Sunday, November 30, 2008

All of the buzzwords in one post: quantitative easing, inflation and printing money

I have received many emails from readers that are concerned about current Fed policy. In this post, I will address the following issues: what is quantitative easing; is the Fed printing money; and finally, will the Fed’s massive liquidity injections lead to inflation.

Quantitative easing (QE) by the Fed has begun. But before we can address the Fed’s QE strategy, we must get one thing straight. First, a QE policy is not a zero interest rate policy (ZIRP). The federal funds target is currently 1%, and although the Fed has initiated a QE strategy, it has not declared ZIRP…yet. The next scheduled meeting is December 15-16, where the Fed may very well set the policy rate closer to 0%.

Without explicitly setting the federal funds target to 0%, the Fed is currently engaging in another non-traditional policy, quantitative easing (QE). Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.

The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%.

In laymen’s terms, the Fed is printing money under the QE policy; the idea of the Fed printing money has clearly caused some confusion for readers. Printing money is a pejorative term that is often associated with inflation, or worse, hyperinflation. In normal times, a QE strategy would certainly result in newly available money, but we are not in normal times.

The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).

What is the difference between money and high powered money? Money is a function of two things
  1. The monetary base, which equals bank reserves plus currency in circulation
  2. The money multiplier, or how quickly the base switches hands in a fractional reserve banking system (for a discussion of money creation, see this wiki article).

The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28. The Fed simply creates new monetary base (reserves) out of thin air; hence, the printing money connotation.

However, banks are hoarding the new base in the form of excess reserves, and lending has slowed significantly relative to the size of the new reserve base. Therefore, the money multiplier is collapsing.
Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.

Prices can drop in a recession (deflation) because the demand for goods and services falls with rising unemployment and declining income. But the 2008 recession is accompanied (or partially caused) by a credit crisis that induces banks to hoard the new base as excess reserves; this adds to the deflationary pressures (possibly reducing the money supply). If deflation were to become embedded into consumer and firm expectations, then the macroeconomy could be facing a severe problem. So for now, and until the economy emerges from its recession, QE will not lead to inflation.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

In the US’ case, I see the Fed getting it wrong as a serious risk to price stability (rising inflation). American consumers are not savers and love to spend; and although some suggest that the American saving behavior has changed, the evidence is far from concrete. Unless saving rises permanently - the economy transitions to a world where consumption is less than 70% of GDP - consumers will be more than happy to swoop up the new bank lending and spend that new easy money.

Rebecca Wilder

Saturday, November 29, 2008

Alistair Poppins?

I love Disney movies, and obviously so does John Ashcroft over at his blog, jka- on- economics UK. Today I will run out and purchase Marry Poppins - you know, support the economy - and watch the UK Banking crisis of 2008 on film. If you like Disney metaphors, this JKA-on-economics post is for you:
It had never occurred to me the Wizard of Oz was an allegory for the US depression of the 1930’s. The yellow brick road a reference to the Gold Standard, the scarecrow representative of plight of the US farmers and more. Imagine how surprised then to realise Mary Poppins was a prophetic allegory of the UK Banking crisis of 2008.

It really should have been obvious. The script included a run on the bank, lots of kite flying, the bottomless carpet bag, the credit crunch explosion from the fireworks of Admiral Boom, a run on the bank. It really is all there.

The film begins with the young and pretty Mary Poppins perched on a cloud high above London in Spring 1910 observing events below. Mary Poppins is the Chancellor of the Exchequer. The action descends to earth where Bert, a cockney jack-of-all-trades is performing as a one-man band at the park entrance. After the end of the show, he strolls down the street and introduces the audience to the well-to-do, but troubled, Banks family. (Bert the cockney chimney sweep obviously the Treasury.)

The Banks family is the British banking system headed by the cold and aloof Mr. Banks, who has formed the idea that a British household ought to be run with the strict authority of a British bank. Mr Banks is the Bank of England or the Governor of the Bank of England himself. His wife is the loving and spirited but highly distracted suffragette Mrs. Banks, (the FSA).

As the script develops, the Banks' latest nanny quits out of exasperation after the Banks children, Jane and Michael run off in pursuit of a wayward kite. The Banks' latest nanny is the FSA supervisor, the kite flying an obvious reference to off balance sheet activity relating to highly leveraged transactions, sub prime debt, CDO, SIV’s, toxic debt etc.

The bank crisis develops as Michael one of the Banks' siblings refuses to deposit his tuppence with the Dawes bank, a misunderstanding develops and a run on the bank ensues. Obviously the Dawes bank is Northern rock, the tuppence, wholesale funding and Michael and Jane representative of the major clearers.

Pyrothecnics ensue as the fireworks from Admiral Boom explode above the roof tops of London. The reference to Boom and bust so obvious, the credit crunch impacts, I can’t believe I missed this.

The crisis abates as Michael puts his tuppence into Northern Rock, Mary Poppins uses her bottomless carpet bag to inject liquidity into the system and re-capitalise the Banks family.

In the film, the next morning, the winds have changed direction, and so Mary must depart. Mr. Banks, now loving and joyful, reappears with the now-mended kite and cheerfully summons his children. The greatly-relieved Mrs. Banks supplies a tail for the kite, using one of her suffragette ribbons. In the park with the children and other kite-flyers, Mr. Banks meets Mr. Dawes Jr.. Mary Poppins her work now done, takes to the air with a fond farewell from Bert.

So there you have it. It’s all going to be OK.
RW: I love Disney movies and this metaphor could certainly be applied to the U.S. banking crisis as well. What about Goonies - can anything be said about that? Probably a stretch.

Rebecca Wilder

Friday, November 28, 2008

Lotteries may be recession-proof but they are not banking-crisis proof

Anecdotal evidence on state lottery sales suggests that consumers are becoming more risk averse, i.e., they are less inclined to purchase lottery tickets because the expected winnings (assume that has not changed) are now not high enough to offset the perceived risk of playing the lottery. If they were willing to gamble before, they they are even less willing to gamble now.

This increased aversion to risk can be tied to consumer saving behavior. As consumers reduce the riskiness of their behavior (more risk averse), they are less inclined to borrow against future income, and hence saving rises. This is the worst-case scenario for some - a permanent increase saving - because it could mean a prolonged recession.

Here is the article from Reuters that illustrates a change in consumer behavior may be on the underway:
Lottery tickets are proving not to be the big business they're cracked up to be in times of financial crisis.

Reuters contacted all 42 state lotteries. Of the 27 that responded, 14 said sales were down from last year, 9 said sales were steady and 4 reported an increase.

"It's been kind of an industry notion that lotteries are recession-proof, but I think what we're experiencing right now is a little bit harsher than slow economies in the past," said Chuck Baumann of the Oregon Lottery.

"People are just counting their dollars and cents," he said in a state where sales are down some 2 percent from last year.

Lotteries are the most common form of gambling in the United States, Gallup opinion polls regularly find, showing that almost 50 percent of Americans buy lottery tickets.

Sales have fallen as much as 10 percent in some states -- a reflection of the economic downturn and lack of a big jackpot in the two main games, Powerball and Mega Millions.

"What we have found with lotto tickets is that they are heavily dependent on the jackpots offered," said Mike Mueller of the South Dakota Lottery, where sales are down 6 percent.


By this time last year jackpots of several hundred million dollars had already been won in Mega Millions, played in 12 states, and Powerball, played in 31 states. The biggest Powerball win was $365 million in 2006, while Mega Millions paid out a record jackpot of $390 million in 2007.

In Kansas, lottery ticket sales are down about 4 percent in the last few months, spokeswoman Sally Lunsford said.

One reason is that convenience stores have gone out of business, meaning fewer places selling tickets, she said.

The most recent North American Association of State and Provincial Lotteries data show that more than $57 billion in tickets were sold in the United States in fiscal year 2006, which for most states ended on June 30, 2006.

Nickie Andrews, 30, who recently returned home to Hoboken, New Jersey, after traveling overseas and is looking for a job, bought a Mega Millions ticket at New York City's Port Authority bus station for the chance to win $86 million.

"When it gets big I usually play," she said. "I don't have a job right now and I have been playing the lottery more ... it's hard and I need money. I used to play every couple of months, now I have been playing it every other week or so."

Pennsylvania lottery spokeswoman Stephanie Weyant said economic uncertainty was holding many players back.

"In general, our players have told us that they are spending less on tickets because they are concerned about the economy," Weyant said.
RW: Reuters blames the declining sales on the economic downturn (the bolded portions). But it seems to me that this may be more indicative of a change in consumer behavior - i.e., increasing risk aversion - rather than the recession.

Amid a banking crisis that heightens uncertainty in almost every U.S. market - labor, housing, credit - consumers are tolerating-less the probability of losing and stepping back from the lottery.

I am still not convinced that consumer behavior has changed fully to incorporate a sharp downturn in the toleration for risk (stronger risk aversion) and surge in the marginal propensity to save. However, the anecdotal evidence - such as states selling fewer lottery tickets - is building. States like California depend on lottery sales for budgetary expenses; a permanent decline in sales would seriously impair fiscal budgets of said States (was that another shoe to drop?).

Rebecca Wilder

Consumers still adding leverage to income; when will this stop?

The NY Times published an interesting article written by an anonymous banker in the credit card industry. It highlights the pitfalls in the credit industry, where lax lending standards are partially to blame for the massive delevering that is likely on the horizon. I simply wonder when consumers will be forced to reduce debt? The massive Fed and Treasury measures designed to shore up real estate and consumer credit markets are clouding the data. It is not clear if/when consumers will stop drawing on existing lines of credit.

According to the NY Times, what goes up must come down:
”He/she said this about the shady business of offering up credit to households: As a banker, let me describe what we do wrong when we accept and review an application for a credit card. First, we don’t verify income. The first ‘C’ of credit: Capacity to repay, is completely ignored by the banks, just as it was in when they approved subprime mortgages. Then we ask for “household income” — as if other parties in the household could be held responsible for that debt. They cannot. And since we don’t ask for any proof of income, the customer can throw out any number they think will work for them. Then we ask if they rent or own and how much they pay. If their name is not on the mortgage, they can state zero. If they pay $1,000 in rent, they can say $500. (Years ago we asked for a copy of the lease to verify this number.) And finally, we don’t ask how much of a credit line the consumer is looking for. The banker can’t even put that amount into the system. There isn’t any place on the application for that information. We simply put unverified information into a mindless computer and the computer gets the person’s credit score and grants them the biggest line that score and income (ha!) qualifies for.

I recently had a client apply for a credit card. She is a homemaker, with no personal income. The house she lives in is in her husband’s name. She would have asked for a $3,000 credit line, just to pay miscellaneous expenses and to establish some credit on her own. So the computer is told that her household income is $150,000; her mortgage/rent payment is zero. The fact is that her husband’s mortgage payment is $7,000 a month (which he got with a no income verification loan). She had a good credit score, but limited credit since she has only lived in this country for the last three years. The system gave her an approval for a $26,000 line of credit!

This has got to stop. People are going to be learning hard lessons over the next years. It would help, though, if the banks could change their behavior now, before things get any worse. Tomorrow is already too late.”
This certainly paints a scary picture of the credit card industry, and I do believe that eventually revolving consumer credit will decline sharply. However, that is not yet evident in the data...still!

The chart illustrates the share of consumer revolving (credit cards) and consumer other (new loan origination not including home equity) credit as a share of total consumer credit. Two things are notable here. First, revolving credit rose relative to other credit during the 2001 recession (the data only goes back to 2000), and reverted back at the conclusion of the recession. It is common for credit growth to decelerate (decline) during a recession.

Second (chart 1), revolving credit took a discrete jump upward in 2004 (upward arrow). Consumer revolving credit accounted for an average of 39% of total credit spanning the years 2000 to mid-2004 and 43% spanning the years 2004-2008.

This surge in the revolving credit share is what the anonymous banker is worried about: lax lending standards on credit cards allowed consumers to become overly indebted to credit card creditors. Interestingly enough, revolving consumer credit was still 43% of overall credit on November 12, 2008. When will it fall?

I suppose that it will fall when consumers are forced to pay down debt (or default). But I don’t see that happening if government intervention prevents consumers from doing so. The Fed is offering $200 billion to shore up consumer lending, including credit card facilities under the new Term Asset-Backed Securities Loan Facility (TALF).

With the Fed’s massive liquidity injections, lending is still very positive, and aggregate revolving credit is not declining. Into 2009, the Fed's balance sheet will rise another $1.2 trillion, where $750 billion of that will go on balance by year’s end. Here is what we know:
  • $450 billion in Term Auction Facility (TAF) lending scheduled through the end of 2009.
  • $200 billion for the new Term Asset-Backed Securities Loan Facility (TALF) to shore up the asset market that backs loans to consumers (student, auto, credit).
  • $100 billion to buy GSE debt this week.
  • $500 billion to buy mortgage backed securities by over the next several quarters.

With the liquidity facilities to come and a $600 stimulus package on the horizon, when will consumers be forced to delever? For now, I will wait to see evidence in the data that consumers are borrowing less. Normally, credit falls during a recession, so I will be looking for a sharp decline in revolving credit.

Rebecca Wilder

Wednesday, November 26, 2008

It's official: the Fed is monetizing government debt

On November 2, I wrote an article about the new-found relationship between the Fed and the Treasury. Here is a bit from the article:
The Treasury is sterilizing the Fed’s liquidity measures, rather than the Fed monetizing the Treasury’s debt (just add this to a long list of unprecedented acts by the Fed and the Treasury).

At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks.
Well, circumstances have changed. Twenty-four days later, and in a rather nontraditional manner, the Fed is now monetizing government debt.
The time has come to officially monetize government debt. Yesterday the Fed announced that it would purchase $100 billion in debt obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Bank next week. And furthermore, it will purchase $500 billion in mortgage-backed securities (MBS) – I like to call this FARP (Fed Asset Relief Program).

The purchase of GSE debt is a direct attempt to reduce the spread on government agency (GSE) debt over comparable Treasury debt, the relative borrowing costs. Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt.

The chart illustrates the difference between newly issued Fannie Mae debt and a comparable U.S. Treasury through 11/24/08. This spread has widened from an average of 29 bps (0.29%) spanning 2006-2007 to 90 bps spanning 2007-2008. Fannie Mae must pay more in order to finance its mortgage obligations, which limits its ability to roll over current obligations, and tightens the terms on new mortgage loans.

By driving down the spreads on GSE debt now, and later on mortgage-backed securities, the Fed gives the GSEs more flexibility in the mortgage market, and they can offer lower rates and better terms for potential homebuyers. That’s the theory.

I am interested to hear why the Fed is supporting the GSE debt and securitized assets that derive their value from the mortgages (MBS) rather than the mortgages themselves. The Fed could allocate a similar stock of resources to mortgages directly, where the effect would be immediate (mitigating foreclosures or offering better terms directly). However, I assume that the Federal Reserve Act prevents the Fed from doing such a thing – that sort of action probably lies in the hands of Congress. Although the immediate effects do appear to be quite positive.

Expect the Fed’s balance sheet to rise by another $100 billion (at least) in two weeks. It is official: the Fed is monetizing government debt.

Rebecca Wilder

Tuesday, November 25, 2008

The irony: EU gets a stimulus package together before the USA

The European Commission will decide on a coordinated fiscal stimulus worth up to $US 164 billion. The sovereing governments would have flexibility in their enactment of the fiscal stimulus - from a cut in value-added tax rates, increased welfare benefits, or perhaps loan aid. It is a fiscal bill for all sizes - S, M and L.

But the kicker is: a multi-country customs union - like the EU - may pass a stimulus package before the U.S.A. does, in December. From Deutsche Welle:
The European Commission plans to unveil a 130 billion euro ($164 billion) stimulus package this week. But countries will have leeway in whether to implement proposed measures such as a cut to value-added tax (VAT) rates.

European countries remain at odds on how to best counter the global financial crisis. In an attempt to bridge the differences of opinion, European Union leaders will put forward a stimulus proposal that gives member countries a set of options for dealing with the crisis, but steers clear of a one-size-fits-all solution.

Details of the European Commission proposal will be released on Wednesday, Nov. 26. Germany said last week that the stimulus plan could be worth 1 percent of the European Union's gross domestic product (GDP), which would equal 130 billion euros.

The Commission said that the stimulus measures will need to be quick, targeted and temporary. They will be a mix of revenue and spending instruments and will be accompanied by structural reforms, according to a draft viewed by Reuters news agency.

EU wants to coordinate actions

"Tomorrow we propose a coordinated EU fiscal stimulus, we will offer guidance to member states on the kind of measures to adopt," said Economic and Monetary Affairs Commissioner Joaquin Almunia in a speech in Brussels.

The Commission will likely suggest temporary VAT rate cuts, temporary increases in benefits to low-income households and the unemployed as well as temporary extensions of benefit pay-out periods.

It also suggested that governments could offer guarantees and loan subsidies to companies to help them attain credit. The Commission will also propose increasing investments in infrastructure and in key sectors such as cars, construction and green technologies.

While the Commission stopped short of mandating solutions, it wants all fiscal measures to be coordinated at the European level so as to "exploit synergies and avoid negative spillovers," Almunia said.

Spending up, deficits up

One of the biggest sticking points is whether European countries should temporarily cut VAT rates. Current VAT rates on goods and services vary from 25 per cent in Sweden and Denmark to 15 per cent in Cyprus and Luxembourg.

On Monday, Britain became the first European country to announce a VAT cut, with leaders saying it would reduce the VAT by 2.5 percentage points to 15 percent through the end of 2009. The move is aimed at boosting consumer spending. Germany and France ruled out similar VAT rate cuts.

President Nicolas Sarkozy said Tuesday he would unveil an economic stimulus package within the next 10 days to help France's key sectors resist the global slowdown. Germany announced earlier this month various stimulus measures including tax breaks and infrastructure spending that it says is worth 32 billion euros over two years.

Almunia cautioned governments against seeking to spend their way out of the economic slowdown, saying "we need to reduce public debt over the medium term."

The fiscal stimulus is likely to cause deficits to increase across Europe, and could push countries such as France, Britain, Ireland, Italy, Greece and Portugal well beyond the EU limit of 3 percent of GDP.

Final agreement expected in December

The final scope of the proposed program will be decided on Wednesday after Commission President Jose Manuel Barroso has the chance to consult with governments.

"Barroso is currently engaged in shuttle diplomacy between the various capitals to try and reach a consensus before Wednesday on the burden-sharing," one EU source told Reuters. "It is not just the big states whom he has to satisfy. The smaller and eastern states for example say they cannot afford to pay 1 percent of GDP. So it will not be as simple as just saying 1 percent of GDP."

EU leaders will formally discuss the proposal at a summit in December.
Rebecca Wilder

A little fun...the Fed, a hedge fund?

Guess who? From Nick Gogerty (hat tip Emre Deliveli's Blog):
There is still time to get in on the World's largest hedge fund. Don't be the last in the pool.
  • It uses greater than 50:1 leverage
  • Is opaque in its holdings, doesn't have to disclose them to congress even though it is an onshore organization
  • Uses various quantitative and qualitative strategies with some of the brightest minds
  • Is growing in assets like crazy over 200% in the last few months due to its wild popularity
  • Management shifts around every couple of years
  • Thinks very long term but is funded mostly short term and will have to roll over a large portion of it assets in a few months
  • Has access to capital almost for free
  • The worlds smartest a and largest investors have been clamoring to participate in its recent "offerings"
  • Charges no maintenance or management fees
  • Has a very long track record of success
  • Has no restriction on who can invest, young old or feeble
  • Technically it doesn't have currency risk ;)
  • You have probably already guessed that the "fund" is the US federal reserve and if you hold dollars or dollar based assets you are along for the ride...

Thanks, Nick for a little comic relief.

Rebecca Wilder

Consumers are gloomy about their finances - who wouldn't be?

Early last month I argued that consumers are gloomy about the recession, rather than the recession and the financial crisis. The ABC consumer comfort index showed that perceived consumer finances were relatively unchanged.

Well, since October 12 that has changed. Alongside a deteriorating labor market, wouldn’t this list create gloomy consumer finances?

October 3 2008 – Treasury Asset Relief Program (TARP) passes as an asset purchase program, where the Treasury will purchase troubled assets from banks.

October 5, 2008 – Secretary Paulson turns part of the TARP funding into a direct recapitalization of banks. The public/banking system – and suggested by Bernanke – assumed that the remaining funds would be used to finance the asset purchase program (TARP).

November 13, 2008 “Treasury Secretary Henry Paulson officially abandoned his original plan to buy troubled assets from financial institutions. While the government will continue to invest in those firms, he said, it would also now focus on the nation's struggling consumers.”

November 18, 2008 “In an interview Monday, Mr. Paulson said the financial system is stabilizing, and he is thinking about how the remaining $410 billion could be best utilized, but that he doesn't plan to tap it unless a further need arises.”

November 24, 2008 – Consumers get the news that they are on the hook for 90% of $309 billion - $29 billion = $280 billion in Citigroup’s losses. This is a risk-sharing program with no return for the taxpayer (except for a few marginal dividend payments and stock shares).
  • Bloomberg published a great article on the risks of this bailout.

November 25, 2008 – The Treasury plans to use part of the TARP monies to finance education loans, auto loans and alleviate terms on some credit-card debt. And then I read this in Bloomberg:

U.S. consumer confidence probably remained at a record low level in November as falling gasoline prices failed to ease concerns about rising unemployment, economists said before reports today.

The New York-based Conference Board’s index of consumer confidence held at 38 for a second month, according to the median forecast in a Bloomberg survey of 66 economists. That is the lowest level since monthly records began in 1967. Another report from S&P/Case-Shiller may show a record drop in home prices in the 12 months ended in September.

Consumers are retrenching amid increasing job losses, tumbling stock and home prices and the worst credit crunch in seven decades. President-elect Barack Obama said yesterday the U.S. may lose “millions of jobs” next year should the government fail to quickly enact a new economic-stimulus package.

“Serious concerns about job stability and incomes have outweighed the increased confidence consumers were able to derive from falling energy prices,” said Dana Saporta, an economist at Dresdner Kleinwort in New York.

RW: Consumers are gloomy about job stability and income, but now they are also gloomy about the handling of the financial crisis. Consumer confidence is going to stay extremely low while the Treasury and the Fed continue to risk the taxpayer’s hard-earned money in a myriad of new programs. This is evident in the finance component of ABC's consumer comfort index.

ABC offers a weekly comfort index, which includes a measure of personal finances. The overall index measures the answers to the three following questions:

  • "Would you describe the state of the nation’s economy these days as excellent, good, not so good, or poor?"
  • "Would you describe the state of your own personal finances these days as excellent, good, not so good, or poor?"
  • "Considering the cost of things today and your own personal finances, would you say now is an excellent time, a good time, a not so good time, or a poor time to buy the things you want and need?"

My answers would be: Negative; more than recessionary negative; and negative

The chart (above) illustrates the weekly index values for the overall ABC comfort index and its personal finance component. Consistent with the other consumer indexes – University of Michigan and Conference Board - the ABC consumer comfort index is historically low. Furthemore, the personal finance index has initiated its decent since October 12.

As Paulson continues to spends taxpayer money in a way that obviously lacks discretion - essentially flip-floppping from day to day - consumers are becoming anxious about the future of their personal finances. Although the survey questions don’t explicitly tie the banking crisis to consumer confidence, consumers are bound to be affected by it.

It is probable that the average consumer does not follow Paulson’t organic use of the TARP funds, but markets certainly do. And markets hate it when Paulson changes his mind; equities fall further, dragging down consumer wealth and finances.

I believe that consumers are reacting not only to job stability and falling labor income, but also the conduct of policy makers as they spend large sums of money. Their efforts have only marginally iomroved the health of credit markets and consumer finances, and consumers are concerned.

Rebecca Wilder

Monday, November 24, 2008

FYI: Some are calling a 100bps FOMC cut by January

Talk about zero interest rate policy: MacroAdvisers - a venerable forecasting firm - is calling a Fed cut of 100 bps by January to make the federal funds target 0% throughout 2009. I'll believe it when I see it and comment then. From Real Time Economics:
Former Federal Reserve Governor Laurence Meyer and former Fed economist Brian Sack on Monday became the latest central bank watchers to forecast a zero federal funds rate early next year.

In a research note Meyer and Sack, now with Macroeconomic Advisers, said once the federal funds rate reaches zero in January the Fed will “immediately implement non-conventional polices” including “targeted purchases of private assets in markets in which the flow of credit is shut off or severely impaired."

The target fed funds rate for interbank lending currently sits at 1%, matching the 2003-2004 low. Officials are widely expected to lower the funds rate another 0.50 percentage point when they meet next month.

Meyer and Sack had previously expected officials to stop there with the fed funds rate at 0.5%. But now they expect another half-percentage-point cut in January, joining Fed watchers at J.P. Morgan and HSBC in forecasting a zero Fed funds target.

Meyer and Sack expect the Fed funds rate to stay at zero “at least through the end of 2009.” They also expect a “significant” fiscal stimulus to be passed.

“These actions will not be able to prevent a difficult economic outcome in coming quarters, but they can play an important role in helping to support a recovery thereafter,” they wrote. – Brian Blackstone
Rebecca Wilder

Canada's labor market is set to decline; expansionary policy will help

Canada has been holding its own. With its stronghold in commodity-based production, profits have soared, growth in commodity production has outweighed (mostly) weak manufacturing , the housing market remained rather resilient , the banking system is ranked number one in the world and the strong Canadian dollar has held core inflation in check.

But with U.S. economic growth expected to post at least a 2.9% annualized decline (I suspect more like 4%) in the fourth quarter of 2008, Canadian exports, which have already declined two consecutive months, will continue their decent into 2009. Alongisde a deteriorating labor market, this is likely to drag down Canada's growth rate into negative territory.

Compared to the U.S., where employment has declined by 1.2 million jobs since the beginning of the year, the job market is strong in Canada, where employment has grown by 203,000 jobs throughout 2008. But the October payroll and anecdotal evidence suggest that the labor market will turn downward into 2009.

October payroll added 10,000 jobs, but only because the election added more public-sector jobs than did the private sector sutract. And consistent with the private payroll, the unemployment rate rose 0.1% to 6.2%.

Headlines suggest that the October payroll is only the beginning, and the unemployment rate is set to rise. From the Globe and Mail:

More than one-fifth of Canadian employers plan to reduce their headcount in the coming year as the financial crisis forces companies to cut costs, a compensation planning survey showed Monday.

Mercer's updated survey showed 22.6 per cent of employers plan to cut jobs and more than half are considering the move.

Employers are also taking other steps to cut costs. One-third said they plan to make changes to their health and benefits program. And half will lower their salary increases next year to about 3 per cent from the average increase of 3.8 per cent they'd planned in the second quarter – a similar finding as that of a Conference Board of Canada report last month.
Mercer recommended employers boost communication with staff through the economic turbulence.

“The majority of employees appreciate transparent and honest communication during tough economic times,” the consulting firm said. “Understanding the issues and the tough decisions to be made may not make things any easier, but it may cultivate a sense of ‘we're all in this together' and actually improve employee engagement.”

Not all sectors are ratcheting down salary increases. In the public sector, only 16 per cent of employers plan to lower pay hikes, the poll said.

The survey results are based on responses from 175 participants.
It's just impossible for Canada to get through this one without the U.S. export market. I expect that the Bank of Canada (BoC) will lower rates at least 50 bps at its December meeting. Furthermore, the BoC has initiated alternative liquidity measures - Term PRA Facility for Private Sector Money Market Instruments and Term Loan Facility - that will help the credit markets going forward.

Canada is expected to get a fiscal stimulus via broad-based tax breaks (note that Finance Minister Jim Flaherty says in the Bloomberg article that the U.S. is not in a recession until 2009 - he is crazy!). The only worry here is that the stimulus measures are just not enough.

Canada is starting from a higher point than the U.S. and its expansionary policy will help going forward. But there is nothing that Canada can do if the U.S. posts a 4% decline in the fourth quarter of 2008. It's like the blind leading the blind.

Rebecca Wilder

Big price tag, little information

I used to think that the government had some super secret bag of statistics that I was not privy to. They – Bernanke, et al., Paulson and Treasury, Inc. – are running around like chicken with their heads cut off, and for each moving part that could potentially cause disaster – the government adds to the list.

Now, it’s the outcome of the Citigroup bailout, which from my reading is a single-institution Treasury Asset Relief Program (TARP) that was not approved by our elected officials in Congress with no actual money switching hands....yet. The bailout includes the government “providing protection” against $306 billion of Citi’s securitized assets.

Here is the joint statement by the Fed, the Treasury and the FDIC:
The U.S. government is committed to supporting financial market stability, which is a prerequisite to restoring vigorous economic growth. In support of this commitment, the U.S. government on Sunday entered into an agreement with Citigroup to provide a package of guarantees, liquidity access, and capital.

As part of the agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup's balance sheet. As a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In addition, Treasury will invest $20 billion in Citigroup from the Troubled Asset Relief Program in exchange for preferred stock with an 8% dividend to the Treasury. Citigroup will comply with enhanced executive compensation restrictions and implement the FDIC's mortgage modification program.

With these transactions, the U.S. government is taking the actions necessary to strengthen the financial system and protect U.S. taxpayers and the U.S. economy.
Mish Shedlock provides a nice list of the terms of the “agreement” here.

RW: It seems that the Treasury, the Fed and the FDIC say the same thing over and over again when they defend some huge bailout – in this case, $306 billion worth "committed to supporting financial market stability, which is a prerequisite to restoring vigorous economic growth".

Wouldn’t you like to see a cost/benefit analysis of the government’s decisions to bailout these financial firms? A nice quantitative investigation of how many jobs would be slashed and aggregate income lost had the government not stepped in. In lieu of a cost/benefit analysis for the Citi deal, we do get this:
We will continue to use all of our resources to preserve the strength of our banking institutions and promote the process of repair and recovery and to manage risks. The following principles guide our efforts:
* We will work to support a healthy resumption of credit flows to households and businesses.
* We will exercise prudent stewardship of taxpayer resources.
* We will carefully circumscribe the involvement of government in the financial sector.
* We will bolster the efforts of financial institutions to attract private capital.
RW: There is entirely too much power sitting in the hands of seven individuals: the five members of the Fed’s Board of Governors, the Treasury Secretary Henry Paulson and the Chairman of the FDIC Sheila Bair.

These actions are being taken without the blessing of the public. Elected officials certainly have their shortcomings, but they are nevertheless elected. Bernanke and Paulson were nominated by the President and ratified by the Congress. It’s like making a copy of a copy of a copy.

Bloomberg put all of the numbers together and came up with $7.4 trillion (hat tip reader Paul Cox). BTW: Bloomberg updated this article to read $7.7 trillion. This is the amount of taxpayer money that the U.S. government is gambling with via lines of credit, liquidity, TARP, currency swaps, and everything else under the sun. Last time I checked, the U.S. economy was worth $14.4 trillion .

If the string of government bailouts is the “best thing to do,” then so be it. But the Fed and the Treasury have been sufficiently opaque about their policy choices, which leads one to question their actions.

Rebecca Wilder

Sunday, November 23, 2008

Has the Fed changed its policy unannounced? PART 2

This post continues an article from last week titled Has the Fed changed its policy unannounced: Poole says yes. Further evidence - a huge shift in nonborrowed reserves since October - suggests that the Fed may have shifted its policy target away from the federal funds rate.

The Fed’s balance sheet is usually only followed by a few policy gurus, but with the Fed’s $1.3 billion in new liquidity measures, everybody is interested. Many questions have been raised regarding the Fed’s actual objectives, as the effective federal funds rate - which closed at 0.49% on November 20 - veers miles away from its target set by the Federal Open Market Committee (FOMC), currently 1%. Accordingly, William Poole suggests that the Fed has changed it policy target without announcement. If you need a refresher, see Poole's interview on Bloomberg here.

A closer look at the construction of banking reserves (the H.3 tables) gives further evidence that Poole may be right.

The chart illustrates the level total reserves, excess reserves and nonborrowed reserves on a weekly basis since the beginning of 2008. Nonborrowed reserves (reserves acquired through methods other than borrowing from the Fed's discount window, like interbank lending or deposits) have surged $290 billion since the two-week reserve period ending on October 22, 2008. An upward swing in nonborrowed reserve positions indicates that interbank lending activity has picked up substantially, which could signal that credit conditions are improving with the Fed’s aggressive liquidity actions.

I don't buy it. Excess reserves are rising precipitously alongside the surge in nonborrowed reserves, as banks continue to hoard the Fed’s $1.3 trillion in new liquidity over the year. Credit conditions remain tight with new consumer and firm lending coming to a grinding halt (Calculated Risk gives a market-based argument that there has been little progress in credit improvement over the last few days).

A closer look at the construction of aggregate reserves shows that since October 22, nonborrowed reserves are surging while the growth in borrowed reserves is generally slowing.

With such dynamic shifts in borrowed and nonborrowed reserve positions, and little or no progress in keeping the effective federal funds rate in line with its target, I have to wonder if the Fed is targeting reserves again.

Paul Volcker targeted nonborrowed reserves in the 1970’s and early 1980’s, and borrowed reserves until the late 1980’s when Greenspan phased into interest rate targeting in the 1990’s. Nonborrowed and borrowed reserves appear to have taken a discrete jump, giving credence to Poole’s accusation that the Fed has changed its policy without announcement.

But the Fed made no such explicit announcement in the 1990's. When the Fed shifted its gears back in the late eighties from a borrowed reserve target to an interest rate target (targeting the effective funds rate), it did so gradually. From Meulendyke (1998):

”The return to effectively targeting the funds rate occurred gradually because other alternatives ceased to work as expected, rather than as a result of specific decision by the FOMC.”

RW: The minutes in the 1990’s do not show any indication that there was an explicit announcement by the Fed until 1997 when the minute reporting changed. The first sentence of the FOMC minutes from the late 1908's through July 1-2, 1997 always started with the following sentence (or some variant of it):

“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions.”
RW: But at the next chronological FOMC meeting on August 19, 1997, the first sentence of the FOMC minutes switched to:
“In the implementation of policy for the immediate future, the Committee seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/2 percent.”
RW: The only announcement made, indicating that the Fed had indeed changed its policy target, occurred in the minutes of that particular FOMC meeting on August 19, 1997.
“In particular, the directive would in the future include specific reference to the federal funds rate that the Committee judged to be consistent with the stance of monetary policy. The Committee also modified the present sentence relating to the intermeeting bias in the directive to recognize that changes in the stance of policy are now expressed in terms of the federal funds rate. These changes were not intended to alter the substance of the directive or the Committee's operating procedures."
As far as my research goes, the Fed never made an official announcement regarding Greenspan’s move to target an interest rate before 1997. But Meulendyke (1998) suggests that the FOMC had been targeting – at least partially – the federal funds rate for some time.
The trend in nonborrowed reserves has changed markedly, and as Poole suggests, may be the result of new and unannounced Fed policy.

Furthermore, I am not sure if we will ever get an official announcement of such a policy shift until well after the FOMC has phased out the old policy. At least for now, transparency (or lack there of) is not one of the Fed's primary policy concerns.

Just a little food for thought.

Rebecca Wilder

Saturday, November 22, 2008

Roubini's list of doom

Forbes lists Roubini's list of 20 (where many are very similar) reasons why consumption is set to decline over the next few years. I am not ready to call on consumption declining permanently yet, but unless policy makers get their acts together on this financial crisis, there may be no other alternative. From Forbes (I added commentary below some of the items):
"Consider the many severe negative factors affecting consumption. One can count at least 20 separate or complementary causes that will sharply reduce consumption in the next several years:

1. The U.S. consumer is shopped-out, having spent for the last few years well above his means.

RW: Of course this is number one; it's the classic deleverage scenario. I still say that consumers will not cut down permanently until they are forced to, i.e., banks say NO MORE! If consumers are forced to "delever", then we will not be able to separate this effect from the "recessionary" effects.

2. The U.S. consumer is savings-less, as the already low household savings rate at the beginning of this decade went to zero/negative by 2006 and now has to rise to more sustainable levels.

RW: This kind of sounds like number 1. If they reduce their debt burden, then by definition, the consumer must be saving.

3. The U.S. consumer is debt-burdened, with the debt-to-disposable-income ratio having increased from 70% in the early 1990s to 100% in 2000 and to 140% in 2008.

RW: Okay, so number three is very similar to 1. and 2. (just 1 reason so far).

4. Not only are debt ratios high and rising, debt-servicing ratios are high and rising, too, having gone from 11% in 2000 to almost 15% now, as the interest rate on mortgages and consumer debt is resetting at higher levels.

RW: 'Tis true, as long as mortgage rates set higher. Let's see what the FDIC and the Treasury come up with here.

5. The value of housing wealth is now falling by over $6 trillion, as home-price depreciation will soon be 30% and reach a cumulative fall of over 40% by 2010. Recent estimates of this wealth effect suggest that the effect may be closer to 12%-14% rather than the historical 5% to 7%. And with home prices falling over 30%, about 40% of all households with a mortgage (or 21 million out of 50 million who have a mortgage) will be under water (negative equity in their homes) with a huge incentive to walk away from their homes.

RW: Finally, the wealth effect. There is not a lot of impressive supporting evidence that a house is, in effect, an ATM card. But I suspect there is a significant wealth effect that will be estimated as soon as enough data is accumulated - this loss in housing wealth is unmatched in modern history.

6. Mortgage equity withdrawal (MEW) is collapsing from the $700 billion annualized in 2005 to less than $20 billion in the second quarter of this year. Thus, with falling housing wealth and collapsing MEW, U.S. households cannot use their homes anymore as ATM machines.

7. The value of the equity wealth of U.S. households has fallen by almost 50%, another ugly wealth effect on consumption.

RW: This will cycle out, as it always does. Unless equity markets do not return to their previous levels within a few months to a year. It took years and years for the equity markets to return to their peak values following the Great Depression.

8. The credit crunch is becoming more severe as the recent second quarter flow of funds data and the Fed Loan Officers' Survey suggests: It is spreading from sub-prime to near prime to prime mortgages and home equity loans; and from mortgages to credit cards, auto loans and student loans. Both the price and the quantity of credit are sharply tightening.

RW: This is clearly a stress point now, but what happens when the Fed's $1.3 trillion and growing starts to seep out of the banking system as money. That's right - more loans.

9. Consumer confidence is down to levels not seen since the 1973-75 and 1980-82 recessions.

RW: That usually happens in a recession.

10. Real wage growth and real income growth have been stagnant in the last few years as income and wealth inequality has been rising. And now with GDP and real incomes falling, real consumption will fall sharply.

RW: I don't really understand what stagnant real income and wages have to do with income and wealth inequalities. Actually, as long as the rich keep on consuming, you will see no change in aggregate consumption even if a portion of the population reduces their spending.

And GDP and real incomes always fall in a recession - again, consumption suffers in a recession! Nothing new here.

11. The Fed is reaching zero-bound on interest rates as the economy gets close to deflation, given the slack in goods, labor and commodity markets. Deflation means consumers will postpone consumption as future prices are lower than current prices, as real rates are positive and rising and as debt deflation increases the real value of households' nominal debts.

RW: This is back to the financial crisis. I have argued that deflation is not a sure thing - actually, far from it. And furthermore, consumers will not alter their behavior until deflation becomes embedded into expectations. As I argue in this post, consumers expect 6.9% over the next year, which is well above zero.

12. Employment has been falling for 10 months in a row and the rate of job losses is now accelerating. In the last recession in 2001, which was short and shallow (eight months from March to November 2001, with a cumulative fall in GDP of only 0.4%), job losses continued all the way until August 2003--with a job-loss recovery and a total cumulative loss of jobs of over 5 million from the peak. In this cycle, job losses have, so far, been "only" slightly over a million, while labor market conditions are severely worsening based on all forward-looking indicators such as initial and continuing claims for unemployment benefits. Massive job losses and concerns about job losses will further dampen current and expected income, and further contract consumption.

RW: This is certainly going to weigh in on consumption. Better believe it!

13. Tax rebates of over $100 billion failed to stimulate real consumption earlier in 2008. Only 25% of the rebate was spent as U.S. consumers are worried about jobs and needed to use funds to pay off their credit cards and mortgages. The tax rebate was supposed to boost consumption all the way through September 2008: In reality, real retail sales and real personal spending rose only in April and May, while starting in June and all the way into July, August, September, October and now the holiday season, real retail spending and real personal spending have been down month after month. Thus, another general tax rebate would be as ineffective as the first one in boosting consumption.

RW: That's what happens when you send a check to overburdened consumers - they save it.
This does not necessarily imply that consumption is going to decline further (although it likely will over the fourth quarter of 2008 and the first quarter of 2009), just that the second stimulus plan should not be a stupid rebate program.

14. The 1990-91 and 2001 recessions were not global; this time around, the IMF is forecasting a global recession for 2009.

15. The recent rise in inflation--that is only now slowing down--reduced real incomes even further for lower-income households who spend more than the average households on gas, transportation, energy and food. The recent sharp fall in gasoline and energy prices will increase real incomes by a modest amount (about $150 billion), but the losses of real disposable income and thus falling consumption from other sources (wealth, income, debt servicing ratios) are much larger and more significant.

16. The trade-weighted fall in the value of the U.S. dollar since 2002 has worsened the terms of trade of the U.S. and reduced further real disposable income and the purchasing power of U.S. consumers over foreign goods.

RW: Well, as long as there is a financial crisis underway, the U.S. dollar is staying strong. However, a decline in the U.S. dollar improves export income, which will fall in the hands of workers who will spend it. All this is an argument is for reducing the U.S. current account, which was going to happen - eventually - in spite of any recession or financial crisis.

17. With consumption being over 71% of GDP, a sharp and persistent contraction of consumption all the way through at least the fourth quarter of 2009 implies a more severe recession than otherwise. Consumption did not fall even a single quarter in the 2001 recession and one has to go back to 1990-91 to see a single quarter of negative consumption growth. But the worsening balance sheet of U.S. consumers in 1990-91 (debt ratios, debt servicing ratios, employment contraction, wealth effects of housing and stock markets) was much less severe than the current downturn.

RW: We are back to 1.-3: saving more and consuming less to reduce debt burden.

18. Monetary easing will not stimulate durable consumption and demand for residential housing, as demand for such capital goods becomes interest-rate insensitive when there is a glut of capital goods; monetary policy becomes like pushing on a string. In the previous recession, the Fed cut the Fed Funds rate from 6.5% to 1% and long rates fell by 200 bps. In spite of that, capital expenditure in the corporate sector fell by 4% of GDP between 2000 and 2004 as there was a glut of tech capital goods and it took years to work out such a glut. Today, there is a glut of housing, consumer durables and autos/motor vehicles; so it will take years to work out this glut and monetary policy is becoming ineffective to resolve that glut.

RW: This is a bit like number 11. But he is failing to mention the effects that fiscal stimulus may have on capital goods and even consumer durables - yup, that could be very positive....and perhaps just enough to get us through the next year.

19. While policy rates are sharply falling, the nominal and real rates faced by households are rising rather than falling: rising mortgage rates, rising rates on credit cards, auto loans and student loans, together with less availability of credit are severely dampening the ability of households to borrow and spend.

RW: They are rising, but if deflation does occur - which Roubini is proposing - guess what will happen to long term interest rates. Yup, they will fall.

20. To bring back the household savings rate to the level of a decade ago (about 6% of GDP) consumption will have to fall--relative to current GDP levels--by almost a trillion dollars. If all of this adjustment were to occur in 12 months, GDP would contract directly by 7% and indirectly (including the further collapse of residential and corporate capital expenditure in a severe recession) by 10%, an exemplification of the Keynesian "paradox of thrift." If such an adjustment were to occur over 24 months rather than 12 months, you would still have negative GDP growth of 5% for two years in a row with a cumulative fall in GDP from its peak of 10%. (Note that in the worst U.S. recession since WWII, such cumulative fall in GDP was only 3.7% in 1957-58). One can only hope that this adjustment of consumption and savings rates occurs slowly over time--four years, say, rather than two.

Even in that scenario the cumulative fall of GDP could be of the order of 4% to 5%, i.e., the worst U.S. recession since World War II. Note that the cumulative fall in GDP in the 2001 recession was only 0.4%--and in the 1990-91 recession only 1.3%. So, the current recession may end up being three times as long and at least three times as deep (in terms of output contraction) than the last two.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for
Rebecca Wilder

The CBO's outlook on housing starts

The housing market continues to be a big thorn in the economy's side. Housing starts maintain their downward trend, sales have hit an undecided bottomed and vacancy and delinquency rates surge. There's still a lot of overhang to work off, and the big remaining question is for how long?

With global capital losses hitting $1 trillion (and counting) – a good-sized portion of that is tied to mortgages and mortgage-backed assets – the stabilization of the U.S. housing market is of up most importance. So how much overhang still needs to be worked off? Well, according to the Congressional Budget office (CBO), that depends on three things:
  • The underlying demographic variables of the housing market: household formation based on population growth and other factors.
  • Vacancy utilization rates, or the new vacancies that are utilized (like a second home) relative to those that are unutilized (for arbitrage opportunities, like the American show "Flip This House", which you can watch here).
  • Credit availability in response to the current financial crisis and the length/depth of the economic cycle.

The CBO estimates (read paper here) that housing construction will bottom in 2008, 2009, or 2010-2011 depending on the path of economic and financial conditions and the demand for utilized vacancies (e.x. second homes). The optimistic scenario: the economy cycles out as normal, financial conditions improve and some of the surge in vacant units can be explained by a permanently higher demand for vacant homes (above 19990's levels), although for reasons that are currently not known. Therefore there is some excess supply still to work off with added foreclosures going forward contributing to the supply. Housing starts bottom in 2008 and rise back to trend levels by the end of 2009.

The cyclical downturn scenario: the economy cycles out as normal, financial conditions improve and excess vacancy rates fall back to 1990s levels. Therefore, there is still a lot excess and vacant supply of homes to work off with added foreclosures going forward contributing to the supply. Starts bottom in 2009 and return to trend early in 2011.

The pessimistic scenario: household formation remains depressed due to ongoing recessionary and financial stresses and both utilized and unutilized vacancy rates fall back to pre-1990's levels. In this case, there is a very long period to work off the excess supply of homes that includes new foreclosures going forward due to prolonged decline in demand. Starts decline through 2009 and slowly stabilize in 2010 and 2011, but do not return to trend levels until 2012.

It is interesting to think about a positive and permanent shock for utilized vacant homes - I hadn't even considered it before reading this paper. I tend to think that the cyclical downturn scenario is the most plausible, which is slightly more pessimistic than my previous assessment of the housing market in August, but since then, credit and economic conditions have taken a sharp turn downward.

Rebecca Wilder

Friday, November 21, 2008

The next shoe to drop in the labor market: the insurance industry

Asset managers, brokers, investment bankers, analysts and insurers alike will see massive job cuts into 2009. From Bloomberg:
"The bloodletting in the financial- services industry will accelerate in coming months, with job cuts doubling to about 350,000 worldwide by mid-2009, said Brian Sullivan, chief executive officer of search firm CTPartners.

Reductions on that scale would be equivalent to 20 percent of the global workforce at financial companies before the credit crisis began, said Sullivan, whose firm has worked with Citigroup Inc. and JPMorgan Chase & Co. Banks, brokerages and funds have eliminated about 170,000 positions worldwide."
The Americas' (the U.S.) financial industry has suffered the most compared to Europe and Asia, with already 0.9% job cuts in Q4, and according to Bloomberg, the worst it yet to come.

As of November 20, 2008, 95% of world financial job cuts occured at banks and brokerage houses. But insurers, with $US143 billion of the almost $US1 trillion in capital losses worldwide, are cutting jobs too. But if you work at AIG, your job is relatively safe. In spite of a record $US61 billion in losses, AIG has cut just 0.8% of its workforce.

Hartford Financial Services has tallied $US7 billion in losses to date - just 11% of AIG's losses - and cut 500 jobs, or 1.6% of its workforce. That is just wrong. But furthermore - and I find this very hard to believe, but nevertheless that's what Bloomberg says - Ambac Financial Group has cut zero jobs to date with an $US11 billion in accumulated losses.

The insurance business accounts for roughly 15% of world capital losses, but the job cuts have been minor compared to those at banks and brokerage houses. In aggregate, the insuarnce carriers, investments sector as reported by the BLS actually added 2,500 jobs in October. But that cant' last for long.

The next "shoe to drop" in the financial bloodletting of jobs will likely be in the insurance industry.

Rebecca Wilder

8% growth will challenge China's social structure

Usually I am fiscally conservative, but right now is no time to adhere to an economic “code of conduct.” To be sure, deficit spending can lead to problems down the road, but at what cost does an economy stave off expansionary spending? Congress is dragging its feet - how much output must we give up to get funding for new infrastructure and for those who need it – the unemployed.

The U.S. welfare infrastructure is not well-equipped to handle 8%-8.5% unemployment, which is why Congress is expected to extend unemployment benefits. But this is especially true for China, whose growth rate averaged 10.8% over 2003-2007, but is expected to slow to around 9.0%-9.5% in 2008, and to 7.5%-8.5% in 2009.

Admittedly, a slowdown to 7.5%-8.5% growth sounds like a mild setback compared to the U.S., where growth it expected to be negative in 2009 (on an average basis). However, the Chinese economy is not equipped to handle the rising unemployment that goes along with slackening demand. The labor market will suffer markedly, and fortunately the government is in a place to spend.
From the Financial Times:

”China’s employment outlook is becoming “grim”, say officials, as the global financial crisis triggers fresh factory closures in the export sector.

Urban unemployment has begun to rise and will increase next year, Yin Weimin, minister of human resources and social security, said on Thursday.

“Stabilising employment is the top priority for us right now,” said Mr Yin, in comments reflecting growing worries about the potential threat to social stability.

“The current situation is grim, and the impact is still unfolding,” he said. “Since October, our country’s employment situation has been affected along with changes in international economic conditions.”

China’s official urban unemployment rate is 4 per cent. But this figure includes only registered urban residents. Tens of millions of rural migrants who have moved to cities to work in factories over the past decade are generally not included in unemployment data if they lose their jobs.

The national economy has been slowing gradually since the start of the year. However, the pace at which it is cooling accelerated sharply in September and October, prompting a steep drop in confidence among companies and some consumers.

Even when the economy was growing strongly, China witnessed a stream of localised protests. Recent trouble has included strikes by taxi drivers in three cities and rioting in a city in Gansu province this week.

Statements by Chinese leaders have shown that they were worried about the social impact of a sharp downturn. In an article in a Communist party magazine this month, Wen Jiabao, the premier, said: “We must be crystal clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development . . . factors damaging social stability will grow.”

Zhang Xiaojian, vice-minister of human resources and social security, said on Thursday competition for jobs among growing numbers of college graduates would intensify if the economy slumped. The authorities jast week unveiled a huge fiscal stimulus programme aimed at keeping growth at about 8 per cent a year.

The slowdown began in the housing market, spreading to related industries such as steel and cement. With Europe now in recession, and many of its other markets slowing, some economists think that Chinese exporters are about to face an extremely tough patch.

In one indication of the gathering slowdown, Japan said its exports to the rest of Asia recorded their first decline for seven years last month, with exports to China dropping 0.9 per cent compared with the same period last year. Japanese companies have been large suppliers of components and other products to the array of factories in China that assemble goods for export.

Two provincial governments this week announced measures aimed at deterring businesses from laying off workers. Hubei and Shandong said companies trying to lay off more than 40 staff would need prior approval from the local authorities."

RW: Fiscally, the Chinese government is in a better situation than it was just six years ago (see above chart). Its revenues totaled 5.8 trillion yuan in 2007, which is 2.7 times greater than those in 2002, 1.9 trillion yuan.

The Human Resources and Social Security Ministry Yin Weimin expects that the government’s spending measures – the stimulus package worth almost $US600 billion – will improve labor market conditions by the second quarter of 2009.

I imagine that estimate weighs in on the optimistic side, and in the interim things will get tough. With labor riots already underway, social conditions will worsen between now and the second quarter of 2009.

Rebecca Wilder

Thursday, November 20, 2008

FDIC spends a little in California

Below-the-radar fiscal stimulus spending: FDIC opens up a temporary office in Irvine, California and will hire "non-permanent employees and contractors". From the FDIC:
"The Federal Deposit Insurance Corporation (FDIC) today announced it will open a temporary office in Irvine, California, to manage receiverships and to liquidate assets from failed financial institutions primarily located in the western states.

This office will act as a temporary satellite of the FDIC's resolutions and receivership operations. Through out its history, the FDIC has used these offices to keep our temporary asset resolution staff closer to the concentration of failed bank assets they oversee.

After conducting a thorough search and competitive bidding process in the southern California market, the FDIC entered into a lease for 200,000 square feet of space located at 40 Pacifica Place, in Irvine. The location and lease were determined to be the best value for the FDIC, considering mission, price and other qualitative criteria listed in our solicitation. The term of the lease is for three years, with two one-year options.

The FDIC will hire non-permanent employees and contractors to meet the workload needs of this office based on the number of closings that occur west of the Rockies, the number of receiverships and the post closing workload.

Grubb and Ellis advised the FDIC on the search. The FDIC expects to gradually move into the space starting at the end of December."
Rebecca Wilder

The first in a round of fiscal spending.....

And away we go. Here is what is likely to be the start of a long list of new government programs/spending. From Real Time Economics:
Amid another huge increase in U.S. jobless claims, the White House said Thursday it now supports an extension of unemployment benefits.

“Because of the tight job market, the President believes it would be appropriate to further extend unemployment benefits, and he would sign the legislation now pending in Congress,” White House spokeswoman Dana Perino said.

The Senate will vote as soon as Thursday on a House-passed measure to extend unemployment insurance by seven weeks for those without jobs whose benefits have run out and 13 weeks for those in states with an unemployment rate higher than 6%.

Earlier Thursday, the Labor Department said the number of U.S. workers filing new claims for unemployment benefits soared again last week to its highest level in 16 years, suggesting more pain ahead for already struggling labor markets.

“The recent financial and credit crisis has slowed the economy, and it’s having an impact on job creation,” Perino said. “The President is always concerned when anybody loses their job and wants to ensure that anybody who wants to work can find employment.”

Initial claims for jobless benefits jumped 27,000 to a seasonally-adjusted 542,000 in the week ended Nov. 15. That’s the highest since July 1992.

“We will continue to aggressively implement the rescue package so businesses and consumers are able to get loans so our economy can once again grow and create jobs.” –Henry J. Pulizzi
Although this is a start, it's not anywhere near Paul Krugman's estimated $600 billion.

Rebecca Wilder

The deflation threat is small

Bloomberg published article today that suggests deflation is a real threat to the U.S. economy. In my opinion, deflation is not going to be a real threat until falling prices become embedded into expectations. However, there is a growing risk that the current credit crisis contracts the money supply enough to drive prices downward over a period of many consecutive months, resulting in negative inflation expectations. But that outcome has a low probability. From Bloomberg:
``The Federal Reserve put deflation back on the table as a significant policy concern,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs, who is now a visiting scholar at the American Enterprise Institute in Washington. ``There does not appear to be any barrier to lowering'' main rate below the current 1 percent level, he said.

Deflation, or prolonged declines in prices, hurt the economy by making debts harder to pay off and lenders more reluctant to extend credit. Japan is the only major economy to have suffered the phenomenon in modern times. `Lesson' for Kohn

``A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive,'' Bernanke's deputy, Vice Chairman Donald Kohn, said in answering questions after a speech yesterday in Washington. ``Whatever I thought that risk was four or five months ago, I think it is bigger now even if it is still small.''
Is deflation a real threat?

I love how Bloomberg turns a completely innocuous statement by Donald Kohn into a suggestion that deflation is a serious concern. The risk of deflation is higher than it was four or five months ago? Ahem, four of five months ago was roughly June or July when annual inflation hit 4.9% and 5.5%, respectively. The price of oil was surging, and gas and food prices were rising precipitously. Of course there’s a bigger risk today – that’s called a recession!

Expectations play an important role here

Back in July – when the price of gas exceeded $4/gallon – the Fed hawkishly followed measures of inflation expectations because once those puppies get imbedded into consumer and firm behavior, then you have a problem. If banks expect prices to rise over the next year, then current interest rates increase. If firms expect prices to rise, then current wages tick up. Rising inflation expectations could create a mess that results in surging inflation.

But just as the Fed was worried about price expectations rising, the Fed will watch closely price expectations falling in this recession-backed credit crisis. If banks expect prices to fall over the next year, then current interest rates fall. If consumers expect prices to fall, then current spending could decline. Falling inflation expectations could create a mess that pushes inflation down, making debts harder to pay back (because current loan terms are usually made at a fixed rate, rather than an adjusting rate) and curtails consumer spending.

Inflation expectations are still elevated

Right now, the average consumer still believes that prices will rise over the next year, and by some measures, by 6.9%. So as long as inflation expectations remain elevated, “deflation” is unlikely to drag the economy down, because current firm and consumer behavior will not change.The chart illustrates annual inflation and inflation expectations spanning the years 1978 to 2008. Annual inflation is old news, but monthly shifts drive the annual numbers, so the trend is a fair assessment of current conditions. The current inflation rate, 3.7%, is still elevated above the average over the years 2000-2008, 2.9%. Furthermore, the US economy is in a recession, and inflation falls during recessions.

Until falling prices become embedded into expectations, I see consumers as slightly better off when labor income is declinine and the U.S. economy is in a recession. The disinflation acts more like a stimulus than a real threat.

The better question is: will current credit conditions cause a contraction in the money supply enough to drive down inflation expectations?

The Fed reports that M1 and M2 rose in October. However, in the week ending November 3, the non-M1 components of M2 (Table 2) contracted. Although the 4-wk moving average still exhibits growth in M2, the deflation scenario presumes that credit market disruptions cause the money supply to contract going forward. Obviously there is a risk here.

The Fed will keep the printing presses on, and eventually, this will “buy” rising prices; at least that’s the theory. To be sure, the Fed’s actions alone are unlikely to get us out of this mess. But at this point, it can’t hurt to keep the presses on, and hope that it is at least partially enough.

By my simple calculations, it would take a record-breaking eight consecutive months of a 1% decline in prices (October's decline, or the biggest since 1947) to drop the annual inflation rate below zero. And if it stayed there, expectations could change, causing disruptions in the macro-economy.

However, it would take a massive downturn in core prices to make that happen because energy – which was most of the story for October’s decline – is unlikely to fall to zero. So Congress has until June, at the very least, to get their act together, pass a stimulus bill, and spend.


For now, declining monthly prices are in some sense a good thing. The oncoming recession is expected to be quite severe, and with labor income remaining depressed, at least consumers will pay less for gas, energy, and other necessities. To be sure, the state of the credit system could cause serious disruptions in normal activity, but that is far from a sure thing, and as long as Congress gets on board and the Fed keeps the printing presses on, the deflation risk is close to zero.

But at this stage in the game, the only sure thing is the speed of light.

Rebecca Wilder