More Than Just Fluff!

Submitted by Leo Kolivakis, publisher of Pension Pulse.

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.

Comments

[illyia]

Leo. Riddle me this: Who is buying all those "manufacturing is up" items? Not counting discounted laptops.

CNBC was suggesting that perhaps high-end goods? Walmart is guiding lower... Businesses are hording cash. January spending down conpared to December?

Who is buying all that stuff? Military?

Heard from a longshoreman that ports are shipping our scrap metal to China? Exports...

Just trying to square...

Thanks, i.

[Anonymous]

http://www.nytimes.com/imagepages/2009/07/31/business/20090801_CHARTS_GR... - your fist instinct appears right.

[Anonymous]

brickwall: leo! nice to meet you