Not the best of all worlds for the Fed
BY RANDALL FORSYTH, BARRON’S — 03/17/10
Despite the central bank’s perceived optimism, falling money and credit threaten renewed economic weakness.
There are three vacancies on the Federal Reserve Board of Governors. San Francisco Fed President Janet Yellen is reported to be White House’s pick to succeed Donald Kohn as vice chairman while Sarah Raskin, Maryland’s commissioner of financial regulation, and Peter Diamond, an economist at the Massachusetts Institute of Technology, have been tipped as leading candidates to fill the other spots.
Not to take anything away from any of their substantial qualifications, perhaps the best nominee for the Fed Board would be Dr. Pangloss. You’ll recall him as the character in Voltaire’s Candide who asserted this was the best of all possible world’s, notwithstanding all of evidence around him to the contrary.
The good doctor would strike the perfect note of optimism, in tune with the upbeat interpretation of the Federal Open Market Committee’s announcement Wednesday that it will maintain its federal-funds target range of 0-0.25%.
That was expected, but the more important statement was that “exceptionally low levels” of that key rate continued to be warranted “for an extended period.” Translated from the Fedspeak, that “extended period” lasts from six-to-nine months, which likely mean no increase in the fed-funds target to 0.5% until December, if then.
At the same time, the FOMC upgraded its assessment of the economy. “Economic activity has continued to strengthen,” the panel observed, “while the labor market is stabilizing,” with unemployment officially at 9.7%. “Business spending on equipment and software has risen significantly,” it added.
“However,” the FOMC continued in best tradition of the two-handed economists so despised by Harry Truman, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls.”
The common interpretation was that the Fed’s policy-setting panel was more upbeat about the U.S. economy, while it continued to expect inflation “to be subdued for some time.” What could be better, Dr. Pangloss might ask, than a recovery with negligible price pressures and near-zero money rates? The stock and bond markets both agreed and moved higher after the release of the FOMC statement at 2:15 PM EDT.
To which the clear-eyed observer might wonder, what’s wrong with this picture?
“Here’s the problem,” writes Joan McCullough of East Shore Partners. “Given the positive spin placed on the recent economic statistics by all the pundits and the ‘rallies’ that celebrated these victories, why is it that the Fed is still keeping rates at zero ‘for an extended period’?”
Nowhere is this disconnect more striking than for homebuilders. The SPDR S&P Homebuilders exchange-traded fund (XHB) closed within two pennies of its 52-week high Wednesday and is up more than 50% from last July and 23% since late October.
Yet, according to BCA Research’s Daily Insights note, “U.S. homebuilder confidence remains at historic lows, and there is little prospect that the backdrop for homebuilders will improve anytime soon.” There remains a large inventory of distressed properties for sale for less than the cost of construction, which can only increase with the mounting tide of foreclosures, as BCA points out. (I guess Dr. Pangloss has been a heavy buyer of the XHB.)
And that is with the Fed buying $1.25 trillion of agency mortgage-backed securities, a program the FOMC confirmed it would wind up on schedule this month. Although those purchases have brought mortgage rates down to record lows relative to benchmark Treasury notes, the Fed buying hasn’t translated into home building.
With regard to the future of securities purchases, the FOMC added it could “employ its policy tools as necessary.” George Goncalves, Treasury analyst at Nomura Securities, infers two possibilities: that the Fed could become more aggressive in its exit strategy from its expansionary policies, if necessary; or the central bank could be pushing back that exit date and may, indeed, have to resume its policy of securities purchases, or “quantitative easing,” in vernacular of Fed watchers.
To be sure, Goncalves adds the latter “scenario would be at odds with the improving economic assessment (confirmed at each meeting since the mid-point of last year) and everything else we hear out in the press.” But consider the statement that the panel could “employ policy tools as necessary;” it might be more than just a hedge against future uncertainties. Instead, it could be “an early sign that the Fed is worried that M2 will drop like a brick because credit creation is nonexistent,” Goncalves observes.
Despite the Fed’s heroic efforts of expanding its balance sheet, which has ballooned the monetary base (reserves plus currency), growth of the money-supply measures, such as M2 (currency, checking deposits and consumer savings instruments), has slowed to a crawl.
While the Fed has expanded the monetary base by 35% in the past 12 months, M2 has grown only 2.1%. That reflects banks’ commercial and industrial loans contracting at a historically unprecedented 20% annual rate in the past six months. To use the cliché, this is what it means for the Fed to “push on a string.”
The broader M3 money measure — which no longer is published by the Fed but is estimated by John Williams’ Shadow Government Statistics — shrank outright, by 3% in the past 12 months. In real terms—that is, after adjusting for inflation — the contraction is even more severe. Every time real M3 has declined, the economy has turned down.
Dr. Pangloss and his bullish cohorts see the delay of the Fed’s eventual rate hikes as good news because it gives the financial markets free money to play with a bit longer. What they miss is that ultra-low rates reflect financial frailty, not robustness. And that the money numbers portend worse weakness ahead instead of strength.