The minutes of the Federal Reserve meeting held in late September were released today. Below we present the economic outlook section of the minutes, along with my comments and interpretation of them.

In general, they paint a picture of an economy that is starting to recover, but a recovery that is still very fragile. Inflation is not seen as likely to cause any serious problems in the short-to-medium term.

“…[O]verall economic activity was beginning to pick up. Factory output, particularly motor vehicle production, rose in July and August. Consumer spending on motor vehicles during that period was boosted by government rebates and greater dealer incentives, and household spending outside of motor vehicles appeared to rise in August after having been roughly flat from May through July.

“Although employment continued to contract in August, the pace of job losses slowed noticeably from that of earlier in the year. Investment in equipment and software (E&S) also seemed to be stabilizing. Sales and construction of single-family homes during July and August, while still at low levels, were significantly above the readings at the beginning of the year. The sharp cuts in production this year reduced inventory stocks significantly, though they remained elevated relative to the recent level of sales.

“Core consumer price inflation continued to be subdued in July and August, but higher gasoline prices raised overall consumer price inflation in August.”

“Cash for Clunkers” was a very successful program, at least in the short term. Housing is starting to rebound, but like autos much of the reason for the turnaround is massive government support for the sector (FAR larger than the support for the auto industry).

“Firms continued to reduce payrolls, but job losses abated further in August, with the decline in private payroll employment the smallest since that of August 2008. Although employment losses continued to be widespread, the rate of decline diminished in most industries.

“The length of the average workweek for production and nonsupervisory workers remained steady, albeit at a low level, and the rate of decline in aggregate hours for this group over July and August was the smallest of the past year. In the household survey, although the unemployment rate rose in August to 9.7 percent, the rise in the unemployment rate slowed, on net, in recent months from its pace earlier in the year.

“The labor force participation rate in August remained at the low level that had prevailed through much of the year. Continuing claims for unemployment insurance through regular state programs fell slightly, on balance, from their earlier peak, but the total including extended and emergency benefits stayed near its recent high level.

“Initial claims for unemployment insurance fluctuated within a narrow range that was consistent with further declines in employment. With labor markets still weak, the year-over-year increase in average hourly earnings of production and nonsupervisory workers slowed further in August, even with the higher federal minimum wage that went into effect at the end of July.”

The job situation is still getting worse, but at a slower pace that earlier this year. There is absolutely no way that the wage side of a wage-price spiral can get any traction under these conditions. Headline inflation might tick up with oil prices and the weak dollar, but deflation at the core level is a bigger danger right now than inflation.

“Industrial production rose in July and August, led by a rebound in motor vehicle production from the extraordinarily low assembly rates in the first half of the year. Manufacturing production outside of motor vehicles increased solidly, likely reflecting stronger demand for materials from the motor vehicle sector and a slower pace of inventory liquidation elsewhere. Business survey indicators suggested further gains in factory output over the near term. Nevertheless, the factory utilization rate in August was only modestly above its recent historical low.”

When you stimulate auto sales you stimulate more than just autos, but also all the things that go into cars. Yes, obviously Cash for Clunkers helped Ford (F), but it also helped parts makers like TRW Automotive (TRW) and raw materials firms like U.S. Steel (X). Still we are digging out of a very deep hole and much of our productive capacity is sitting idle.

“Real personal consumption expenditures increased modestly in July, led by a strong advance in motor vehicle purchases, which were boosted appreciably by the government’s ‘cash-for-clunkers’ program. This program contributed to a further surge in motor vehicle sales in August to their highest level since the first half of 2008.

“After declining in July, sales at retailers, excluding those at motor vehicle dealers, building materials stores, and gasoline stations, rose significantly in August, suggesting an increase in real consumer expenditures on non-motor-vehicle goods for the month.

“Even so, many determinants of spending continued to be tepid. In particular, the weak labor market continued to restrain growth in household income, and the prior declines in household net worth probably continued to weigh on spending. However, an increase in household net worth since March, a rise in nominal labor compensation in July, and increases in various measures of consumer sentiment indicated some improvement in the outlook for consumer spending.”

People are poorer than they were a year ago, but richer than they were in March. Thus spending has started to pick up again, but if we don’t see incomes start to rise, and people going back to work, the consumer rebound could be short lived.

“Data from the housing sector indicated that a gradual recovery in activity was under way. Although single-family housing starts fell modestly in August, this decrease followed five consecutive monthly increases, and the number of starts in August was well above the record low reached in the first quarter of the year.

“In contrast, in the much smaller multifamily sector, where credit conditions were still particularly tight and vacancy rates remained high, starts continued to be down, on net, in 2009 after a significant fall in the second half of 2008. The sales data for July indicated further increases in the demand for both new and existing single-family homes.

“Even though new home sales remained modest, they had been sufficient, given the slow pace of construction, to pare the overhang of unsold new single-family houses: In July, the level of inventories of such homes was about one-half of its peak in the summer of 2006, and the months’ supply had fallen considerably from its record high in January. Sales of existing homes in July were at their fastest pace since mid-2007, and pending home sales agreements suggested that resale activity would rise further in following months.

“Although sales of distressed properties remained elevated, the rise in total sales of existing homes over the summer appeared to have been driven by an increase in transactions involving nondistressed properties. The apparent modest strengthening of housing demand was likely due, in part, to improvements in housing affordability stemming from low interest rates for conforming mortgages, a lower level of house prices, and possibly the first-time homebuyer tax credit.

“In addition, demand may have been buoyed by a sense that house prices were beginning to stabilize. Through the end of the second quarter, many house price indexes had smaller year-over-year declines than they had shown earlier this year, and some indexes recorded positive changes for the second quarter.”

If you cut back far enough on the construction of new houses, eventually the inventory of unsold houses will decline. This is particularly true if you throw a boatload of money at the sector to stimulate sales. While the first-time homebuilder tax credit gets the most ink, the Fed buying up every mortgage-backed security in sight has artificially depressed mortgage rates and made houses more affordable.

The big question now is, what happens to the housing market after this massive intervention ends, and how long can we afford to keep this Welfare for Realtors program going?

“Real spending on E&S appeared to be stabilizing after falling sharply for more than a year. Business purchases of transportation equipment seemed to be expanding solidly in the third quarter. Nominal shipments and orders for high-tech equipment in July were significantly above their second-quarter averages; moreover, a few major producers of high-tech equipment reported some signs of improvement in demand.

“Business investment in equipment other than high tech and transportation showed tentative signs of stabilization. Some forward-looking indicators of investment in E&S improved, suggesting that conditions had become less adverse than earlier in the year. Monthly surveys of business conditions and sentiment recently recovered to levels consistent with a modest rise in business spending, and corporate bond spreads over Treasury securities narrowed further.

“In contrast, conditions in the nonresidential construction sector generally remained quite poor, and measures of construction spending excluding energy-related projects stayed on a downward trajectory through July. Vacancy rates continued to rise, property prices fell further, and financing for nonresidential construction projects remained very tight. The nominal book value of businesses inventories continued to fall in July, which contributed to further declines in inventory-to-sales ratios; however, those ratios stayed elevated.”

Businesses, at least big businesses, can now get credit again at reasonable rates, and as a result investment in equipment and software (E&S) has stopped falling off a cliff. However, with so much capacity sitting idle, we will probably not see a very robust rebound. Commercial real estate is a disaster zone, and with so much of it sitting empty, there is little reason to build more.  Inventories are still high relative to sales, but in much better shape than they were.

“After narrowing to a 10-year low in May, the U.S. international trade deficit widened in June and July, as strong increases in exports were more than offset by sizable rises in imports. The July trade data provided additional evidence that the levels of both exports and imports probably reached their trough in the second quarter. About one-half of the increase in exports of goods and services in July was in exports of automotive products; the other gains were widespread across other major categories of exports.

“As with exports, the largest increase in imports of goods and services in July was in automotive products, reflecting some recovery in North American motor vehicle production. Imports of consumer goods, capital goods, and industrial supplies also rose markedly. Imports of oil increased more moderately, with the rise wholly reflecting higher prices.”

World trade has probably hit bottom, and with it the end to the dramatic improvements in the trade deficit. Cash for Clunkers resulted in an increase in both imports and exports of autos and parts, most likely that was all back and forth over the Detroit river since the U.S. and Canadian auto industries are deeply interconnected.

“Real gross domestic product (GDP) in the advanced foreign economies contracted more moderately in the second quarter than in the first quarter, with growth resuming in several countries. In Japan, a trade-related rebound in industrial production led to an increase in overall output. Government incentives for motor vehicle purchases contributed to a modest expansion of the German and French economies, but the Euro-area economy as a whole contracted slightly as inventory drawdowns weighed on activity.

“Output also fell in Canada and the United Kingdom. Purchasing managers indexes (PMIs) rose further in the major economies during the intermeeting period, and reached levels consistent with stabilization or moderate expansion of output in the third quarter.

“Indicators of consumer sentiment continued to increase, but remained well below pre-recession levels, in part because of concerns about rising unemployment. In most emerging market economies, particularly in Asia, economic activity rebounded in the second quarter; however, output declined again in Mexico. Indicators of activity in the third quarter pointed to a continued expansion of output in most emerging market countries, and PMIs moved into the expansionary range in many of them.

“International trade in emerging market economies picked up, supported by Chinese demand, while demand from advanced economies still appeared weak.”

Most areas of the world are starting to recover or are at least sinking more slowly. Emerging markets by and large are rebounding sooner and faster than the more mature economies like Europe and Japan. Mexico is the major exception to this, which is not a big surprise since its major sources of income have been hit very hard. Those are oil, which is still far lower in price than a year ago, although well off its lows.

It’s not just a price issue with Mexico, though, since its biggest oil field, Cantarell, is very rapidly running dry and production is plummeting. The other big source of foreign exchange is remittances from people working in the U.S. (both legal and illegal) and with unemployment rising rapidly here many are going home, or at least not sending as much money home.

“In the United States, core consumer price inflation remained subdued in July and August, as price increases in housing services moderated and durable goods prices declined. Overall consumer price inflation increased in August, boosted by a sharp upturn in energy prices, particularly those of gasoline.

“The latest available survey data indicated that gasoline prices edged up further in the first half of September. Consumer food prices were little changed in August. According to the preliminary September release of the Reuters/University of Michigan Surveys of Consumers, median year-ahead inflation expectations decreased modestly in the first half of September, but remained somewhat above the low levels posted at the beginning of the year.

“Longer-term inflation expectations from this survey stayed in the narrow range that has prevailed over recent years. The producer price index for core intermediate materials rose in August, its third consecutive monthly increase; over those three months, the index retraced about one-third of the decline of the previous eight months. All measures of nominal hourly compensation and wages suggested that labor costs had decelerated markedly this year amid the considerable weakness in labor markets.”

Inflation is not a problem, particularly at the core level. It is not likely to become one over at least the next year.
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