Decision Time for the US Federal Reserve: what should they do this week?

Last week had two main events or influences. The first was the rise in wheat prices that led to follow on rises in other agricultural commodities, the frenzy surrounding this was increased when Russia announced a ban on grain imports from August 15th to the end of this year. This calmed down and prices retraced for wheat late on Friday with prices falling from a high of US $8.68 per bushel to US $7.25 per bushel and it is at this new level this morning. However its impact has hit other prices as for example the price of feed barley in Europe was 90 Euros per tonne in mid-June and is now 210 Euros per tonne. Adding to this we have seen the price of oil rise since the end of May, if we look at the price of Brent Crude Oil it fell to a recent low of US $70.20 per barrel on the 20th May and is US $80.76 per barrel this morning. Now commodity prices have a tendency to ebb and flow to say the least but it is curious that the world is so fixated on deflation/disinflation at a time almost to the exclusion of anything else when there are plainly some inflationary pressures around.

The second impact/event was the publication of employment and unemployment statistics by the Bureau of Labor Statistics in the US. These were disappointing numbers and I will look at them in detail in a moment but their initial impact involved a fall in equity markets as the US Dow Jones Industrial Average fell over 140 points. However in a theme familiar to regular readers we then saw US equities  recover and in effect brush off the poor economic news and in the end the Dow Jones closed just some 21 points lower. European equity markets are rallying this morning with the UK FTSE the German Dax and the French CAC 40 all up by more than 1% so the net effect of these figures has quickly disappeared at least as far as equity markets are concerned. However there are clear economic implications for the US central bank the Federal Reserve which has a policy setting meeting tomorrow and faces calls for new action. Of course the cries for new action are probably influencing the recovery of equity markets as we are close to a consensus in some areas that the Fed should act and it is this which I wish to discuss today.

The Choice facing the US Federal Reserve bank

Essentially the current argument is driven by what has happened over the past two years. In response to the credit crunch the US Federal Reserve undertook an extraordinary programme of monetary stimulus to try to support the US economy. Interest rates were slashed such that the official range is now in a range between zero and 0.25% which compares with 5.25% before the crisis and the Fed undertook a programme of Quantitative Easing which expanded her balance sheet to some 2.3 trillion dollars. According to its own website the Fed had a balance sheet of US $869 billion on August 7th 2007 and as of the latest figures now has one of just under 2.33 trillion. So there has been an expansion of approximately US $1460 billion which is an extraordinary level of intervention/stimulus for the US economy.

This was expected to have follow-on effects for the US economy and provide a boost with both short-term and longer-term interest rates falling. As we there were direct effects on the rates at which US companies can borrow as the Fed intervened directly in the corporate area as opposed to the Bank of England whose own efforts were mainly indirect by buying sovereign debt.

Economic Growth

After the falls caused by the credit crunch US economic growth did rally in response to the monetary and fiscal stimulus applied. The problem if we look at the last three-quarters of US growth is the trend. After a rise to 5% in the last quarter of 2009 we saw 3.7% in the first quarter of 2010 and then 2.4% in the second quarter. Now the US use of annualised numbers does exacerbate the trend of falling growth rates but in essence since the heady days of the last quarter of 2009 the growth rate has halved. Looking at the components of US economic growth does not help either as  a reasonable proportion has been restocking of inventories which has a limit as firms will look to sell these inventories and if they cannot then they will cut back.

Now economists looking at the trends are starting to reduce their forecasts for economic growth in 2011. For example Goldman Sachs have reduced it from 2.5% to 1.9%. Looked at like this the effects of all the stimulus measures are starting to look rather weak and temporary.

US Employment and Unemployment

Fridays figures continued a disappointing trend. If we go beyond the headline figure of a fall in employment of 131,000 jobs we see that the US private sector created some 71,000 jobs. This is quite low for this stage of the recovery. To add to the gloom the employment figures for June were revised down from -125,000 to -221,000. Somehow in the midst of this the Bureau of Labor Statistics managed to report an unchanged unemployment rate of 9.5% and it managed this by reducing the estimated size of the labour force. We have seen this sort of thing in the UK where we have seen falls in employment and increases in estimates of the non-working population. It is recorded differently in the US  as an example it is recorded in one section of the report as individuals “marginally attached to the labor force” and this category has risen by 340,000 over the past year to 2.6 million.

Another section which unfortunately questions the statistics being produced is the way back months are being revised. I pointed out earlier that the employment figures for June were revised down substantially. Well this is a consistent theme. If we look at 2009 we see that the figures for 11 months were revised down later and only one was revised up. The downward revisions totalled some 677,000 and the upward 60,000 leaving us with a net figure of minus 617,000 for the year.

So if the statistics from the BLS continue at the same level of reliability as 2009 then an already disappointing employment situation is in fact worse than that. As a side issue the credibility of the BLS will be hit further unless it finds a solution to its errors which seem pretty much always to be in the same direction.

Interest Rates

One feature of US economic policy is the very low-level of interest rates which are prevalent in the US economy. At the short end they under the Fed’s control and they are below 0.25%. If we look at the rates for US government bonds we see rates which are low and they fell further on Friday. The yield on two- year government bonds fell to 0.51% and on ten-years it fell to 2.81%. I have written before on the thirty year mortgage rate which is below 4.5% but less on corporate rates.

US corporates with a good credit rating can borrow at extremely low rates. As an example of this IBM borrowed some US $1.5 billion last week for three years and paid only 1% on it so it could hardly get much cheaper!

Comment

So here we see the source of the problem to my mind. Personally I feel that the Federal Reserve did the right thing in trying to influence corporate interest rates as much as possible with its asset buying programme as compared with the Bank of England which spent its money apart from a relatively small section on government debt. As discussed above the rates at which corporate borrowers can borrow are now extremely low. Economic theory would predicts that companies would use this money to invest and thereby boost the economy. If we look at the growth figures this may have happened but the effect is looking somewhat temporary.

This leads me to a conceptual problem for those who are pushing for QE 2.0. By definition the call means that QE 1.0 has either not worked or not worked as well as expected. I have written before about “thought bubbles” well some parts of the economic profession appear trapped in one here where they can only think of one policy and ignore the fact that one has now to contemplate that the policy has only been a partial success. Indeed it is possible that it is failing. If this is so what good will more of it do? To this question they appear to have no answer.

If I had a vote this week I would vote for no change. This is for several reasons. If we put aside the fact that I have questioned QE many times on here and have voiced doubts about it then the evidence is now questioning it. If this is so then doing more of something which is failing does not seem logical. Also recoveries do not happen in a straight line and so I would want more evidence of a US economic slowdown before I added to what already are extraordinary stimulus measures. Some members of the Fed are likely to agree with me as their last meeting minutes said that conditions would have to “worsen appreciably” before they acted again.

What might the Federal Reserve do on Tuesday?

During this crisis we have seen the Fed make panic moves. I remember one weekend panic cut in interest rates of 0.75% particularly. So one cannot rule out a move on Tuesday. What might they do?

1. As interest rates are so low a cut seems valueless. Some are suggesting that the Fed. could announce that rates will stay low for an even longer period than currently expected. I struggle to see any point to this after all nobody is expecting a rate rise for ages.

2. More asset purchases. Apart from the logical flaw that they are only taking place because previous asset purchases have failed this would be such a big move it would risk undermining confidence in the economy. So this could quite easily backfire.

3. A technical change which would pump around US $250 billion a year into the economy. Should the Fed act this is the most likely move. As part of its asset purchases it bought large amounts of Mortgage Backed Securities or MBS’s. At the moment it is receiving interest and principal payments on these of some US $ 250 billion or so per year and is using this to pay down the amount of debt it has. The Fed could choose to reinvest this money in what has been described as QE-lite. The most likely place it would put this money would be in US Treasury Bonds although if you are logical then in fact it should go into the MBS market and the corporate bond sector.

Conclusion

The pressure from the markets appears to be building but to my mind central banks should keep a clear mind and not respond to such pressure. If they are weak they may go for option 3 above but to my mind they should be strong and wait. Unfortunately economic data is slow to arrive and often only gives partial answers.

Personally I also think that the whole debate questions QE as a policy weapon, as in if it works why are we having this debate at all? In the words of John Maynard Keynes sometime monetary policy is like “pushing on a piece of string” and what we may be seeing at this time is that the transmission mechanism between the monetary stimulus and the real economy is only partially working at best.

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6 thoughts on “Decision Time for the US Federal Reserve: what should they do this week?

  1. The ‘World’ is not talking about deflation. US,UK,EU are talking about deflation. I asked the question before, why do you think bread and meat price increases are inflationary at a time when credit is either not available or not requested and wages are flat?
    US QE went to reduce corporate borrowing rates. Where do you think the new investment goes by and large? Overseas and/or more robotics etc. It helped increase corporate earnings but not the general economy in the US. The US lower 90% have seen little or no real increase in earnings power for 30 years. What they have done is borrow against property over the last 10 years to try to compensate. Now they have nowhere to go. The only viable route for the US government is to reduce taxes for the middle/lower earners and compensate by taxing the top 10% more. Its ‘un-american’, but then so has the shattering of the ‘american dream’ over the last 30 years or so.
    In the medium /long-term it will probably matter little, as ‘globalisation’ has spelt the death-knell of the middle-classes anyway.

    • Hi JW
      As to the world talking about deflation I should have been more specific as I meant the news media referring to the countries you mention although of course Japan needs adding to the list. Regarding the issue of commodity price increases having potentially inflationary influences at a time when the overall economy is struggling then this can be true. I was looking recently at the UK response to the 1973/74 oil price shock not because I feel the recent wheat moves will have anything like the same influence but because it illustrates a time when we suffered from high inflation of over 25% at its peak in a recession, so we got inflation in an economic contraction due to an exogenous oil price shock. Inflation and recession is an unpleasant combination which has plenty of effects.The equally plausible inflation and stagnation is not much better.

      One of the potential effects does tie in with your view on squeezing everybody who is not in the top 90% of income/wealth. If wage rises are limited or zero in real terms then their position declines unless they have heavy enough debts which decline in real terms even faster!

  2. In the 1970s wages in the UK were linked to inflation as measured by RPI. Wage increases took place sometimes several times in a year. The current situation is nothing like that at all.
    I think in your last paragraph you meant ‘not in the top 10%’. I think with US CPI at 1% its going to take a very long time for their debts to decline.
    We need to look at velocity of money as a measure of risk of inflation. Its non-existent. Credit is constrained. Prices of food, commodities and energy are going up, but that is deflationary given the moribund state of the velocity of money. What is happening in Us, UK, EU is a reduction in ‘earnings’ relative to the past and the rest of the world. It has to happen as we have borrowed from the future for years, 90% , perhaps 99% of us will have to get 20/30% ‘worse off’ over the next 5/10 years.
    Putting up interest rates to protect ‘capital’ will make the situation worse. The hard economics , such as austrian school etc, don’t apply, that was dealing with a single currency in a nation state, this is a global event not seen before.

  3. Following on from JW’s view that wages are static and the current level of increasing food prices are deflationary.
    So what would happen if the speculators (aka banks) were to get ‘inflationary expectations’ or for whatever other reason reallocate some of their resources from treasuries to commodities. This may already be starting.
    Given that the banks have a lot of liquidity (due to the FED buying their MBS’s etc) and that a large proportion of investors are ‘waiting on the sidelines’ with cash the effect could be catastrophic.
    I read that ETF bidding on commodity contracts was largely to blame for the commodity spikes of 2007 and if this were repeated in the current climate we may see a sinking dollar, rising interest rates and higher prices also.
    Somebody tell me my thinking is flawed because this scenario scares me.

  4. On the UKQE has anyone noticed that the Secured Commercial Paper Facility has not received funding from the Asset Purchase Facility of the BoE. Wasnt this supposed to be a lifeboat for SME working and trade capital? Heralded as supporting a “broad population” of companies other than investment-grade FTSE big boys, its produced apparently ziltch in terms of support. SMEs left to sink or swim, yet again. The SME sector should justifiably question the discriminatory nature of these various support operations.

    • Hi Shireblogger
      I too have been disappointed at the Bank of England’s lack of enthusiasm for buying any sort of private-sector paper as part of its asset purchases or QE programme. Out of the £200billion for the assets purchased using central bank reserves only £1.245 billion was spent on private-sector assets and all of that was spent on corporate bonds. Since it has had the opportunity to purchase private-sector assets using Treasury Bills as finance it has only built up a stock of £348 million which is disappointing. It could and should do more for example in could switch say from some of its shorter dated gilts to private-sector paper, after all the gilt market is so strong at the moment it would hardly notice it, and it might give a boost to private-sector industry. I have got the feeling that commercial paper is at the wrong end of a rather short stick!

      When I originally wrote about the Bank’s post-QE ability to buy private-sector assets using Treasury Bills as finance on the 5th February I pointed out the following.
      “I am sure there will be plenty of speculation about why this was released on the HM Treasury website in the evening and not with the Bank of England’s announcement.”
      It has felt more and more like a policy which the Bank of England has never really supported…

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