and Freddie Mac to large insurers to securities clearinghouses—not to mention rates on consumer loans such as mortgages that are linked to Treasury yields.

The risk for all these borrowers is that the downgrade to double-A-plus, even though by just one of the three major rating firms, could result in slightly higher interest rates. Those costs might be small for each borrower, but in total could essentially mean a tightening of credit in the country at a time when a weak economy can ill afford higher rates.

The world needs more safe assets.  The safest asset just became a little bit less safe.  That can’t be good.  The sad part is that there really shouldn’t be any doubt the US can and will repay its debt in full.  Any way you cut it, this is a self-inflicted wound.

Good luck today.

Be Wary of Entitlement Reform

I stumbled on this Robert Samuelson op-ed piece via Marginal Revolution.  I think Tyler Cowen was impressed with this sentence:

Older Americans do not intend to ruin America, but as a group, that’s what they’re about.

The key argument Samuelson wants to make is that Social Security and Medicare are not income protection programs, but welfare to the middle class.  He trots out this:

...some elderly live hand-to-mouth; many more are comfortable, and some are wealthy. The Kaiser Family Foundation reports the following for Medicare beneficiaries in 2010: 25 percent had savings and retirement accounts averaging $207,000 or more; among homeowners (four-fifths of those 65 and older), three-quarters had equity in their houses averaging $132,000; about 25 percent had incomes exceeding $47,000 (that’s for individuals, and couples would be higher).

Dean Baker had a reaction as he quickly notes that Samuelson defines down wealthy:

Let's see, we have retirees who have their Social Security checks, plus a stash of $207,000. If someone at age 62 were to take that $207,000 and buy an annuity this money would get them about $15,000 a year. Add in $14,000 from Social Security and they are living the good life on $29,000 a year. And remember, 75 percent of the elderly have less than this.

Samuelson's failures are even more egregious when one actually reads the Kaiser Family Foundation report which he cites as evidence for his position.  To give you a taste:

Half of all Medicare beneficiaries had incomes below $22,000 in 2010; less than one percent had incomes over $250,000

You can see where this is going; Samuelson is trying to co-opt a piece is titled "Protecting Income and Assets" into an attack on entitlements.  Skip to the summary of the report:

While a small share of the Medicare population lives on relatively high incomes, most are of modest means, with half of people on Medicare living on less than $21,000 in 2010. The typical beneficiary has some savings and home equity, but asset values are highly skewed and are significantly higher for white beneficiaries than for black or Hispanic beneficiaries. The income and assets of Medicare beneficiaries overall are projected to be somewhat greater in 2030 than in 2010; yet, only a minority of the next generation of beneficiaries will have significantly higher incomes and assets than the current generation, with much of the growth projected to be concentrated among those with relatively high incomes. Racial disparities in both income and assets are projected to persist for the next decades.

As policymakers consider options for decreasing federal Medicare spending and addressing the federal debt and deficit, this analysis raises questions about the extent to which the next generation of Medicare beneficiaries will be able to bear a larger share of costs.

The upshot of this report contradicts Samuelson's arguement.  In reality, the very wealthy that would get means-tested out of Medicare and Social Security are few in number; if you want real program savings, you need to dig deeper. He is simply hoping none of his readers will click through to actually read the report.

I don't even need to go into how Samueslson lumps together Social Security and Medicare and aging population and exploding medical costs for a narrow segment of the population.

This is just a PR-piece that is part of an effort to role part entitlement spending.  The broader goal from the Wall Street Journal:

House Majority Leader Eric Cantor on Wednesday suggested that Republicans will continue a push to overhaul programs such as Medicare, saying in an interview that "promises have been made that frankly are not going to be kept for many" and that younger Americans will have to adjust.

I often hear complaints that older Americans are sucking resources from the rest of the nation.  Consider what would happen in the absence of income protection for those older than 65 - many more would rely on their children for support.  That group then will be less able to save for their own retirement and, perhaps more importantly, would not be able to transfer resources down to their own children.  In other words, eliminate income protection for the 65 and older group places the next group in a position of choosing between supporting their parents or financing their kids college education.  Or giving up a job to take an elderly parent into their home.  

You get the idea.  It is not obvious that everyone else will be better off if you reduce income protection programs. The costs stay the same; they just shift.  

Now, you can argue that as long as we just focus on efforts on cutting benefits for younger Americans, there will be plenty of time for adjustment.  But what will be the costs of the adjustment?  Failure to have an effective insurance mechanism against old age - and given the market failures in the insurance industry, it is reasonable to believe the government needs to maintain a strong role in providing such insurance - will induce younger Americans to save more.  Great, you might say, households need to save more anyway.  But do we really need to hasten the process of deleveraging that is already underway?  That will simply slow near term growth, worsening the budget situation.

Interestingly, one of the complaints about China is that consumer spending is low because its citizens lack a sufficient safety net.  Shouldn't the reverse argument work for the US as well?  

In short, I am wary of entitlement reform.  It is not evident that is will lead to anything more than cost-shifting, and not necessarily positive or even zero-sum shifts.  What we really need is thoughful, aggressive healthcare reform that reduces costs while improving outcomes, something that it appears every other industrialized nation can manage.  

 

Jobs Report and the Fed

The jobs report was somewhat better than expectations.  Admittedly, this isn't saying much.  But it was "good" enough to give the Fed pause before rushing into a fresh round of easing.

The headline NFP gain of 117k jobs was a combination of a not-terrible 154k gain in the private sector and a 37k loss on the public side of the ledger.  Overall, simply a sideways movement.  From the perspective of policymakers, however, the numbers will suggest that recession fears are overblown.  And the 10 cent gain in hourly wages will suggest to some FOMC members that a renewal of deflation fears are also equally overblown.  

It is true that, as Calculated Risk notes, the survey period was before agents turned cautious as the debt farce deepened.  But, then again, the Fed would simply argue they need to see how much of that caution is quickly reversed.

Now, they could turn their attention the the household survey, and note that both labor force participation rates and the employment to population ratio continue to decline.  But they could attribute these effects to largely structural causes, and as such beyond their purview.  This too would also argue against any significant change in policy.

The implied inflation expectations from the TIPS market is 193bp and 225bp at the 5 and 10 year horizons, respectively.  Still well above last summer's lows.  The Fed has repeatedly argued they can't do anything about growth, but can fight deflation.  But this doesn't appear to be a strong deflationary signal.  This too argues against significantly policy shifts.

Financial market chaos argues for a shift in policy, but traditionally the Fed has resisted until the impact on actual economic activity becomes more evident.  Again, an argument against looser policy.  

On net, and with the benefit of the labor report in our back pocket, I think Neil Irwin at the Washington Post is most likely correct:

The Fed is holding its regular meeting on monetary policy next week, and leaders of the central bank will surely discuss the weakening outlook, whether they should do anything in response and what such a response might consist of. Their public statement following the meeting will likely reflect the worsening outlook for the economy, but they appear inclined not to make any policy changes until more evidence has become available and there has been more time to weigh it.

They will offer the possibility of further action, but none will be forthcoming next week.  Now, all that said, I think the Fed should get ahead of this one - failure to do so has not yielded positive results in the past.  But what the Fed should do and will do are two different things.

Good News That Is Really Not So Good

Markets are all over the place this morning, gripped by fear as participants try to anticipate each other's behavior in a fast moving environment.  A mid-day rally appears to have been prompted by this:

U.S. stocks rose, erasing an early tumble, amid speculation the European Central Bank was preparing to buy Italian and Spanish bonds to halt the region’s debt crisis.

Skip a paragraph and one finds this:

Stocks erased losses after Reuters said the European Central Bank is pressuring Italy to make further reforms in return for buying Italian and Spanish bonds. Italy’s government will announce plans to speed up state-asset sales, liberalize the labor market and introduce a balanced-budget amendment into the country’s constitution, Sky TG24 reported today, citing unidentified officials.

Really?  Really?  Clearly one of those "beatings will continue until moral improves" sort of things.  The history of European-debt crisis is that one economy finds itself under pressure, "help" is offered in return for fiscal austerity, austerity worsens the underlying economic situation and thus the fiscal position, and funding pressures resume.  

Apply, rinse, repeat.  

It gets better:

The ECB would be willing to buy more bonds of deficit-hit countries once they take “concrete” steps to stabilize their finances, European Central Bank council member Luc Coene said.

“Certainly the ECB is ready to make major efforts to relieve the situation, but first the countries have to take steps,” Coene, head of Belgium’s central bank, told RTBF radio in Brussels today. “It doesn’t make sense to pour water into a bucket with a hole in it.”

It incredibly difficult to stabilize finances in a debt-deflation spiral.  The nations of the Eurozone do not have the escape valve of printing their own currencies.  They do not have the escape valve of currency depreciation.  Indeed, they face the very opposite issue - although market participants increasingly believe the Eurozone will jettison the periphery (and maybe even part of the core), the Euro stays relatively strong.  Why?  Whatever is left over is certain to be a hard-money union. 

These defects set the stage for a debt-deflation spiral.  Fiscal austerity only intensifies that spiral - as proven by the ongoing challenges in the Eurozone.  Yet that lesson has yet to be learned at the ECB.  Using Coene's analogy above, the ECB is not really pouring water into the buckets as much as punching fresh holes.

ECB rallies have short half-lives; enjoy this one while you can.

That. Was. Unpleasant.

The rapidity with which confidence can shift is nothing short of a wonder of nature.  I am not sure there was any terribly new news today.  The evidence the US economy is weakening has been mounting for weeks.  That equities had not sold off yet was something of a testament to the underlying profit situation. 

But now fear grips financial market participants as the rush to cash or cash equivalents accelerated.  A rush to judgment on the US economy?  Felix Salmon tries to paint a positive picture:

Firstly, this is not necessarily a Bad Thing. If you’re saving for retirement, stocks are cheaper now, and your 401(k) contribution goes further than it did a few weeks or months ago. That’s good.

Secondly, if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there.

Put those two things together, and you can even be quite happy about today’s sell-off. If you’re a debtor rather than a saver, then falling interest rates are good for you. If you want to buy a house, then falling mortgage rates — not to mention falling home prices — are also good news. And if you want to invest in some wonderful future income stream, then money’s cheap right now to do so.

This seems to me to be a point in the recovery where you do not want the 10-year Treasury plunging to 2.41 percent.  Felix offers a bit more pessimism:

Still, the future of the global economy is very uncertain, and southern Europe in particular is still far from any kind of sustainable resolution. The US economy has no particular exposure to Greece — but Italy is another matter entirely. This is a global sell-off, with European markets down just as much as those in the US; Asia’s sure to follow suit when it opens. Now that the Fed has stopped dropping dollar bills on the US economy, it’s hard to see where confidence and optimism are going to come from in the coming months.

Yes, will the Fed come to the rescue?  Ryan Avent:

The good news is this: the Fed can't help but act. On Tuesday, I worried that the Fed would stand pat at its meeting next week, leaving the economy to dip into recession before it finally reacted in late August or following its September meeting. That no longer seems like the most likely outcome to me; events are moving too fast. Ben Bernanke may not announce a new policy next week, but I believe he will hint at new Fed easing—potentially at new purchases, but perhaps also at other available tools. The drop in inflation expectations should force the Fed's hand.

Inflation expectations are coming down, with the 5 year TIPS measure less than 2 percent but the 10 year TIPS measure is still 2.23 percent (down just 4bp from yesterday).  Looking at the past week, I think Avent is on the right track – the Fed should be ready to get ahead of this mess, and next week is an opportune time.  That said, the Fed has tended to be late in the game throughout the past few years.  You have a lot of policymakers that need to fundamentally shift their intellectual framework to come to terms with a rapid shift in policy.  And they could easily point to the 10 year implied inflation expectation and say it need to fall further before we will act.  Same with the 5 year implied inflation expectation – it was bouncing along near 1.2 percent by late August last year.

In other words, it took considerably greater worries on the deflation front to prod the Fed into action last year.

In my view, Avent’s policy prescription is correct.  For goodness sake, get ahead of this thing.  Does another $200 billion on the balance sheet really matter that much?  But the history of the last few years it this:  They get to the right solution, but it takes some time.  Now, one would think they learned some lessons in the last few years, and would tighten up the timeline.  At the same time, though, one would have thought they learned their lesson from last years ill-timed turn toward hawkishness.  Yet, they once again eagerly walked into that track this year as well. 

The slow learning curve on Constitution Ave. argues against action next week.  The reality of the world argued for action last month.  Go figure.

Of course, the slowest learning curves are in Europe.  Via the Wall Street Journal:

The euro zone’s inflation outlook has remained largely unchanged since the European Central Bank‘s July policy meeting, ECB President Jean Claude Trichet said Thursday, noting that he would not rule out further rate increases despite the ECB broadening its efforts to support fragile financial markets.

Speaking in a television interview with Dow Jones Newswires, Trichet said “our judgment is very much the same as in the previous meeting a month ago. We consider that we’re still in a situation where the risks are more on the upside… and that we will have to monitor the situation very closely.”

It speaks for itself.  With policymakers across the Atlantic seemingly oblivious to their own dire situation, the fear gripping financial markets is completely understandable. 

Bottom Line:  The market nosedive does not yet guarantee Fed action in the near future.  History has shown the Fed tends to react with a lag.  They should have learned better by now, but if they had learned anything, they would not have pushed forward with hawkish rhetoric earlier this year.  Arguably, they will hold firm, let the markets think they are out of the game and further bid down implied inflation expectations, and then, once the damage is done, up the level of stimulus.  Terrible way to run an economy, I know. Still, it would be remiss to declare anything is certain before the employment report is released.  A downside surprise could promt the Fed into more rapid action.  I am now entirely speechless on the European situation – with Trichet's ongoing hawkish stance, it has truly devolved into one of those slow-motion train wrecks that one only sees in the movies.

On the International Front

Lots of little bits and pieces in the news today.  First off, from Bloomberg:

China, the largest foreign investor in U.S. government securities, joined Russia in criticizing American policy makers for failing to ensure borrowing is reined in after a stopgap deal to raise the nation’s debt limit.

People’s Bank of China Governor Zhou Xiaochuan said China’s central bank will monitor U.S. efforts to tackle its debt, and state-run Xinhua News Agency blasted what it called the “madcap” brinksmanship of American lawmakers. Russian Prime Minister Vladimir Putin said two days ago that the U.S. is in a way “leeching on the world economy.”

Spare me the feigned indignation.  If you are unhappy, just don't buy the debt.  If there is a problem in the US, China and others were the enablers.  Or, another perspective is that because foreign central banks accumulated massive currency hoards to maintain a competitive trade advantage, the US was effectively force to run huge deficits to offset the demand drag.  And it's not like the portfolio is faltering:

The comments reflect concern that the U.S. may lose its AAA sovereign rating after President Barack Obama and Congress put off decisions on spending cuts and tax increases to assure enactment of a boost in borrowing authority. China and Russia, holding a total $1.28 trillion of Treasuries, have lost nothing so far in the wake of a rally in the securities this year.

I also enjoy the complaints of Putin in light of this Bloomberg article:

Roustam Tariko, billionaire owner of Russian Standard Bank and Russian Standard Vodka, completed the most expensive home purchase in Miami Beach since 2006 when he bought a $25.5 million estate on Star Island in April.

The transaction made Tariko the neighbor of another wealthy Russian with a taste for Florida luxury living. Vladislav Doronin, chairman of Moscow-based real estate developer Capital Group, paid $16 million in 2009 for the Star Island home previously owned by Shaquille O’Neal, the now-retired professional basketball player.

“In Russia, it’s a status thing now,” Jorge Uribe, a real estate agent with One Sotheby’s International Realty Inc. in Coral Gables, Florida, said in a telephone interview. “If you’re wealthy and you say you have a place in Miami, it’s like saying back in the old days, ‘I own a place in Ibiza or Monaco.’ It’s a cocktail conversation thing.”

At least somebody in Russia still wants to buy American.  The article also has this great material:

The seller of the property, Thomas H. Morgan, declined to discuss details of the transaction. Morgan, the founder of Morgan Energy Corp., a closely held oil and gas exploration company based in Englewood, Colorado, said it’s no surprise that foreigners are stepping up to buy while Americans hold back.

“Americans don’t want to put down 80 percent or pay cash,” Morgan said in a telephone interview. “A lot of Americans are tapped out.”

Morgan, who said his “hobby” is building trophy homes, constructed the Star Island mansion in 2003.

Really, how many "Americans" are really in the market for these homes?  As for hobbies, I considered trophy houses, soon after my yachting phase and a related diversion into polo ponies.  None of those really worked for me; I settled on gardening.

Currency intervention is all the rage this week:

Japan followed Switzerland in seeking to stem appreciating exchange rates that threatened to damage export competitiveness, selling the yen for the first time since the aftermath of the nation’s earthquake in March.

Japan acted alone in the market, while officials were in contact with other nations, Finance Minister Yoshihiko Noda told reporters today. The yen slid 2.7 percent to 79.21 per dollar at 1:39 p.m. in Tokyo, still above its two-month average. Noda suggested the Bank of Japan may follow with monetary stimulus, saying he hoped it would take appropriate action. The BOJ brought forward by a day the end of its scheduled policy meeting.

I can't really blame Japanese officials.  There economic experience long ago argued for more foreceful monetary policy, including unabashed foreign currency purchases (I could argue the same for another central bank that will remain nameless).  I am sympathetic to the Swiss.  Once, long ago, I argued that internally that the Swiss Franc was a safe-haven repository, something long-time market participants always knew.  I was laughed out of the room, as Switzerland was "too small."  Well, they are too small to be a good safe haven, yet safe haven they are.  And a 23% currency gain for a small economy in just six months is understandably unnerving.

The ultimate lesson of recent interventions:  The world definitely needs more safe havens.

Europe continues to deteriorate, under the watch-full eye of vacationing leaders (cut them some slack, it's August, after-all):

The European sovereign-debt crisis placed new strains on the Continent's banks on Wednesday amid signs that some lenders are finding it harder and more expensive to fund themselves.

The cash crunch for some European Union banks underscores the challenges that central bankers and regulators face in preventing the bloc's economic and debt problems from seeping into the bank-funding markets.

The barometers that central banks and analysts use to monitor stress aren't showing extremely heightened levels. But certain gauges are flashing warning signals: Bank funding from the European Central Bank increased and European banks and corporations have had to turn to the currency markets for dollar funding, instead of borrowing from one another or selling debt.

Worse, hat tip Calculated Risk, via the New York Times they don't seem to have any sense of urgency:

Even more worrying is the fact that the European Financial Stability Fund, Europe’s so-called bazooka rescue fund that it endowed last month with the powers to recapitalize weak banks, will not be able to offer any such aid for at least two months.

According to a stability fund official, staff members there are working night and day to recast the entity, but do not expect to be finished until the end of August. At that point, it must be approved by the parliaments of the 17 countries that use the euro currency.

END OF AUGUST!?!  PARLIAMENTS OF 17 COUNTRIES?!?  These guys might actually be worse than our guys, and that is saying a lot if you have been watching Washington this past month.

Finally, although not international, a big hat tip to Barry Ritholtz for bring this piece from the Onion to our attention:

Claiming he wasn't afraid to let everyone in attendance know about "the real mess we're in," Federal Reserve chairman Ben Bernanke reportedly got drunk Tuesday and told everyone at Elwood's Corner Tavern about how absolutely f***ed the U.S. economy actually is.

Bernanke, who sources confirmed was "totally sloshed," arrived at the drinking establishment at approximately 5:30 p.m., ensconced himself upon a bar stool, and consumed several bottles of Miller High Life and a half-dozen shots of whiskey while loudly proclaiming to any patron who would listen that the economic outlook was "pretty god***ned awful if you want the God's honest truth."

I particularly liked this part:

After launching into an extended 45-minute diatribe about shortsighted moves by "those bastards in Congress" that could potentially exacerbate the nation's already deeply troublesome budget imbalance, the Federal Reserve chairman reportedly bought a round of tequila shots for two customers he had just met who were seated on either side of him, announcing, "I love these guys."

And this:

While using beer bottles and pretzel sticks in an attempt to explain to the bartender the importance of infusing $650 billion into the bond market, the inebriated Fed chairman nearly fell off his stool and had to be held up by the patron sitting next to him.

 You just have to find the humor in this stuff, because the reality is looking pretty sad.