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.     

More Banks Downgraded

Today’s news: 28 Spanish Banks were downgraded by Moody’s Investors Service.  Included in this list were Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA).

Moody’s’ cut the ratings of 16 Spanish banks on May 17. 

Again, the argument can be made that this move was "too little, too late."

Yet, perhaps the most important thing to realize is that especially if the move by Moody’s is “too little, too late,” the situation in the banking system has not improved even though a substantial amount of time has passed since the banks entered into this “dark” region.

That is, maybe the banks should have been downgraded six months ago…or, nine months ago…or twelve months ago.  What we should reflect upon is that the banks have not improved their financial condition over this six months…or, nine months…or, twelve months…so that the ratings would not have had to be dropped!

The banks did not respond to the conditions because everyone in Europe seemed to believe that the problems faced by the banks were “liquidity” problems and not “solvency” problems, and that eurozone governments also did not face “solvency” problems.

The conditions cited by Moody’s for the downgrade included the weakness of Spain’s sovereign debt and the increasingly larger losses being recognized by the banks on commercial real estate loans.

Today, Spain requested funds for a banking bailout from members of the eurozone.  The lingering question still remains about when Spain, itself, is going to ask for a formal bailout.  Spain’s bonds are now trading near peak level spreads over German bonds of the same maturity.  The concern here is that these high yields cannot lead to a sustainable financing of the national government.

The situation of Italy is not unlike that of Spain, so there is concern over when the financial markets are going to turn more strongly on the government of Italy.

But, no one seems to have the will to act.  Still no leaders have arisen.  The general belief that the solution must ultimately rest with Germany receives cries of strong protest from German officials.  Short-term plugging of the dike is about all anyone can do. 

It is becoming more and more obvious that the only way the European situation will be corrected will be when the European governments “bite-the-bullet” and actually accept the fact that there is a massive need for structural reforms in most countries.  However, these government officials, in the past, postponed actions over and over again arguing that the problems were just ones of “liquidity.”  Now they have moved to claiming short-run cash injections will solve the “solvency” problems. 

The possibility that European government officials will really consider structural reforms for their societies still seems a distant fantasy. 

There has been talk of a banking union with the eurozone.  Yet, no one really seems serious about giving up their national interests when it comes to forming a banking union.  And, no one seems to want to create a system of deposit insurance like we have in the United States. And, no one seems to want to bear the burden of forming some central regulation agency.  Without some give, somewhere along the line…nothing will happen!

The deeper problem is that banks are not seemingly resolving their balance sheet problems with the time given them by their respective central banks.  Liquidity has been pumped into both the United States financial system and the European financial system.  Yet, few banks seem to be lending indicating they are in a “holding pattern” until things get better.

Still, things have not gotten appreciably better.  If they had, Moody’s would not have had to downgrade all the banks they have downgraded…at this late date.

And, this applies equally to the United States banking system, where commercial real estate loans also plague many banks.

Furthermore, in Europe and in the United States, economic recovery is not going to take place as long as their banking institutions are not lending. 

To me, moving to a QE3 will do no more to right the banking system in the United States nor will a QE3 do anything more to help the economy start growing faster.  Just as in 1937, having more excess reserves in the banking system does not mean that the banks are solvent or that will start lending.  Other things must happen for the banks to start lending and one of these things is to honestly recognize the serious weaknesses that exist within the banking system and continue to re-structure the banking system as smoothly as possible so as to bring solvency back to the industry.

And, this is true of Europe.  Further provision of liquidity to European banks is not going to help them.  European officials, as well as the banks themselves, must accept the reality of the situation and move on.  The banking system needs bailing out.  Several governments in Europe need bailing out.  Solvency is the issue.  Recognizing this and re-structuring their societies is necessary to move forward into the future. 

Any bright future for Europe will only face further delay by postponing the re-structuring that ultimately needs to take place.      

It's About Debt, Stupid!

Much has been made during the recent economic recovery, which began in July 2009, about the excessive debt loads faced by small businesses and households.  The high debt levels have been given as a contributing factor to the economic collapse in the United States that appeared late in 2007.  In addition, these high levels of debt have been associated with the slow economic recovery

One of the major books published during this time period has been the work of Carmen Reinhart and Kenneth Rogoff titled “This Time is Different.”  The research presented in this book highlights the role that debt can play in the collapse of an economy and the subsequent slow recovery associated with debt-related economic crisis. 

Well, some good news is coming to us from the household sector.  It seems as if households are achieving some success in reducing their debt payments, which will allow them to continue to reduce their debt loads and increase their consumption expenditures.

“The Federal Reserve estimates that the household debt service ratio, a ratio of debt payments to disposable personal income, fell to 10.9% in the final three months of 2011 as a result of low interest rates and reduced debt levels.  That was the lowest reading since 1994.  Total financial obligations, which add in rent payment, homeowners insurance and property tax payments, were 16 percent, the lowest since 1984.”  This is an article by Floyd Norris in the New York Times (http://www.nytimes.com/2012/04/20/business/not-exactly-a-miracle-but-us-debt-levels-are-falling.html?_r=1&ref=business). 

Norris writes, “debt levels have fallen.  Over all, households owe about $13.2 trillion, nearly $600 billion less than in late 2008….low interest rates mean that servicing that debt costs less.  The Commerce Department says that mortgage interest payments, in dollars, are lower than at any time since 2005.”

Norris continues, “In this country, the deleveraging process has some way to go, with many foreclosures still pending….”  And, “To get the deleveraging process under way, it is important for lenders to race reality, admit losses and deal with them.”

Not all the reduction of debt has been voluntary: “”The McKinsey Global Institute estimates that about two-thirds of the reduction came from the cancellation of debt, through writeoffs and foreclosures.” 

Debt reductions, however, are debt reductions.  According to Reinhart and Rogoff, deleveraging is something an over-leveraged economy needs.

That is, these statistics are a positive sign. 

Furthermore, commercial bank lending has finally begun to rise.  This may sound contradictory to the above comments, but the crucial thing is that the bank lending is coming in areas that relate to business and not to the consumer and can be a positive contributor to economic growth.  In fact, this kind of loan growth is necessary for economic growth to be sustained, even if at a modest 2.0% to 2.5% rate. (See my post “Loan Growth Continues to Pick Up at Commercial Banks,” http://seekingalpha.com/article/499921-loan-growth-continues-to-pick-up-at-commercial-banks.)  I take this to be a good sign.

Finally, let me just add that I don’t perceive that economic growth will become robust for a little longer.  But, this does not mean that economic growth will not continue even at a tepid pace.  Analysts wring their hands over the latest numbers on the jobless claims and other recent indicators of the employment situation. (http://professional.wsj.com/article/SB10001424052702303425504577353550599537484.html?mod=ITP_pageone_0&mg=reno64-sec-wsj)  The situation in the labor market is very worrisome.

However, the situation in the labor market is not just a short-run problem.  As I have pointed out numerous times over the past two years the un-employment rate is not the crucial one at this time.  The crucial indicator of the situation in the labor market is the under-employment rate.  I place this rate at around 20 percent of the eligible workers in the country.

There have been several articles recently in the daily press that discuss this point.  One of the better ones is “A Workforce on the Wane” in the Financial Times. (http://www.ft.com/intl/cms/s/0/8995b476-887c-11e1-a727-00144feab49a.html#axzz1saIOacDe)

Furthermore, it is not only in the labor market that we find an under-utilization of resources.  The capacity utilization in the manufacturing sector rests below 80 percent.  Before economic really begins to pick up in the future, businesses are going to have to deal with their surplus capacity, something that has steadily been growing since the 1960s. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage)

Dealing with under-employment and with under-utilization of capital is a long-run problem that must be dealt with over time.  The problem is, that as long as there are so many potentially productive resources out-of-line with what is needed in the economy, economic growth will remain slower than we would like it to be.  Re-training and re-structuring must be accomplished before higher growth rates can be sustained. 

The news on debt loads and debt levels is encouraging.  The direction begun must continue.  It is good that the commercial banks have stepped up this business lending for this is needed to underwrite the meager expansion that has already begun.  But, this is a long-term affair and efforts to try and get too much out of the recovery too soon will only make the future more precarious. 

Economic Growth Will Continue: Entering the Next Stage

I continue to be more optimistic about the path of economic growth that is occurring in the United States.  There are still potential “bumps-in-the-road” like the recession in Europe (http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe) and the slowdown in the economic growth of China.  Still, the economic recovery in America goes on.

On the positive side, I am encouraged by the fact that bank lending is getting stronger. (http://seekingalpha.com/article/499921-loan-growth-continues-to-pick-up-at-commercial-banks) The important signal, to me, coming from the banking data, is that the health of the banking system is improving.  Although many commercial banks still have major problems, the system, as a whole, is getting stronger and this is allowing for greater loan growth.  In the first quarter of 2012, the annualized rate of growth in loans and leases at commercial banks was almost 6.5 percent.  This is good.

Today, we got some encouragement from the housing industry: “Building permits in March 2012 were at a seasonally adjusted annual rate of 747,000, up 4.5 percent from the revised February rate and up 30.1 percent from March 2011. Housing starts in March 2012 were at a seasonally adjusted annual rate of 654,000, down 5.8 percent from February’s revised estimate but up 10.3 percent from March 2011.”  The decline from February to March was due to unseasonal strength in the housing area because of the very mild winter weather experienced this year.  The year-over-year rate for March is much more indicative of the pick up in this construction.

The economic recovery is continuing. 

On the negative side, I still believe that economic growth will continue to be anemic compared with historical trends.  As I have argued before (http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate), I am expecting economic growth to be in the 2 percent to 3 percent range, but I believe growth will be closer to the former figure than the latter.

There are several reasons for this.  One reason is that under-employment will still remain high.  I don’t care that much about un-employment in the current case because under-employment has remained in the 20 percent range and as long as this condition exists in the United States, consumer spending will remain relatively weak.  Furthermore, this condition just adds to the pressure for families to deleverage and get out from under the debt loads they have been carrying.  This helps to account for the very weak consumer loan data at commercial banks.

There are also other reasons for only moderate economic growth.  State and local governments still have a ways to go before they become a positive force in the economy again.  With declining property values and huge problems in the pension area, these governmental bodies will continue to slash payrolls and other budget items in an effort to return to some form of fiscal prudence. 

And, there is one other area that I believe will continue to weigh on the economy over the near future.  I have written from time-to-time about the impact the last fifty years of credit inflation has had on the productive capacity of the United States manufacturing base.  Credit inflation is not good for producing improvements in the productivity of capital.  And, if the productivity of capital is not increasing then economic growth is going to suffer.

The effects of this credit inflation are picked up in the utilization of our productive capacity.  In the 1960s, capacity utilization in the United States was well in excess of 90 percent.  There has been a secular decline in capacity utilization in America as the peak of every business cycle over the past fifty years has been at a lower utilization of our capital base. At the last cyclical peak we were using slightly more than 80 percent of our capacity.  At the present time capacity utilization is increasing as the economy has expanded since June 2009, but we remain around 78 percent. (The March figure of capacity utilization of 78.6 percent was released this morning.)

I believe that the economic growth rate of the United States will remain below the post-World War II level of about 3.2 percent as the rate of capacity utilization continues to lag.

The problem with this is that this growth rate will not accelerate as potential inflation problems arise. 

This inflation problem is raised by Francesco Guerrera in the Wall Street Journal: “Sowing Seeds of the Next Major Crisis.” (http://professional.wsj.com/article/SB10001424052702304818404577347641050572260.html?mod=ITP_moneyandinvesting_0&mg=reno64-sec-wsj)  For one, the Federal Reserve has pumped massive amounts of reserves into the banking system.  This was done to protect against a greater financial crisis than was experienced and to prevent the banking system from collapsing.  The post-crisis problem is about the ability of the Fed to remove these reserves from the banking system without jump-starting another crisis. But the question is, if the commercial banks have all these excess reserves (about $1.5 trillion of them) and if the banks are beginning to lend again, where is all this money going to go?   

If the economy will not grow much faster, the answer is that the money will force up prices.  These are not “normal” times.  As Guerrera states, “Unfortunately, there is little ‘business as usual’ around. Not at a time when Europe is in recession, the U.S. in the throes of an anemic recovery and even China is slowing down. And not when bank balance sheets are saddled with decaying leftovers of the crisis—asset-backed securities, bad loans and litigation—and vital parts of the system, such as derivatives trading, are gummed up by fears of new regulations.”

This scenario has “stagflation” written all over it.   The economy will continue to grow, but maybe we should start to prepare for our next series of problems.

The Federal Reserve Was Quiet in the First Quarter

In the first quarter of 2012, the Federal Reserve was very quiet.  The reserve balances that commercial banks held at the Fed actually declined by about $4.0 billion during the quarter to total $1.563 trillion on March 28.

Securities held by the central bank declined by slightly more than $15.0 billion as the Fed’s portfolio of Treasury securities, Federal Agency securities, and mortgage-backed securities all fell during the period.  Over the last four weeks of the quarter, very little took place in the Fed’s holdings although, in aggregate, there was a small decline.  

The factors supplying reserve funds to the banking system actually declined by about $48.0 billion but this was offset by around $44.0 billion in factors absorbing reserve funds.

The biggest item impacting the decline in reserve funds being supplied was the reduction in Central Bank liquidity swaps that occurred as the financial crisis in Europe resided and most of this took place in the last four weeks of the quarter. This was offset on the liability side of the Fed’s balance sheet by a number of operational factors, none overly significant.

These data just reconfirm the signals that Chairman Bernanke has given Congress, financial markets, and the academic world about the current stance of monetary policy.  The Federal Reserve is not doing a lot right now, but will not back off from the quantity of reserves it has injected into the banking system over the past two years, and stands ready to do more if the need should arise.

And, short-term interest rates continue to remain exceptionally low.  Since the Fed is doing little or nothing to supply more reserves to the banking system, the fact that the short-term interest rates are staying so low implies a lack of strength in the demand side of the market.  This, I believe, is an important thing to keep our eyes on because if the demand for funds begins to pick up, this will put pressure on short-term interest rates and the Fed will either have to step in to prevent this rise because of economic or banking reasons, or, let the rates begin to increase.  This is an area to watch.    

This all sounds pretty dull, but…the central bank really likes things dull!

For one, only 16 banks were closed by the FDIC in the first quarter of 2012, compared with 18 banks being closed in the last quarter of 2011.  We will have to wait for over a month and a half before we know how many more banks left the banking system through mergers and acquisitions.  Last year, the banking system lost, on average, 60 banks per quarter and only 23 of these were banks that were closed by the FDIC.  The number of commercial banks in the banking system continues to decline, but in an orderly and calm fashion.  Dull is good!

Economic growth continues, but it is not exceptional. (For more on this see my post http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) There is not too much more that the Fed can do in terms of stimulating more rapid economic growth, but it does hope to contribute to a turn-around in the housing area. 

But, the economy is growing, and, baring shocks related to gas prices, a collapse of the eurozone, or an economic slowdown in China…among other things…it should continue to grow over the next several years, although the expansion will not be robust. 

This is not all bad since many households and businesses are still reducing debt loads and trying to get their finances in order. 

The problem is in the employment area.  It is not just that the unemployment rate continues to stay too high, it is that under-employment still hovers around 20 percent.  A reason the unemployment rate might not drop too much over the next six to twelve months is that if the job market becomes more active, people who are now not considered to be a part of the labor force will re-join the labor force hence helping to keep unemployment rate higher than desired.

One thing is apparent and that is the Fed does not seem to be doing anything dramatic about getting the unemployment rate done more rapidly in advance of the Presidential election in the fall.  Given the lag-in-effect of monetary policy, the Fed has done just about all it can to achieve lower unemployment numbers this summer and fall. 

This may be one reason why we are not seeing the announcement of another round of quantitative easing.  The current Fed has already been accused of being one of the most “political” central bank administrations ever.  Announcing another round of quantitative easy at this time would only exacerbate those cries.  And, in my mind, would be able to achieve little or nothing in terms of a more vibrant economy and labor market through the end of the year. 

Thus, I believe the Fed will remain relatively benign over the course of 2012.  Again, dull is good when it comes to central banking.  But, this doesn’t mean that the central bank will not act during the year if there is a real need for action, coming from the banking sector, the economy, Europe, or elsewhere. 

Ben Bernanke: "Please Understand Me!"

“Please Understand Me,” the title to the 1984 book building on the Myers-Briggs personality-type tests, constantly comes to mind each time I hear a new effort by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, to “communicate” with the public.

Tuesday, Mr. Bernanke gave the third of his scheduled four lectures at George Washington University about Federal Reserve monetary policy.  This has followed efforts to get the minutes of the meetings of the Open Market Committee out to the public in a more timely fashion; efforts to have periodic meetings with the press to discuss the policies of the central bank; and the recent efforts to make the economic and interest rate forecasts of the members of the Open Market Committee available to the public. 

Now, Mr. Bernanke has felt the need to get out among “the people” and discuss the conduct of monetary in a series of four lectures aimed at expanding, within an academic environment, his rationale and analysis of what the Federal Reserve did and what the Federal Reserve has achieved. 

The continuously expanding efforts of Mr. Bernanke to get his personal viewpoint across only lends credence to the feeling that “the world”, especially the financial community, doesn’t understand what Ben is trying to do and how his efforts are succeeding. 

No one in such a leadership role that I can think of has felt the need to plead, within the community that he operates, to justify his actions, as Mr. Bernanke has.

Can you imagine Paul Volcker or William McChesney Martin (Fed Chairman from April 1951 to February 1970) publically defending their actions while they were still in office?

“The Fed’s efforts prevented a ‘total meltdown’ of the financial system at a time when fears of a second Great Depression were ‘very real,’ Mr. Bernanke said Tuesday…” (http://professional.wsj.com/article/SB10001424052702303404704577307800005459694.html?mod=ITP_pageone_1&mg=reno64-sec-wsj)

It was not pretty…what the Federal Reserve did…but it achieved its end.  A second “Great Depression” did not take place. 

Mr. Bernanke, a student of the Great Depression who learned a great deal from Milton Friedman, pursued a policy that was consistent with Friedman’s analysis of the events of the 1930s.  In the period 1929 to 1933, Mr. Friedman estimated that the Federal Reserve allowed the M2 money stock in the United States to decline by one-third!  The conclusion that Mr. Friedman drew from this is that the Federal Reserve should have done whatever was possible to have kept the M2 money stock from declining!  

This lesson did not escape Mr. Bernanke under the circumstances. The Fed’s policy during this period of financial crisis was to throw as much “stuff” against the against the wall as possible to make sure that enough of the “stuff” stuck on the wall that another Great Depression would be avoided.

What is there not to understand with this policy?

Sell Bear Stearns, rescue AIG, bailout the banking system, by mortgage-backed securities and so forth…. 

And, in a time of panic, when uncertainty reigned, anything was acceptable. (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

This was all “stuff” that was thrown against the wall. 

Mr. Bernanke has followed the game plan.  The money stock did not decline in this instance.  However, the Fed does not control the money stock directly.  In terms of things it can control, like the monetary base, the Fed expanded the monetary base from about $850 billion in August 2008 to $1.7 trillion in January 2009.  In February 2012 the monetary base averaged about $2.7 trillion.  Excess reserves at commercial banks rose from about $2.0 billion in August 2008 a current level of around $1.6 trillion.

This expansion of monetary assets is historically unique!  The “stuff” got put out there!

And, the “stuff” will stay out there as long as there are weak spots in the economy and the financial system.  For example, the banking system is still extremely weak with more than 800 banks on the FDIC’s list of problem banks and more than that are on the edge of being problem banks.  And, this is with large numbers of home foreclosures in the future along with a continued weakness in the commercial real estate area.  Bank failures along with bank consolidations still proceed at a relatively rapid pace.   

Whether we get another round of quantitative easing or not, we will see the “stuff” around for some time yet.  Excess reserves in the banking system of around $1.6 trillion!  My guess is that we won’t see this declining by much until the banking system gets a lot healthier.

What is there not to understand about what the Fed has done and is doing?

Mr. Bernanke seems to feel that it continually needs explanation and justification.  I believe that this feeling is just Mr. Bernanke’s problem.   

Treasury Bond Yields Will Continue to Rise

Treasury bond yields are on the rise and will continue to do so over the next year. 

In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.

The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time.

This is not true, however, of short-term yields. 

I continue to believe this.

The yield on the 10-year Treasury security has been extremely low for several months now.  Around the end of July 2011, the yield on the 10-year was about 3.00 percent.  It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.

Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).

The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond.  At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically).  On August 10 the yield had become negative, trading around a -0.155 percent yield.  That is, we had a negative real rate of interest. 

For a good portion of the time since then the yield on the 10-year TIPS has been negative.  Yesterday, this issue closed at -0.056 percent yield.

The reading on this behavior?  The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System. 

The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate.  The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero. 

Why would investors invest in something that had a below-zero interest rate on it?  The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield.  This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.

One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time.  You do not find this type of behavior taking place except in times when there is a flight to quality.

One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.

The movement in Treasury yields last week was a movement back into riskier assets.  This is confirmed in a New York Times release this morning concerning the actions of hedge funds. (See “Hedge Funds Ditch Treasuries in Droves: Report”, http://www.nytimes.com/reuters/2012/03/19/business/19reuters-hedgefunds-treasuries.html?src=busln&nl=business&emc=dlbka32_20120320)

“A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…

Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months.

It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”

This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. (See “Bond Bear Market is Growling but Yet to Roar,” http://professional.wsj.com/article/SB10001424052702303812904577291770173587542.html?mod=ITP_moneyandinvesting_6&mg=reno-secaucus-wsj)

Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.

Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time.  The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.”  This will continue, I believe, for the short-term. 

I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range.  This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions. 

These yields will begin to rise along with economic growth as the economy picks up steam.  However, I don’t see that there will be much “steam” in the next three or four quarters. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) 

Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate.  Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.

Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop.  Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.