The Federal Reserve just released its “Beige Book,” which is largely a collection of anecdotal information about the state of the economy in the various Federal Reserve districts. Below are some of the key passages and my reactions to them. In the interest of space and to highlight the key trends, I have edited out most of the individual district information. However, if you want to read the full report, go to:

“Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.”

This is a much better tone than in recent months, with talk of actual stabilization. Up to this point, the best that could be said that things were generally getting worse at a slow rate. Now, overall, it looks like the deterioration has stopped but the improvement has not yet begun.

“The majority of Districts reported flat retail sales. Richmond, Philadelphia, Chicago, Atlanta and Boston remarked that retailers continued to carefully manage inventories, keeping them in line with low sales levels. A majority of Districts confirmed that the “Cash for Clunkers” program boosted traffic and sales…Most regions reported some improvement in residential real estate markets…Downward pressure on home prices continued in most Districts…Reports on commercial real estate suggest that the demand for space remained weak and that nonresidential construction-related activity continued to decline…Loan demand was described as weak and many Districts reported that credit standards remained tight. Most Districts reported improvements in manufacturing production…Labor market conditions remained weak across all Districts…Wage pressures remained minimal across all Districts. Consumer prices were described as being steady in most Districts…”

Flat retail sales would be a major improvement over the declines that most retailers have been experiencing. However, the tight control of inventories does help explain how most of the retailers managed to post better-than-expected earnings in the second quarter. With just a little bit of a pick up, they might be well positioned to exceed expectations in the third quarter.

The housing market does appear to have turned, at least with respect to activity, if not pricing. The focus in now turning to problems in the commercial real estate market since the residential market has at least stabilized.

The labor market is still ugly. Those that are employed are not going to be seeing raises for awhile. There will be no wage price spiral, so the outlook for inflation is pretty good…for now.

“Consumer spending remained soft in most Districts…shoppers remained focused on essentials and continued to refrain from purchasing discretionary and big-ticket items…the cash-for-clunkers program helped boost traffic and sales, although Cleveland and Kansas City also remarked that used car sales were adversely affected by the program. The sustainability of the higher recent pace of new vehicle sales was questioned.”

Discounters like Family Dollar (FDO) and Walmart (WMT) are much better positioned than traditional mall-based retailers. Cash for Clunkers helped out overall demand, and was obviously good for firms like AutoNation (AN), however the program is now over. The big question going forward is if the C4C program helped tap pent-up demand, or simply pulled forward demand from the future. In other words, were the cars being sold cars that would have been bought anyway in October or November, or was it incremental demand?

“Residential real estate markets remained weak, but signs of improvement continued to be noted…Most Districts noted that demand remained stronger at the low-end of the housing market…the first-time home buyer tax incentive was spurring sales…Reports on house prices generally indicated ongoing downward pressures…Construction remained at low levels…Reports on commercial real estate markets indicated that demand for space remained weak and that construction continued to decline in all Districts…vacancy rates increased…demand for space remained weak…Construction remained at very low levels, with modest improvements noted in public construction.”

The low end of the housing market is where most of the bank owned ex-foreclosures are, at least for now. I am expecting foreclosures to go upscale in a big way over the next year or so. The tax credit is going to expire at the end of November, so no more “cash for castles” unless Congress extends it. The same questions about pulling forward demand exist for housing as for cars.

However, realtors have more clout in D.C. than do autoworkers, so there is a good chance that the program will be extended. Commercial real estate is just starting its decline and is going to be ugly for a few more years. The only thing keeping any activity going is public construction, which is largely due to the stimulus package. Most of that part of the stimulus bill was back-end loaded, so that cushion will continue into 2010, but private commercial construction is dead for the time being.

“Reports on the demand for nonfinancial services were mixed…the demand for service sector business remained soft, although the pace of decline was described as having slowed…Demand for transportation services were mixed, with some Districts noting stabilization at weak levels. Reports indicated that freight volume declines were moderating…”

Note that they did not say that freight volumes were picking up, just declining at a slower rate or stabilizing. Freight volumes are a great indicator of the overall current pace of activity.

“Most Districts reported that loan demand was weak and that credit standards remained tight…further weakening in loan demand across most categories…an increase in demand for auto loans…”

Weak loan demand is certainly in line with the record drop in consumer credit in July. Cash for Clunkers stimulated auto loan demand. The program is over now, so auto loan demand is likely to slip back next month, along with auto sales.

“Most Districts reported modest improvements in the manufacturing sector…slight-to-moderate increases in new orders…increases or planned increases in automobile and automobile-related production…The near-term outlook among manufacturers varied, but the majority of reports indicated that manufacturers were cautiously optimistic.”

This confirms what the ISM report said last week. Generally, manufacturing is starting to recover before the service sector of the economy.

In general, this was a weak report, but not nearly as dismal as what we were seeing in the spring or early summer. However, we already knew that from most of the other reports out there. The picture that is painted is that the recession is over but the recovery has not yet begun. Inflation is not the problem for now — getting the economy going again is.

Several government programs have helped to stabilize the situation — Cash for Clunkers in autos, the first-time-buy credit in housing and the stimulus bill in non-residential construction. While not mentioned in the report, the Fed’s buying of just about every residential mortgage being produced and then some has helped to keep mortgage rates down and contributed to the stabilization of the housing market. Those measures are temporary, and many are about to run out.

The acid test will be if the economy can continue to function without the artificial supports. In my opinion, it is far too early to take the training wheels off, though eventually we are going to have to do so.
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Read the full analyst report on “AN”
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