The Federal Reserve just released the minutes to its Sept. 21st meeting. Here are some of the highlights and my interpretation of them:
On the recent buying of T-notes:
“…[P]urchased about $28 billion of Treasury securities, with maturities concentrated in the 2- to 10-year sector of the nominal Treasury curve, although purchases were made across both the nominal and inflation-protected Treasury coupon yield curves…”
These purchases are meant to offset the roll off of its mortgage-backed securities portfolio. With mortgage rates are near record lows, refinancing activity has been robust (but given the vast number of people who are not eligible to re-finance since the value of the house is less than the amount of the mortgage, less than a similar drop in mortgage rates might normally bring about).
If the Fed were not making these purchases, they would effectively be tightening monetary policy. Given 9.6% unemployment and virtually no inflation, that would mean that they were totally ignoring their legal mandate to promote both full employment and price stability.
The staff’s assessment of the state of the economy:
“Private businesses increased employment modestly in August, but the length of the workweek was unchanged and the unemployment rate remained elevated. Industrial production advanced at a solid pace in July and rose further in August. Consumer spending continued to increase at a moderate rate in July and appeared to move up again in August.
“The rise in business outlays for equipment and software looked to have moderated recently following outsized gains in the first half of the year. Housing activity weakened further, and non-residential construction remained depressed. After falling in the previous three months, headline consumer prices rose in July and August as energy prices retraced some of their earlier decline while prices for core goods and services edged up slightly.”
We found out on Friday that the situation was much the same in September as well. The economy is growing but very slowly, and the pace is not fast enough to create the number of jobs needed to absorb the millions of unemployed — to plug the growth in the labor force due to population growth.
On Housing:
“Housing activity, which had been supported earlier in the year by the availability of homebuyer tax credits, softened further in July. Sales of new single-family homes remained at a depressed level. Sales of existing homes fell substantially in July, and the index of pending home sales suggested that sales were muted in August.
“Starts of new single-family houses in July and August were below the low level seen in June, and the number of new permits issued in August appeared to signal that little improvement in new homebuilding was likely in September. House prices declined modestly in July after changing little, on net, in recent months.”
Historically, housing is what pulls the economy out of recessions. That is because it is usually extremely interest rate sensitive. The Fed lowers interest rates to get the economy moving again, and the first place it affects is the housing market.
With the popping of the housing bubble and the massive overhang of existing homes on the market, including the shadow inventory of homes where the owners are far behind in their mortgage payments, there is little need to build new houses. Existing homes are very good substitutes for new homes.
Each new home build generates a lot of economic activity that reverberates through the economy. The weak housing market is probably the single most important reason that the recovery has been so sluggish. There is no easy solution to this problem. The screw ups by the banks in handling foreclosures and the paper work associated with them has resulted in a de-facto foreclosure moratorium in most of the country.
While that might provide some short term relief, it simply pushes the problem further down the road. As a result of the foreclosure process problems, there are tens of thousands — if not more — properties where the title is now unclear. This mess could take awhile to resolve, and the resulting uncertainty is not going to help in the long run.
On Inflation:
“Inflation remained subdued in recent months. Headline consumer prices rose in July and August as energy prices rebounded after their decline over the previous three months. At the same time, prices for core goods and services moved up slightly. At earlier stages of production, producer prices of core intermediate materials moved down, on net, during July and August while most indexes of spot commodity prices increased. Survey measures of short- and long-term inflation expectations were essentially unchanged.”
Deflation should be a much bigger concern for the Fed than runaway inflation, particularly if measured by the core CPI. The message of the bond market is very clear on that matter. A ten-year bond yield of less than 2.4% can only make sense if we are likely to see prices fall over the next decade, as it would take very little inflation to wipe out all of the return for delaying consumption for a decade.
On the Trade Deficit:
“The U.S. international trade deficit narrowed in July after widening in June. The rise in exports in July more than offset their decline in June, as overseas sales of capital goods rose sharply. Most other major categories of exports were little changed in July, although exports of automotive products posted their first decline since May 2009.
“The narrowing of the trade deficit in July also reflected a broad-based decline in imports following their large increase in June. Imports of consumer goods fell substantially in July, while imports of industrial supplies, capital goods, and automotive products also moved down. In contrast, imports of petroleum products remained about flat in July.”
The decrease in the trade deficit from June to July was very good news, and will be one of the biggest positive factors in third quarter GDP growth if it can continue. We will see on Thursday if the momentum kept up in August. The trade deficit was the real villain in the slow down in growth in the second quarter. Had net exports remained at the same level as in the first quarter, real GDP growth would have been over 5%.
The trade deficit is a much bigger economic problem than the budget deficit, particularly over the short to medium term. It is what drives our indebtedness to the rest of the world, not the budget deficit.
Looking Forward:
“…[T]he staff lowered its projection for the increase in real economic activity over the second half of 2010. The staff also reduced slightly its forecast of growth next year but continued to anticipate a moderate strengthening of the expansion in 2011 as well as a further pickup in economic growth in 2012. The softer tone of incoming economic data suggested that the underlying level of demand was weaker than projected at the time of the August meeting.
“Moreover, the outlook for foreign economic activity also appeared a bit weaker. In the medium term, the recovery in economic activity was expected to receive support from accommodative monetary policy, further improvements in financial conditions, and greater household and business confidence. Over the forecast period, the increase in real GDP was projected to be sufficient to slowly reduce economic slack, although resource slack was anticipated to still remain elevated at the end of 2012.
“Overall inflation was projected to remain subdued, with the staff’s forecasts for headline and core inflation little changed from the previous projection. The current and projected wide margins of economic slack were expected to contribute to a small slowing in core inflation in 2011, which was anticipated to be tempered by stable inflation expectations. Inflation was projected to change little in 2012, as considerable economic slack was expected to remain even as economic activity was anticipated to strengthen.”
Translation, the economy is going to continue to grow slowly, no double-dip on the horizon, but the pace of growth is not going to be enough to improve people’s lives. Inflation is not going to be a problem anytime soon. Resource slack is another way of saying high unemployment and low capacity utilization.
Participants Views:
“Although participants considered it unlikely that the economy would reenter a recession, many expressed concern that output growth, and the associated progress in reducing the level of unemployment, could be slow for some time. Participants noted a number of factors that were restraining growth, including low levels of household and business confidence, heightened risk aversion, and the still weak financial conditions of some households and small firms.
“A few participants noted that economic recoveries were often uneven and were typically slow following downturns triggered by financial crises. A number of participants observed that the sluggish pace of growth and continued high levels of slack left the economy exposed to potential negative shocks. Nevertheless, participants judged the economic recovery to be continuing and generally expected growth to pick up gradually next year…
“Participants noted that the housing sector, including residential construction and home sales, continued to be very weak. Despite efforts aimed at mitigation, fore-closures continued to add to the elevated supply of available homes, putting downward pressure on home prices and housing construction.”
The key points are no new recession, but very slow growth, so it continues to feel like a recession. While the U.S. does not have a lot of experience with recessions caused by financial meltdowns, the previous one being in the early 1930’s there are international parallels that can be drawn, and yes a financial crisis-induced downturn tends to have a slower recovery period than a slow down that is induced by Central banks to cool down high inflation or one that is caused by the inventory cycle.
I would agree that the weak housing situation to the list of reasons why growth will continue to be sluggish. The loss of about $8 Trillion of household wealth from the collapse of the housing bubble is the main reason why households and some small businesses are in a weak financial condition. It is certainly a key part of the reason why people are trying to save rather than spend right now.
“Inflation had declined since the start of the recession, and most participants indicated that underlying inflation was at levels somewhat below those that they judged to be consistent with the Committee’s dual mandate for maximum employment and price stability. Although prices of some commodities and imported goods had risen recently, many business contacts reported that they currently had little pricing power and that they anticipated limited, if any, increases in labor costs.
“Meeting participants noted that several measures of inflation expectations had changed little, on net, over the intermeeting period and that analysis of the components of price indexes suggested disinflation might be abating. However, TIPS-based inflation compensation had declined, on balance, in recent quarters. While underlying inflation remained subdued, participants saw only small odds of deflation.
“Participants discussed the medium-term outlook for monetary policy and issues related to monetary policy implementation. Many participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate or if inflation continued to come in below levels consistent with the FOMC’s dual mandate, it would be appropriate to provide additional monetary policy accommodation. However, others thought that additional accommodation would be warranted only if the outlook worsened and the odds of deflation increased materially.”
I wish the minutes spelled out exactly why the participants felt the odds of deflation were so low, given the already low levels of inflation and all the things they cite as putting additional downward pressure on inflation. While I do not think that deflation is the most likely scenario, the risk of it is far from negligible. Since it is based on people betting using real money, I would put a lot more faith in the spreads between TIPS and normal T-notes than in surveys in gauging inflation expectations.
Just how bad do things need to get before those who favor waiting decide to get up off their butts and do something — you know, like their job, to provide an environment conducive to both full employment and price stability? Then again, most of the regional bank presidents are bankers, who have never had to face prolonged periods of unemployment with little or no savings. It might be nice if they occasionally got to know what life is like for most citizens.
“Participants reviewed the likely benefits and costs associated with a program of purchasing additional longer-term assets–with some noting that the economic benefits could be small in current circumstances–as well as the best means to calibrate and implement such purchases. A number of participants commented on the important role of inflation expectations for monetary policy: With short-term nominal interest rates constrained by the zero bound, a decline in short-term inflation expectations increases short-term real interest rates (that is, the difference between nominal interest rates and expected inflation), thereby damping aggregate demand.
“Conversely, in such circumstances, an increase in inflation expectations lowers short-term real interest rates, stimulating the economy. Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.
“As a general matter, participants felt that any needed policy accommodation would be most effective if enacted within a framework that was clearly communicated to the public. The minutes of FOMC meetings were seen as an important channel for communicating participants’ views about monetary policy.”
I agree that the effects of quantitative easing are likely to be relatively small, and that the Fed is in danger of trying to push on a sting. Fiscal stimulus would be far more effective at this point. However, given the likely gridlock in Congress (we already have had it for 2 years given the now normal rule that you need 60 votes to get anything passed, but it is only likely to get worse), it does not look like we are going to get any additional fiscal stimulus.
Thus the choice is to do nothing and have millions of people remain out of work for very long periods of time, their unemployment benefits and savings exhausted, and their skills deteriorating — in short, being driven into destitution, or buying up some long-term T-notes, thus increasing the money supply, the key effect of which would be to weaken the dollar, and thus help reduce the trade deficit.
Remember, if not for the worsening of the trade deficit, economic growth would have been over 5% in the second quarter and that would have probably brought down unemployment by about 0.6 points (rough approximation based on Okin’s law). I would not expect miracles from additional monetary stimulus, but I do think it would help at the margin.
Buying long-term T-notes would also lower the interest burden on the Treasury. The buying of long term t-notes could well increase inflation expectations, which as they note lower the real interest rate. It is thus possible that the yield on say the 10 year T-note would actually rise, despite the additional buying pressure of the Fed.
If that were to occur, then one of the better ways of playing it would be to short T-notes, either directly or through a short bond ETF like TBT. The increase in the money supply is likely to be bullish for both equities and commodities. This is particularly true until the slack in the real economy is absorbed.
Since the money will only slowly be absorbed by the real economy in building of new capacity and inventories, the money will slosh over into financial assets, most likely stocks and commodities. It will also likely weaken the dollar. That would have positive implications for increasing exports, and replacing some imports with domestically produced products.
The earnings of U.S. companies from overseas operations would also be translated back into more dollars, thus enhancing overall earnings. If the Fed does decide to launch QE2 (a second round of quantitative easing) it will be a very bullish development for the stock market, but potentially a bearish one for the bond market.
Zacks Investment Research
