October is becoming my lost month. Between the beginning of Fall term and my annual conference in Portland, the month is a blur, and time to blog becomes a luxury. Now, however, I can see the light at the end of the tunnel. And we can also see the light at the end of the tunnel after this long recession, with a GDP report that confirms what everyone thought - the economy turned the corner in the third quarter of this year. Policymakers undoubtedly breathed a sigh of relief, and rightly so. That said, it is far too early for complacency; I found the underlying details less than comforting, especially in comparison to Wall Street's ebullient reaction to the data.

That the recession would end was never in doubt. Indeed, the timing is almost exactly what one would have expected given the steep declines in spending in the first half of 2008 that triggered the flood of job losses later in the year. Spending, consumer spending most importantly, would not fall indefinitely, especially with the benefit of significantly lower energy costs beginning in the second half of last year. Moreover, as the Wall Street Journal notes, rebuilding household balance sheets is not accomplished by just increased savings; a default can do the job much more quickly, quickly adding to household cash flow. Indeed, I admit to being surprised that strategic defaults are not much higher.

As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation. To be sure, Bernanke & Co. have shifted direction often during the past two years. But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high.

Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:

A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.

The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

Simon Johnson at the Baseline Scenario has a nice piece bemoaning the US pursuit of a rebalancing agenda at the upcoming G20 meeting. I largely agree with Johnson's tone. Something that sounds nice, but to which no parties, particularly China and the US, can make a credible commitment. It is, however, keeping some poor staffer at the US Treasury busy 24-7. Johnson's third point, however, misses some important points:

Where is the evidence that this kind of “imbalance” had even a tangential effect on the build up of vulnerabilities that led to the global financial crisis of 2008-09? I understand the theoretical argument that current account imbalances could play a role in a US-based/dollar crisis, but remember: interest rates were low 2002-2006 because of Alan Greenspan (who controlled short-term dollar interest rates); the international capital flows that sought out crazy investments came from Western Europe, which was not a significant net exporter of capital (i.e., a balanced current account is consistent with destabilizing gross flows of capital); and the crisis, when it came, was associated with appreciation – not depreciation – of the dollar.

The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.

Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:

As Calculated Risk noted, the commentary on the August Consumer Sentiment number from the University of Michigan ran along the generally positive tone echoed by the Wall Street Journal:

Main Street is beginning to feel some relief, though, according to the Reuters/University of Michigan preliminary reading of consumer sentiment for September, released Friday.

I was somewhat distressed this morning when I realized that, with the absence of Brad Setser, I would have to do my own analysis of the trade data - data Brad taught me how to analyze over a decade ago. I may be a little rusty.

The good news in the data was the widely touted revival of global trade, an indication of economic healing. The bad news in the data was the return of an old enemy, a pattern of unbalanced trade. To be sure, I would not focus too intently on a single data point, but the July numbers raise the possibility that the external sector will weigh on US GDP growth in the third quarter. That, of course, is the price to be paid for attempting to revive growth via household spending as a portion of that spending flows overseas in the form of increased imports.

It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and the Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issue by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From a policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?

The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmanufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month.

Data flow continues to support those who argue that if the recession is not already over as of July, it soon will be. The July jobs report - while not exactly cheery news for those still losing their jobs - is another clear indicator that the employment picture is turning. Still, excitement over the end of the recession aside, the data also reveal that the economy is recovering in fits and starts, with tell-tale signals that the consumer orgy of this decade is not likely to be repeated.

The July employment report in many ways spoke for itself. Possibly most important is the clear improvement in the pace of job losses:

Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic underwriting conditions). But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Seriously, a rate hike in this environment? Or anytime before the end of 2009? At the moment, I just can't see it happening. That said, long rates are higher, and inflation expectations in some corners of the market are rising. What is going on? My explanation for recent market action revolves around three themes:

1.) Financial Armageddon appears to have been avoided - at least for the moment. The "all but explicit" implicit guarantee that no significant US financial institution will be allowed to fail established a return to financial stability. And with that stability comes an end to the flight to safety that buoyed Treasury prices. Something off a conundrum for Treasury Secretary Timothy Geithner - cheap financing of the staggering US deficit appears to be dependent on financial instability.

At the moment, the economic dynamic is exceedingly complicated. An understatement, I fear. The crosscurrents in the data and the markets are treacherous, and I suspect will have Fed officials scratching their heads. Hold steady with existing plans? Step up the liquidity provisions? More actively engage plans to tighten policy? The latter option seems almost inconceivable; for the moment, the debate will focus on the issue of further easing. At this point, I think the Fed will sit tight, allowing further easing to come from the already active TALF program, rather than expanding outright purchases of Treasuries.

The core issue is the steep rise in Treasury yields, which apparently were kept in check only by the expectation that the Fed would continued to gobble up the endless stream of securities issues by the US Treasury. The Fed sank that hypothesis at the last FOMC meeting, and a subsequent statement by Federal Reserve Chairman Ben Bernanke made clear that the Fed does not have a 3% target on 10 year Treasury yields. Since then, yields have climbed as high as 3.75% before prices rebounded Thursday, bringing yields down to 3.61%. Should we be concerned with the gains?

Is the economy turning a corner? And, if so, which corner is it turning?

In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. Hence why the risk remains that Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

The Fed took an interesting risk by holding policy steady on Wednesday. With green shoots all the rage, policymakers are ready to step to the sidelines as they monitor the progress of their many programs. And clearly, they must have known that the 3% level on 10-year Treasuries was dependent on the expectation that policymakers would expand the pace of outright purchases of those assets, but are betting that economic conditions will remain sufficiently weak to prevent a crippling increase in rates.

Still, given that policymakers continue to see the economy in decline, albeit at a slower rate, the odds favor additional easing in the months ahead, especially considering expectations of a widening output gap. Recall that labor markets, and the threat of deflation, kept the Fed easing well past the end of the recession in 2001.

Mark Thoma directs us to a Washington Post article detailing the slow start-up of the Federal Reserve's much discussed but little used TALF program. At this juncture, a critical constraint appears to be counterparty risk - no one trusts the US government to hold parties to their contractual obligations:

Sources involved in the program said private investors have been reluctant to work with the government, which they view as an unreliable business partner. ... There are restrictions on the business activities of participants in the program. ... But perhaps more significant ... is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. ...

Mark Thoma directs us to a Washington Post article detailing the slow start-up of the Federal Reserve's much discussed but little used TALF program. At this juncture, a critical constraint appears to be counterparty risk - no one trusts the US government to hold parties to their contractual obligations:

Sources involved in the program said private investors have been reluctant to work with the government, which they view as an unreliable business partner. ... There are restrictions on the business activities of participants in the program. ... But perhaps more significant ... is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. ...