The Fed's True Dilemma

ISSUE: The Fed’s True Dilemma – GDP today showed a severe drop in inventories.  And everyone knows about the inventory cycle; NEC head Larry Summers was just talking about it this past weekend. The severe inventory drop is one of the first events that has alerted a widespread audience (instead of a few technical observers) to the idea that although the cycle correction still is severe, the economy could be closing in on an end game for recession. Summers, himself, has vaguely spoken of this recession as going on for the unspecified period of ‘some time.’ So far there is little talk of the potential for a STRONG economic recovery yet this severe drop in inventories certainly raises that specter. Several Fed observers have said that history shows us that the challenge for a central bank is to NOT TAKE AWAY THE STIMULUS TOO SOON. 

Yet, in this cycle in the midst of the crisis the Fed was being assailed for not having an exit strategy. Recessions are about strong cyclical forces that play one way then shift to the other. Yet a number of structural issues have been at work in this recession that has had (1) an ongoing housing crisis, (2) a financial crisis, (3) booming and busting oil prices, (4) severe damage to consumers’ wealth via housing, jobs and the stock market decline. These strong structural issues are still in play and are not fully remedied. 

Yet, the economy appears poised for a sharp increase in growth once the recession part plays out as the inventory figures hint. There is a huge stimulus program that is just beginning to uncoil. Plus there is the usual cyclical rule: Severe recessions promote strong recoveries. The question is how the Fed will react to that if it happens? Will it be pressured by monetarists to pull back on the stimulus? Will the Fed pull it back too soon? If it does react to the cyclical forces what of the still remaining structural imbalances? When the strong cyclical rebound that is an economic recovery plays out, will the economy be able to sustain expansion if the Fed begins to dismantle its help programs and raise rates? These issues make up the Fed’s true dilemma.    

Stressing out

Isn’t it interesting that when everything was fine but about to tailspin out of control no one was worried?  But now that conditions are not-so-good the authorities, in a effort to ‘appease’ our fears, have embarked on a course of action playing the game ‘what if”…What if ‘what’ you ask? Well what if, ’things get even worse?’

 

Isn’t that an encouraging game to play? And how many of us really want banks to beef up even more capital just as the economy is preparing to bottom? Whose money will they do this with?  

 

Sure regional banks may still get worse. Banks with traditional mortgage loans did not have to mark them to market if those loans were ‘threatened’ were still performing. But securitized mortgages at money center banks and held by securities firms were being marked lower based on actual events as well as speculation. Now with those onerous and pro-cyclical accounting rules (mark-to-market) out of the way, the threat of securitized security mark downs is lessened but small banks may run into the buzz saw of reality.

 

In part this is a warning that business cycles send out ripples of bad events that hit some sooner and some later. It is not necessarily a sign of worsening in the cycle if regional banks begin to accrue losses on their loan and mortgage portfolios. It is just part of the current cycle playing itself out. 

 

So, what’s the point? I am unsure of the role that stress tests are supposed to play. Are they supposed reassure us that banks are okay even under much worse conditions? Are they supposed to motivate banks to raise more capital? If so, how does that wok? Telling a bank it is as good as insolvent is not usually a good way to attract suitors, unless by that you mean the M&A crowd. Is that the idea? Is it to push banks and their shareholder/bondholders to cut new deals they would not be willing to cut absent the push near the precipice from the Fed’s? Is this the ‘GM strategy’ applied to banks?

 

Enquiring minds want to know…

 

You have heard my rant on stress tests before. If banks have securities they cannot evaluate now, how do they evaluate them under hypothetical and worsened situations? That part of it does not even make sense. It is not just voodoo economics, it is illogic in action and the brain child of Tim Geithner.   

 

So let’s wait for, then read, these stress test results with real open minds about what they are, what they did, and they have as their objective. It is far from clear what role they are playing and whose purpose they serve. Be careful about getting too reassured by the results. 

Timmy Rocks the Markets

Markets rallied as Tim Geithner testified. Not the sort of result you'd expect. Tim's record with markets has not been good. 

But the gain puts yesterday's sell-off in sharper relief. Sure earnings have been bad but today's earnings reports were bad too. Stock prices are going up today. Geithner did say something nice about bank capital today. But it was hardly an overarching statement about all banks. We know that some banks have enough/too much capital. But who are they? How many are there? Who is capital short? No word on them.

Markets rallied because they had sold off so much yesterday on bad earnings news as well as on fear of what Tim might have said today. 

I didn't really think that Tim said very much. But that 's the point. Today was the dog that didn't bark.

It's not the end of the recovery. Stocks are not falling off the face of the earth. They just had a really bad day after a series of really good weeks. I'd say the weeks still have it, if 'it' is the trend.  

We have been exploring trends in bank and market lending in various past cycles and we still do not see anything in this cycle that that says that the transition to recovery is in danger. That TARP banks may not be bastions for strong consumer lending -as the WSJ graphic showed on Monday of this week --should not be surprising. But when you plug a hole in a bucket you hope it will not lose the water that is in it rather than to hold more than it has. Tarp lending is a process and since it is occuring in a recession we must remember that the trend for lending growth in an ordinary recession is down not up. If TARP keeps lending from falling faster, or further,  that might be enough. 

The TARP is hard to evaluate. So far we'd call it a success, but it might turn out to be an expensive success.

As Bad As It Gets?

More and more analysts are coming over to our position which is that the worst of recession is behind us and that recovery lies not far ahead.

That bull stock market rally in a bear market is looking more like a real bull. Still, cowboys don't seem to want to ride it. Skepticism abounds. But hope is gaining on it. 

Banks are still fragile and I do not write off their risk. But I am less concerned with the Fed on the job and with so many lending facilities in place. It's a patch-work quilt, but it's a warm one. So the banking sector improvement is good news,even if it is not uniform. Some banks may be exaggerating their health. Others are just bristling to get Uncle Sam off their balance sheet so they can write big bonus checks again. But with all the government help out there, including debt guarantees, I think some banks are just a bit too quick to repay TARP funds, a bit too greedy, a bit too much like old times, and still flirting with too-big-to-fail issues. Bankers need to lean some humility.

For all its brain power Wall Street still does not seem to get it.  The rush to get back to their check books could be their undoing. I wonder if anyone else wonders about those protesters with the pink banner and dollar signs on it?  How did they crash these  high level meetings so easily? Wasn't it convenient for Goldman Sachs that wants to repay its TARP to have 'protesters' on the stage railing for their money back when this is exactly what Goldman wanted to do ever since the worst of  the storm passed? Am I the only one who wonders about that?  

Jobless claims have dropped sharply but in a holiday-shortened week. The data are seasonally adjusted- the day count is not the issue-  but the adjustment is hard to do. Easter is an especially vexing holiday because it  is not fixed on the calendar, being a creature of the lunar calendar, not the Gregorian. So you get many more different Easters than say Christmases. There is already some suspicion that Easter and the cold weather combined to supress retail sales. 

But it is jobless claims that are the most intersting since claims usually spike and peak out close to the end of recession. The average count after a claims peak to the end of recession is eight weeks.  We are already making that count since the large drop in claims makes it look like the peak came two weeks ago. Relly? Six to go for recovery? Could be... 

   

Good Bank/Bad Retailer

It's a variation on theme. I'm tired of good bank/bad bank.

Good cop/bad cop

Good dog/bad dog

and so on...

Oh the Wells Fargo earnings are a comin' down the street...

Wells Fargo led the way to the promised land of huge earnings quite unexpectedly. Earlier this quarter Citibank and a number of others said they were making money - and not with printing presses; that's the Fed's job. Hey 0-0.25% interest rates from the Fed are good for something. 

Bank earnings- from red ink to red herring?

Still, in the wake of this change on the accounting rules according to St Mark we still have to ponder this: good asset/bad asset?  One can only wonder how much -if any- of the Wells Fargo loans are in the money due to our friend Mr Mark-to-market being sent off to his room? Some? Any? None? Inquiring minds would like to know. Since no one reports all of us can guess... markets did their usual schtick by buying the rumor of better results, we'll see what happens when the facts are released. 

Good Fed/Great Fed!

Low rates have prompted a spurt in refinancing. The California market has jumped to life but much of the sales improvement is on foreclosures and house prices have dropped more sharply in the West as a region than anywhere else. Hard to imagine that sort of thing 'helped' bank profits because you have to write-off the foreclosed property before you can mortgage it and collect the fee. I was a bit suspicious of Wells when I saw the press release say there had been a reduction in the number of loans that Wells deemed to be unrecoverable. Was that mark to market at work or the step-up in foreclosures or something else? Once we know more we can assess this notion of better earnings with greater certainty. 

Good consumer/bad consumer

Meanwhile, retailers are stepping back from the good start in early 2009 this month to tend to their wounds. Wal-Mart was disappointed with a 1.4% SSS gain while Saks Fifth Ave, took the fifth then drank it, over its 23.4% drop in sales. Target's SS sales dropped by 6.3% almost grounds for a celebration toast compared to Saks. .

Good Easter/Bad Easter

So retailing is still on the rocks and blaming Easter. Easter is one of those migratory holidays that is lunar in nature and so does not meld well with our Gregorian calendar. It's timing appears as well, looney. As a rule Easter meanders all over the calendar and retailers always seem to find it a problem. 

Good Car Sales/Bad Store Sales

This year with a very troubled consumer, retailing is more of an issue than usual. We sure hope Easter is a mere hiatus for the consumer. Retail sales should not be too bad since the vehicle sales will keep things up for the overall total. But we are not out of the woods and for now I'd rather see Good Retailer/Bad Bank since the former can help to pull the latter out of trouble. But a good bank or better bank, as far as earnings go, won't do a thing to bring people into retailing establishments.  I don't want banks to crumble and we do need them to improve but the consumer is the key to recovery, make no mistake about it. 

Good stocks/bad stocks

At least the pop in bank stocks helped to get the stock market up. That's a continuing breath of fresh air that will help to stir the debate. Good stock market or bad stock market? Bull market or rally-in-a-bear market? By the time the pessimists are won over it will be time to sell again. 

  

  

SDRs for China - Does it even make sense?

China's protestations to dump the dollar in favor something else, are entirely without guile.  It’s not simply a financial problem because the US runs deficits nor is it just that China’s huge claims on the US are now in jeopardy of exploding into a valuless puddle, like Monte Python's Mr Creosote who eats one 'wafer-thin mint' too many. It's China wanting to flex is muscle. But China does not seem to have an idea where to flex or what to flex. It has no idea that it just might have become muscle-bound, with its own muscles getting in the way of what it really wants to achieve.

Indeed, China's desire to accumulate wealth and its desire to generate a strong export engine of grwoth have undermined each other as was inevitable. 

Tough Nuggies China, and others.

It was CHINA’s decision to pursue a course of export-led growth… and Japan’s and Korea’s and Germany’s and…so on. So with all that stuff flying around the world, where does it land? What does this huge surplus in motion imply for everybody else? Oh yeah, the reserve currency makes it all balance, doesn't it?  So the US gets the goods, the current account deficit and they get the reserve accumulation. What happens when that accumulation is too much? Fiddle dee dee, a problem for another day. 

Too many too-large countries with polices of export-led growth,  combined with the IMF’s failure to play the role as any kind of FX cop -- those are the ingredients that got us here. If you like it was also market failure – failure by markets that simply assumed they had the price right or that there was an end game to China's export/reserve accumulation gambit.  Markets were ‘cool’ with what was going on. Lots of Fx reserves in China, Japan, Taiwan, OPEC countries- no sweat. The sweat came later. 

It was wrong to conclude that complacency over the growing size of fx reserves and arbitrary fx pricing (by China) was equilibrium. It was wrong to think anything good was coming of all those trade patterns and stubborn deficits and surpluses.  At the very least since China’s FX rate is pegged (crawling peg) there should have been no welfare considerations attached to its trade and no applicability of WTO rules to protect China's interests since China is/was price-fixing at the macro-economic level. Any basic economic STUDENT should be able to see that. But international economics is so much more about international politics… And what you allow you also must sanction, at least for appearances. So China's policy got implicit back-door approval. 

When this sort of TRADE DEPENDENCY happens what else happens? 

China did not set out to accumulate FX reserves as much as it set out to have export led growth. The reserves were a by-product,and for a while, an enjoyable one. If China wanted to it could have tried to develop its domestic demand. But it did not do this. It is very disingenuous of China to turn on its own policy and it’s the ramifications it should have been able to see and to blame the US and blame the dollar. Where its policies would lead, to reserve accumulation and to a tangled web of extraction, was a pretty clear bet. For the past several years it has been made even clearer, but China had no plan 'B'. Instead, it is easier to blame the US for China's failed polices.  

As the principal reserve unit, the US really had no control of these events. 

What did CHINA think would happen after it accumulated $2trln or $3trln or $10trln THEN decided it had enough?  This sort of policy shift is a bit like Mr Madoff and his Ponzi scheme. Madoff claimed in court that he knew’ this day would come…’ as it surely would. And so would/has China’s. The transition from export led growth and its transformation to something else is hard to achieve, time consuming, and disruptive.  Actually China probably did see it coming, but it needed to grow so fast and absorb the upwardly mobile workers so it did not want to take the time or effort to retool its focus. It took the path of least resistance.  

Now China and other exporters are caught in the natural trap of the business cycle. I have no sympathy for countries that pursue aggressive trade expansion then cry FOUL and PROTECTIONISM when demand overseas collapses and they suffer the consequences. What else could they suffer?   

I have recently looked at the ratio of imports to GDP and their behavior in this cycle for the US and for a batch of EMU countries and found – interestingly- that the ratios had not fallen so much in recession – not a record drop certainly. The drop off in imports (other countries’ exports) is mainly due to the drop in GDP in importing countries. EVEN IN THE US that is true. The drop in imports relative to US GDP is not that large (i.e. it’s the drops in GDP that have been large and the drops in imports that have moved 'in tandem.'). Of course let’s remember here that import elasticities are greater than ‘unity’ in value. So when GDP drops, imports (others’ exports) drop by more (in percentage terms) as matter of statistical regularity. So if you live off that upside (in good times exports grow faster than GDP) you suffer that ‘exaggerated’ downside in a period of decline- nothing WTO can do about that…

Interestingly, US imports of trucks and cars are UP in unit terms in Q1 even though domestic unit sales are off at a 28% annual rate. Is that ‘protectionism’? No.

IT'S THE REAL THING...  

Everyone talks as if what is happening is all financial related but it's not IT”S REAL- its real sector stuff that is the real conundrum. The financial sector has merely been too accommodating, well, until it wasn't. 

Of course we have to finance our real imbalances. And the imbalances are the real problem, not the financing vehicle, though it plays a role. The idea that switching global monetary policy out of the dollar while these real sector imbalances stay in place is so much Fantasy Land, Disney could open a new theme park based on the idea. Call it CHINA LAND! 

I could go on but I’ll stop here. You get the idea. I think this is a much richer place to go to look for answers about what is going on in the world economy. SDRs are a red herring. If ‘we’ (El Mundo) go off the dollar standard who will run the deficits to permit ‘everyone else’ to have export led growth?  How does a shift to SDRs help that? 

It doesn't.

So what is China really after with its SDR talk? It is simply looking for a way to take US prestige down a notch. It's all about politics and power and trying to get even after something goes wrong. Saving face. It's very Asian.

Anticipation...what is still true

Still true after this week...

It is still an out look for growth, more than continued recession.

It is still an economy that seems to have its worst times behind it.

It is still true that revisions keep making the past seem worse.

But it is still true that the past is worse than today.

And that is the good part that is still true - despite all the bad news.

Conundrum

As to recovery, it is still true that most economists expect a weak recovery.

But it is still true that such an outlook is poorly grounded in economic history and logic.

Something new?

One question is this: do we think that this cycle is driven by the usual cyclical forces or do we think that some structural change has rendered the economy different, making the last two recoveries so feeble and impacting this one as well? If so what are those new forces?

Maybe not...

I don't think any such new set of forces exists to justify current pessimism on growth. I think instead that the last two recessions were very different slow-motion recessions that we can understand in a conventional framework of analysis. It is not so much that they were less destructive, because they did a lot of damage in the labor market but much of that damage was done in the name of 'recovery'. These two recent recessions are a good example of what economists warn of when they talk about the cost of being 'out of equilibrium' and debate about getting adjustment over quickly or not. The recessions in 1990 and 2001 were not severe in terms of the peak to rough declines in GDP or the intra-recession job loss. But the recessions were stretched out in another way. Even though the formal recession periods themselves were not so long or severe the recovery periods were the Post War period. Because the recession did not have the cleansing sharp drop in activity, the forces to build momentum in recovery consolidated more slowly, effectively pushing some of the disequilibria -no longer called 'recession' - into the recovery period.

Stylized Factoid:

In recessions, where the cleansing power of the recession is strong, recession ends clearly and it marshals the forces of recovery more quickly.

The wrong precedents

In the last two recessions, economic growth in the first four quarters of recovery posted growth rates of only 2% to 3%. In the previous recoveries since 1957 first year growth in a recovery ranged from 6.1% to 9.5% with the exception of the 'weak' recovery of 4.5% growth in the 1970 recovery period. These recovery periods are in no way similar to the ones of the past two cycles and neither were their respective recessions similar.

Job growth as a cycle discriminator...

One main difference we can identify is the loss of jobs. In the typical recession job loss is severe declining by 2% to 4% to a cycle low that comes right near the end of recession in a compressed period of 12 months or less ( yes, even tough some recessions last longer, severe job losses are back-loaded). In the 1990 recession jobs did fall nearly 2% to their trough but it took them 17 months to make that 'small' drop and the low point came well into recovery. In 2001 the cycle's drop for jobs was only about 1% and that took about 17 months to reach its low point as well. GDP began to grow in both of those periods before the job drop played out causing the NBER to say that the recession had ended and leaving us with these weak-looking recoveries after recessions that were less than brutal. That does not make them a new paradigm.

What job growth says Vs what economists forecast

Not surprisingly, the weakest recessions with the greatest, fastest job loss, spawned recoveries with the strongest and most vigorous job gains. This recession is the worst in post war history its job losses are the worst even in percentage terms. So accordingly we should expect job growth in the recovery period to be much improved compared tot eh last two recoveries along with income growth and GDP growth. Yet that is not the consensus view in this cycle.

Why?

The bleak view

To be in the low profile-slow growth camp for recovery you need a reason. Many are pointing to a weak stock market or impaired consumer balance sheet or weak home prices or sagging foreign growth or some other long run factor as the likely retardant - but those just do not cut it. Those factors will eventually come into play determining the sustainability of growth after recovery is achieved. But recovery itself is about the business cycle itself and its peculiar dynamics of jobs lost; jobs gained, of income lost; income gained and, of confidence lost; confidence regained. Those forces are classic and they are beginning to turn up, as should the economy in a more traditional fashion. These cyclical forces overpower any of the structural issues named above. Structural issues will become more important after the forces of recovery are spent. At that time the economy will find a more hostile environment. I think economists are wrong to put these sorts of issues ahead of the power of the known business cycle with forces which promise to be so strong and which history has shown are coiled for action.

Recession/recovery in this cycle

It is still true that recessions with the worst job growth are followed by recoveries with the best job growth. That job growth puts income growth back on track quicker and helps to fuel strong GDP growth in recovery. So why look for weak recovery in this cycle? I think a lot about recession is misunderstood. And this time there is a political dynamic. We have a new president who wants a more interventionist government. To get that you need an economy that is floundering not one set for a strong recovery. We also have some special financial sector problems that have encouraged a bleaker view of economic prospects. To be sure special actions to bolster the financial sector were needed and will continue to be needed, but with them the prospect for a strong 'normal' recovery is improved.

Optimism defended

For me it is the sheer cycle force of recession that dominates all other trends. Models don't predict recession period results well or track their dynamics well. So don't expect macro simulations to produce results. But you can still see that there are clear patterns of behavior common to most cycles. I still think cycle-forces, not structural forces, are what are driving this recession. Cyclical forces drove oil prices higher, and turned the consumer over. Lehman's failure had widespread shock impact for about four months, adding to the slide. But the economy is beginning to mend itself. The initial shock from Lehman has passed and oil prices have largely unwound their gains. When the economy turns the corner it will be on two wheels and growth will ramp up as it has in the past cycles at the end of severe recessions. Everything we know about business cycle dynamics points to such a result. Even in 1982 with all sorts of banking sector problems the economy was able to muster a strong recovery as traditional recovery forces overpowered banking sector weakness. Now with mark to market rules neutered, the banks have an opportunity to reset sights on longer term goals as they did in 1982 and 1983. That will be important in getting lending going in recovery. It may also help banks to participate in the PPIP and remove some of their questionable assets from their balance sheets. With the backstopping of the Fed and Treasury the recovery path still looks even more likely --- and more likely to be solid.