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Consumer Spending Halts, Income Stagnant, and Pending Home Sales Drop

By Rom Badilla, CFA – Bondsquawk.com

August 3, 2010

Today’s economic data releases suggest that the U.S. recovery may be slowing as we head into the second half of 2010.  The Commerce Department released figures that both Personal Income and Personal Spending failed to grow in June, following a tenth of a percent downward revision in the May readings to final levels of 0.3 and 0.1 percent, respectively.  June’s flat readings disappointed economists as surveys called for an increase of 0.2 percent in Personal Income and a move higher of 0.1 percent in Personal Spending.

BNP Paribas added the following look behind the headline numbers in a morning email to clients:

Personal income did not change for the first time since September 2009, consistent with the aggregate income data from the June employment report, which were particularly weak dropping by 0.5% m/m. Annual benchmark revisions were released with this report. Personal spending trajectory was revised notably down, which resulted in a much higher savings rate. Savings rate in June was 6.4% up from an upwardly revised 6.3% in May (was previously estimated at 4.0%). Core PCE was flat on a monthly basis, implying a y/y rate of change of 1.4% down from 1.5% m/m in May.

Factory Orders unexpectedly dropped in June giving more reason of a slowdown in manufacturing activity, according to the U.S. Department of Commerce.  Factory Orders fell by 1.2 percent versus surveys of a decline of 0.5 percent.  To add insult to injury to the disappointment of missing expectations, the prior period’s reading was revised downward from an initial release of -1.4 percent to a final -1.8 percent.

Pending Home Sales dropped 2.6 percent on a month over month basis in June as government tax incentives expired for prospective home buyers.  Economists were expecting a bounce of 4.0 percent after May’s massive decline of nearly 30 percent.

Pending Home Sales gives insight into forthcoming Existing and New Home Purchases which does not bode well for the millions of homes sitting idle on the market.  BNP Paribas added that “Pending home sales are recorded when a sale contract is first signed. Existing home sales are recorded when a mortgage is closed, implying there is usually a one to two months lag between the series. Therefore, pending home sales freefall points to further weakness existing home sales in July. Housing demand outlook for this year remains very uncertain.”

The Bureau of Economic Analysis released its Personal Consumption Expenditures Price Index (PCE) which is another gauge of inflation and price pressures.  The PCE Core index was flat for June as surveys called for a month over month increase of 0.1 percent.  In addition, PCE Core for May was revised downward by a tenth of a percent to a final reading of an increase of 0.1 percent.  Given this data, inflation expectations should remain subdued in the coming months.

Posted by Rom on August 3, 2010 under Bond Chatter,Fed Watching

More Quantitative Easing on the Way?

August 3, 2010

The Federal Reserve purchased tremendous amounts of fixed income securities such as Treasuries, Agencies, and Mortgage Backed Securities during the height of the financial crisis and recession in order to pump money back into the system and to promote growth.  Now with the Fed’s balance sheet at nearly three times its original size from before the onset of the crisis, the question becomes what to do with it.  As economic data releases reveal that the recovery may be stalling, the Federal Reserve may consider further action to stimulate growth by maintaining or adding more to their balance sheet when they meet next week, according to the Wall Street Journal article, “Fed Mulls Sumbolic Shift.”

Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed’s forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.

Moving to stop the Fed’s portfolio from shrinking would prevent monetary policy from slightly tightening in the face of a weakening recovery.

The central bank’s $2.3 trillion portfolio has nearly tripled in size since 2007.

Buying new bonds with this stream of cash from maturing bonds—projected at about $200 billion by 2011—would show the public and markets that the Fed is seeking ways to support economic growth. It could also be a compromise that rival factions at the Fed support, as officials differ about whether and how to address a subpar recovery.

Whether the Fed makes any move next week depends in large part on economic data, particularly the government snapshot of the jobs market due Friday. Since Fed officials last met in June, data on consumer confidence and spending have softened and job data haven’t improved. But overall financial conditions have improved somewhat, with a rebounding stock market.

Officials in the Fed’s anti-inflation camp aren’t convinced the economy is slowing significantly and are wary of taking new actions. Others are eager to consider new steps to address recent signs of a slowdown and persistent high unemployment.

Fed officials aren’t yet prepared to take the larger step of resuming large-scale purchases of mortgage-backed securities or U.S. Treasurys. But they are holding open that option if the economy deteriorates. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, the Fed would be more likely to act.

Read the Full Article

Posted by Rom on under Bond Chatter,Fed Watching

U.S. Economic Growth Slows as Consumers Spend Less

By Rom Badilla, CFA – Bondsquawk.com

July 30, 2010

The U.S. Department of Commerce released data suggesting that economic growth slowed in the second quarter of this year.  Gross Domestic Product increased by a 2.4 percent annualized rate which disappointed surveys.  Economists were expecting GDP growth to come in at 2.6 percent.  Despite the slowing trend, economic activity in the first quarter was revised upward from 2.7 to 3.7 percent which can be attributed to a pickup in inventories.

In addition, it is apparent that people are spending less these days which is a drag to top-line growth as consumer activity represents about two-thirds of the economy.  Personal Consumption increased by only 1.6 percent in the second quarter, missing forecasts of 2.4 percent.  To add salt to the wound, consumer activity was revised downward in the preceding quarter from 3.0 percent to 1.9 percent.

Looking beyond just the headlines, the numbers look even worse for future prospects of the economy since inventories and government spending account for most of the activity.  Of the 2.4 percent in GDP growth, inventory accumulation represents 1.05 percent and government spending added 0.88 percent.  Once inventories are replenished and add in the fact that government spending is unsustainable, the economy will have one less leg to stand on and growth should slow down in the months ahead.

Price pressures remain subdued for the most part.  The GDP Price Index, which is a comprehensive indicator of inflation, increased 1.8 percent versus surveys of 1.1 percent and after a revised prior period of 1.0 percent.  Stripping out food and energy, prices increased by 1.1 percent which were above the median survey as economists expected a 1.0 percent increase.  The prior period was revised upward by 0.5 to 1.0 percent.

Business conditions in the Mid-West appear to be improving as surveys in both manufacturing and non-manufacturing activity increased.  The Chicago Purchasing Manger Index came in at 62.3 from 59.1 in the prior period.  Also, NAPM Milwaukee increased to 66.0 from 59.0.  Economists were expecting a reading of 56.0 and 57.0, respectively.

According to the University of Michigan, consumer confidence in July increased slightly.  The widely followed sentiment index increased to 67.8 from 66.5.  The increase surprised economists since consensus surveys were at 67.0.  With this in mind, consumer confidence is still at depressed levels.  Consumer confidence in the last 10 years reached a high of 112.0 at the beginning of this decade with an average of 86.0, in the 2 years before the official onset of the recession.  While today’s increase is a step in the right direction, the fact remains that this measure has a long way to go before waving the all clear signal.  As always, job growth will be the key in the coming months.

Given the deluge of generally gloomy economic data, Treasury yields are down, approaching recent lows again.  Stocks on the other hand, appear to be in denial as the S&P is close to unchanged.  Check back later today for Bondsquawk’s market recap across ALL bond sectors.

Posted by Rom on July 30, 2010 under Bond Chatter,Fed Watching

San Francisco Federal Reserve’s Economic Outlook

July 29, 2010

The San Francisco Federal Reserve released a report suggesting a ”bumpy road” for the U.S. economy as we wrap up 2010 and head into next year.  The Fed expects growth to be “lackluster” with unemployment to be relatively stagnant by the end of the year.  Also, the Fed expects employment will take “several years before it returns to more normal levels.”  Here’s the full text.

Thanks very much for coming today. The topic of my talk is the economic outlook. My remarks represent my own views and not necessarily those of my Federal Reserve colleagues. Recent economic data have been disappointing and there’s no denying that the economy has hit a bit of a rough patch. Still, I believe that the recovery that has been in train for about a year is still on course, albeit at a more subdued pace. We economists keep a list of words we use to describe economic growth. It’s very carefully calibrated from “torrid” at one end to “freefall” at the other. Unfortunately, after a period when it looked like the recovery was building up a head of steam, we lost some of that momentum this spring. We’ve been moving down that list of words from “rapid” for a brief time late last year to “moderate.” And now we are getting close to merely “modest.” The silver lining is that we’re still better than “meager” and “anemic.” And, thankfully, we are still several notches above “double dip recession.”

As I just mentioned, recent data have been less than stellar. The upward trend in spending and consumer confidence that had appeared to be steadily building has dissipated. Consumer spending had grown smartly—another word on our list—through the spring. But, it appears that this surge was just a short-lived bounce from the very steep spending plunge that occurred in the wake of the financial crisis. In May and June, retail sales fell. Consumer confidence had likewise been on the mend. But bad news about the fiscal crisis in Europe, the volatility in the stock market, and continued weakness in housing and employment have taken their toll.

Auto sales are a telling barometer of households’ reluctance to open their pocketbooks. Sales of motor vehicles have plateaued at about an 11.3-million-vehicle annual rate. That’s well up from the trough of about 9 million seen in early 2009, but about 30 percent below the over 16 million we saw the previous decade. Perhaps not surprisingly, with unemployment and debt levels still high, ordinary Americans are weighed down by worries about the future. The old car in the garage is still going, the old washer still gets the clothes clean, so they’re putting off big-ticket purchases and limiting spending mainly to essentials.

Housing, of course, was one of the main causes of our problems. So it was very encouraging many months ago when housing started showing signs of coming back. Sales volume picked up, home prices stabilized, and the mood of panic abated. More recently, though, housing has slipped back into the doldrums. The tax credit for first-time homebuyers provided a shot in the arm. But now that that program is winding down, sales have slid back to very low levels. Not many houses are selling, despite rock-bottom interest rates, very favorable home affordability, and improvements in the availability of credit. Given this weak demand, new construction is nearly dormant. So the harsh reality is this: In the aftermath of the worst housing bust in over 70 years, it may take a long time before buyers will be able to get out of their heads the old rock-and-roll refrain “we won’t get fooled again.”

For commercial real estate, the situation is even worse. The weak economy has driven vacancies up. Nationally, the price of commercial real estate has fallen about 40 percent, greater than the decline in home prices of about 30 percent.

One of the things that brought us back to growth was fiscal stimulus from the federal government, which trimmed taxes and increased spending. That stimulus will play a smaller role going forward. On top of that, state and local government budgets across the country are under immense strain. Spending by these government units accounts for about 12 percent of the economy, and spending cuts and tax increases at these levels mean that this sector won’t contribute to economic recovery for some time.

Now, the ability of economists to forecast the economy is often compared—usually unfavorably—to the ability of meteorologists to forecast the weather. In our defense, economic forecasting faces hurdles meteorologists don’t have to deal with. As the Nobel prize-winning physicist Murray Gell-Mann quipped: “Think how hard physics would be if particles could think.” Well, in our field, the “particles”—men and women who work, shop, run businesses, and invest—do think, though admittedly not always coolly and calmly. And, in this sense, perception can matter as much as hard numbers.

Households, businesses, and investors have endured painful economic and financial trauma over the past few years. It will take considerable time for confidence and trust to heal. We know from past experience here and around the world that recoveries from financial crises take a lot longer than recoveries from “usual” recessions. Indeed, businesspeople and consumers today are extraordinarily cautious and averse to all kinds of perceived risks, whether from the economy, financial markets, or government policies. This caution is manifesting itself in a reluctance to invest or hire unless absolutely necessary.

The fiscal crisis in Europe provides a case in point of how confidence can turn on a dime. Fortunately, European governments and the International Monetary Fund appear to have acted effectively to stop the crisis from spreading. Therefore, I expect confidence to slowly rebuild after the recent stumbles.

Of course, eventually, housing, commercial real estate, and other hard-hit sectors will return. After all, the population of the United States grows by over 2½ million people a year and those people need roofs over their heads. And all of those old cars and washing machines will eventually start looking pretty creaky compared with the snazzy stuff in the showrooms. We’ve already seen just this process take place in technology where both consumers and businesses have overcome their hesitation to buy the latest gear. I don’t know how much confidence it takes to buy an iPad or an iPhone, but whatever it is, millions of people obviously have it.

Although discouraging, the recent softness in the economic data looks much more like a bump in the road of what we already thought would be a gradual recovery, rather than a swerve into the ditch. Importantly, monetary policy remains highly supportive of recovery. Interest rates are extraordinarily low. And we’ve seen a marked improvement in the willingness of investors to take on reasonable risks, as measured by interest rate spreads between corporate securities and safe Treasury securities, as well as other metrics. At the same time, even though the bank loan market hasn’t fully recovered, banks are somewhat more willing to extend credit.

Our forecast at the San Francisco Fed is for GDP growth of about 2½ percent this year. We expect growth to pick up steam next year to between 3½ and 4 percent. Such a growth forecast pales compared with past recoveries from deep recessions, for the reason I noted earlier: It takes a long time to bounce back from financial crisis. Still, if the economy expands at this pace, we should see some job growth over the next year and a half.

But that growth could be lackluster. Unless the economy picks up faster than I expect, unemployment will come down with agonizing slowness. The official June unemployment rate was 9½ percent. That’s about half a percentage point below its recent peak, but still terribly high. And this figure masks how bad the problems really are. If you count all the people who want jobs but have given up looking and all those who are working part time for economic reasons, this broader measure of unemployment is 16.5 percent—enormously high by historical standards.

And there’s more: The share of people who have been out of a job for more than six months has skyrocketed during the recession. In the past two recessions, this figure peaked at about 23 percent. This time, it’s double that—46 percent. That’s right. Nearly half the people we officially count as unemployed have been out of work for more than six months. Long-term unemployment is particularly troublesome because it erodes job skills and attachment to the labor market, and places tremendous hardships on families. This rise in long-term unemployment is a measure of how deep and prolonged this recession has been, plus the fact that we really have not seen much job creation yet. As the economy improves, most of the long-term unemployed are likely to find jobs in the industries in which they previously worked. However, a significant fraction of the jobs lost in the recession may never come back. Some workers will need to shift to other expanding sectors of the economy. That process will require retraining and time, and it means the economy will take that much longer to return to its potential.

Indeed, given the outlook for only modest growth through the end of the year, I expect unemployment to end 2010 at about its current level of 9½ percent. Once growth picks up to a more robust pace, the unemployment rate should gradually decline, but only to about 8½ percent by the end of next year. I expect it will take several years before it returns to more normal levels.

I’d like to switch now to a topic that’s been hotly debated in recent months—inflation. For every expert who’s convinced we’re in danger of an episode of runaway prices, you can find another expert just as convinced that we’re due for a sustained deflation, that is, continuously falling prices. I think these outcomes are highly unlikely. I expect inflation to remain low, dipping to around 1 percent, but not get stuck in negative deflationary territory. Then inflation should move gradually back to about 2 percent as the economy fully recovers.

Let’s take a moment to examine the fear of higher inflation. Much of it is based on the view that the Fed has been creating huge amounts of money in recent years to boost the economy—“printing money,” if you will. Now it’s true that the Fed has taken extraordinary steps to get the economy moving. The monetary base—that is, the amount of currency in the economy plus the reserves held by banks at the Fed—has jumped to about $2 trillion from about $830 billion two years ago. In normal times, such an increase in the money supply would be highly inflationary because too much money would be chasing too few goods, driving prices up. But, these are not normal times. Not at all. Simply put, the vast majority of this “money” isn’t getting out into the economy and circulating. Instead, it’s just sitting collecting electronic dust. In fact, the standard measure of the money stock in use by households and businesses is called M2. It includes currency and various types of bank deposits. Despite a more-than-doubling of the monetary base, this measure has risen only 11 percent over the past two years, significant, but hardly alarming.

Wage and price data show that inflation has been trending lower, rather than higher. The consumer price index, or CPI, has risen a little over 1 percent over the past 12 months. The most recent monthly readings on CPI inflation are even lower. This very low level of inflation illustrates just how much slack there is in the economy and matches what businesspeople say: in this weak economy, they have little pricing power. You can see it at many levels. Weak demand is reducing the ability of vendors to boost prices, which is lowering cost pressures on businesses. At the same time, businesses have little ability to impose price increases on their own customers. With unemployment so high, workers are happy to have jobs and not inclined to press for raises. Over the past year, private sector employee compensation has grown only about 1½ percent. With the economy recovering slowly, I don’t see this picture changing anytime soon.

Given this widespread weakness, should we be worried about deflation instead? There is a small risk of deflation, especially if it takes longer for the economy to recover than I expect. But I view a sustained period of deflation as unlikely for a couple of reasons. First, price trends aren’t nearly as sensitive to the state of the economy as they used to be. For example, core inflation, which strips out volatile food and energy prices, was running at about an annual rate of 2.6 percent at the onset of the recession, higher than the rate of about 2 percent that most members of the Fed’s policymaking committee have said is appropriate. That inflation rate has dipped to 1.3 percent today, two-and-a-half years into arguably the worst recession since the Great Depression. In other words, despite such an awful downturn, we’re now only about as far below the desired rate as we were above it before the recession started.

One reason for the relatively muted response of inflation to the recession is expectations. The public is pretty confident that the Fed will do what it takes to eventually return to and maintain a low, positive rate of inflation. In the jargon of economists, inflation expectations are well anchored. The Fed earned this credibility over decades during which it kept inflation low and stable. We see evidence of this anchoring in survey responses of the general public and economic forecasters, as well as in the prices that financial market participants pay for securities that protect against inflation. This anchoring of expectations helps tame inflationary swings, putting both a floor on how low inflation will go and a ceiling on any potential rise.

What all of this means is that the economy is still on a recovery path, with moderate growth, and that inflation will remain very low. But we face significant risks to this outlook and need to remain vigilant. Thank you very much.

Posted by Rom on July 29, 2010 under Fed Watching

Durable Good Orders Fall, Federal Reserve Releases Regional Survey Report

July 28, 2010

The U.S. Commerce Department released a report that new orders for manufacturing durable goods continues to decline which provides further evidence that the economy is slowing.  The Durable Good Orders dropped for the second consecutive month as the Index declined 1.0 percent in June after a revised 0.8 percent fall in the previous month.   The drop disappointed as economists were expecting a 1.0 percent increase.  This is the first consecutive monthly drop since January 2009 when new orders posted straight negative readings for the preceding seven months.

Durable Goods ex Transportations declined 0.6 percent in June versus surveys of a monthly increase of 0.4 percent.  The index was revised upward in May from an initial increase of 0.9 percent to a final increase of 1.2 percent.

BNP Paribas’ economics team offered the following color on today’s data releases in an e-mail sent to clients.

Durable goods orders fell by 1.0% m/m well below market and our expectations. Boeing orders jumped to 49 in June from just 5 planes in May, however, many of these orders were booked at the end of June and they were not reflected in the June’s report. As such, non-defense aircraft orders was down by 25.6% m/m. Defense orders dropped 6.8% m/m, following two months of declines in April and May. Ex-defense was down by 0.7% m/m. Computers & electronics fell by 1.9% m/m, machinery was down 0.7%. On a positive side, vehicles and parts orders increased by 2.5% in June, while electrical equipment was up by 3.7%. There has been some moderation in core capital goods (non-defense, ex aircraft). The index increased by 0.6% m/m following a 4.6% increase in May. On a 3-months annualized basis core capital goods were up 25.1% following a 32.5% increase in the previous month. Core capital goods shipments, which strips out spending on both defense and aircraft, increased by 15.8% on a 3-month annualized basis in June, following a 17.8% increase in May. This category most closely aligns with business investment in equipment and software in GDP, and it is still suggestive of a very strong gain in equipment and software investment in Q2 (we expect an 18% q/q AR increase in Q2) but points to a more moderate gain in Q3.  Overall, today’s report is consistent with the recent fall back in the ISM manufacturing index and slower export growth, and we expect further moderation in durable goods orders as the inventory cycle fades over the second half of the year.

The Mortgage Bankers Association released its weekly applications index which suggests further declining demand for housing.  The MBA Mortgage Applications Index for the week ending July 23 fell 4.6 percent to 720.6.  This decline falls after the index increased 7.6 percent in the previous week.  Comparatively and despite the low interest rate environment, the Index is far off from the highs of 1856.70, set in May of 2003.

The Federal Reserve released its so-called Beige Book regional survey which discusses economic conditions as reported by the central bank’s 12 district banks.  Today’s report comes after last week’s statement by Fed Chairman Ben S. Bernanke that the “the economic outlook remains unusually uncertain.” Last month’s Beige Book reflected that the U.S. economy strengthened in all 12 regions in April and May, while also noting that growth in many was subdued. 

Here’s some highlights of today’s report by the Federal Reserve, followed by the full text.

  • Labor Markets “improved modestly” across regions
  • Wage pressures remained “largely contained” across most districts with Dallas reporting pressure “mostly nonexistent”
  • Credit conditions were “tight” in most districts
  • Most districts reported “sluggish” residential real estate
  • Some districts reported “modest increases” in the economy
  • Economic activity “continued to increase”
  • Economic recovery slowed in some areas
  • Commercial real estate markets “continued to struggle”
  • Increases in retail sales were modest in most regions
  • Manufacturing expanded while some districts noted slowing

Beige Book Full Text

Economic activity has continued to increase, on balance, since the previous survey, although the Cleveland and Kansas City Districts reported that the level of economic activity generally held steady. Among those Districts reporting improvements in economic activity, a number of them noted that the increases were modest, and two Districts, Atlanta and Chicago, said that the pace of economic activity had slowed recently.

Manufacturing activity continued to expand in most Districts, although several Districts reported that activity had slowed or leveled off during the reporting period. Districts also noted improved conditions in the services sector. The five Districts reporting on transportation noted increased activity. Tourism activity also increased across the Districts, although the Atlanta District noted concerns about decreased leisure travel to the Gulf Coast. Retail sales reports generally indicated a continued rise in spending, and several Districts noted that necessities continued to be strong sellers, while big-ticket items moved more slowly. However, most Districts that reported on auto sales noted declines in recent weeks. Activity in residential real estate markets was sluggish in most Districts after the expiration of the April 30 deadline for the homebuyer tax credit. Commercial real estate markets, especially construction, remained weak. Banking conditions varied across the Districts, with some Districts noting soft or decreased overall loan demand; credit standards remained tight in most reporting Districts. Recent rains had mixed effects on crop conditions, while activity in the natural resources sector increased. Overall labor market conditions improved modestly across the Districts, with several reports of temporary hiring. Consumer prices of goods and services held steady in most reporting Districts. Input prices also held largely steady, with only a few reports of cost increases. Wage pressures continued to be contained on the whole.

Manufacturing and Other Business Activity
Manufacturing activity in most Districts continued to move up since the last report, although the pace of activity slowed or activity leveled off in the New York, Cleveland, Kansas City, Chicago, Atlanta, and Richmond Districts. Automobile manufacturing was a bright spot for the Cleveland, Chicago, and St. Louis Districts. Automobile parts suppliers also experienced increased demand in both the Richmond and Chicago Districts. Fuel demand at refineries in the San Francisco District improved, while gasoline demand was steady in the Dallas District. Firms in the semiconductor manufacturing industry reported relatively strong sales or demand growth in both the Boston and San Francisco Districts. Firms in aircraft and parts manufacturing saw sales pick up in both the San Francisco and Dallas Districts. Manufacturing firms in the Boston, Philadelphia, Kansas City, and Dallas Districts were optimistic that demand would continue to improve in the following months. However, Cleveland’s contacts expect demand growth to taper off, Philadelphia noted that the balance of positive over negative views had narrowed, and Atlanta reported fewer firms planning expansions in production. Richmond, Chicago, and Dallas reported that firms in construction-related manufacturing experienced weak demand; construction supplies sales were flat in Kansas City, and Minneapolis reported that a firm in the sector was increasing production. Steel production declined in both the Chicago and Cleveland Districts. Some manufacturers in the Atlanta and San Francisco Districts reported high excess production capacity. Capacity utilization was below pre-recession levels in Cleveland and edged lower among steel producers in Chicago.

Activity in the services sector improved across most Districts since the previous report. The freight transportation industry experienced gains in the Cleveland, Atlanta, Kansas City, Dallas, and Philadelphia Districts. Boston, Minneapolis, and Dallas reported a pickup in demand for some consulting firms. Tourism activity increased in the San Francisco, New York, Minneapolis, Richmond, Kansas City, and Atlanta Districts. Atlanta reported that leisure travel decreased in the Gulf Coast, but some of the lost tourist traffic was offset by the presence of cleanup crews, oil company workers, and the National Guard. Information technology firms saw increased business in the Philadelphia, Chicago, and St. Louis Districts, while activity was flat in the Minneapolis District. Demand for healthcare services was flat in both the San Francisco and Richmond Districts, while activity increased in the Boston District.

Consumer Spending
Reports on retail sales during the early summer months were generally positive, although in most Districts the increases were modest. Retail sales in the New York, Philadelphia, Minneapolis, and Kansas City Districts were higher than year-earlier sales, and Dallas reported solid gains. But sales in the Boston District were mixed compared with the previous year. Recent sales increased slightly in the Cleveland, Atlanta, Chicago, and San Francisco Districts; sales in the Richmond District weakened; and sales in the Kansas City District were flat compared with the previous report. Several Districts cited apparel, food, and other necessities as recent strong sellers, while big-ticket items were weak sellers. Contacts reported satisfactory inventory levels in the New York District, mixed inventory levels in the Boston District, and low or declining inventory levels in the Richmond, Atlanta, and Chicago Districts. The outlook for sales was mixed: Retailers in the Philadelphia, Cleveland, Kansas City, and Dallas Districts reported that they expect modest positive sales growth in the upcoming months; contacts in the Cleveland, Atlanta, and Chicago Districts reported a less optimistic outlook going forward than in the previous report; and retailers in the Boston District reported a cautious outlook.

The Districts that reported on auto sales during the early summer months generally noted a decrease in recent sales. Since the previous report, auto sales in the New York, Philadelphia, Cleveland, Richmond, Chicago, and San Francisco Districts declined, while auto sales in the Kansas City District increased and were unchanged in the Dallas District. Compared with last year, auto sales in the Atlanta and St. Louis Districts were higher. New York, Philadelphia, Cleveland, Chicago, Kansas City, and Dallas all reported that inventory levels were low or declining. Auto dealers anticipate little change in sales for the rest of 2010 in the Philadelphia District and expect sales to increase slowly in the Dallas District. Contacts in the Kansas City District expect continued strong demand, while those in the Cleveland District do not anticipate strong growth in the coming months.

Real Estate and Construction
Nearly all Districts reported sluggish housing markets in the months since the homebuyer tax credit expired on April 30. While some Districts, such as Boston and St. Louis, reported an increase in May and June home sales on a year-over-year basis, some contacts noted that these sales may reflect closings of homes under contract by the April tax credit deadline. The Boston, Philadelphia, Atlanta, and Kansas City Districts reported that home sales are expected to weaken going forward. Residential construction remained limited in several Districts. In the Atlanta District, residential construction activity softened from already weak levels. Homebuilders in the Cleveland District do not expect a turnaround in new home construction any time this year. Builders in the Chicago District are not introducing new inventory without a signed contract on a home. Housing starts were expected to decline for the second half of the year in the Dallas District and to increase slightly over the next three months in the Kansas City District.

Commercial and industrial real estate markets continued to struggle in all twelve Districts. Overall, vacancy rates were flat to slightly increased and continued to exert downward pressure on rents. Construction activity remained weak in most Districts. The New York District noted that commercial development remained generally sluggish despite some pickup in office and retail leasing in New York City. Atlanta, Minneapolis, and Dallas reported that construction activity continued to be weak or to decline, and Cleveland reported that the increase in construction from previous reports has begun to diminish. Philadelphia reported that projects funded with federal stimulus support were near completion with no prospects for additional major construction, while Chicago reported that public infrastructure construction picked up. Developers reported difficult credit conditions in the Cleveland, Richmond, St. Louis, and Kansas City Districts, while the Dallas District reported a few developers going out of business. The outlook for commercial and industrial real estate across the Districts ranged from further declines in activity to slow growth.

Banking and Finance
Reports on banking conditions were largely mixed across the Districts. Banking activity in Richmond and loan demand in Kansas City increased modestly. Overall loan demand was reported as soft or weak in Cleveland, Atlanta, and Dallas, while total outstanding loan volume decreased in recent months in St. Louis but was steady in Philadelphia and San Francisco. Demand for commercial loans was flat to increasing in the Philadelphia, Cleveland, Richmond, Chicago, and Kansas City Districts; in contrast, St. Louis reported a decrease in commercial loans outstanding, while New York, Atlanta, and San Francisco reported restrained or decreasing demand in this lending category. Demand for consumer loans was weak in Cleveland and eased in Philadelphia; Atlanta and St. Louis indicated a decline in consumer lending; but demand for consumer loans increased in New York and Kansas City. Demand for residential mortgage loans eased in the Philadelphia District but increased in the New York District; Cleveland reported residential mortgage activity below expectations at given rates; and real estate lending decreased in St. Louis. Credit was limited for commercial real estate loans in Chicago, and demand fell for these loans in New York and Kansas City.

Most Districts reporting on credit standards continued to note that lending standards remain restrictive. New York reported tighter credit standards for all categories except consumer loans, while Kansas City reported tighter commercial lending standards. Reports on credit quality were mixed in Cleveland and Kansas City, while quality was stable in San Francisco. Credit quality improved slightly in Philadelphia, Richmond, and Chicago. In the Dallas District, nonperforming loans have stabilized and are not expected to worsen. Meanwhile, Philadelphia, Cleveland, and Richmond continued to report delinquencies above historic norms. Delinquency rates in the New York District decreased for consumer loans but experienced little or no change in other categories.

Agriculture and Natural Resources
Recent rains improved the dry conditions in the Minneapolis and Dallas Districts and reduced irrigation needs in the Kansas City District. In contrast, excess precipitation caused some crop damage in the Chicago District and some delays in the winter wheat harvest in the Kansas City District. Parts of the Atlanta District experienced some crop stress due to dryness and heat. Contacts reported that crops were in good condition overall in the Atlanta, Minneapolis, Kansas City, and Dallas Districts, but crop conditions worsened slightly in recent weeks in the Chicago District and were mixed in the St. Louis District compared with last year. Producers in the Chicago District continued to expect good yields for their corn and soybean crops, and the outlook for cotton yields in the Dallas District has improved.

Overall, activity in the energy sector increased since the previous report. Oil production in the Atlanta District and oil and natural gas production in the Cleveland District were relatively unchanged, but other activity picked up throughout the Districts during the reporting period. The number of drilling rigs increased in the Dallas District, and production continued to expand in the Kansas City District. Additionally, oil exploration in the Minneapolis District and oil extraction in the San Francisco District increased. Activity in the Minneapolis District’s mining sector increased in recent weeks, as did production and demand for coal in the Cleveland District. Kansas City reported that contacts expect to see continued growth in energy production.

Labor Markets, Wages, and Prices
Labor market conditions improved gradually in several Districts. New York, Chicago, Minneapolis, Richmond, and Atlanta all reported that labor markets improved, albeit modestly in some cases, while Boston and Dallas reported that employment was steady. Philadelphia, Atlanta, Richmond, Chicago, and Minneapolis reported that temporary employment experienced increased demand. Contacts in the Philadelphia, Atlanta, Dallas, and San Francisco Districts said that they continued to rely on temporary staff over permanent hires. Cleveland, Richmond, and Chicago saw hiring in the manufacturing sector. Cleveland also reported some new job openings in the healthcare industry. Boston and Cleveland noted that firms in some services industries were hiring mostly for replacement. Dallas reported that firms in the energy industry experienced significant regional layoffs as a result of the deepwater drilling moratorium. San Francisco noted continued high levels of unemployment and limited hiring.

Wage pressures remained largely contained across most Districts. Boston, Philadelphia, Richmond, Minneapolis, and San Francisco reported little or no change in wages, while Cleveland, Chicago, and Kansas City reported that wage pressures were small or remained subdued. Dallas reported that wage pressures were mostly nonexistent, with the exception of the airline industry.

Prices of final goods and services were relatively stable in most Districts. Several Districts indicated that prices of raw materials also held steady, and only a few Districts reported input price increases. Steel prices moved slightly higher in the San Francisco District, but Cleveland and Chicago reported that steel prices were down. Chicago and San Francisco noted an increase in energy prices, but Atlanta reported that energy prices were mostly stable since the onset of the Gulf oil spill. Increased prices were noted for some metals by the Philadelphia, Minneapolis, and San Francisco Districts. Transportation costs increased in the Atlanta, Dallas, and San Francisco Districts, and the Richmond District noted that shipping lines were attempting to raise rates.

Posted by Rom on July 28, 2010 under Bond Chatter,Fed Watching

Wag the Dog

By Rom Badilla, CFA – Bondsquawk.com

July 26, 2010

Fueled by positive earnings surprises, the equity markets have soared giving the bulls reason to run.  Last week’s gain of 3.5 percent for the S&P 500 is the second highest weekly gain in 2010.  Since the recent lows set at the beginning of July and the onset of earnings season, the S&P 500 has advanced an astonishing 7.8 percent to 1108.9 as of this morning.  While the jump has been spurred by fundamentals as many of the companies so far have surpassed analysts earnings forecasts, even the technicians have reason to believe in the strength of this rally.   As past support levels become layers of resistance, the S&P 500 blew past prior lows of 1040 and 1065 in addition to the 50-Day moving average at 1085.  Even with the “Death Cross” pattern starring at the many faces of investors, the S&P 500 is making a push to its next layer of resistance at the 200-day moving average of 1110-1115.

While the rally may have some legs to it in the near term and as we enter the second half of earnings season, there are other markets that continue to keep their eyes on the ball as for determining the fate of the U.S. economy.

The 2-Year Treasury which is more in-line with the Federal Reserve’s monetary policy and is heavily influenced by macro drivers, remains unimpressed with the recent bull run in stocks.  Despite the long-end of the yield curve selling off and retreating from recent highs due to a lack of conviction as reflected by the Merrill Lynch MOVE Index, the 2-Year has not moved much at all.  Last week, the 2-Year remains unchanged at 0.58 percent.  Going back further to the onset of earnings season and while the S&P climbed from its recent lows, the 2-Year has declined 2-3 basis points.

Indeed this shouldn’t be surprising to those who follow from ten thousand feet above, since the Federal Reserve maintains rhetoric that rates will remain low for an extended period of time.  While the 2-Year is “anchored” by the Fed’s target rate which hasn’t changed in awhile, the fact remains that the short-end of the Treasury curve has risen on strong economic data and declined as the recovery story falters. 

From late January to the beginning of July, the 2-Year has dropped 30 basis points. During that time, the 2-Year reached a recent high of 1.06 percent in late April when the S&P 500 was north of 1215 and the economic numbers save for employment that is, pointed to stronger growth.  Since then and after the recent spate of disappointing macro data, the two year has dropped close to 50 basis points while stocks have fallen.

It is paramount to note that the relationship, which exhibits a high correlation, held up until the beginning of July and before equities started to take its cue from earnings (The correlation on a change basis for the trailing 6 months stands at 0.57 and at 0.83 by using just the values.  1.0 reflects perfect correlation and -1.0 shows having an inverse relationship).

2-Year U.S. Treasury Yield & the S&P 500 - Trailing 6-months

The bulls may think that the worst is behind us given the fact that the market is “forward looking” and is in general, a reflection of the overall U.S. economy.  Indeed, there is evidence from a bottom-up point of view that the recovery should continue.  However, we all should know that the tail should not “wag the dog” as earnings and profits of each and every company are a byproduct of the general economy.  In addition, earnings which are “rear view” in nature are coming in higher due to beaten down expectations.

The fact remains that the macro picture is revealing an economic slowdown and as Bernanke stated last week that the outlook remains “unusually uncertain.”  As we all know, the bulls hate uncertainty and require comfort much in the same way, I need a cushy pillow for a good night’s rest.

Having said that, it appears that rest is a luxury that the U.S. economy cannot afford.  As David Rosenberg of Gluskin Sheff pointed out that, “80% of the economics community has cut GDP growth forecasts to an average of 2.5% for the rest of the year from the 3% call in April – not to mention that over 80% of the economic indicators over the past month have come in below consensus estimates.”  In addition, ECRI has fallen off a cliff as mentioned here last Friday.

The many who follow us here on Bondsquawk, should know that price is the true arbiter of value for any investment.  Respectfully, the recent rally in stocks (on low volume that is) should not be discounted.  However, if we look at it with the proper and broader context, it is apparent that the 2-Year is suggesting something completely different from its equity counterpart and that the economy is still facing significant headwinds.

Posted by Rom on July 26, 2010 under Bond Chatter,Fed Watching
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Some Thoughts on Deflation

By John Mauldin – Investors Insight

July 25, 2010

Inflation in the US is now just below 1%, whether you look at the CPI, the Cleveland Fed’s measure, or the Dallas Trimmed Mean CPI. The Fed’s favorite, the PCE, is also approaching 1%. The Dallas numbers are a little behind, but they are at all-time lows.

image001 

The classic definition of deflation is an economic environment that is characterized by inadequate or deficient aggregate demand. Prices in general fall, and normal economic relationships start to fall apart.

The Super-Trend Puzzle

I am a big fan of puzzles of all kinds, especially picture puzzles. I love to figure out how the pieces fit together and watch the picture emerge, and have spent many an enjoyable hour at the table struggling to find the missing piece that helps make sense of the pattern.

Perhaps that explains my fascination with economics and investing, as there are no greater puzzles (except possibly the great theological conundrums, or the mind of a woman, about which I have only a few clues).

The great problem with the economic puzzles is that the shapes of the pieces can and will change as they rub against one another. One often finds that fitting two pieces together changes the way they meld with the other pieces you thought were already nailed down, which may of course change the pieces with which they are adjoined; and suddenly your neat economic picture no longer looks anything like the real world.

(Which is why all of the mathematical models make assumptions about variables that allow the models to work, except that what they end up showing is not related to the real world, which is not composed of static variables.)

There are two types of major economic puzzle pieces. The first are those pieces that represent trends that are inexorable:  they will not themselves change, or if they do it will be slowly; but they will force every puzzle piece that touches them to shift, due to the force of their power. Demographic shifts or technology improvements over the long run are examples of this type of puzzle piece.

The second type is what I think of as “balancing trends,” or trends that are not inevitable but which, if they come about, will have significant implications. If you place that piece into the puzzle, it too changes the shape of all the pieces of the puzzle around it. And in the economic super-trend puzzle, it can change the shape of other pieces in ways that are not clear.

Deflation is in the latter category. I have often said that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA transplant that makes you viscerally and at all times opposed to deflation. Deflation is a major economic game changer. You can argue, as Gary Shilling does, that there is a good kind of deflation, where rising productivity and other such good things produces a general fall in prices, such as we had in the late 19th century. And as we have experienced that in the world of technology, where we view it as normal that the price of a computer will fall, even as its quality rises over time.

But that is not the kind of deflation we face today. We face the deflation of the Depression era, and central bankers of the world are united in opposition. As Paul McCulley quipped to me this spring, when I asked him if he was concerned about inflation, with all the stimulus and printing of money we were facing, “John,” he said, “you better hope they can cause some inflation.” And he is right. If we don’t have a problem with inflation in the future, we are going to have far worse problems to deal with.

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

The Elements of Deflation

Just as every school child knows that water is formed by the two elements of hydrogen and oxygen in a very simple combination we all know as H2O, so deflation has its own elements of composition. Let’s look at some of them (in no particular order).

First, there is excess production capacity. It is hard to have pricing power when your competition also has more capacity than he wants, so he prices his product as low as he can to make a profit, but also to get the sale. The world is awash in excess capacity now. Eventually we either grow the economy to utilize that capacity or it will be taken offline through bankruptcy, a reduction in capacity (as when businesses lay off employees), or businesses simply exiting their industries.

I could load the rest of the letter with charts showing how low world capacity utilization is, but let’s just take one graph, from the US. Notice that capacity utilization is roughly in an area that we associate with the bottom of past recessions (with one exception).

image002 

Deflation is also associated with massive wealth destruction. The credit crisis certainly provided that element. Home prices have dropped in many nations all over the world, with some exceptions, like Canada and Australia. Trillions of dollars of “wealth” has evaporated, no longer available for use. Likewise, the bear market in equities in the developed world has wiped out trillions of dollars in valuation, resulting in rising savings rates as consumers, especially those close to a wanted retirement, try to repair their leaking balance sheets.

And while increased saving is good for an individual, it calls into play Keynes’ Paradox of Thrift. That is, while it is good for one person to save, when everyone does it, it decreases consumer spending. And decreased consumer spending (or decreased final demand, in economic terms) means less pricing power for companies and is yet another element of deflation.

Yet another element of deflation is the massive deleveraging that comes with a major credit crisis. Not only are consumers and businesses reducing their debt, banks are reducing their lending. Bank losses (at the last count I saw) are over $2 trillion and rising.

As an aside, the European bank stress tests were a joke. They assumed no sovereign debt default. Evidently the thought of Greece not paying its debt is just not in the realm of their thinking. There were other deficiencies as well, but that is the most glaring. European banks are still a concern unless the ECB goes ahead and buys all that sovereign debt from the banks, getting it off their balance sheets.

When the money supply is falling in tandem with a slowing velocity of money, that brings up serious deflationary issues. I have dealt with that in recent months, so I won’t bring it up again, but it is a significant element of deflation. And it is not just the US. Global real broad money growth is close to zero. Deflationary pressures are the norm in the developed world (except for Britain, where inflation is the issue).

image003 

Falling home prices and a weak housing market are one more element of deflation. This is happening not just in the US, but also much of Europe is suffering a real estate crisis. Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.

In the short run, reducing government spending (in the US at local, state, and federal levels) is deflationary in the short run. Martin Wolfe, in the Financial Times, wrote the following last week (arguing that that the move to “fiscal austerity” is ill-advised):

“We can see two huge threats in front of us. The first is the failure to recognize the strength of the deflationary pressures …  The danger that premature fiscal and monetary tightening will end up tipping the world economy back into recession is not small, even if the largest emerging countries should be well able to protect themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in management of the financial sector and in export-dependency, that are needed if a sustained and healthy global recovery is to occur.”

Finally, high and chronic unemployment is deflationary. It reduces final demand as people simply don’t have the money to buy things.

Deflation that comes from increased productivity is desirable. In the late 1800′s the US went through an almost 30-year period of deflation that saw massive improvements in agriculture (the McCormick reaper, etc.) and the ability of producers to get their products to markets through railroads. In fact, too many railroads were built and a number of the companies that built them collapsed. Just as we experienced with the fiber-optic cable build-out, there was soon too much railroad capacity, and freight prices fell. That was bad for the shareholders but good for consumers. It was a time of great economic growth.

But deflation that comes from a lack of pricing power and lower final demand is not good. It hurts the incomes of both employer and employee, and discourages entrepreneurs from increasing their production capacity, and thus employment.

That is why it will be important to watch the CPI numbers even more closely in the coming months. The trend, as noted above, is for lower inflation. If that continues, the Fed will act. I did a summary of Bernanke’s 2002 speech on deflation a few weeks ago. For those who didn’t read it, here is the link.

If the US gets into outright deflation, I expect the Fed to react by increasing their assets and by outright monetization, buying treasuries from insurance and other companies, as putting more money into banks when they are not lending does not seem to be helpful as far as deflation is concerned. More mortgages? Corporate debt? Moving out the yield curve? All are options the Fed will consider. We need to be paying attention.

One final thought before I hit the send button. Recessions are by definition deflationary. One of the things we learned from This Time is Different by Rogoff and Reinhart is that economies are more fragile and volatile and that recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.

I think we can take it as a given that there is another recession in front of the US. That is the natural order of things. But it would be better to have that inevitable recession as far into the future as possible, and preferably with a little inflationary cushion and some room for active policy responses. A recession next year would be problematic, if not catastrophic. Rates are as low as they can go. Higher deficits are not in the cards. Yet unemployment would shoot up and tax collections go down at all levels of government.

That is why I worry so much about taking the Bush tax cuts away when the economy is weak. Now, maybe those who argue that tax increases don’t matter are right. They have their academic studies. But the preponderance of work suggests their studies are flawed and at worst are guilty of data mining (looking for data that supports your already-developed conclusions.)

Professor Michael Boskin wrote today in the Wall Street Journal:

“The president does not say that economists agree that the high future taxes to finance the stimulus will hurt the economy. (The University of Chicago’s Harald Uhlig estimates $3.40 of lost output for every dollar of government spending.) Either the president is not being told of serious alternative viewpoints, or serious viewpoints are defined as only those that support his position. In either case, he is being ill-served by his staff.”

As noted at the beginning of this letter, I find it very encouraging that there is a movement among Democrats to think about at least postponing the demise of the Bush tax cuts until the economy is in better shape. Those who advocate letting them lapse are in effect operating on our economic body without benefit of anesthesia. If they are wrong, the consequences will be most severe.

We need to think any tax increase through very thoroughly.

John is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered in multiple states. John Mauldin is President of Millennium Wave Securities, LLC a FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). He is a frequent contributor to numerous publications, and guest on TV and radio shows as well as quoted widely in the press.

Posted by Rom on July 25, 2010 under Bond Chatter,Fed Watching

White House to Allow Tax Cuts for Wealthy to Expire

July 22, 2010

Treasury Secretary Timothy Geithner said the Obama administration will allow tax cuts for the wealthiest Americans to expire despite calls from a small group of Democrats to delay tax increases. Kelly Evans talks to John McKinnon in Washington.


(Source: The News Hub)

Posted by Rom on July 22, 2010 under Bond Chatter,Fed Watching

Big Ben Speaks Out

July 22, 2010

Discussing why the markets didn’t like what they heard from the Fed chairman, with Jim Lacamp, Macroportfolio Advisors; Andrew Busch, BMO Capital Markets Global; Sen. Judd Gregg, (R-NH) and CNBC’s Steve Liesman.


(Source: CNBC)

Posted by Rom on under Fed Watching

Bernanke Says Outlook “Remains Unusually Uncertain”

July 21, 2010

Today, Chairman Ben S. Bernanke presented his semiannual monetary policy report to Congress.  Below are some highlights, followed by the full text.

  • Bernanke Says Fed is prepared to act as needed to aid U.S. Growth
  • U.S. Banking System has “improved significantly”
  • Fed sees “subdued inflation” over next several years
  • Fed expects “gradual decline” in unemployment rate
  • Fed sees continued moderate growth over several years
  • Fed is “prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.”
  • Bernanke says slow labor market recovery inhibiting spending
  • Bernanke says rising household, business demand should aid growth
  • Bernanke says economy’s expansion proceeding at “moderate pace”
  • Bernanke reiterates that rates to stay low for “extended period”
  • Fed over the long term, to cut assets to more normal size
  • Asset sale decision dependent on jobs and inflation expectations
  • Bernanke says “economic outlook remains unusually uncertain”

Chairman Dodd, Senator Shelby, and members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress.

Economic and Financial Developments
The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth. In particular, real consumer spending appears to have expanded at about a 2-1/2 percent annual rate in the first half of this year, with purchases of durable goods increasing especially rapidly. However, the housing market remains weak, with the overhang of vacant or foreclosed houses weighing on home prices and construction.

An important drag on household spending is the slow recovery in the labor market and the attendant uncertainty about job prospects. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, a pace insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount of time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers’ employment and earnings prospects.

In the business sector, investment in equipment and software appears to have increased rapidly in the first half of the year, in part reflecting capital outlays that had been deferred during the downturn and the need of many businesses to replace aging equipment. In contrast, spending on nonresidential structures–weighed down by high vacancy rates and tight credit–has continued to contract, though some indicators suggest that the rate of decline may be slowing. Both U.S. exports and U.S. imports have been expanding, reflecting growth in the global economy and the recovery of world trade. Stronger exports have in turn helped foster growth in the U.S. manufacturing sector.

Inflation has remained low. The price index for personal consumption expenditures appears to have risen at an annual rate of less than 1 percent in the first half of the year. Although overall inflation has fluctuated, partly reflecting changes in energy prices, by a number of measures underlying inflation has trended down over the past two years. The slack in labor and product markets has damped wage and price pressures, and rapid increases in productivity have further reduced producers’ unit labor costs.

My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared forecasts of economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The forecasts are qualitatively similar to those we released in February and May, although progress in reducing unemployment is now expected to be somewhat slower than we previously projected, and near-term inflation now looks likely to be a little lower. Most FOMC participants expect real GDP growth of 3 to 3-1/2 percent in 2010, and roughly 3-1/2 to 4-1/2 percent in 2011 and 2012. The unemployment rate is expected to decline to between 7 and 7-1/2 percent by the end of 2012. Most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal, and the majority saw the risks to growth as weighted to the downside. Most participants projected that inflation will average only about 1 percent in 2010 and that it will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced.

One factor underlying the Committee’s somewhat weaker outlook is that financial conditions–though much improved since the depth of the financial crisis–have become less supportive of economic growth in recent months. Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk-taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States. In response to these fiscal pressures, European leaders put in place a number of strong measures, including an assistance package for Greece and €500 billion of funding to backstop the near-term financing needs of euro-area countries. To help ease strains in U.S. dollar funding markets, the Federal Reserve reestablished temporary dollar liquidity swap lines with the ECB and several other major central banks. To date, drawings under the swap lines have been limited, but we believe that the existence of these lines has increased confidence in dollar funding markets, helping to maintain credit availability in our own financial system.

Like financial conditions generally, the state of the U.S. banking system has also improved significantly since the worst of the crisis. Loss rates on most types of loans seem to be peaking, and, in the aggregate, bank capital ratios have risen to new highs. However, many banks continue to have a large volume of troubled loans on their books, and bank lending standards remain tight. With credit demand weak and with banks writing down problem credits, bank loans outstanding have continued to contract. Small businesses, which depend importantly on bank credit, have been particularly hard hit. At the Federal Reserve, we have been working to facilitate the flow of funds to creditworthy small businesses. Along with the other supervisory agencies, we issued guidance to banks and examiners emphasizing that lenders should do all they can to meet the needs of creditworthy borrowers, including small businesses.1 We also have conducted extensive training programs for our bank examiners, with the message that lending to viable small businesses is good for the safety and soundness of our banking system as well as for our economy. We continue to seek feedback from both banks and potential borrowers about credit conditions. For example, over the past six months we have convened more than 40 meetings around the country of lenders, small business representatives, bank examiners, government officials, and other stakeholders to exchange ideas about the challenges faced by small businesses, particularly in obtaining credit. A capstone conference on addressing the credit needs of small businesses was held at the Board of Governors in Washington last week.2 This testimony includes an addendum that summarizes the findings of this effort and possible next steps.

Federal Reserve Policy
The Federal Reserve’s response to the financial crisis and the recession has involved several components. First, in response to the periods of intense illiquidity and dysfunction in financial markets that characterized the crisis, the Federal Reserve undertook a range of measures and set up emergency programs designed to provide liquidity to financial institutions and markets in the form of fully secured, mostly short-term loans. Over time, these programs helped to stem the panic and to restore normal functioning in a number of key financial markets, supporting the flow of credit to the economy. As financial markets stabilized, the Federal Reserve shut down most of these programs during the first half of this year and took steps to normalize the terms on which it lends to depository institutions. The only such programs currently open to provide new liquidity are the recently reestablished dollar liquidity swap lines with major central banks that I noted earlier. Importantly, our broad-based programs achieved their intended purposes with no loss to taxpayers. All of the loans extended through the multiborrower facilities that have come due have been repaid in full, with interest. In addition, the Board does not expect the Federal Reserve to incur a net loss on any of the secured loans provided during the crisis to help prevent the disorderly failure of systemically significant financial institutions.

A second major component of the Federal Reserve’s response to the financial crisis and recession has involved both standard and less conventional forms of monetary policy. Over the course of the crisis, the FOMC aggressively reduced its target for the federal funds rate to a range of 0 to 1/4 percent, which has been maintained since the end of 2008. And, as indicated in the statement released after the June meeting, the FOMC continues to anticipate that economic conditions–including low rates of resource utilization, subdued inflation trends, and stable inflation expectations–are likely to warrant exceptionally low levels of the federal funds rate for an extended period.3

In addition to the very low federal funds rate, the FOMC has provided monetary policy stimulus through large-scale purchases of longer-term Treasury debt, federal agency debt, and agency mortgage-backed securities (MBS). A range of evidence suggests that these purchases helped improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads.

Compared with the period just before the financial crisis, the System’s portfolio of domestic securities has increased from about $800 billion to $2 trillion and has shifted from consisting of 100 percent Treasury securities to having almost two-thirds of its investments in agency-related securities. In addition, the average maturity of the Treasury portfolio nearly doubled, from three and one-half years to almost seven years. The FOMC plans to return the System’s portfolio to a more normal size and composition over the longer term, and the Committee has been discussing alternative approaches to accomplish that objective.

One approach is for the Committee to adjust its reinvestment policy–that is, its policy for handling repayments of principal on the securities–to gradually normalize the portfolio over time. Currently, repayments of principal from agency debt and MBS are not being reinvested, allowing the holdings of those securities to run off as the repayments are received. By contrast, the proceeds from maturing Treasury securities are being reinvested in new issues of Treasury securities with similar maturities. At some point, the Committee may want to shift its reinvestment of the proceeds from maturing Treasury securities to shorter-term issues, so as to gradually reduce the average maturity of our Treasury holdings toward pre-crisis levels, while leaving the aggregate value of those holdings unchanged. At this juncture, however, no decision to change reinvestment policy has been made.

A second way to normalize the size and composition of the Federal Reserve’s securities portfolio would be to sell some holdings of agency debt and MBS. Selling agency securities, rather than simply letting them run off, would shrink the portfolio and return it to a composition of all Treasury securities more quickly. FOMC participants broadly agree that sales of agency-related securities should eventually be used as part of the strategy to normalize the portfolio. Such sales will be implemented in accordance with a framework communicated well in advance and will be conducted at a gradual pace. Because changes in the size and composition of the portfolio could affect financial conditions, however, any decisions regarding the commencement or pace of asset sales will be made in light of the Committee’s evaluation of the outlook for employment and inflation.

As I noted earlier, the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. At some point, however, the Committee will need to begin to remove monetary policy accommodation to prevent the buildup of inflationary pressures. When that time comes, the Federal Reserve will act to increase short-term interest rates by raising the interest rate it pays on reserve balances that depository institutions hold at Federal Reserve Banks. To tighten the linkage between the interest rate paid on reserves and other short-term market interest rates, the Federal Reserve may also drain reserves from the banking system. Two tools for draining reserves from the system are being developed and tested and will be ready when needed. First, the Federal Reserve is putting in place the capacity to conduct large reverse repurchase agreements with an expanded set of counterparties. Second, the Federal Reserve has tested a term deposit facility, under which instruments similar to the certificates of deposit that banks offer their customers will be auctioned to depository institutions.

Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.

Financial Reform Legislation
Last week, the Congress passed landmark legislation to reform the financial system and financial regulation, and the President signed the bill into law this morning. That legislation represents significant progress toward reducing the likelihood of future financial crises and strengthening the capacity of financial regulators to respond to risks that may emerge. Importantly, the legislation encourages an approach to supervision designed to foster the stability of the financial system as a whole as well as the safety and soundness of individual institutions. Within the Federal Reserve, we have already taken steps to strengthen our analysis and supervision of the financial system and systemically important financial firms in ways consistent with the new legislation. In particular, making full use of the Federal Reserve’s broad expertise in economics, financial markets, payment systems, and bank supervision, we have significantly changed our supervisory framework to improve our consolidated supervision of large, complex bank holding companies, and we are enhancing the tools we use to monitor the financial sector and to identify potential systemic risks. In addition, the briefings prepared for meetings of the FOMC are now providing increased coverage and analysis of potential risks to the financial system, thus supporting the Federal Reserve’s ability to make effective monetary policy and to enhance financial stability.

Much work remains to be done, both to implement through regulation the extensive provisions of the new legislation and to develop the macroprudential approach called for by the Congress. However, I believe that the legislation, together with stronger regulatory standards for bank capital and liquidity now being developed, will place our financial system on a sounder foundation and minimize the risk of a repetition of the devastating events of the past three years.

Thank you. I would be pleased to respond to your questions.

Posted by Rom on July 21, 2010 under Fed Watching
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