The Federal Reserve considers the recent jump in Treasury yields more as a reflection of a better economic outlook than a signal it needs to step up purchases of U.S. government debt, according to central bank officials who declined to be identified.
This follows Federal Reserve Chairman Ben Bernanke's efforts to discredit the idea that 3% is a magic number:
The move above 3% isn’t fundamentally important, [Bernanke] suggested. “We are not targeting a particular interest rate” with the long term Treasury note purchase program, he said.
The confusion over the Fed's policy intentions stems from the now familiar conflict between what the Fed defines as "credit easing" and what market participants define as "quantitative easing." The latter requires some quantitative goal, something the Fed acknowledges. But no such target has been defined, nor has the Fed committed to a 3% rate. This is something of a failure of Fed communications - they cannot adequately define their policy intentions to a group of market participants yearning for the simple target rates they have come to expect. But committing to a rate target would rob policymakers of a signal that the economy was improving. Former Fed Governor Lyle Gramley:
The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley. “The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.
And no doubt there is still plenty of smoke. So much, in fact, that practitioners are extremely at odds over what signal we should get from the Taylor Rule. From Bloomberg:
The Federal Reserve may soon need to raise interest rates, said John Taylor, the former Treasury official who devised the “Taylor Rule,” a formula for rate- setting based on the outlook for inflation and growth.
“My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said yesterday at an Atlanta Fed conference in Jekyll Island, Georgia.
Fed Chairman Ben S. Bernanke said earlier this week at the conference the Fed was prepared to withdraw monetary stimulus “in a timely way” to prevent inflation from becoming a threat when the economy recovers. Former Federal Reserve Chairman Alan Greenspan said yesterday that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve.
Taylor, a Stanford University professor, disagreed with economists who say his rule suggests the need for stimulus and justifies cuts in the federal funds rate to negative territory. Laurence Meyer, vice chairman of Macroeconomic Advisers, said in March the rule might suggest the need to reduce the funds rate to minus 7.5 percent by the end of 2009.
He said his rule, based on inflation and economic growth compared with the long-term potential for growth, suggests a fed funds rate of 0.5 percent. The central bank has cut rates to between zero percent and 0.25 percent.
Taylor's calculation - I believe - is based on the current figures for inflation and the output gap. The more dire -7.5% figure is a prediction based on expected widening of the output gap and decrease in core inflation. Of course, what is most important is the Fed's estimate of the Taylor Rule. The FT suggested last month that the Fed's estimate was on the pessimistic side:
The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.
The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.
A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.
Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorised at the last meeting, which included $300bn of Treasury purchases.
The Fed chose not expand the program, however, the pause supported by those green shoots. I genuinely believe that Bernanke & Co. are concerned that the money they are pumping into the economy will light a fire they can't control, and thus from this point on will be much more cautious about the pace of easing. They will want confirmation of economic stagnation prior to an accelerated pace of bond purchases. And Wednesday's data was consistent with the stagnation story.
The retail sales report disappointed traders who were oddly optimistic about the condition of consumers. From the Wall Street Journal:
Sales at auto dealers ticked up. Excluding automobiles, retail sales were down 0.5% in April. The steepest declines were among sellers of big-ticket items, such as home-furnishing stores and appliance dealers, as households remain wary about major purchases.
People need food, people need electricity, but they don't need a brand-new piece of furniture right now so they just aren't buying," said Randy Weires, the sole employee working the 14,000-square-foot showroom of Carr's Furniture & Appliances in Old Town, Fla., a store his sister and her husband bought four years ago. Carr's is eliminating its appliance offerings -- including dishwashers, microwaves, and refrigerators -- because of weak demand and recently began selling used furniture alongside the pricier new options.
Funny how the market for $10,000 ovens disappears with the housing boom. Surprise - people are thinking that maybe this is too much to pay for a device primarily used to boil water. The simple fact is that the consumer is downshifting, with very real and long lasting implications for business behavior. One of the best examples of this came from Briggs and Stratton (NYSE:BGG):
Briggs & Stratton Corp., which supplies engines for mowers, tillers and tractors, recently noted consumers are shifting away from riding equipment to lower-horsepower equipment, a trend that holds implications not only for equipment makers but also the retailers, said Raymond James analyst Budd Bugatch. Higher horsepower riding equipment has a higher average selling price and margin "for everyone in the channel," he said.
Note the "everyone in the channel" quote. Consumer downgrading crushes profit margins across the board. And this is a problem that will not be easily fixed; as I argued earlier this week, households are likely to remain credit constrained despite the heroic efforts from the Fed.
A second disconcerting signal was the unchanged inventory to sales ratio for March, holding at a still too high 1.44 months despite a sharp fall in inventories. Green shoots aside, firms find it hard to match the pace of sales declines, which suggests that we need to be prepared for additional capacity reduction in the months ahead. This also suggests that while initial claims looks to have rolled over, the pace of layoffs will not drop precipitously. We should learn more on that this morning.
Finally, on the deflation watch, commodities are not seeing the economic turnaround suggests by the rapid run up in stocks, yesterday's setback notwithstanding. From the WSJ, steelworkers are protesting plant closings:
Although ArcelorMittal has already cut production in half and shut down plants and blast furnaces around the world -- including some iron ore operations idled Tuesday in Indiana -- it still makes more steel than customers need and expects global steel demand to sink by up to 20% this year.
Ironically, falling metal demand may be met with additional supply as emerging markets crank up production to keep workers employed. From Bloomberg:
China, the world’s largest aluminum producer, may have restarted as much as 1.4 million metric tons of capacity in April, according to an analyst at Aluminum Corp. of China Ltd.
The country may produce as much as 12.6 million tons of the metal this year, Ru Xiaojie, an analyst at the company’s Henan branch, said today in Beijing at a conference. Ru said after her speech that the analysis represented her own views.
Alcoa Inc., the largest U.S. aluminum producer, this week said there is still “significant oversupply” in the global market and restarts by Chinese smelters aren’t needed. Chinese smelters may resume output at too many smelters in April and May, which will depress prices, the China Nonferrous Metals Industry Association also said this week.
“Due to a quick restart of idled aluminum smelters in April, the demand for the raw material alumina has increased, leading to restarts of alumina refineries as well,” Ru said.
Aluminum futures in Shanghai rose 0.2 percent to 12,860 yuan a ton at 9:48 a.m. local time. Prices have rallied 12 percent this year after the government bought excess metal to support domestic producers.
The rally in copper is also proving difficult to maintain:
Copper prices fell for the fifth straight session in New York, the longest slump since December, after a report showed U.S. retail sales dropped unexpectedly in April.
The metal has tumbled 7.1 percent in five sessions on signs that a rebound in the global economy will be subdued. Retail sales declined 0.4 percent last month, following a 1.3 percent drop in March, the government said today. Economists forecast sales would be unchanged, according to the median of 67 estimates in a Bloomberg News survey.
The report “adds to the list of reasons why the recovery won’t be as strong as people had been expecting,” said Michael Pento, the chief economist at Delta Global Advisors Inc. in Holmdel, New Jersey. “I wouldn’t be surprised to see copper consolidate and head a bit lower.”
Finally, another Wall Street Journal article paints a dreary picture of the overall industrial sector:
U.S. railroad freight traffic is running about a fifth lower than a year ago. It is one of several less-obvious indicators that all isn't well, despite the financial-market rally since early March.
The slump in weekly rail traffic reflects sluggish industrial activity and consumption. Shipments of industrial products are down almost a third in the past year, while raw materials like coal, metals and crops also show steep drops. The pace of decline has picked up relative to the first quarter's 16% fall, according to Credit Suisse analyst Chris Ceraso.
In commodities, while crude oil and copper have been on a tear, prices for lumber and natural gas remain depressed. Lumber is exposed to construction and has been in a bear market since 2004, so it might be regarded as a special case. Still, there is little sign of a rebound.
Natural-gas prices, meanwhile, are perhaps half the marginal cost of production. Such weakness reflects a glut of natural gas, exacerbated by falling electricity demand, down 6% in March. That can't be put down merely to quiet building sites.
Note the pace of decline accelerating since the first quarter, again suggesting that the green shoots story has been overplayed. Some stability, yes. A slower rate of decline overall, likely. But enough to start looking for the next economic boom? No.
Where does this leave us? The Federal Reserve is caught; policymakers are warily watching the economy, worried that their liquidity injections will catch fire. On the other hand, they suspect that the economy will demand greater stimulus, if their estimates of the Taylor Rule are any guide. Caught, they want to remain flexible, and hence are unwilling to commit to numerical targets, either money growth or long rates.
Hard to blame them; for the last decade, excessive easing has always caused something seemingly good that was followed by something very bad. But with the output gap certain to widen, the bias will be on the side of additional easing, while the timing will be data dependent.
The green shoots story is looking a little tired today; a wide swath of indicators in the commodities market suggests that overall demand remains subdued. That will not stop a segment of market participants from playing up the green shoots story - they want to get ahead of the next big move. I remain wary that there is any room for an easy bounceback; I can't shake off memories of 2001-2003, and I don't see where we get another asset bubble in the U.S. to crank up the wealth engine.