Economic Trends and Risks

Policy Statement -- Growth has Returned

The Fed policy makers ended a 2-day meeting Wednesday with an encouraging summation which mimicked other comments from the Fed Chairman and others.  The policy statement  noted that "economic activity has picked up" (read has turned positive) after the August statement that "activity is leveling out" and the June conclusion that the "pace of economic contraction is slowing".

The statement notes that conditions in the financial markets have improved further and activity in housing has increased.  Household spending seems to be stabilizing but remains under the pressures of job losses, sluggish income growth, lower housing wealth and tight credit.  (see Aug 13's related post Fundamental Drags on Consumer Spending)

The bottom line is that the Fed policy makers expect a strengthening of economic growth as inflation pressures remain subdued "for some time".

The near 0% policy rate is expected for an "extended period" as the Fed purchases of mortgage backed securities ($1.25 trillion) and agency debt ($200 bln) will be slowed and completed by the end of the first quarter of 2010.  The Fed's purchases of Treasury securities ($300 bln) will be completed by the end of October 2009. 

The policy statement included no comment on the timing or instruments to be used in the eventual reserve draining needed to reverse the massive inflow of reserves required to provide liquidity to the financial markets.   Market expectations center on term reverse RPs (repurchase operations) or term reserve deposits (turning reserve balances into term investments).

The reserve draining is likely to start before the Fed begins to lift the policy rate.   Timing depends on the shape of the economy as risk lies in either direction.   My growth outlook shows modest growth in the 2% - 3% range beginning in the current quarter.   But history would argue for a stronger lift after the severe economic collapse and nearer timing for the snugging of reserves and liquidity.  Consumer spending may provide the forewarning given its expected slow growth over the coming year. 

Risk for Higher Long Yields

The global move from dollar safety leaves the dollar value at an annual low.  While the dollar gained value early in the year as global economic/financial fears were still rising, the move now is toward higher yielding assets in China, Brazil, Europe and elsewhere.

Meanwhile the U.S. Treasury is flooding the market with debt as the budget deficit is expected to reach $3 TRILLION over fiscal years 2009 and 2010. 

A drop in demand for dollar denominated assets and the supply explosion in Treasury debt leaves a clear risk that longer yields will shift sharply higher (i.e. prices lower) as the 2010 expected turn in Fed policy approaches.

We haven't seen that movement yet.  10 year Treasury notes are trading near 3.4% as 30 year bonds stand at just 4.2%.  But remember, the Fed is targeting a 0%-0.25% overnight policy rate.  The outlook for all yields turn with the rise of Fed policy rates.

Inflation fears are more worry than reality given the huge output gap, the large unemployment rate (read  low wage pressures) and low capacity utilization rate -- the key indicators of inflation pressures.  Without rising inflation expectations the outlook on yields hasn't shown much movement.  And the Fed is ramping down the massive funds provided through the alphabet soup of funding/lending programs (TAF, TSLF, PDCF, TARP, CPFF, etc), stealing that inflation argument from the hawks.

Treasury demand from foreigners continues to run strong but fears are tied to an eventual slipping away given the massive supply and talk that China will begin investing in IMF funds as it moves to a less dollar-centric currency system.  Ironically, central banks and other "official" accounts are just 14% of the massive $314 bln of net foreign Treasury coupon purchases over the last year.  Private demand commands the 86% majority.

 

That massive foreign demand was sufficient to keep a lid on long term yields over the last half decade but given the massive size of the government's financing needs that support should be softening and may only wait for the anticipated turn in Fed policy. 

The bigger picture notes that near term there is no substitute for the dollar as the premier reserve currency.  But, the massive financing need should begin to weigh on yields as the attraction of dollar based assets falls with the improving global economy.  Higher Treasury yields will carry in to higher corporate borrowing rates as well.

Regional Economies

The Federal Reserve released the Beige Book Wednesday – a largely anecdotal report on the twelve regional economies to be used at the next Fed policy meeting.  The big picture is the same seen in the economic reports discussed on these pages but there are some regional differences that add detail.

 

Boston retailers, manufacturers, and software and IT services providers are more confident about their companies' and the economy's eventual recovery. Residential real estate sales rose in recent months, although prices continued to fall; commercial real estate markets remain very soft

New York labor market remains soft.  Manufacturing contacts report some pickup in activity and remain optimistic about the near-term outlook. Housing markets in northern New Jersey and upstate New York have shown some signs of picking up, especially at the lower end of the market; however, the purchase and rental markets for New York City apartments continued to weaken, led by the high end. Bankers report rising delinquency rates across all categories of loans, as well as some further weakening in loan demand and continued tightening in credit standards.

Philadelphia region manufacturers reported a steady rate of shipments and a slight increase in new orders. Retailers indicated that sales of back-to-school merchandise had picked up. Third District banks reported level loan volume and further declines in credit quality.  Bankers anticipate demand for credit to remain soft as businesses and individuals continue to reduce indebtedness.

Reports from Cleveland district factories indicated that production was flat to up slightly.  Credit availability continues to be an issue for residential and commercial contractors. Sales by District retailers were steady to down slightly. Capital spending remains at low levels and little change is expected in the upcoming months.

Richmond area manufacturers reported solid increases in activity. Mortgage lenders mentioned a pickup in purchase loans that was concentrated in low-to-middle tier homes. Demand for commercial loans remained subdued. Contacts across the service sector observed contracting employment and wages.

Atlanta’s inventory of unsold homes remains elevated given the supply of foreclosed properties, and this is said to be keeping downward pressure on home prices. Manufacturing activity continued to improve.  Banking contacts reported that credit availability remained tight. The pace of layoffs broadly slowed, but few contacts outside of temporary staffing noted any plans to expand payrolls in the near term.

The decline in economic activity in the Chicago District leveled off. Consumer spending increased from the previous reporting period, and the decline in business spending slowed. Manufacturing and construction remained at low levels, although both sectors showed signs of improvement.

St. Louis economic activity remained weak. Both manufacturing and services activity contracted at a slower pace. Residential and commercial real estate markets conditions continue to be weak. Overall lending activity decreased moderately in the three-month period ending in July.

Modest decreases in activity occurred in the Minneapolis District consumer spending, agriculture, and commercial real estate and construction. The manufacturing, energy, mining and residential real estate sectors saw moderate increases. Labor markets were mixed, and wage increases were subdued.

The Kansas City District economy generally held steady. Residential real estate activity softened and commercial real estate market remained fragile. Banking conditions remained tepid partly due to moderately declining loan demand and a negative outlook for loan quality. Falling grain prices and weak livestock exports put downward pressure on agricultural profits. Even though input prices were expected to rise, producers did not anticipate passing additional costs through to retail prices.

Economic activity in the Dallas District firmed somewhat. Despite the slight improvement, several contacts expressed disappointment that conditions had not improved more. Most contacts are hesitant to predict a significant turnaround in the near term.

Economic activity on the West coast showed continued scattered signs of firming.  Upward price pressures remained quite modest overall, and upward wage pressures were largely absent. Retail sales stayed anemic, while demand for services continued to erode. District manufacturing activity remained stuck at very low levels. Banking contacts reported that District lending activity eased on net and credit quality continued to deteriorate.

Manufacturing's Positive Growth

The August ISM survey on manufacturing came in better than expected showing the first positive growth in a year and a half and the highest level since June 2007.  The ISM index comes from a survey of manufacturing purchasing managers and provides a forward read on actual manufacturing orders, production, employment and other conditions.

More than the 52.9 overall index, where a flat 50 marks positive from negative growth, were the strong 60+ levels of new orders and production.  All but three of the nine sub-components showed levels above the break-even 50.  The continued declines were in employment, inventories and import demand as order backlogs, export orders and prices added to the gainers.

As noted, the strong components present very positive expectations for August factory orders and industrial production.  Explaining some of the recent pop is the rebound in motor vehicle activity given the "cash-for-clunkers" government program.  From June to August domestic car sales have surged 60% as light trucks rose 27%.  However, the ISM index shows 11 of the 18 manufacturing industries reported growth in August.  

The strong 9.6 point rise in the ISM new orders index to 64.9 is the highest in over four and a half years.  It argues for a still larger gain in August factory orders after today's reported fourth consecutive monthly gain.  The bottom appears to have been in March.

 

Increased order demand should bring another lift to manufacturing production as seen in the strong 61.9 level in the ISM production component.  July showed a 1% gain as non-vehicle production rose 0.2% -- the first gains for either in nine months. 

 

As I've noted in earlier posts, the sum of the economic data reflect a return to recovery as the ISM report adds further confirmation.  The National Bureau of Economic Research's official declaration of the end of recession is a waiting game given the risks (and embarrassment) of rushing the call and getting it wrong.