Thursday, February 18, 2010

More Than Just Fluff!

What a hockey game between Team Canada and Switzerland. The Swiss really played well and it went into overtime, and then a shootout where our star, Sidney Crosby, scored the game winner.

If we play like that against the Russians, they're going to have us for lunch. Hockey is a game of momentum and when the tide shifts, you could find yourself in an awkward spot very quickly.

This brings me to tonight's topic. At 4:30 this afternoon, I received the now famous release from the Federal Reserve:

The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.

Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19.

In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. Primary credit is provided by Reserve Banks on a fully secured basis to depository institutions that are in generally sound condition as a backup source of funds. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010.

Easing the terms of primary credit was one of the Federal Reserve's first responses to the financial crisis. On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC's target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days. On December 12, 2007, the Federal Reserve created the TAF to further improve the access of depository institutions to term funding. On March 16, 2008, the Federal Reserve lowered the spread of the primary credit rate over the target federal funds rate to 1/4 percentage point and extended the maximum maturity of primary credit loans to 90 days.

Subsequently, in response to improving conditions in wholesale funding markets, on June 25, 2009, the Federal Reserve initiated a gradual reduction in TAF auction sizes. As announced on November 17, 2009, and implemented on January 14, 2010, the Federal Reserve began the process of normalizing the terms on primary credit by reducing the typical maximum maturity to 28 days.

The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC's 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds. The Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread.

So why is the Fed removing liquidity? What does this mean for the bond, stock, currency and commodities markets? Everyone is wondering whether this the seismic shift that will jolt markets?

Relax. All the Fed is doing so far is removing excess liquidity that was in place in light of extraordinary circumstances. The Fed did not do this to support the greenback since the US dollar was already rallying prior to this move, no doubt helped by the troubles in Europe.

To understand why the Fed is beginning to tighten, all you have to do is look at the recovery that is going on right now in the United States. First, the Conference Board Leading Economic Index (LEI) for the U.S. increased 0.3 percent in January, following a 1.2 percent gain in December, and a 1.1 percent rise in November:

Says Ataman Ozyildirim, Economist at The Conference Board: "The U.S. LEI has risen steadily for nearly a year, led by an improvement in financial markets and a manufacturing upturn. Consumer expectations and housing permits have also contributed to these gains over this period, but to a lesser extent — especially in recent months. Current economic conditions, as measured by The Conference Board Coincident Economic Index (CEI), have also improved modestly since July 2009, helped by strengthening industrial production, despite continued weakness in employment."

Adds Ken Goldstein, Economist at The Conference Board: "The cumulative change in the U.S. LEI over the past six months has been a strong 9.8 percent, annualized. This signals continued economic recovery at least through the spring."

Second, U.S. industrial production jumped 0.9% in January signaling an economic recovery:

Industrial production in the U.S. climbed more than expected in January, marking a sustained economic rebound for manufacturing, utilities and mining.

Factories increased production of consumer goods and business equipment, highlighting advances in all major component indexes.

“Manufacturing in general has looked good over the last several months,” said Russell Price, senior economist with Ameriprise Financial Inc. in Detroit. “Even though inventories remain tight, new orders continue to improve, and the sector in general looks very positive.”

The 0.9 percent increase follows a 0.7 percent gain in December, according to a Federal Reserve report released Wednesday. Manufacturing rose 1 percent, while mining and utilities both climbed 0.7 percent.

The increase beat expectations - economists polled by Bloomberg predicted a 0.7 percent jump.

The capacity utilization rate, a measurement of industrial capacity and how much of it is being used, rose 0.7 percentage points to 72.6 percent, which is still well below its 80.6 percent average from 1972 to 2009.

The industrial production index, which is seasonally adjusted, is expressed as a percentage of output relative to a base year. The current base year is 2002 and equals 100. In January, the index was at 101.1, meaning the economy has only just surpassed its level of industrial production from almost eight years ago.

January output was 0.9 percent above its year-earlier level of 100.1.

Industrial production is a key determiner of the gross domestic product, and therefore closely monitored by the Federal Reserve when setting monetary policy.

And it's not just manufacturing that's looking good. A couple of weeks ago, Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada, wrote that the U.S. recovery is more than just fluff. Importantly, I quote the following:

As it turns out, surprisingly, real output in the service sector, the heavy-weight component of the U.S. economy (66%), is no longer in recovery mode but clearly already in expansion mode! As Chart 3 clearly shows, in the United States, real activity in this sector is already up 1.7% relative to its level at onset of recession.


The overall picture, then, is relatively simple. Service output is expanding, activity in the goods sector is recovering rapidly, and construction remains the weak link by far. However, this last sector accounts for less than 10% of activity.

In that weekly, Yanick also mentioned that U.S. monetary policy is too accommodating:

The Federal Reserve’s real key rate stands at about -200 basis points. If we factor in the expansion of the central bank’s balance sheet, we sink to about -500 basis points, the same depth in the accommodating zone as in 1975 (blue star in Chart 14). And everyone remembers what happened next back then. Inflation literally ran away, forcing the Federal Reserve to raise its key rate to a record high, which in turn caused the recession of 1982.

On the basis of our measure of the output gap, which is much closer to the situation that prevailed during the 1991 recession, not because the downturn was less severe this time but rather because of the unusual occurrence of capacity destruction in the economy, monetary policy in the United States seems overly accommodating right now.

Under the circumstances, the recovery under way in the U.S. economy should spur the Federal Reserve to action early in the second half of 2010, that is, sometime around August.

Other forecasters predicting no rate hikes before 2011 are assuming that potential GDP was not affected during the crisis and that its growth will remain strong going forward. With credit set to flow less freely in future, we do not regard this as the most likely of assumptions.

Last week, Marco Lettieri , another economist at the National Bank of Canada, followed up with a weekly stating that U.S. inflation dynamics suggest policy is too accommodative and concluded by stating:

Though we do not expect inflation to escalate out of control, it would be wise to be forward looking and keep inflation expectations in check. The current environment no longer warrants zero-percent interest rates to allow the economy to grow and labour conditions to improve. In our opinion, inflation may surprise on the upside, especially as the U.S. economy tones up through the first half of 2010, revitalized by increased business investment and an improving labour market. We continue to expect the FOMC to begin normalizing interest rates at its meeting of August 2010.

You can keep up-to-date with the latest from the National Bank of Canada's economic research team by going to their site. In my opinion, they are among the best economists out there, always looking forward, not backward.

So while the markets might react negatively to the Fed's latest move, please keep in mind that policy is still way too accommodating. This means that dips in stocks will continue to be bought and there is still a strong likelihood that speculative bubbles will percolate up in certain sectors (my money is in alternative energy).

Forget what the bears and skeptics claim. The U.S. recovery is more than just fluff.

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