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Ben Testifies, We Interpret
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Highlights include General Motors Corp. (GM - Analyst Report), Fannie Mae (FNM), Freddie Mac (FRE), Fifth Third Bancorp (FITB - Analyst Report) and Regions Financial (RF - Analyst Report).
Below is a long excerpt from Fed Chairman Ben Bernanke's prepared remarks for today's testimony before the joint economic committee. I intersperse my comments and interpretation between paragraphs.
Unlike his predecessor, Bernanke actually speaks in language that most people can understand. However, there are a number of things that deserve further explanation.
"The U.S. economy has contracted sharply since last autumn, with real gross domestic product (GDP) having dropped at an annual rate of more than 6 percent in the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of some 5 million payroll jobs over the past 15 months.
"The most recent information on the labor market -- the number of new and continuing claims for unemployment insurance through late April -- suggests that we are likely to see further sizable job losses and increased unemployment in coming months."
We would note that there is some tentative good news on the labor front in the form of the four-week moving average of new claims turning down. The news is not good enough yet to claim that the recession is over, but it is a hopeful sign.
It remains to be seen if the recent bankruptcy of Chrysler and the possible bankruptcy of General Motors (GM - Analyst Report) will result in the new claims number turning back up. New claims are released every Thursday morning -- it is a number that I will be watching very closely.
However, just because the rate of new claims declines that does not mean that the unemployment rate will follow. Continuing claims continue to soar, which indicates that while firms may be slightly slowing the rate that they are laying off workers, they have not started to hire. There is better than 50-50 chance that we see double-digit unemployment (U-3) before this is all over.
"However, the recent data also suggest that the pace of contraction may be slowing, and they include some tentative signs that final demand, especially demand by households, may be stabilizing. Consumer spending, which dropped sharply in the second half of last year, grew in the first quarter.
"In coming months, households' spending power will be boosted by the fiscal stimulus program, and we have seen some improvement in consumer sentiment. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market and the declines in equity and housing wealth that households have experienced over the past two years. In addition, credit conditions for consumers remain tight."
It is true that consumer spending was much stronger than expected in the first quarter. The stimulus program should help a bit going forward. Still, there is an intense need to rebuild the savings rate. That which is saved is by definition not spent. It is hard to save when you are out of work, have had your hours cut, or your pay cut.
The retirement nest eggs of the whole baby boomer generation have been devastated just as they approach the point where they will want to start to retire. I have my doubts about the sustainability of the higher consumer spending. Most of the strength in the first quarter was actually in January, and reflected in part, a very large cost of living increase in Social Security payments. That is unlikely to be repeated next year.
"The housing market, which has been in decline for three years, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes have firmed a bit recently, though both remain at depressed levels. Although some of the boost to sales in the market for existing homes is likely coming from foreclosure-related transactions, the increased affordability of homes appears to be contributing more broadly to the steadying in the demand for housing.
"In particular, the average interest rate on conforming 30-year fixed-rate mortgages has dropped almost 1-3/4 percentage points since August, to about 4.8 percent. With sales of new homes up a bit and starts of single-family homes little changed from January through March, builders are seeing the backlog of unsold new homes decline--a precondition for any recovery in homebuilding."
Increased sales activity does not mean that prices are likely to rise anytime soon. There is another huge wave of foreclosures going on right now due to the removal of foreclosure hiatus programs by Fannie Mae (FNM) and Freddie Mac (FRE) as well as some of the big banks. This means that there is still lots of distressed inventory in the pipeline.
Without a doubt, near record low interest rates have helped mitigate the situation. However the bigger effect has been in refinancing of existing mortgages. This is probably a significant factor in the stronger-than-expected consumer spending.
In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak. Spending for equipment and software fell at an annual rate of about 30 percent in both the fourth and first quarters, and the level of new orders remains below the level of shipments, suggesting further near-term softness in business equipment spending.
Recent business surveys have been a bit more positive, but surveyed firms are still reporting net declines in new orders and restrained capital spending plans. Our recent survey of bank loan officers reported further weakening of demand for commercial and industrial loans. The survey also showed that the net fraction of banks that tightened their business lending policies stayed elevated, although it has come down in the past two surveys.
Spending on equipment and software has collapsed for a very good reason -- namely that the existing capacity is not being used. Why should a company buy a new lathe when they have ten of them sitting and gathering dust on the shop floor?
Investment is always a much more volatile part of GDP than consumer or government spending. When it starts to go up, it could go up very significantly. However, I do not expect that to happen any time soon. At the very least, we need to see capacity utilization get back up over 75% from the current 69.3% before we start to see any real pick up on business spending on equipment and software. Even 75% is a level that has historically indicated a very deep recession. Normal is about 80%.
Conditions in the commercial real estate sector are poor. Vacancy rates for existing office, industrial, and retail properties have been rising, prices of these properties have been falling, and, consequently, the number of new projects in the pipeline has been shrinking.
Yes, Commercial Real Estate (CRE) will be the big negative story this year, just as Residential Real Estate was the big negative economic story last year. There are thousands of small/medium sized banks ($1 to $10 billion in assets) that are very over exposed to CRE.
As a result, the FDIC will be busy shutting down banks all year long, and well into 2010. When the stress tests come out I would expect that CRE will be a very significant issue and will probably end up requiring several of the regional banks in the tested 19, such as Fifth Third Bancorp (FITB - Analyst Report) and Regions Financial (RF - Analyst Report), to raise new capital, thus diluting the current shareholders.
CRE will also be a drag on the economy, causing the recovery -- when it comes -- to be anemic, due to lower spending on non-residential structures. Fortunately, CRE tends to be a lagging indicator of the overall economy. Better to have lagging sectors falling apart than leading sectors.
The Economic Outlook
We continue to expect economic activity to bottom out, then to turn up later this year. Key elements of this forecast are our assessments that the housing market is beginning to stabilize and that the sharp inventory liquidation that has been in progress will slow over the next few quarters.
Final demand should also be supported by fiscal and monetary stimulus. An important caveat is that our forecast assumes continuing gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment.
While inventories of homes -- both new and used -- have started to decline, they still remain far too high. The current wave of foreclosures has the potential to significantly increase the inventory of existing homes for sale again. There is no reason to expect that construction of new homes will pick up any time in the near future. While only new housing activity really directly adds to GDP, I would view any increase in housing starts as a medium-term negative to the economy.
There could be a bit of a rebound from other inventories. However, be careful in how it gets interpreted. Think about it this way: if a store usually sold 100 units per month and held 100 units in inventory, and then all of a sudden demand falls to 50 units, and stays there, then in the next month, they would have to drop their new orders to 0 from their previous 100.
In reality, they probably would not do that (not being certain that the new level of demand would stay at 50). They might say drop their new orders to 25 in the first month, and then 30 in the next month, and 35 the month after that until they finally got to the point where they were holding 50 units of inventory for their new stable level of 50 units sold per month. Yes, going from 25 to 35 would look like a sustained recovery, even if total end demand remained at 50 forever.
"Even after a recovery gets underway, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes."
This will not be a V shaped recovery. At best we are looking at a U, and there is a very real possibility that we are looking at an L. After both of the last two recessions, unemployment remained high (and even rose) for a very long time after the recession formally ended. That is likely to be the case this time around as well.
The "green shoots" that everyone has been talking about really mean that we are moving from the vertical portion of the U or the L, to the horizontal. They do not say if there will be a right-side vertical (forming the U), let alone when it will come.
"In this environment, we anticipate that inflation will remain low."
For the time being, deflation remains a much bigger threat than inflation. This is mostly because the velocity of money has slowed dramatically. Remember the monetary equation for GDP: Money x Velocity = Price x Quantity. V has plunged, resulting in both Price (inflation) and Quantity (production) going down. The Fed has been desperately fighting this by increasing M. It does this by expanding its balance sheet.
Historically, the Fed only had short term T-bills on the asset side of its balance sheet. This made it relatively easy to shrink the money supply by letting those bills roll off. Now not only do the Fed assets hold more credit risk, they are also have a much longer duration. By the end of the year, the Fed will own almost 25% of all the FNM/FRE backed paper in existence.
If the Fed has to drain money from the system because V picks up, it will have to actually sell those securities, dramatically driving up mortgage rates. So through 2010, the danger is deflation; longer term, inflation remains a very significant threat.
Below is a long excerpt from Fed Chairman Ben Bernanke's prepared remarks for today's testimony before the joint economic committee. I intersperse my comments and interpretation between paragraphs.
Unlike his predecessor, Bernanke actually speaks in language that most people can understand. However, there are a number of things that deserve further explanation.
"The U.S. economy has contracted sharply since last autumn, with real gross domestic product (GDP) having dropped at an annual rate of more than 6 percent in the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of some 5 million payroll jobs over the past 15 months.
"The most recent information on the labor market -- the number of new and continuing claims for unemployment insurance through late April -- suggests that we are likely to see further sizable job losses and increased unemployment in coming months."
We would note that there is some tentative good news on the labor front in the form of the four-week moving average of new claims turning down. The news is not good enough yet to claim that the recession is over, but it is a hopeful sign.
It remains to be seen if the recent bankruptcy of Chrysler and the possible bankruptcy of General Motors (GM - Analyst Report) will result in the new claims number turning back up. New claims are released every Thursday morning -- it is a number that I will be watching very closely.
However, just because the rate of new claims declines that does not mean that the unemployment rate will follow. Continuing claims continue to soar, which indicates that while firms may be slightly slowing the rate that they are laying off workers, they have not started to hire. There is better than 50-50 chance that we see double-digit unemployment (U-3) before this is all over.
"However, the recent data also suggest that the pace of contraction may be slowing, and they include some tentative signs that final demand, especially demand by households, may be stabilizing. Consumer spending, which dropped sharply in the second half of last year, grew in the first quarter.
"In coming months, households' spending power will be boosted by the fiscal stimulus program, and we have seen some improvement in consumer sentiment. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market and the declines in equity and housing wealth that households have experienced over the past two years. In addition, credit conditions for consumers remain tight."
It is true that consumer spending was much stronger than expected in the first quarter. The stimulus program should help a bit going forward. Still, there is an intense need to rebuild the savings rate. That which is saved is by definition not spent. It is hard to save when you are out of work, have had your hours cut, or your pay cut.
The retirement nest eggs of the whole baby boomer generation have been devastated just as they approach the point where they will want to start to retire. I have my doubts about the sustainability of the higher consumer spending. Most of the strength in the first quarter was actually in January, and reflected in part, a very large cost of living increase in Social Security payments. That is unlikely to be repeated next year.
"The housing market, which has been in decline for three years, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes have firmed a bit recently, though both remain at depressed levels. Although some of the boost to sales in the market for existing homes is likely coming from foreclosure-related transactions, the increased affordability of homes appears to be contributing more broadly to the steadying in the demand for housing.
"In particular, the average interest rate on conforming 30-year fixed-rate mortgages has dropped almost 1-3/4 percentage points since August, to about 4.8 percent. With sales of new homes up a bit and starts of single-family homes little changed from January through March, builders are seeing the backlog of unsold new homes decline--a precondition for any recovery in homebuilding."
Increased sales activity does not mean that prices are likely to rise anytime soon. There is another huge wave of foreclosures going on right now due to the removal of foreclosure hiatus programs by Fannie Mae (FNM) and Freddie Mac (FRE) as well as some of the big banks. This means that there is still lots of distressed inventory in the pipeline.
Without a doubt, near record low interest rates have helped mitigate the situation. However the bigger effect has been in refinancing of existing mortgages. This is probably a significant factor in the stronger-than-expected consumer spending.
In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak. Spending for equipment and software fell at an annual rate of about 30 percent in both the fourth and first quarters, and the level of new orders remains below the level of shipments, suggesting further near-term softness in business equipment spending.
Recent business surveys have been a bit more positive, but surveyed firms are still reporting net declines in new orders and restrained capital spending plans. Our recent survey of bank loan officers reported further weakening of demand for commercial and industrial loans. The survey also showed that the net fraction of banks that tightened their business lending policies stayed elevated, although it has come down in the past two surveys.
Spending on equipment and software has collapsed for a very good reason -- namely that the existing capacity is not being used. Why should a company buy a new lathe when they have ten of them sitting and gathering dust on the shop floor?
Investment is always a much more volatile part of GDP than consumer or government spending. When it starts to go up, it could go up very significantly. However, I do not expect that to happen any time soon. At the very least, we need to see capacity utilization get back up over 75% from the current 69.3% before we start to see any real pick up on business spending on equipment and software. Even 75% is a level that has historically indicated a very deep recession. Normal is about 80%.
Conditions in the commercial real estate sector are poor. Vacancy rates for existing office, industrial, and retail properties have been rising, prices of these properties have been falling, and, consequently, the number of new projects in the pipeline has been shrinking.
Yes, Commercial Real Estate (CRE) will be the big negative story this year, just as Residential Real Estate was the big negative economic story last year. There are thousands of small/medium sized banks ($1 to $10 billion in assets) that are very over exposed to CRE.
As a result, the FDIC will be busy shutting down banks all year long, and well into 2010. When the stress tests come out I would expect that CRE will be a very significant issue and will probably end up requiring several of the regional banks in the tested 19, such as Fifth Third Bancorp (FITB - Analyst Report) and Regions Financial (RF - Analyst Report), to raise new capital, thus diluting the current shareholders.
CRE will also be a drag on the economy, causing the recovery -- when it comes -- to be anemic, due to lower spending on non-residential structures. Fortunately, CRE tends to be a lagging indicator of the overall economy. Better to have lagging sectors falling apart than leading sectors.
The Economic Outlook
We continue to expect economic activity to bottom out, then to turn up later this year. Key elements of this forecast are our assessments that the housing market is beginning to stabilize and that the sharp inventory liquidation that has been in progress will slow over the next few quarters.
Final demand should also be supported by fiscal and monetary stimulus. An important caveat is that our forecast assumes continuing gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment.
While inventories of homes -- both new and used -- have started to decline, they still remain far too high. The current wave of foreclosures has the potential to significantly increase the inventory of existing homes for sale again. There is no reason to expect that construction of new homes will pick up any time in the near future. While only new housing activity really directly adds to GDP, I would view any increase in housing starts as a medium-term negative to the economy.
There could be a bit of a rebound from other inventories. However, be careful in how it gets interpreted. Think about it this way: if a store usually sold 100 units per month and held 100 units in inventory, and then all of a sudden demand falls to 50 units, and stays there, then in the next month, they would have to drop their new orders to 0 from their previous 100.
In reality, they probably would not do that (not being certain that the new level of demand would stay at 50). They might say drop their new orders to 25 in the first month, and then 30 in the next month, and 35 the month after that until they finally got to the point where they were holding 50 units of inventory for their new stable level of 50 units sold per month. Yes, going from 25 to 35 would look like a sustained recovery, even if total end demand remained at 50 forever.
"Even after a recovery gets underway, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes."
This will not be a V shaped recovery. At best we are looking at a U, and there is a very real possibility that we are looking at an L. After both of the last two recessions, unemployment remained high (and even rose) for a very long time after the recession formally ended. That is likely to be the case this time around as well.
The "green shoots" that everyone has been talking about really mean that we are moving from the vertical portion of the U or the L, to the horizontal. They do not say if there will be a right-side vertical (forming the U), let alone when it will come.
"In this environment, we anticipate that inflation will remain low."
For the time being, deflation remains a much bigger threat than inflation. This is mostly because the velocity of money has slowed dramatically. Remember the monetary equation for GDP: Money x Velocity = Price x Quantity. V has plunged, resulting in both Price (inflation) and Quantity (production) going down. The Fed has been desperately fighting this by increasing M. It does this by expanding its balance sheet.
Historically, the Fed only had short term T-bills on the asset side of its balance sheet. This made it relatively easy to shrink the money supply by letting those bills roll off. Now not only do the Fed assets hold more credit risk, they are also have a much longer duration. By the end of the year, the Fed will own almost 25% of all the FNM/FRE backed paper in existence.
If the Fed has to drain money from the system because V picks up, it will have to actually sell those securities, dramatically driving up mortgage rates. So through 2010, the danger is deflation; longer term, inflation remains a very significant threat.
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