Quick Take on FOMC Minutes: Letting the Hawks Have Their Day, Raising Downside Risks

When does the Fed first tighten? We will know the answer by September. By that time the economy will have worked through enough of the current downside risks listed in the most interesting addition to the minutes. To the extent that the recovery is still intact by the fall we could very well see the first steps towards removing monetary accommodation in the fourth quarter. The more interesting question will be whether the Chairman has the support to do something if those downside risks cause the recovery to falter, and what that something would be.

The minutes contain what is, by now, the rather standard argument between the hawks and doves on inflation risk in a high unemployment economy. To me, the more important addition to the minutes is the much broader view on the potential for downside in the economy in the second half of the year:

“While rising energy prices posed an upside risk to the inflation forecast, they also posed a downside risk to economic growth. Although most participants continued to see the risks to their outlooks for economic growth as being broadly balanced, a number now judged those risks to be tilted to the downside. These downside risks included a larger-than-expected drag on household and business spending from higher energy prices, continued fiscal strains in Europe, larger-than anticipated effects from supply disruptions in the aftermath of the disaster in Japan, continuing fiscal adjustments at all levels of government in the United States, financial disruptions that would be associated with a failure to increase the federal debt limit, and the possibility that the economic weakness in the first quarter was signaling less underlying momentum going forward.”

I believe that this view is shared by Bernanke, Dudley and Yellen.

The hawks have the upper hand right now in driving Fed policy; the Chairman, Dudley, and Yellen will have their day again if the economy falters as they fear it will. It seems to me that there is no other rational political way for the Chairman to play his hand.

The “Great Stall” In Action

Looking at the 64,000 private sector jobs created in September, after accounting for the usual 24,000 in health care, the rest were either in temporary business services or at restaurants (which is kind of temporary work as well). Thankfully people who are employed still like to eat out.

Against all this, local government employment contracts -- a sure sign of federal stimulus money falling away. There was also the announcement of a 300,000 jobs takeaway from the total because of benchmark revisions that go in effect in February. This essentially removes the net add from the BLS's broken birth/death adjustment

Here we are after nine consecutive months of growth in private sector jobs and the broad U-6 unemployment rate sits at 17.0% compared with 17.3% when the year began. Total private payrolls are just shy of 108 million -- the last time payrolls were this low, prior to the current recession, was March 1999. A decade of employment gains wiped out and at the current pace it will take another decade to get back to the pre-recession peak at 115.6 million. On the good news front, the tenure of long-term unemployment has been shrinking since May.

Unknown healthcare and tax costs are having a negative impact but not nearly as much as the lack of demand growth from any important sector of the economy. The policy plan now is to boost exports through a depreciated dollar with quantitative ease offsetting any rise in interest rates related to foreign debt holders wanting a higher yield to compensate for the loss on holding dollars.

The “Great Stall” Opens Volatility Season for Stocks

The “Great Recession” didn’t give way to the “Great Depression” – rather it transformed itself into the “Great Stall”. The July ISM data underscored the current circumstance with reported declines in net new orders in the manufacturing and non-manufacturing sectors. It is hard to interpret the ADP reported increase of 42k jobs in July as heralding an upswing in employment, especially when it contains a drop of 21k jobs at goods-producing firms and a decline of 6k jobs at manufacturing firms. Unemployment claims for the week of July 31st are out this morning and have again surprised to the upside. Recognition of sustained low growth, plus the rising risk of deflation inherent with a stalled economy having substantial resource slack, will hit the equity market precisely when the volatility season begins and reaches its peak in October.

Fed Officially Between "Rock" and "Hard Place"

The FOMC is officially worried about growth and deflation risk and they are at the ready to act if need be. Financial conditions have become “less supportive of economic growth” but don’t believe for a minute that the reason rests on ”developments abroad” -- the economic recovery is now “proceeding” rather than “continued to strengthen” while everything aside from business spending is either weak or depressed. The shift of the phrase regarding the “moderate pace of recovery” from starting the sentence about the Fed’s anticipation of a gradual return to full employment in the context of price stability to the end of the sentence and then starting the sentence with “Nonetheless” speaks volumes – in Fedspeak. More surprising was adding that “underlying inflation has trended lower” before their standard line about substantial slack and restrained cost pressures. The Fed is telling us that deflation risk is now on the table.

To underscore their concern about deflation and lower growth, the ”monitor the outlook” phrase was broken out into a separate paragraph. As for Hoenig’s dissent, it had to stay considering that its removal would’ve signaled that the Fed lurched to one step from pressing the panic button.

The FOMC is now confronted with limits of monetary policy when rates are zero. The banking system is stuffed with cash but the liquidity is sitting in reserves at the Fed essentially against legacy assets of too many bad loans and broken securities. The cash isn’t there to lend out—banks haven’t even taken down as many Treasury securities relative to total bank credit as they normally do at this point in the cycle. Nonfinanical corporations are also sitting on a mountain of cash, but it matches a mountain of long-term debt raised to put cash in the coffers and lower the volume of short-term obligations—and net worth is still well below the pre-recession peak. At some point, the corporate cash will go into hopefully productive capital investments, but the opportunities aren’t there yet.

The Fed is officially between the “rock” and the “hard place”

Consumers Drop the Baton

Retail sales are not as negative as the headline, but they were also never as positive as April’s headline. Core retail sales, sales without spending for autos, building materials and gasoline, was up 0.10% in May after falling 0.22% in April. Discretionary retail sales, purchases of items people don’t have to buy, fell 0.05% in May after falling 0.26% in April. Positive and negative volatility in several spending categories can be tied to the boom in house buying in April. Bottom line, consumers only spend when they have to and they don’t spend much -- spending is not the recreational activity it was prior to the recession. Unemployment is still at extraordinary high levels, there is no equity to take out of homes, and the stock market has proven of late to be an unsteady source of wealth to fund purchases. This economy is still a long way from consumers picking up the growth baton from manufacturers. And manufacturers are facing renewed headwinds of their own, thanks to the cheapening of European exports into Asia. Second half GDP growth is not going to surprise to the upside.

May Employment -- This Is What a Deleveraging Economy Looks Like

It is time to stop searching for the right letter to describe the recovery. It isn’t a V and it won’t be a W, it is a hyphen – flat, low growth indicative of an economy in the process of deleveraging. There is no other interpretation for an add of only 41,000 private jobs plus the downward revision to the April jobs numbers. The median number of weeks out of work climbed to record 23 weeks and of those unemployed 46% have been out of work for more than 26 weeks. And the data from Labor is that much more suspect – in the worst recession since the 1930s the birth/death add in the 12 months ending in May added 427,000 jobs against a reported decline of 831,000 jobs. Without the adjustment the number of jobs lost would have been 51% bigger. The percent of firms surveyed that are hiring plus one-half of those standing still dropped to 54.1% from 66.7% last month. Judging from still elevated jobless claims, the slowdown in new job listings posted on the internet, and the fading impact of government stimulus, it is difficult to see how job growth strengthens from here in a politically acceptable time frame to the levels that cut into unemployment.

Home and Equity Valuations -- Nowhere to Go But Sideways

By focusing on the monthly bounces in the housing data one risks missing the bigger point – the two main assets supporting household balance sheets and, by extension, the global economy at large, have nowhere to go but sideways. Equities and homes are priced to a level that can be appraised as fair or expensive, depending on one’s view point, but neither can realistically be called cheap.When the equity bubble popped in 2000 the economy could weather the collapse because a housing bubble could replace it. A “bubble-swap” followed by "double-burst" occurred in the late 1970s, when the culprit was a deep recession followed by soaring price inflation followed by a deeper recession. Today there is no potential for unlocking domestic equity valuations as there was in 1982. As for housing, it took 20 years before the real dollar volume of existing home sales cracked the high of the late 1970s. The potential for global growth is locked up in the Asian trade surplus. Once that spending power is unleashed on the world real economic recovery can begin. Until then, governments can only buy time by swapping leverage for leverage. Majestic Research