Tim Duy's Fed Watch

Did The European Deal Just Collapse?

To be sure, I have been bearish on Europe.  From last week:

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months.

It turns out a "few months" might have been wildly optimistic.  It was quickly evident that bond markets didn't show the same enthusiam equity markets expressed for the supposed deal.  That was huge red flag.  The second red flag was the Bank of Spain announcing a stagnant 3Q GDP.  From the Associated Press:

The Bank of Spain suggested that the flat growth calls into question the government's goal of reducing its deficit to 6 percent of GDP in 2011, from 9.2 percent last year...

...It said domestic demand fell because of lower government spending as a result of deficit-reducing austerity measures taken by regional governments and because of a moribund real estate market. Household and business spending posted small increases. Spain's economic woes stem largely from the collapse of a property bubble.

The Bank of Spain said there is still time to meet the deficit reduction target by the year's end but warned that fresh measures may be necessary.

Yes, you read that right...the Bank of Spain blamed missing deficit reduction targets on fiscal austerity and then suggests additional fiscal austerity as the solution.  And as all nations in the Eurozone increasingly pursue fiscal austerity, we can only expect the nascent European recession to deepen.  Eventually, the European public will have had enough of the downward spiral.  How long will it be before Spain decides to aggressively push for a Greece solution of "voluntary" debt relief?  

Finally, a lynchpin in the European debt deal - Greece - apparently isn't ready to abide by the terms of that deal.  The public pressure is now too much.  From the Financial Times:

Greece’s prime minister unexpectedly announced a referendum to approve a second EU bail-out deal for his austerity-hit country, less than a week after it was agreed with international creditors at a European Union summit...

...One senior EU official told the Financial Times that Mr Papandreou had appeared reticent about the components of the bail-out package during talks at last week’s summit of EU presidents and prime ministers but no one was prepared for the referendum announcement that came “like a bolt out of the blue...

...The vote would probably be held in January, when Greek bondholders were expected to sign up for a voluntary 50 per cent haircut being negotiated with the International Institute of Finance, wrapping up the new bail-out package. One Athens banker said: “This is a worrying decision by the prime minister. It could derail the whole process even before it’s properly started.”

Not only are the details of the grand European plan still in flux, but so are the broad brushstrokes!  Clearly, the Greeks have just brought back into play all the uncertainty last week's summit was meant to dispell.  It is not unreasonable to think the Greek electorate is more willing to technically default and start from scratch than their leaders. Indeed, shouldn't this be our baseline scenario?  

Bottom Line:  Last week's European Summit accomplished far less than even the reduced expectations going into last week.  The cracks began appearing before the ink was dry.  More worrisome is that the Greek leadership didn't even believe they were on board in the first place.  Simply put, the world economy is no less fragile than it was a week ago.  And in that fragility still lies the recession risk for a still struggling US economy. 

 

Waiting, Waiting, Waiting

US markets are closed, with everyone left waiting for the news from Europe and the 3Q11 US GDP report.  Expectations appear to be high for both, but I am considerably more certain the latter will deliver on those expectations.  Europe is certainly more interesting.  Over the last few weeks, market participants looked to have grasped at every little straw that offered hope on the European story, and it remains to be seen whether or not that will continue when rumours turn to news.

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months.  Some specific concerns:

The goalposts are already moving.  The Eurozone economy is headed into recession - the combination of fiscal austerity and financial turmoil have already set in motion the inevitable contraction of demand that will soon threaten deficit reduction goals across the continent.  And it is only a matter of time before the ratings agencies recognize this as well.  The European solution, of course, will be additional fiscal austerity.  It didn't work in Greece, and it won't work for the Eurozone as a whole.

The lack of sufficient ECB participation.  The German contingent has effectively shut down the ECB.  From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery.  But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

When in doubt, turn to financial engineering.  The faith in financial engineering never ceases to amaze me.  Efforts to leverage up the EFSF are almost comical, and they reveal another problem in this exercise - no one (in particular, Germany) is willing to bring sufficient resources to the table.  Wolfgang Munchau:

Leverage can have different economic functions, but in these cases it simply disguises a lack of money.

The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality.

Turning to developing nations for help.  If it wasn't so sad, it would almost be funny.  Reports of BRIC participation as EFSF investors have been circulated for weeks.  The latest version that reportedly sparked today's market rally:

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.

My goodness, have the Europeans learned nothing from the Americans?  Sure, we let the fox into the hen house and didn't have the common sense to chase him out a decade ago.  The Europeans are now opening the doors and inviting in the fox.  Michael Pettis had a long, must read piece on this topic earlier this month:

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

The idea on the table is for the BRICs to buy into the EFSF, not struggling debt directly.  Even so, they need Euros to buy EFSF debt, which will represent a capital inflow into Europe.  The periphery nations are struggling to rebalance internally.  The strong Euro is not helping matters.  Ultimately, additional capital inflows from the BRICs will only add additional strength to the Euro, encouraging further contractionary external adjustment that only complicates the internal adjustment challenges.  The Europeans really should be seeking a European solution, not adding more external stakeholders to the fray.

I guess we should all get some good sleep tonight, as tomorrow will be a busy day. 

Wither CDS?

Something I have been wondering about in the context of the supposed "voluntary" writedowns being forced upon holders of Greek debt - what exactly is the point of the credit default swap market for sovereign debt if politicians will act to ensure that any default never triggers a credit event?  The FT provides an answer:

Now, politicians are seeking to take their revenge: not just with the recent introduction of bans on some trading of credit default swaps but also in their attempts to ensure that any haircut on Greek government bonds does not trigger a credit event.

Combined, these two events could spell the end of the credit default swaps market, say bankers.

The end of the credit default swap market might not be without consequences:

But these aims could backfire. Some bankers believe, rather than lowering borrowing costs, these moves will have the reverse effect and also restrict lending to their banks and companies.

In the wake of the CDS ban, some banks are already pushing alternative strategies that risk driving up government bond yields even further. Last week Citigroup, the leading US bank, recommended selling the bonds of France, Italy and Spain because of the trading ban while other banks have warned they could unload peripheral bonds if CDS payouts are ruled out on Greece.

Not exactly a good time for higher rates in the periphery.  Will the loss of the CDS market ultimately improve or undermine financial market functioning?  This is outside my area of expertise, leaving me particularly curious on how events unfold.

Floating Rate Treasuries

Reports circulated today that the US Treasury is considering a new type of debt.  From Bloomberg:

The U.S., seeking to attract investors who might otherwise avoid Treasuries amid a $1.3 trillion budget deficit, is considering the sale of floating- rate notes in what would be its first new security since it began offering inflation-linked debt 14 years ago.

The Treasury Department said this month it asked Wall Street’s biggest bond dealers for recommendations on structuring securities with coupons that rise or fall with benchmark rates. Officials are scheduled to gather with the 22 primary dealers, who include Goldman Sachs Group Inc. and JPMorgan Chase & Co., on Oct. 28 as it decides whether to go further during their regular meeting that precedes each quarterly refunding.

I find this idea intriguing.  On the surface, with US 10-year debt hovering around 2 percent, there seems to be plenty of demand to dry up whatever Treasury issues.  And it looks like a wise move to lock in as much debt as possible at those low rates.  That said, at some point in the future (hopefully) rates will rise, and it is easy to see an inflection point where investors, wary that monetary policy may shift abruptly, would be wary to add to their Treasury holdings.  Having a floating rate product on hand could be important in such circumstances, preventing any abrupt funding shortfalls and rates spikes by offering investors a form of insurance against rising rates.

Daniel Indiviglio at the Atlantic offers up some potential problems with such a product.  First, he correctly notes the desire to lock in today's low rates.  Second:

Tying U.S. debt costs to how interest rates rise and fall could also be dangerous. For every $1 billion in floating-rate debt that the Treasury issues, a 0.5% (50 basis point) increase in interest rates would result in its debt costs rising by $5 million. You can imagine how quickly U.S. debt costs could rise if the government had something like $1 trillion in floating rate debt and interest rates jumped a few percent in a year. Suddenly, the government would have to issue tens of billions of dollars in additional debt just to keep up with rising interest rates.

As I noted, I think this product would be particularly useful in the expected transition to higher rates and would not expect it to be a primary funding mechanism.  I can also see a benefit in a mechanism that explicitly penalizes the fiscal authority for overspending should actual fiscal constraints emerge in the future.  Consider it something of an automatic stabilizer - more spending power automatically emerges when the economy dips and debt costs fall, and vice-versa.  Indiviglio offers another potential problem:

And if you think that the government puts too much pressure on the Federal Reserve to act now, just wait until it directly controls a portion of the nation's interest costs. Floating-rate note would likely include a benchmark rate controlled by the Fed. So if the U.S. is ever struggling to meet its debt obligations, the Fed may feel obligated to keep interest rates lower than it otherwise would. If it increases rates, a payment shock could affect U.S. financial stability. Due to this, floating-rate debt could lead to higher inflation, since the Fed may feel pressured to leave interest rates lower for longer.

I thought the Federal Reserve would be a natural buyer of such debt.  Consider the current (what I think overplayed) worry that the Federal Reserve is threatened by huge captial losses on its existing portfolio when interest rates rise.  There is some concern that the Fed will resist raising rates to avoid the erosion of it capital base, as it would lose some of its independence if monetary policymakers needed a capital injection from the US Treasury.  In addition, there is a related concern that should the Fed need to raise interest on reserves abruptly to control inflation, then the Fed's expenses will surge well above the interest paid on its Treasury portfolio.  Yet again another trip for a Treasury bailout.  

While I was not concerned much about these scenarios, note that they would both be eliminated if the Fed held a significant portion of floating rate debt in its portfolio.  It would automatically create a revenue stream to support higher interest on reserves.  Obviously, the risk of capital loss would recede.  Moreover, a large Federal Reserve holding of such debt would protect the taxpayer as well - higher debt servicing cost would just flow right back to the US Treasury (after Federal Reserve expenses).  Finally, note then-Federal Reserve Governor Ben Bernanke made a similar proposal in his famous 2003 Japanese monetary policy speech.  Essentially, a floating rate portfolio eliminates some imagined or real constraints on monetary policy, reducing the risk that additional quantitative easing will turn inflationary.

In short, I think the US Treasury has good reason to consider adding floating rate debt - and should find a ready buyer not only in Wall Street, but just across town.

On That Double-Dip

Dean Baker admonishes those concerned about a double-dip:

...The economy looks to be growing in a range of 2-3 percent. This is roughly fast enough to keep even with the growth of the labor force. That implies that we are making zero progress in putting people back to work.

Unfortunately, because many economists misread the economy and raised the specter of a double-dip, this slow growth is likely to be seen as good. It isn't and the double-dippers have done the country a serious disservice by creating a set of incredibly low expectations against which economic performance is now being measured.

As I have previously stated, the economy was clearly not in recession in the third quarter, and therefore near-term data would certainly not be consistent with a recession. Indeed, this has been the case. If you expected the bottom to fall out of the economy in the fall, you have been disappointed.

Moreover, the primary reason to believe in a reasonably high probability of recession had little to do with the US data to begin with. To be sure, the overall low rates of growth in this "recovery" does imply that downward negative shocks will push us more easily into recession, and this suggests we may face an increase in recession scares in the years ahead. That said, the first half slowdown is really only a supporting character in the recession story. The lead character was and remains the European situation.

And despite the seemingly endless optimism on Wall Street that Europe will come to an agreement that forestalls a deeper crisis, the reality appears to be very different. My interpretation is the press reports suggest complete and total disarray among European government, as 17 economies all with different objective functions struggle to define the meaning of "Union." This is not stuff for the feint of heart. The differing objective functions and the subsequent need to make all parties happy by itself suggests that at best only a partial solution is at hand, and we are way beyond partial solutions. Moreover, beyond governmental agreement comes the issues of force feeding capital to the banks and the willingness of Greece's bondholders to accept a significantly higher haircut without creating a credit event. I kind of hate to be a pessimist, but good luck putting all that in place by next Wednesday.

Meanwhile, as Edward Harrison points out, while Wall Street may be buying what the EU is selling, European financiers see the writing on the wall. Italian yields are nearing 6%, effectively unwinding the efforts of the ECB to contain the crisis with their earlier bond-buying campaign. Moreover, yield spreads throughout Europe are blowing out. Calculated Risk was always found of saying "we are all subprime now." Well, increasingly it looks like all of the Eurozone is the periphery.

Finally, over at The Street Light, Kash reports Greece is most likely on their last austerity package:

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

Does this get better before it gets worse? History says no. Back to Edward Harrison:

It seems to me that we risk a true Armageddon scenario here from dithering.

A major credit event in Europe looks inevitable. Would a European meltdown endanger the US recovery? We are looking at two channels, trade and financial. I tend to discount the trade channel. As a general rule, I think the propagation of such shocks is too weak to alter the fundamental cyclical forces underlying the US economy. The potential for financial shocks, however, keeps me up at night - this is the key to the US recession story. There is a nontrivial chance that credit event in Europe triggers a credit event in the US. This following quote from Bloomberg only increases my unease:

“We have looked very carefully at bank exposures both to foreign sovereigns and to foreign banks,” Bernanke said. “The exposures of U.S. banks to the most troubled sovereigns --Portugal, Ireland and Greece -- is quite minimal. So the direct exposures there are not large.”

That sounds just a little too much like there is no housing bubble and the subprime crisis is "contained." When it comes to how financial events resonate throughout the US economy, it seems best to bet against Federal Reserve Chairman Ben Bernanke.

Because of the uncertainties surrounding the European crisis and whether or not it induces a regime change in the US economy, forecasters lack conviction about the recession calls, with most circling around 50-50. At the same time, however, I don't see that the competing forecast could in anyway be called optimistic. Optimistic relative to recession, but the baseline forecast remains that of an economy still struggling along in the 2-3% range - a range no one thinks is acceptable given the current high levels of unemployment.

Finally, the forecasts of a double-dip did not do a disservice by changing expectations, as Baker suggests. In fact, I think clearly the opposite occurred. The concerns about the double-dip prodded the Federal Reserve to step up their stimulus efforts, with possibly more on the way. Ultimately, the Federal Reserve was pushed to go where it should have been in the first place.

P.S. I think that we are sufficiently past the last recession that the next recession stands on its own. The term "double-dip" is not really accurate.

Widespread Lack of Conviction

Menzie Chinn at Econbrowser looks at the OECD data and concludes the world is close to stall speed. Alcoa is an early victim, as the impact of the European financial crisis becomes evident.  Via Reuters:

[Alcoa] CEO Klaus Kleinfeld warned of weak economic conditions through the year, particularly in Europe, "as confidence in the global recovery faded."

That sapped aluminum demand from the automotive, industrial products, construction and packaging sectors since the second quarter, with only the aerospace and transport sectors growing.

Can the global economy recovery?  WIll the damage be limited to Europe?  With growth teetering on an edge, it would be nice to have one old US recession indicator back in the tool kit - the yield curve.  With short-term interest rates at zero, it is impossible for the yield curve to invert, a traditional indication of recession.  Bloomberg reports on an effort to overcome this challenge and regain that tool:

The bond market indicator that has predicted every U.S. recession since 1970 shows that the economy has about a 60 percent chance of contracting within 12 months.

The so-called Treasury yield curve, adjusted for distortions caused by the Federal Reserve’s record low zero to 0.25 percent target interest rate for overnight loans between banks, shows that two-year notes yield 20 basis points, or 0.20 percentage point, less than five-year notes, according to Bank of America Corp. research. The unadjusted gap of 79 basis points at the end of last week indicates the chance of recession at about 15 percent...

...“The adjusted curve is giving a powerful signal for an upcoming U.S. recession,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America, one of the 22 primary dealers of U.S. government securities that trade with the Fed. “If that happens, the Fed’s target rate could remain near zero beyond 2014,” more than a year longer than the central bank has indicated, he said in an interview on Oct. 3.

More on the topic can be found at the FT Alphaville blog, including this chart:

Alas, still not the defining indicator we could hope for.  While 60% is better than even, it is still a call that lacks conviction.  As are the other outlooks reported by Bloomberg.  First:

Goldman Sachs Group Inc., another primary dealer, puts the odds of another recession at 40 percent, the firm’s economists wrote in an Oct. 3 report. 

Next:

JPMorgan Chase & Co. economists said in an Oct. 7 report that they see “a soft growth picture, but one that is not falling into recession at the moment.” The firm, also a primary dealer, forecasts the 10-year note yield will end the year at 2.25 percent.

Then:

“Markets these days give mild signs of a collapse,” Gross said in an Oct. 4 Bloomberg Television interview with Lisa Murphy. The odds of recession in developed economies is about 50 percent, with the U.S. on the “brink,” he said. “This is one of those times where you are worried about the return of your money.”

60%, 40%, 50%.  Still seems to be only one firm with a strong conviction:

A “contagion” of economic indicators have come together to signal the economy is tipping into a contraction, according to Lakshman Achuthan, co-founder of ECRI, a research firm that predicts changes in the economic cycle.

“You have wildfire among the leading indicators across the board,” Achuthan said in a radio interview on Sept. 30 on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “It’s a vicious cycle that is going to get quite a bit worse.”

Truth be told, I can't admit to being much better.  I am seduced by the logic that room for recession is limited given the failure of many sectors, notably autos and housing, to fully or even begin to recover from the last recession.  That said, the near-term policy picture in the US looks dismal and I am extremely wary to dismiss the European financial crisis as something easily resolved.  Moreover, while some attributed Monday's rally on Wall Street to a positive reaction to the news that China was moving to support their banks, I saw only an indication the Chinese economy is on a very weak footing.  Combining these thoughts with the memory that the safe bet over the past three years has been on the weak side of the coin, I too am pushed over the edge with better than even odds of recession.  And while I will be searching for clues about the Fed's intentions in the release of the FOMC meeting minutes, I suspect that if the seeds of recession are already planted, policymakers are already too far behind the curve to engineer a timely rebound.

A Boom in 2013?

While searching through market commentary, I came across these remarks, via Bloomberg:

“We are focusing on major U.S. equities now, looking past the European stock markets because there’s too much volatility there,” Tim Hartzell, who oversees about $350 million as chief investment officer for Houston-based Sequent Asset Management, said in a telephone interview. “The Fed is still accommodative and we’re entering into an election year, when politicians are usually pulling various levers to make the economy grow.”

Put aside the issue of the Fed's level of accommodation for the moment.  Instead, will politicians be in a position to stoke growth during the upcoming election year?  As it stands, policy will turn increasingly contractionary in the months ahead.  Moreover, conventional wisdom is that a weak economy favors Republicans, who can run on the "are you better off than four years ago?" platform.  And looking at the latest news of declining median incomes in the post-recession period, combined with an economy that has dramatically underperformed relative to the Administration's expectations when the stimulus was proposed in 2009, that argument has some legs.  

Sure, we can argue that Republican intransigence is the core policy problem.  But at the same time, the Administration had no back-up plan for an L-shaped recovery, joined the fiscal austerity parade, and continued to place faith in reaching a "Grand Bargain" on the debt rather than focusing on the issue at hand - the unemployment crisis. When all is said and done, I suspect that from the view of the average voter, this Administration owns the economy lock, stock, and barrel.

Politically, it makes sense for the Republicans to thwart Democratic attempts to reduce unemployment, and instead keep the focus on the "failure" of such policies to date.  And they would like the Federal Reserve kept in line as well.  Stan Collender on the recent attempt by Republican leadership to prevent additional easing:

In other words, now that the GOP has made it all but impossible for fiscal policy to be used to improve they economy, they want to make sure that the only other tool the government has at its disposal -- monetary policy -- isn't used either. 

Why take on the Fed?  The Republicans have some direct control over fiscal policy because they can either refuse to consider a proposal in the House where they are in the majority or can filibuster legislation in the Senate where they are in the minority.  Because the Fed is an independent agency, the GOP can only do what they did today in the letter by threatening to bring down the wrath of god if it dares take any action to get the economy moving.

Maybe we will see an extension of payroll tax break and business-tax credits, but that only limits the contractionary turn in fiscal policy. Better than nothing, but far short of what is necessary.

So assume fiscal policy is locked up in Washington through 2012, and the Republicans win the White House.  What will policy look like in 2013?  I would like to hear the views of the gang at Capital Gains and Games.  I see two possible outcomes.  One is to embrace fiscal austerity with both arms.  The other is to abandon fiscal austerity, as it was only a useful weapon to win back the White House.  Instead, do exactly the opposite and embrace the mantra that "Reagan proved deficits don't matter."  That seems like a strategy designed to win in 2016.  But it pushes meaningful policy action out until 2013 rather than 2012 - bad news for the unemployed and financial markets.

Too Early to Sound the All Clear?

Last week I wrote:

The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire.

Consistent with this prediction, the September employment report painted a picture of an economy still wading through knee-deep mud, but not in economic collapse. That said, prior to the report, Barry Ritholtz offered some wisdom regarding individual data points versus trends:

What does matter is the overall vector of a given economic sector. Vectors include the rate of acceleration or deceleration, persistency, direction etc. Think overall “trend” and changes thereto. For employment, this means: Are we seeing an increase in the factors that lead to hiring? What is the ratio between hires at big firms vs small firms? Are Wages increasing, staying flat, or decreasing; Temp workers getting hired, total hours worked etc. What are the likely data and modeling errors? Collectively, those factors all add up to an issue of the employment situation roughly improving, maintaining a stability, or getting worse.

Hence, each data point should be looked at in terms of whether it is continuing the overall trend, or suggesting a reversal in trend. Everything else is noise.

With trends in mind, the data did little to dispel my concern that private sector hiring rolled-over earlier this year, especially when combined with last week's read on employment via the ISM nonmanufacturing report:

Trends notwithstanding, Bloomberg offers up some optimisim on the outlook:

A string of stronger-than-projected statistics -- capped by the news on Oct. 7 of a 103,000 rise in payrolls last month --has prompted economists at Goldman Sachs Group Inc. and Macroeconomic Advisers LLC to raise their growth forecasts for third quarter growth to 2.5 percent from about 2 percent. That’s nearly double the second quarter’s 1.3 percent rate and would be the fastest growth in a year.

“The U.S. economy doesn’t look like it’s double-dipping at all,” said Allen Sinai, president of Decision Economics Inc. in New York. “But it is a crummy recovery.”

The article offers up the usual caution on Europe and increasingly tight fiscal policy when the New Year begins. But the bottom line is correct - on the basis of existing data, the recession call looks like a long-shot.

Getting to the recession call requires generally ignoring the incoming data on the real economy and instead focusing on financial markets. Then recognize that in recent experience, financial distress leads to broader economic distress. Moreover, at the moment, the slowdown in US economic growth coupled with the possibility of sovereign default in Europe are combining in such a way as to expose the inherent vulnerabilities in a still-under-capitalised global financial system. See Edward Harrison here.

And although there is optimism the European situation can be resolved in three weeks, they seem to be walking a very fine line between attempting to recapitalize the banking system without undermining sovereign debt ratings while maintaining what effectively amounts to a pegged exchange rate system that is fundamentally inconsistent with the economic needs of more than one nation. In addition, they have an odd situation where every nation needs to issue Euro-denominated debt, but no nation can actually print Euros as a backstop. It's as if each nation issues only foreign-denominated debt, with ultimately no lender of last resort on a national level. Of course, the European Central Bank could fill this role, but will they?

My experience is that when a financial landscape is as ugly as we see here, there is no rescue plan. Things tend to get much worse before they get better. That seems to be what financial market are telling us.

With that cheery thought in mind, I offer another distressing correlation. While I generally find monetary aggregates difficult indicators in the best of time, this caught my attention:

Since the end of the 1990's, there has been a negative correlation between M2 growth and industrial production growth. It appears that financial market disruptions of the current magnitude are sufficient to drive substantial changes in spending. If this correlation continues to hold, then I need to rethink my belief that any recession in the near term will be relatively mild considering the lack of rebound from the last recession. Perhaps underneath today's seemingly comforting data something very ugly is brewing. Which means enjoy these big rallies on Wall Street while you can.

Don't Let Monetary Policy Off The Hook

Re-reading Federal Reserve Chairman Ben Bernanke’s latest testimony to Congress left me increasingly puzzled by his conclusion:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

This is a clear effort to shift the focus away from monetary policy onto the fiscal side of the equation.  But I think there is a significant flaw in that position.  Fiscal policymakers will be completely unable to address medium- or long-term budget issues as long as there exists a sizable output gap and high levels of unemployment.  Persistently low levels of output will necessitate deficit spending, and low interest rates will justify that spending.  That is the lesson of Japan.  Nor will the economy naturally gravitate toward such any other outcome – we are stuck in a liquidity trap.  That is also the lesson of Japan. 

Assuming the proximate cause of the current US economic environment is indeed a liquidity trap, then a solution to that problem lays solely in the hands of monetary policymakers.  In short, the primary economic challenge is to lift the US from the zero bound floor; until that happens fiscal policy will limp along like that of Japan, with ever-growing debt that does little than serve as a partial stopgap.  The deficit spending becomes a long-run outcome rather than a short-run solution.

Simply put, the Federal Reserve needs to take responsibility for ending the liquidity trap.  Instead, as Scott Sumner summarizes:

The Fed has plenty of credibility, that’s not the problem.  The problem is that they are using the credibility to assure investors that low inflation is here to stay.  With the right target, there would probably be no need for massive quantitative easing, or other extraordinary policies.

First and foremost, low inflation is the primary objective of Fed policy.  They have repeatedly set expectations that the increase in the balance sheet is only temporary, and will be reversed as soon as possible.  On not one but two occasions this cycle they prematurely shifted gears to setting expectations for tighter policy, which is effectively the same thing as engaging in tighter policy.  They have offered a half-hearted attempt to remedy this situation by announcing a commitment to low rates, but have made it remarkably clear it is not a real commitment.  From the Fed minutes:

Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects. 

Fear of inflation prevents the Federal Reserve from making an unconditional commitment.  And therein lies the stumbling block to real policy change.  It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way. 

More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation.  Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound.  And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.

Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge.  Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers.  How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy?  Yet here we are.

Where should the Fed go from here?  First and foremost, they need to make a commitment to pull away from the zero-bound.  As Sumner suggests, they need this commitment clearly defined by a target such as reestablishing nominal GDP or price level.  The need to implement open-ended action to achieve this target.  My suggestion is to announce they will make permanent additions to their balance sheet by purchasing on the secondary market $5 billion of US Treasury securities every week until the target is reached.  I think they need to make permanent additions to be credible – they have clearly expressed that previous balance sheet expansions should be viewed only as temporary. 

Won’t this amount to monetization of deficit spending?  Yes, but if Sumner is correct, less than might be feared, as the commitment is more important than the size of the purchases.  And I already arrived at the conclusion, aided by Bernanke’s 2003 speech, that the situation requires a greater coordination of monetary and fiscal policy.  Moreover, even if sizable purchases are required, there is no reason this needs to be a problem. As Bernanke has already explained, the Fed simply needs to make clear its target and once that target has been reached, they will adjust policy appropriately to maintain the nominal GDP or price level trend.  In other words, purchases will be suspended and policy will by that point revert to traditional interest rate management, with the possible reduction of the portion of the balance-sheet expansion that to-date has been viewed as temporary.

Once the Fed achieves normal monetary conditions, the ball will be back in the hands of fiscal policymakers, who may then soon understand that policy is a lot different when interest rates create real constraints on spending and taxes.  But that is a battle for another day.

Bottom Line:  It is ludicrous for the Fed to declare the primary economic responsibility is now on fiscal policy.  As long as we are in a liquidity trap, fiscal policy is stuck in a never-ending cycle of deficit spending.  Absent that spending, the economy will simply slip backwards into recession again and again.  The exit from the liquidity trap can only come from the monetary side of the equation.  Try as he might Federal Reserve Chairman Ben Bernanke cannot escape his policy responsibilities.  And we shouldn’t let him.

The Fed Drops the Ball

(Note:  I am feeling bearish today, especially looking back to lost opportunities to get ahead of the current environment.)

By mid-summer it was evident the recovery was in jeopardy, that the slowdown in economic activity could not be entirely explained by temporary factors, that unemployment would remain unacceptably high, and that the slow motion train wreck that is the European experiment would be resolved only in the aftermath of financial chaos.

The Fed had the opportunity to get ahead of the curve.  They chose not to.  To be sure, they offered some half-hearted support to the existing policy stance.  But this amounts to bring a knife to a gunfight. 

At this point, we are faced with mounting recession forecasts.  The Economic Cycle Research Institute publicly announced their recession call last week, confidently expecting to extend their 3-0 forecasting record.  Nouriel Roubini already offered up his recession call.  Today, Goldman Sachs placed 40% odds on recession in 2012. 

And in the Goldman Sachs call lays the obstacle to an aggressive monetary response, as opposed to the simple rearranging of the deck chairs currently underway.  There may be widespread belief that the seeds of the recession are planted and beginning to sprout, but the near-term data certainly will not confirm a recession is underway.  From the Wall Street Journal:

So far, as many economists point out, the worst readings on the economy come from sentiment measures rather than hard numbers on economic activity.

The pessimism among consumers and businesses alike may be reactions to political uncertainty and the volatility in the stock market, while the nuts-and-bolts data on the U.S. economy look better.

In the latest round of data, August construction spending surprisingly rose 1.4% when a 0.4% drop was expected. September factory activity beat forecasts as well. The Institute for Supply Management said the sector’s expansion strengthened for the first time since June.

The data point to real gross domestic product growing at an annual rate above 2% in the third quarter, more than double the pace of the first half.

The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire.  We are really looking for whatever acceleration we see in third quarter GDP growth to ebb in the fourth quarter, a bad omen for the fiscal drag we will experience as the payroll tax credit expires.  On top of that, you have to believe in unicorns and fairies if you think the European crisis is going to go anywhere other than from bad to worse in the next three months.  The lesson of the past two years is the Europeans will arrive late and bring a club to the gunfight.  Indeed, while today’s late rally was credited to the latest round of optimism on Europe, via Bloomberg:

Equities rebounded after the S&P 500 fell below 1,090.89, the closing level required to give the index a 20 percent slump from the three-year high reached on April 29. Stocks rose after the Financial Times quoted Olli Rehn, European commissioner for economic affairs, as saying there is an “increasingly shared view” that the region needs a coordinated approach to halt the sovereign debt crisis. After U.S. markets closed, Belgian Prime Minister Yves Leterme said a “bad bank” to hold Dexia SA (DEXB)’s troubled assets will be set up.

the reality is likely less optimistic:

“People are looking for optimism anywhere they can get it,” said Christopher Bury, co-head of fixed-income rates at Jefferies & Co., one of the 22 primary dealers that trade with the Federal Reserve. “You have these random stories and the market reacts, but how many times have we been down this road where these are just words?”

One additional note on the global environment – signs are emerging that the long running Chinese property boom is running into trouble.  From Deustche Bank and via Business Insider:

In recent weeks, the number of phone calls received by an author of this report from China-based property agents has increased several fold, indicating a significant rise in the urgency for developers to raise cash from selling properties. A property consultant told us that he recently received requests to help raise RMB10bn for cash-strapped small and medium-sized property developers – this amount is a huge multiple of what he is used to dealing with. In the offshore market, where many Chinese developers seek foreign currency funding due to lack of access to domestic funds (the domestic stock, bond and trust loan markets are closed to them due to policy tightening, and banks are also very stringent), their USD bond yields have surged to 20-25% in past weeks from around 10% before August. This means that even the offshore markets are now largely closed to Chinese developers…

The Chinese government will act to cushion the downside for their property sector, but what will be the consequences of even a short-term slowdown for a global economy already on the downside?

Put aside the non-recessionary real economy data and instead turn to the financial markets for hints.  There the signals are decidedly more pessimistic.  Equities are heading into bear market territory, interest rates are collapsing, spreads between Treasuries and corporate debt are widening, commodity prices are in virtual free-fall, and the TED spread, while still well short of the highs reached during the financial crisis, have more than doubled from 15bp in the spring to 38bp now. 

There is no way to read the ongoing financial turmoil as anything other than increasing fear that a recession is underway.  Perhaps it is all simply a growth scare, and that in a few months we will wonder what all the fuss was about.  But ECRI believes it is already too late for that story:

A new recession isn’t simply a statistical event. It’s a vicious cycle that, once started, must run its course. Under certain circumstances, a drop in sales, for instance, lowers production, which results in declining employment and income, which in turn weakens sales further, all the while spreading like wildfire from industry to industry, region to region, and indicator to indicator. That’s what a recession is all about.

About the only good news is that, as pointed out by Goldman Sachs, perhaps the downside will remain limited:

The downside risk is of course that these financial spillovers--or conceivably some other shock, perhaps greater fiscal tightening in 2012 than we now anticipate--prove sufficient to push the US economy into recession; both a quantitative model and our subjective assessment put recession risk in the neighborhood of 40% at this point. For now, we still think the base case is that the US economy avoids this outcome. The cyclical sectors of the economy are already quite depressed--in particular, homebuilding is barely above the depreciation rate of housing--so downside looks more limited.

Cold comfort, according to ECRI:

It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.

Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.

With the US, we know that fiscal policy is off the table as gridlock rules the day in Washington.  What more, it looks like the Federal Reserve resistance to additional action is at least partly based on a conviction this is no longer a problem for monetary policy – it is up to fiscal policy now.  To be sure, financial markets today were at least initially buoyed by Federal Reserve Chairman Ben Bernanke’s comment:

The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.

But, after financial market participants sober up, they should recognize that this is nothing new.  The Fed will offer more support.  A hint from Bernanke as quoted by the Wall Street Journal:

Republicans also pressed the Fed chairman on the risk that the central bank could be stirring inflation with its efforts to pump money into the financial system to bring down interest rates. Mr. Bernanke dismissed such worries. He said a spurt in consumer prices earlier this year was already receding and that unemployment was a bigger threat.

"Right now, frankly, we're much further away from full employment than we are from price stability," he said. With that comment was a hint: The Fed might not be hurrying to do more to help the economy right now, but it is still leaning in that direction.

The only question is when and how much.  Already, though, it is arguably too late.  Recession or just slow growth, the policy delay will weigh heavily on the unemployed.  Moreover, the Fed chair gives us little reason to believe he has much to offer:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

How different is this view from that of Dallas Federal Reserve President Richard Fisher in defending his last dissent?

One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority. These actions are not within the Fed’s purview; they are the business of Congress and the president.

I fail to see the wisdom in neglecting policy options simply because Congress is falling down on the job. 

It seems that Bernanke is more center-right of Fed policymakers than center-left.  Which suggests that he will need to be dragged kicking and screaming into another round of asset purchases.  And, unfortunately, we will first need to see more citizens added to the ranks of the unemployed for that to happen.

Perhaps events will evolve in such away that the current round of pessimism will prove unfounded.  But even if we avoid recession, the slow growth and constant threat of recession serve as a reminder that policymakers have fallen far short of doing what is needed to lift the economy from the zero bound.  And, worse yet, neither monetary nor fiscal authorities appear particularly worried about achieving such a goal.