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 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.    

The Debt Crisis Goes On and On

When it comes to a debt crisis almost everyone seems to quote from the book “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff.  A debt crisis takes a long time to create and it takes a long time for a debt crisis to unwind.

Yet, no one seems to heed this conclusion.

Instead we hear that we need more monetary stimulus, a QE3, before the upcoming presidential election in the United States.  We need immediate tax cuts.  We need fiscal stimulus.  We need an export policy to spur on the economy.

Let me repeat the conclusion written above: it takes a long time to create a debt crisis.

In my mind it took the United States approximately fifty years to create its debt crisis. 

Now, the second part of the equation: it takes a long time to unwind a debt crisis.

How long?

Jamil Baz, chief investment strategist at GLG Partners, a part of the Man Group, suggested that the current debt crisis “will take a minimum of 15 years for the economy to reach escape velocity and attain a level consistent with healthy growth.  This is because debt levels need to come down by at least 150 percent of GDP in most countries.  History suggests that you cannot reduce debt by more than 10 percentage points a year without social and political dislocation.”

Fifteen years!

Geeeeeeeeeee!!!!!!

Over the past five years, the debt situation has gotten worse.  According to Mr. Baz, for eleven the eleven developed countries most mentioned when it comes to the debt crisis, the weighted average of government debt to GDP has risen from 381 percent in June 2007 to 417 percent at the present time.

Deleveraging, at least in the public sector, has not taken place during these sad economic times…in fact, just the opposite has occurred.

And, when you add on the private debt the situation has deteriorated even more amongst these developed nations.

Why aren’t businesses hiring?  Why aren’t people spending?  Why aren’t government policies working? 

Because, Mr. Baz argues, deleveraging has not even started yet! 

All we have heard is a lot of hot air escaping from the balloon.  But, the balloon is not taking off and will not take off as long as there is still substantial deleveraging left…in the United States…and in most of the rest of the developed world.

And, when the debt begins to be reduced…watch out for economic growth.  The International Monetary Fund has estimated that, under current circumstances, every dollar cut from government deficits will lead to a two-dollar reduction in GDP.  This multiplier effect is higher now, the IMF states, than it was before 2008…four times higher!

The policy tools that people are turning to are not effective.  Additional government stimulus, or even the talk of it, points to even more debt being created which, in a cumulative way, just adds to the problem.  Monetary stimulus that creates inflation to reduce the real value of the debt will just result in higher bond yields that would raise the costs of servicing the debt and this just will exacerbate the problem.  And, policies to cause exchange rates to fall to jump-start an export-driven recovery are being tried by just about everyone with no one winning the game.

Fifty years of credit inflation…here in the United States…and in Europe…have created the debt crisis.  More of the same policy will only add to the crisis…not solve it. 

But, for fifty years, public officials would not listen to warnings that more and more credit inflation would result in a situation like the one we are now in.

Another five…or, ten…years of credit inflation will not heal the situation!

Unfortunately, there are no good, painless solutions. 

The ironic thing is that interest rates are so low in this situation!  The ten-year United States Treasury issue is trading just under 1.50 percent.  The ten-year German government bond is trading around 1.25 percent. 

The investment community is so spooked by the debt crisis that the “safe” bet today is in either US Treasury securities or German Bunds.  And, some US Treasury indexed bonds are trading at more than a NEGATIVE one percent rate of interest.  The ten-year indexed bond is trading around a NEGATIVE 0.60 percent.

In economics, everything is relative.

However, officials don’t acknowledge the problem.  Debt is subject that is best not discussed.  For most of the past fifty years, debt has not been present in aggregate models of the economy…academic, private, or government models. 

Still, it takes a long time for a debt crisis to become the dominant factor of an economy.

Unfortunately, it takes a long time for the debt crisis to subside.  This debt crisis will not be over when the next president of the United States is elected.  In all likelihood, the debt crisis will not be over when a president of the United States is elected in 2015. 

Maybe it is time to acknowledge this problem and really start to deal with it.  We have seen what continuing to ignore it does.   

All is Quiet on the Federal Reserve Front

Another quiet week at the Federal Reserve.  This month was very similar to last month…and the month before…and so on.

In terms of monetary policy the Fed is doing very little.  There seems to be very little the Fed can do at this time. 

The economy is still growing…but is growing quite slowly.  The recently revised figure for real GDP growth stands at 2.0 percent, year-over-year.

In terms of the state of the economy, the Fed can do next to nothing to get the economy growing faster before the Presidential election.  President Obama…what you see is what you get!

Chairman Bernanke and the Fed stands ready to act if things go south.  Again, there is very little the Fed will be able to do at this time before the election, but, if the economy begins to get worse, the Federal Reserve is prepared to do something to show that it is “on the watch.”  That is the least it can do to help the sitting President.

And, the Federal Reserve continues to keep an eye on the banking system.  I continue to interpret the stance of the Federal Reserve as one that aims to preserve the health of the banking system. 

I still believe that the banking system is not that healthy.  Therefore, in my view, the Fed continues to keep the banking system “well liquefied” so as to allow the banks to work out their asset difficulties as smoothly as possible.  The banking system continues to shrink due to bank closures and through consolidating acquisitions.  The FDIC is doing a very good job in overseeing the reduction in the number of banks in the banking system.

This banking policy, however, is dependent upon the Federal Reserve keeping plenty of excess reserves in the banking system.

In the banking week ending June 28, 2012, excess reserves in the banking system totaled $1,427 billion, roughly equal to the amount of excess reserves that were in the banking system on March 28, 2012 ($1,489 billion) and the amount that banks held on December 28, 2011 ($1,471 billion).

The Federal Reserve just does not want to “shake this tree.”  Bad dreams of 1937, I guess.

In order to achieve this relatively constant level of excess reserves in the banking system the Federal Reserve has basically done very little in supplying new reserves to the banking system and has consistently worked to offset operating factors that a could increase or decrease the excess reserves in the system.

There are two factors that should be mentioned, however, because these are things the Federal Reserve has had to “work around” in order to keep excess reserves relatively constant.

One of these has to do with the European financial situation.  In order to support European central banks and the European banking system, the Fed provided liquidity swaps to the European Central Bank, the Swiss National Bank, and the Bank of England.  In the latter part of 2011, these liquidity swaps increased quite rapidly as the financial condition of the eurozone deteriorated. 

Since the end of 2011, however, the central bank liquidity swaps originated by the Federal Reserve dropped substantially, falling by almost $73 billion. 

This removes reserves from the banking system.  And, in some way the Federal Reserve had to offset this movement in order to keep excess reserves in the banks relatively constant.

This the Federal Reserve did…quietly…and efficiently.

The other “overt” action the Fed took was to allow currency in circulation to increase by almost $35 billion over the past six months. 

Ever since the recession hit in late 2007, the public has been demanding cash holdings at a record rate.  Year-over-year, for example, the currency holdings of the public rose by over 8.0 percent, a rate that has been maintained for much of the past five years. 

This, demand for currency is not a good sign!  It is a sign of individuals, families, and businesses keeping cash-on-hand to help them meet their day-to-day needs.  This is money used by people in economic distress, not people who are employed and economically healthy. 

The Federal Reserves supplies currency to the banks and the public on demand.  Thus, it must operationally replace the currency it supplies in order to keep excess reserves relatively constant.  This is has been doing, not only the last six months…but over the last twelve months…and over the last five years.

In addition to these activities, the Federal Reserve has also altered, slightly, the composition of its securities portfolio.  Over the past six months, the total funds in its securities portfolio has hardly changed, but the Fed has substituted Mortgage Backed Securities in its portfolio for United States Treasury securities and Federal Agency Securities.  Over the past six months, the Fed increased its holdings of Mortgage Backed Securities by almost $18 billion but had allowed its portfolio of Treasury securities and Agency securities to decline by a little more than $18 billion.  This action was to help keep mortgage interest rates low to support the housing market.

In aggregate, the Federal Reserve kept a pretty “even keel” over the past six months continuing to help stabilize the banking industry and see that there was plenty of liquidity in the financial system to support further economic growth if it occurred.  The operations the Fed engaged in were primarily “offsetting” actions to keep the excess reserves in the banking system relatively constant.  In this, one could say that the Fed was very successful.

Talk still abounds about another round of quantitative easing, QE3, or more of “operation twist” or some other Fed action.  I continue to believe that the Federal Reserve can do very little at this time to achieve more growth out of the economy.  I further believe that the Federal Reserve will achieve little more in stabilizing the banking system by injecting more reserves into the banking system. 

The Fed does need to stay alert for signs of another recession in the United States, particularly given the recession now occurring in Europe and the slowdowns taking place in the economies of China and India. 

Consequently, I believe that the Federal Reserve should remain quiet…as it has for the past six months.  There is very little positive it can add to the economy right now.  In my mind, central banks are doing their best job when things are relatively calm and adjustments are taking place without a great deal of intervention by the regulators.  So, as of this minute…I am happy with what the policy of the Federal Reserve seems to be.