Why Do investors care? Here’s the explanation courtesy of Econoday:

May 5, 2010

According to the Institute for Supply Management, the Manufacturing sector grew at the fastest rate since 2004. The ISM Manufacturing Index, which is one of the key reports monitored by the Federal Reserve in setting monetary policy, came in at a roaring level of 60.4 for March on Monday signaling expansionary economic activity. A reading above 50 typically signals economic expansion and the index has surpassed 60 only nine times (not including today’s print) in the last 25 years. Usually, when manufacturing activity gets hot, it stays hot for several months. Those nine occurrences can be broken down into two separate periods.

The last time the index entered the 60′s from depressed levels was in December 2003, six months after the Federal Reserve lowered short term borrowing rates to a then low of 1.00 percent to spur economic activity. In June 2004 and after a string of Index readings of above 60 in six out of the seven following months, the Fed changed course, tightened policy ,and jacked up the Fed Funds target by 25 basis points.

Prior to that, the Index posted readings above 60 in three out of four months beginning in September 1987 (right before Black Monday). As with the case in 2004, 6 months after the initial reading, the Fed changed course and tightened policy and jacked up the Fed Funds target by a quarter percent.

ISM Manufacturing and Federal Funds Rate

Back to now, there are rumblings that the economy is on the road to recovery and a Fed rate hike is in the not too distant future, as soon as late 2010 or early 2011. At the last FOMC meeting, Thomas M. Hoenig was the lone dissenter of current policy and stated that continuing to communicate expected low levels of the federal funds rate for an extended period of time was no longer warranted.

According to a Bloomberg survey of economists, the Federal Reserve will be increasing rates by quarter point increments as early as the 3rd Quarter of this year. Furthermore, J.P. Morgan’s Treasury Client Survey which includes institutional fund managers are 92 percent neutral or bearish on U.S. Treasury prices.

In my view, and unlike the aforementioned situations, the Federal Reserve currently has their hands tied and will not be raising rates for quite some time, possibly mid to late 2011 at the earliest.

In both periods, conditions were healthy enough where the economy could handle tighter monetary policy. Specifically, consumer confidence was relatively high as people were optimistic with economic conditions and loan growth was positive. The University Michigan Survey of Consumer Confidence Sentiment averaged 89.9 in the 1987 episode and 95.4 in the 2003 time frame. According to data provided by Federal Reserve, Consumer Credit during those periods increased on average 3.5 billion and 9.4 billion per month, respectively.

A positive outlook, which is facilitated by improving employment conditions, allows people to borrow and spend more, which in turn creates more jobs and improves activity. Indeed it is a circle but a spark needs to be somewhere.

Unfortunately, people in the US see the world through gray colored glasses and with a half empty view these days as the Michigan Confidence Sentiment is currently at a depressed 72.2 reading. This is further supported by the lack of demand for borrowing. Consumer Credit has been declining in 12 out of the last 13 months with an average decrease of 8.9 billion per month. Economists are expecting the latest release which is due on May 7th to be another decline of 4 billion. While the error between actual and expected can be large with equally big revisions to prior numbers, the signs are not encouraging.

Consumer Credit Historical Chart

The Federal Reserve has pumped a tremendous amount of liquidity into the system and has made the current environment accommodative to borrowing. Typically when short term rates are low, a bank can borrow short at one rate and lend farther out the maturity spectrum at a higher rate. This spread results in profit for the banks. However in today’s climate of risk aversion, money is stagnant as it sits there as excess reserves on bank balance sheets. Instead of lending, banks are buying safer Treasuries according to a Bloomberg report. Essentially, they can still capture a spread but with no credit risk.

It’s a healthy and prudent trade for a bank but isn’t exactly what the Federal Reserve had in mind in trying to promote economic growth. For Bernanke and company, creating an environment suited for borrowing when no one is in the mood for borrowing is like pushing on a string.

The government needs to start implementing programs designed at job creation, with an emphasis on the private side, to create that spark. Unfortunately, tax dollars have been spent on other programs and any additions will be faced with strong opposition going forward. In the absence of that, the destruction of excessive debt in some form or fashion needs to occur in order to promote sustainable growth.

Outside of either defaulting or paying it off, the only way to achieve debt destruction is through the passage of time. Apparently this is evident by the recent decline in Consumer Credit as borrowers are content with the debt that they currently have. With higher taxes on the horizon and a slow job recovery, an age of austerity will redefine the way we do business here in the US. Because of this, we will not be seeing loan generation by banks for the foreseeable future which will in turn, keep the Federal Reserve on hold.