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Market Weak as Fed Votes Against Tightening

Here is a sampling of what the Fed has had to say recently.

At their June policy meeting the Fed lowered their outlook for the economy and some members expressed concern about the risk of deflation. When Fed chief Bernanke delivered his semi-annual policy report to Congress he said that the policymakers “recognize that the economy remains unusually uncertain”; a circumstance that is very unfriendly to future investment. St. Louis Fed boss Bullard wrote a paper in which he opined that “the US is closer to a Japanese-style outcome today than at any time in recent history.”

The following is a recap of some recent economic data.

The ISM Manufacturing Index has fallen three months in a row. The New Orders component of this index is down a dozen points the last two months and is now at its lowest level in a year. New Orders for Durable Goods has fallen two month in a row, so too have Retail Sales. In July the Consumer Sentiment Index from the University of Michigan fell to a calendar year low, it was one of the biggest monthly declines in its history and was the largest one month fall since the Lehman debacle in the fall of 2008 and as way of explanation, the smallest proportion of consumers in the sixty year history of this report anticipate an increase in their income in the year ahead. Despite record fiscal stimulus and monetary accommodation the Core Consumer Price Index remains below one percent at a fifty year low. And, finally, according to the Household Survey, Employment has fallen for three months in a row, a total of 495k; in July 570k Full-Time workers were either fired or reduced to Part-Time; and the Rate remains under ten percent only because of the combination of the biggest three month decline on record in the Civilian Labor Force and the biggest ever three month increase in the Not in Labor Force category, not employed but not counted as unemployed. The Establishment Survey might tell a better story, but a three month average private sector payroll gain of 51k is down more than 100k from the previous period and even if you add up the entire 2010 private sector jobs increase it would still fall short of erasing the losses seen in five individual months during the recession.

Hmmm, let’s see; the Fed thinks the future path of the economy is suspect and the latest data seem to support that view. Just knowing that, my guess is that when the Fed meets this week they are going vote against tightening. I think that is a reasonable conclusion to make.
Circumstances are such that in order not to tighten the Fed will have to vote not to tighten. That because inaction by the Fed on reinvesting the proceeds from its maturing and pre-paid Mortgage Backed Securities (MBS) portfolio is a de facto tightening, to do nothing will in essence be a drain of cash out of the system. As the Wall Street Journal explained in an article last week, “The issue: whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead…Moving to stop the Fed’s portfolio from shrinking would prevent monetary policy from slightly tightening in the face of a weakening recovery.”
As Bernanke explained in a recent appearance, before the release of the WSJ article I quoted above, “Currently, repayments of principal from agency debt and MBS are not being reinvested, allowing the holdings of those securities to run off as the repayments are received.” In contrast, the Fed’s Treasury holdings do get reinvested into similar maturities of US government paper, in part because there is no desire to shrink this portion of their holdings.
In early summer 2007 the Fed held $790 billion worth of securities, all of them Treasuries and most of those relatively short-term. The latest Fed statement shows that they now have more than $2 trillion worth of securities on their books; $777 billion Treasuries and more than one trillion mortgage backed securities. Buying MBS was seen as a necessary evil, not a purchase the Fed would contemplate in a perfect world and not something they want to invest in for the long term. But, as you can see, the amount of Treasuries on the Fed’s books is not abnormal. It should be noted that the duration of the maturities on their book is longer now than it was before the financial crisis began a few years ago and they may at some point, said Bernanke, try to adjust down the duration of the government securities; rolling the MBS proceeds into short term Treasuries would be one way of maintaining the accommodation while readjusting the Treasury portfolio to a more desirable average maturity. Even policy hawk Charles Plosser of the Philly Fed can agree to the strategy, says the WSJ , “But Mr. Plosser said he was open to reinvesting proceeds from maturing mortgage bonds into Treasury securities. Part of the appeal of such a move is that the Fed in the long-run wants its portfolio to be in Treasury bonds and not mortgage debt, and this would move it in that direction.”
I think all parties concerned can agree this is one of those tricky periods for the economy, one that has a more than a faint echo of another such time. “There is the general fear which many people entertain that excess reserves of the present magnitude must sooner or later set in motion inflationary forces which, if not dealt with before they get strongly under way, may prove impossible to control,” sad a Fed staff memorandum in December 1935. This nagging possibility could not be shaken even though the labor market remained moribund. In July 1936 the Fed decided to increase bank reserve requirements, a move that they insisted in their announcement was not tightening, “the easy money policy remains unchanged and will be continued…” They followed up with a similar two step plan in early 1937 that was to be completed on May 1 of that year. “Following a wave of criticisms, Chairman Eccles issued a statement on March 16, 1937 to clarify his reasoning,” writes Athanasios Orphanides in his paper Monetary Policy in Deflation: the Liquidity Trap in History and Practice. Chairman Eccles statement said, “I wish to correct erroneous interpretations which have been circulated with reference to my position on credit and monetary policies. I have been and still am an advocate of an easy money policy and expect to continue to be an advocate of such a policy so long as there are large numbers of people who are unable to find employment in private industry, which means that the full productive capacity of the nation is not being fully utilized. …An ample supply of funds at reasonable rates exists and will exist after the increased reserve requirements take full effect on May 1.” As Orphanides tells it in his paper, “On May 1, 1937, the final leg of the tightening was completed. With that in place, excess reserves fell back to levels as low as had not been seen since several years earlier. May 1937 also marked the peak of the incomplete expansion from the Great Depression of 1929-1932. The economy promptly returned to recession.”
History may not always repeat itself, but it can rhyme. In any other words, if the Fed does not vote against tightening they will indeed be tightening and I don’t know if that is exactly what they want to be doing at this tricky moment for the economy.
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