No Pressure on Interst Rates

When are interest rates going to rise?  Risk-free interest rates that is?  Short-term interest rates?

Interest rates have risen…and fallen…on government debt that was once considered risk-free because these governments have faced solvency problems. 

But, what about interest rates on United States Treasury debt?  And, what about money market interest rates?   And, what about the Federal Funds rate?

The Federal Reserve has indicated that the target Federal Funds rate will remain where it is now until the end of 20--, you put in the last two numbers. 

The upper limit of the target Federal Funds rate has been at 25 basis points since December 16, 2008.

The upper limit of the target range will only be challenged if the Federal Reserve decides to tighten up on monetary policy…something that is out-of-the-question at this time…or if business activity picks up and the demand for funds increases, thereby putting pressure on short-term interest rates to rise.

Certainly, QE1 and QE2 impacted the supply side of the market and helped to keep the Federal Funds rate below 25 basis points. 

Over the past year, however, there has been next to no demand pressure on the Federal Funds rate to rise.  Over the past year, the effective Federal Funds rate, on a daily basis, has varied between six basis points and eighteen basis points.  Although the rate has been toward the upper end of this range in the past three months, the Federal Reserve has actually seen its portfolio of securities decline over this time period indicating that there has been little or no pressure on the Federal Funds rate to rise. (See my August 7 post about recent Fed activity.)

This lack of pressure on short-term interest rates is a sign of two things at this time.  First, it is a sign of the weakness in economic growth in the United States economy and the consequent lack of pressure on the banking system to lend. 

This lack of weakness is also seen in the financial instruments with a longer term.  Mortgage interest rates are at historically low levels, yet analysts claim that they could be even lower than they are now.  A New York Times article points up the fact that mortgage interest rates could even be lower than they are now but commercial banks have not let them fall as much as they could.  The demand for mortgages is just not that strong.  

One argument given for why the banks are keeping rates as high as they are in the current market is that their costs have risen due to the new regulations that the banks are facing.

Still, the indication is that there is no demand side pressure on interest rates in the current market.

There is a second argument for the lack of pressure on United States interest rates and this has to do with the fact that the United States Treasury market is receiving a substantial amount of funds seeking a “safe haven” in a world of great uncertainty. 

The United States is not the only beneficiary of this “move to safety”.  David Wessel, in the Wall Street Journal, writes about the “subzero” interest rates that now are being “paid” on the two-year government bonds of Switzerland, Denmark, Germany, among others. 

And, we have seen a negative yield on the ten-year inflation-adjusted Treasury bond (TIPS) since August of 2011. 

The point is, that the demand for funds is close to non-existent and this is not a good sign. 

Sure, some firms are borrowing but these are generally the larger companies who are taking advantage of the very low interest rates.  But, these funds are not being used to expand plant and equipment. 

But, with the demand for funds being so low and with little or no indication that a pickup in demand will appear anytime soon, other problems exist.  Savers are earning next to nothing on their money and the many of the elderly are finding it hard to make ends meet.  And, as Wessel points out in the Journal article, “banks and insurance companies start to run into trouble.  They make much of their money by borrowing at short-term rates and lending at higher long-term rates, or effectively, guaranteeing higher rates to their customers.  That doesn’t work so well when yields on two- or three-year securities are negative.”

To me, this is a place we must look to pick up signs of an improving economy.  Demand pressure must start to build in the financial markets indicating that the economy is growing stronger.  The must be some indication that demand pressure is being felt in the Federal Funds market forcing the Federal Reserve to react in an effort to keep the effective Fed Funds rate from rising. 

This is a reason, in my mind, for opposing any kind of further quantitative easing (QE3) in the near term.  If there is no demand side pressure on the money markets, shoving more money into the banking system will not create more demand given where interest rates currently are. 

Business loan demand has been increasing slightly but there is no indication that what we have seen is significant to put any pressure on the banking system.  And, merger and acquisition activity remains week thereby providing us with another sign that the demand for financial resources is remaining tepid.

Right now the Federal Reserve has stated that it can see the Federal Funds rate target remaining in place to the end of 2014. 

If they really believe that this will be the case then they are indicating that they expect the economy to stay extremely week until that time.  This would mean that the economic recovery would be in its sixth year.  And for there to be no demand pressure on short-term interest rates during this time, economic growth would still need to be around two percent and unemployment would have to hover around eight percent.

The fact that there is little pressure on interest rates to rise is not a good sign!        

Fed Sees No Pressure on Interest Rates

The Federal Reserve has seen little or no demand pressure in the money markets over the past six months or so.  Consequently, the Fed has not had to add securities to its portfolio during this time to combat any pressure for interest rates to rise. 

The Board of Governors of the Federal Reserve System met last week and decided not to change the current stance of monetary policy, although the Board felt that it needed to be alert to any possible needs for additional monetary stimulus if the economic growth appears to be decelerating or if the unemployment situation seems to be deteriorating. 

My read on this is that the Federal Reserve believes that it can do little more than what it has already done to try and stimulate further economic growth or lower unemployment.  However, it says that it needs to stand ready in case the situation gets worse. 

This is basically the same policy the Federal Reserve has been following for the past year. 

To me the most important monetary variable to watch at this time is the excess reserves held by the banking system.  This is very important for two reasons.  The first is that I believe that the excess reserves statistics tells us something about what is going on in the banking system and the money markets.  To understand what is going in the banking system and the money markets is important because the primary target the Federal Reserve is focusing on at this time is the Federal Funds rate and what is going on with respect to excess reserves tells us something about what is happening to the supply and demand for funds in the Fed Funds market.

Federal Reserve policy right now is to keep the Federal Funds rate between zero and 25 basis points.  It has been focusing on this range since late 2008.

In attempting to keep the Federal Funds rate within this range, the Fed has been very successful.  The effective Federal Funds rate, the actual funds rate times the quantity of funds lent at the each rate, gives us a weighted average of where the funds rate was trading each day.  Over the past year the effective Federal Funds rate has traded between a low of 6 basis points and a high of 19 basis points. 

The demand side of the market represents the need of the commercial banking system for additional reserves.  The supply side of the market is dependent upon the Federal Reserve System supplying funds or withdrawing funds from the market to keep the Federal Funds rate from within the range it is aiming for.

My reading of the movement in the effective Federal Funds rate for the past year is this: the effective Federal Funds rate was relatively level, around 8 basis points, during from August 2011 into January 2012, roughly the first six months of the year.  After January the rate increased up to the middle of July when it reached 19 basis points and then dropped off to about 14 basis points where it now resides.

The important question, especially for this past six months is the reason for the rise in the effective rate…was it because of demand pressures coming from the banking system…or, was it because of supply conditions created by Federal Reserve actions.

In terms of overt actions during this six-month period, the Federal Reserve did little or nothing.  In fact, the securities portfolio of the Fed actually declined by about $16 billion from May 2, 2012 to August 1, 2012. 

What did put reserves into the banking system, however, was general operating factors, in this case the Treasury, writing checks on its Federal Reserve account, and these checks were then deposited in the banks.  At tax time, April, taxes are paid into government accounts at commercial banks and then drawn into the Treasury’s General Account when the Treasury is going to write checks.  In order to minimize the disruptions in the banking system, the Treasury attempts to keep its deposits there as constant as possible.  Thus, its General Account at the Federal Reserve can experience wide swings during tax time and afterwards.

The Treasury’s General Account at the Federal Reserve fell by $84 billion between May 2 and August 1.Thus, the reserve balances of commercial banks at the Federal Reserve rose by about $60 billion during this time period and excess reserves in the banking system rose by about $37 billion.  So the Federal Reserve acted in a relatively passive way during this time period although the banking system gained in excess reserves during the time period.  The Effective Federal Funds rate did rise over this same time period, but was the rise demand driven? 

My belief is that there might have been a little demand pressure during this time period but I don’t think that the pressure was substantial.  Certainly there has been some pickup in bank lending over the past six months, but the bank loan demand remains relatively tepid.  Most of the loan demand was in business loans at the 25 largest banks in the United States and these banks are highly liquid.  There would little need for them to go to the money markets to finance the loans.

Evidence that there was not much demand side pressure over this time period is that the Fed actually reduced its holdings of market securities.  The little pressure that might have been felt in the Fed Funds market was probably due to the where government checks were paid and the consequent slight dislocation of short-terms funds within the banking system.  The back off in the effective Fed Funds rate this past week is evidence that these funds are well distributed and the banking system is comfortable with how reserves are distributed throughout the industry.

One further note on the excess reserves situation: total reserves in the banking system actually declined by about 7 percent over the past year.  At the same time, required reserves in the banking system rose by just under 28 percent.  These figures capture the huge movement of funds in the financial system from money market funds and other short-term assets back into the banking system, primarily into transactions balances.  This movement has resulted in the M1 money stock increasing at very high, historical, rates of growth, but this increase is coming from individuals and businesses moving assets around and not from loan growth that is underwriting economic activity.  Monetary policy is just not doing much these days except keeping the banking system liquid and helping the FDIC continue to close banks without disrupting financial markets.  I believe very strongly that the Federal Reserve could achieve very little more in this economy if it opened up the monetary spigots much further.  The Open Market Committee was right in keeping monetary policy unchanged. 

Federal Reserve Review as of August 1, 2012

The Board of Governors of the Federal Reserve System met last week and decided not to change the current stance of monetary policy, although the Board felt that it needed to be alert to any possible needs for additional monetary stimulus if the economic growth appears to be decelerating or if the unemployment situation seems to be deteriorating. 

The European Central Bank met last week and produced an outcome that was very similar to the one chosen by the Fed.

My read on this is that the Federal Reserve believes that it can do little more than what it has already done to try and stimulate further economic growth or lower unemployment.  However, it says that it needs to stand ready in case the situation gets worse. 

This is basically the same policy the Federal Reserve has been following for the past year. 

To me the most important monetary variable to watch at this time is the excess reserves held by the banking system.  This is very important for two reasons.  The first is that I believe that the excess reserves statistics tells us something about what is going on in the banking system and the money markets.  To understand what is going in the banking system and the money markets is important because the primary target the Federal Reserve is focusing on at this time is the Federal Funds rate and what is going on with respect to excess reserves tells us something about what is happening to the supply and demand for funds in the Fed Funds market.

Federal Reserve policy right now is to keep the Federal Funds rate between zero and 25 basis points.  It has been focusing on this range since late 2008.

In attempting to keep the Federal Funds rate within this range, the Fed has been very successful.  The effective Federal Funds rate, the actual funds rate times the quantity of funds lent at the each rate, gives us a weighted average of where the funds rate was trading each day.  Over the past year the effective Federal Funds rate has traded between a low of 6 basis points and a high of 19 basis points. 

The demand side of the market represents the need of the commercial banking system for additional reserves ofter driven by loan demand.  The supply side of the market is dependent upon the Federal Reserve System supplying funds or withdrawing funds from the market to keep the Federal Funds rate from within the range it is aiming for.

My reading of the movement in the effective Federal Funds rate for the past year is this: the effective Federal Funds rate was relatively constant, around 8 basis points, from August 2011 into January 2012, roughly the first six months of the past year.  After January the rate increased up until the middle of July when it reached 19 basis points and then dropped off to about 14 basis points where it now resides.

The important question, especially for this past six months is the reason for the rise in the effective rate…was it because of demand pressures coming from the banking system…or, was it because of supply conditions created by Federal Reserve actions.

In terms of overt actions during this six-month period, the Federal Reserve did little or nothing.  In fact, the securities portfolio of the Fed actually declined by about $16 billion from May 2, 2012 to August 1, 2012. 

General operating factors actually put reserves into the banking system: in this case the Treasury, writing checks on its Federal Reserve account, and these checks were then deposited in the banks.  At tax time, April, taxes are paid into government accounts at commercial banks and then drawn into the Treasury’s General Account when the Treasury is going to write checks.  In order to minimize the disruptions in the banking system, the Treasury attempts to keep its deposits there as constant as possible.  Thus, its General Account at the Federal Reserve can experience wide swings during tax time and afterwards.

The Treasury’s General Account at the Federal Reserve fell by $84 billion between May 2 and August 1 as the Treasury spent tax money that had been collected earlier.

Thus, the reserve balances of commercial banks at the Federal Reserve rose by about $60 billion during this time period and excess reserves in the banking system rose by about $37 billion.   

So the Federal Reserve acted in a relatively passive way during this time period although the banking system gained in excess reserves.   

The Effective Federal Funds rate did rise over this same time period, but was the rise demand driven? 

My belief is that there might have been a little demand pressure during this time period but I don’t think that the pressure was substantial.  Certainly there has been some pickup in bank lending over the past six months, but the bank loan demand remains relatively tepid.  Most of the loan demand was in business loans at the 25 largest banks in the United States and these banks are highly liquid.  There would little need for them to go to the money markets to finance the loans.

Evidence that there was not much demand side pressure over this time period is that the Fed actually reduced its holdings of market securities.  The little pressure that might have been felt in the Fed Funds market was probably due to the where government checks were paid and the consequent slight dislocation of short-terms funds within the banking system.  The back off in the effective Fed Funds rate this past week is evidence that these funds are well distributed and the banking system is comfortable with how reserves are distributed throughout the industry.

One further note on the excess reserves situation: total reserves in the banking system actually declined by about 7 percent over the past year.  At the same time, required reserves in the banking system rose by just under 28 percent.  These figures capture the huge movement of funds in the financial system from money market funds and other short-term assets back into the banking system, primarily into transactions balances.  This movement has resulted in the M1 money stock increasing at very high, historical, rates of growth, but this increase is coming from individuals and businesses moving assets around and not from loan growth that is underwriting economic activity.   

Monetary policy is just not doing much these days except keeping the banking system liquid and helping the FDIC continue to close banks without disrupting financial markets.  

 I believe very strongly that the Federal Reserve could achieve very little more in this economy if it opened up the monetary spigots any further.  In this respect, I believe that the Open Market Committee was right in keeping monetary policy unchanged. 

The Fed Disappoints the Stock Market

The stock market had been up most of Wednesday morning…the Dow-Jones average was up 30 points or more almost from the start.

Somewhere around 2:00 PM, Eastern Standard Time, the Open Market Committee of the Federal Reserve System produced a statement summarizing the results of its two-day meeting.  The gist of the meeting is captured in this sentence: “The committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

The stock market immediately went down.  The Dow moved into negative territory.

Disappointment…

Investors in stocks are looking all over for positive news so that they can justify higher stock prices.  Last week they rallied as “Super Mario” Draghi, President of the European Central Bank, promised unconditional support to the Euro.  They rallied the week before on something else…and they rallied earlier on another thing…

Investors were putting their hopes on the Federal Reserve that it would come up with a QE3…or another Operation Twist…or something else…that would possibly help spur the economy on and rationalize buying into a rising stock market.

This, in spite of the fact that the earlier actions of the Fed…QE1…or QE2…or whatever…had done little or nothing to spur on economic growth…bring down unemployment…or anything else.

This is the state that investors…business people…families…find themselves in these days…hoping and hoping that something positive will take place.

In the extreme, it shows us just where everyone is concerning the leadership in the United States…and the leadership in Europe…and the leadership elsewhere in the world.

Two words keep coming up to capture the essence of the situation…uncertainty and risk.

No one seems to know what is going on…and no one seems to be presenting any ideas about how we can move into a better future. 

The only positive spin that analysts could put on the Fed’s statement: “The Fed signaled more strongly it will take action as needed to boost the economy…”

Big whoops!

Man, I learned a lot from this…

But, let’s look at the situation.

For one, there is very little that the Federal Reserve can do to “goose up” the economy at this time.  The Fed acted to stop the liquidity crisis that plunged the financial system into a crisis.  The Fed has done about all it can to calm down the solvency crisis.  The Fed has poured more than a trillion dollars into the banking system to provide time for the banking system to shrink in numbers and the FDIC to close problem banks. 

The Fed cannot make businesses and families borrow.  The Fed cannot hire people and put them back to work.  The Fed cannot eliminate the foreclosures and bankruptcies that are still looming in families, small business, and in local governments.  The Fed can do only so much…

And, to use economic terms, over time a central bank can only impact “nominal” variables, like the monetary base and the money stock and prices, and not “real” variables, like real economic growth and the unemployment rate.

Still, investors were looking for some sign that a (somewhat) trusted institution was going to provide some kind of leadership that would help.

Where there is a vacuum…people keep looking for someone or some thing that will fill in the void. 

In this case, to me, investors were looking for too much.  There is very little that the Federal Reserve can do now.  This is especially true since so many of our economic problems are coming from structural dislocations and not from cyclical movements.  These structural problems that exist within the economy are not going to be overcome, over night.  I have tried to express this repeatedly in my blog.

The good news is that the United States economy is recovering.  Not as quickly as we would like but it is recovering.  There are many potential bumps-in-the-road ahead…like the recession in Europe and the slowdown in the rest of the world…like the “fiscal cliff” facing Congress and the President…along with several other impending problems.  But, the economy is growing.

The bad news is that there seems to be an almost total absence of confidence in our elected officials and their appointees…and in the institutions we used to have so much faith in.  And, until this confidence begins to rise, the structural problems that are the essence of any real future economic recovery will just tend to languish.

Whether or not the Federal Reserve comes up with any more “stimulus” to combat further economic slowdown is irrelevant to me.  I believe that the financial markets should stop looking for their “savior” to come from the halls of the Fed…although, unfortunately, it looks like it might be the only show in the town of Washington, D. C.    

The Banking System Through the First Half of 2012

Total reserves in the banking system have actually dropped from June 2011 to June 2012 by about 6.6 percent or about $110 billion.  These are according to the latest figures released by the Federal Reserve.

Yet, required reserves in the banking system have increased by a little over $21 billion during this time period representing a rise of almost 28 percent.

The reason why these numbers are moving in opposite direction is that individuals and businesses are continuing to move their assets from short-term interest bearing instruments into currency or into transaction accounts at financial institutions.

Coin and currency in the hands of the public rose by 8.5 percent, from June 2011 to June 2012.  Cash holdings are continuing to run at relatively high annual rates because a lot of people are keeping their funds in currency these days because of the bad economic times.  This high of a rate of increase in currency holdings is a sign of weakness in the economy and the bad financial condition so many people find themselves in.  It is not a sign of economic health.

The M1 money stock measure increased by 16.0 percent over the past 12 month period.  One can note right off that this figure is down from the March 2011 to March 2012 period which was 17.4 percent and also down from the December 2010 to December 2011 period which was 18.4 percent. 

Since the rate of increase in currency outstanding has not changed much from the end of the year, this means that the other components of the M1 measure of the money stock have declined.  And, this is true.  The June-over-June rate of growth for the non-currency component of the M1 measure of the money stock now rests at 16.0 percent. 

The M2 measure of the money stock was growing by a little more than 9.0 percent in June, down since the end of last year, but this decline has not been caused by a drop in the non-M1 component of M2 which has remained relatively constant through the first half of 2012. 

The movements of funds are very clear:  small-denomination time accounts at financial institutions are down by 17.0 percent, June-over-June; retail money funds are down by almost 3.0 percent; and institutional money market funds are down by almost 8.0 percent. 

Individuals are moving funds from short-term interest bearing assets to currency holdings and transaction accounts either because of their economic situation or because of the low interest rates.

As a consequence, the required reserves at commercial banks have grown quite rapidly.  Since, there are so many excess reserves in the banking system, the total reserves in the banking system can decline while the required reserves in the banking system can increase.  This is not the case in more "normal" times. 

And, the transaction accounts at financial institutions can also increase at historically high rates, at almost 28.0 percent, year-over-year, and yet this rise is not looked on as inflationary because of the massive movement of funds around the financial system.

It can be seen, however, that loans and leases within the banking system are now increasing at a faster pace.  Total loans and leases increased at a 5.3 percent year-over-year rate in June, the highest rate of increase in a long time. 

More specifically, commercial and industrial loans (business loans) expanded at a 14.0 percent annual rate in June, with C&I loans at the largest 25 domestically chartered banks in the United States rising by almost 17.0 percent.  This is the strongest showing since the economic recovery began.

The questions one must ask here are about the type of business loan the banks are making and what kind of impact are these loans having on the various measures of the money stock? 

At the present there is no indication that these business loans are going for productive uses, for purchasing physical capital goods…investment goods.  They may be going into the financing of inventories…physical goods that are not getting sold…or information technology.

Furthermore, if these loans are having any impact on the money stock measures it is small relative to the huge flows of funds coming into the transaction-type accounts from short-term interest bearing assets.  Hence, they cannot be seen as “inflationary” at the present time.     

Commercial real estate loans continue to decline, both at the largest banks and in the rest of the banking system.  As I have discussed many times, this decline will continue well into next year because of the condition of the commercial real estate market.

Interestingly, consumer-type loans at the largest banks, consumer credit and home equity loans, declined over the past year while these types of loans did increase modestly at the smaller banks.

I still have a great deal of concern for the health of the “smaller” banks in the banking system.   Five more depository institutions were closed this past week bringing the total number of banks closed this year to 38. 

But, this is not the only number we should be looking at.  From March 31, 2011 to March 31, 2012 82 banks were closed in the United States.  But, over the same time period, the number of banks in the banking system dropped by 190.  Obviously, quite a number of banks left the banking system during this time period through merger or acquisition.  It is my view that the banking system will continue to lose individual institutions from its numbers, maybe not at the almost 4 per week rate of the period ending March 31, 2012, but at a similarly rapid rate for the next twelve months are so.  This is what the Federal Reserve and the FDIC are attempting to achieve as smoothly as possible. 

The pressure may be lessening in this area.  Over the past three months, the cash assets at both the largest 25 domestically chartered banks in the United States have declined, as have the cash assets at the rest of the domestically chartered banks.  And, excess reserves in the banking system have also declined modestly.

My interpretation of the stance of the Federal Reserve right now is to accept the high rates of growth of the M1 and M2 measures of the money stock as these rates are due to individuals and businesses re-arranging their assets and not due to the Fed’s monetary stimulus.

Business lending may be getting stronger, but, as of this point in time, there is little or no indication that this lending is going into constructive physical assets.  This area, however, needs to be watched.  On the other side, one also needs to continue to watch what happens to the commercial real estate area.  As discussed before, many of these loans are loans that are paid off at maturity and these maturity dates are coming due over the next 12-to-36 months.  Many of these loans may not get refinanced.  This could be very difficult on the banks…especially the “smaller” ones.

Finally, the Federal Reserve…and the FDIC…are still keeping a close eye on the health of the banking system.  Especially the Fed does not want to do anything silly at this time…like it did in 1937…and prematurely remove excess reserves from the banking system before the system is ready to “let them go.”  I still believe that there are a lot of banks in the system that are technically insolvent and that the Fed and the FDIC are being extra careful to “not rock the boat” while these institutions need to be closed or merged out of business.  This remains a major concern at the Fed.   

US Industrial Production Continues to Expand

The US economy continues to grow but the pace of expansion is still modest.  Industrial production expanded in June at a 4.7 year-over-year pace.  This put the average rate of expansion for the quarter at 4.7 percent, year-over-year, up slightly from a 4.4 pace of the first quarter. 

Since the current economic recovery began in July 2009, the highest quarterly increase in industrial production came in the third quarter of 2010.  At that time industrial production was increasing at a 7.1 percent, year-over-year rate. 

As can be seen in the accompanying chart, the rate of increase dropped off from that date and seems to have settled in the three-to-five percent range, a rate that is rather anemic for this time in the business cycle, but a rate that is consistent with other current measures of economic growth.

Real GDP, for example, grew at a 2.0 percent year-over-year rate of growth in the first quarter of 2012, and has only average in the 1.5 percent to 2.0 percent range for the past year.

As reflected in almost all of the data, economic growth is taking place but not at a very rapid pace.

There are three reasons for this slow pace of economic growth in my mind.  The first reason is the huge debt overload that exists within the US economy.  I have written on this in "The Debt Crisis Goes On and On."  Individuals, businesses, and state and local governments, overloaded with debt at not able to spend as abundantly as in the past because they are attempting to get their balance sheets back in line.

Second, there is a great deal of uncertainty in the world these days.  Washington, D. C. is in a mess and there seems to be no leadership around, especially in the White House.  As Larry Summers stated during his recent term in Washington, “the parents are not at home.”  This lack of leadership in the US, combined with the economic crisis in Europe and the lack of leadership there, leaves us all wondering what is in store for us in the future.  And, unfortunately, what we contemplate for the future is not very optimistic.

Third, there are some serious structural matters in the economy that still need to be resolved.  For example, I believe that underemployment in the United States is still around 20 percent.  That is, one out of every four individuals of working age are either unemployed, employed in a part-time job but would like to work full time, or, have left the work force.  The workforce participation numbers are now back where they were in the 1960s.

And, we continue to get stories about how the American society is bifurcating.  David Brooks writes of "The Opportunity Gap" emerging in our country, a gap in which “the children of the more affluent and less affluent are raised in starkly different ways and have different opportunities.”  The ramifications of this split has been researched and discussed by numerous people now and it indicates that we need more than just economic stimulus and good intentions to solve the structural problems that are growing worse every day.

This structural problem is also seen in the data on the capacity utilization of American manufacturing.  The data just released indicate that industry is using just under 79 percent of its capacity.  Thus, capacity utilization continues to increase in the current recovery.

However, note in the accompanying graph that capacity utilization was around 90 percent in the mid-1960s and has trended downward every since.  In fact, this trend matches, to a high degree, the increase in the underemployed in the United States.

Most obvious in the trend is that the peak utilization in every cycle seems to be lower than that achieved in the previous cycle.  Capacity utilization continues to increase in the current recovery but is still below the peak achieved in the 2003-2007 period…which was below the peak of the cycle in the mid-1990s. 

There are significant structural dislocations in the United States economy and a policy of government intervention and economic stimulus is not going to correct the situation.

Mr. Bernanke, in testimony before Congress today, seemed to be cognizant of the problems the US economy is facing.  “Mr. Bernanke’s cautious testimony underscored the Fed’s reluctance to ride once again to the aid of a plodding economy. The central bank has intervened repeatedly when the economy appears at risk of sliding back into recession, and Mr. Bernanke’s testimony Tuesday included his standard promise to maintain that vigilance. But the Fed has not acted with similar urgency to reduce the persistently high rate of unemployment when growth is merely lackluster.”

To me, this is about all the Federal Reserve can do right now. (See my post on "The Fed is Doing Enough For Now.") The economy is recovering but not at the speed we would like.  However, sometimes there is only just so much that can be done in terms of aggregate economic policy. 

The Federal Reserve is Doing Enough...For Now

The economy is recovering.  It is not recovering as fast as we would like, but it is recovering.

Within this recovery there may be only so much that government can do to speed on this recovery.  In my mind, we need to keep this thought in mind when considering what else the Federal Reserve can do at the present time. 

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, I believe that he is not saying much because he has said enough for the time being. 

The market is concerned about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point because he believes that the Fed is doing enough…for now! 

One part of the Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

But, some members of the Federal Reserve’s Open Market Committee are concerned about the weakness that still exists in the economy.

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There are other concerns at work, however.

There is real concern over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.  

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

In terms of the economy, the Fed has done about all it can do right now.  The major thing it has done…at least for the time being…is to stop any cumulative movement in the economy to a period of price deflation.  This is the big theoretical concern that exists in a period like this, the possibility that the economy will decline into a period of debt-deflation.

However, protecting the economy from a period of deflation does not eliminate the problem I discussed earlier this week, the problem of the extensive debt buildup in the economy.  The deleveraging of the economy is still something that needs to take place.

The deleveraging of the economy will still take some time.  For now, I would argue that the Federal Reserve has done and is doing about all it can to keep the expansion going.  The economy is recovering.  It certainly is not recovering as rapidly as we would like it to recover, but it is recovering.  Sometimes only so much can be done to assist a recovery and the rest must be accomplished by letting the system do its own part.  In the current situation, reducing the debt load is what the economy needs to do and it takes time for an economy to achieve this.     

Mr. Bernanke Needs to Speak Out About QE3...or, Has He?

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, he is staying pretty silent. 

The market concern is about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point for political reasons. 

He stated just the other day that the Federal Reserve is not swayed by political factors.

We can save the further discussion about the political nature of the Fed for another day.

The Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There is real concern, however, over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.

Can Mr. Bernanke tell us all of this in a way that will convince us?  Should Mr. Bernanke tell us all of this in an attempt to convince us?

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

Other than the fact that I don’t believe that “operation twist” can really be effective, I believe that Mr. Bernanke and the Fed are “spot on” concerning what monetary policy should be at this time.  To me, the primary thing that is currently impacting US Treasury rates is the “flight to quality” in financial markets that is taking place internationally and this is dominating what the Fed is doing and everything else.