Friday, July 30, 2010

Three Key Points About the GDP Data

This is not meant to be an exhaustive line-by-line analysis of today's GDP report but rather intended to highlight some key pieces of useful information contained in it.

1) Today's report included revisions going back to 2007 and the new data show that the recession was deeper than previously estimated, particularly in 2008.

While overall GDP growth between Q4 2006 and Q1 2010 has now been revised down to +0.2% from +0.4% previously estimated, the contraction in 2008 -on a Q4 to Q4 basis- has now been revised to double from the original number (-2.8% now vs. a -1.9% initially).

Compounding the picture of an even deeper recession than assumed earlier, personal spending fell by twice as much (-1.2%) as the previous estimate for 2009, with a much sharper decline taking place in the first half of last year than the original number had suggested.

2) Although the Q2 2010 GDP number came in slightly on the low side (at 2.4% annual rate) of the market consensus, the sharp upward revision to the Q1 number to 3.7% from 2.7% initially reported translates into a 3.1% growth rate in the first half of the year. While far from impressive, it validates the premise that despite the distinct unevenness and at times disappointing tone of the various data, the economy is on a 3% to 3 1/4% growth path. We would not assign any particular significance with ominous overtones to the slower pace of growth in Q2, as this is the normal course of quarterly fluctuations in such data.

Source: Bloomberg. Haver Analytics

3) In fact, two specific elements in the Q2 data should be viewed as moderately constructive. a) Capital spending surged 17%, following a 7.8% increase in Q1. This shows a robust comeback of capital spending, following devastating declines in the 2007-2009 period, making that sector one of the key engines of growth in the current phase. b) Despite the intense uneasiness over the failure of labor markets to improve at a faster pace so far, personal consumption held up at an acceptable 1.6% rate of growth vs. 1.9% in Q1. While still unimpressive, it does indicate that there is still a core rate of spending (largely reflecting pent up demand from the "dark" for the economy period of 2008-09), that, despite the high unemployment rate, provides a moderate base that continues to support the recovery moving forward.

In a nutshell, there is little in today's data that can be used to fuel fears of a double-dip, a scenario we have been deeply skeptical of in this column. While it is true that the recovery remains on an unimpressive trajectory, it is still moving ahead, with a natural change in the composition of growth, as is to be expected for this phase of the cycle (less contribution to growth from inventories, but with capital spending slowly puking up the baton).

Anthony Karydakis

Monday, July 26, 2010

A Practical Guide to this Week's Economic Releases

With the much criticized, but hardly surprising, results of European bank stress tests out of the way, the U.S. Treasury market's attention has already turned to this week's three coupon auctions and a barrage of scheduled economic releases.

Among the various economic reports on this week's calendar, certain of them occupy a more prominent role, as they have the potential to provide fresh insights into the state of economic activity at the turn of the quarter.

Although generally (and appropriately so), the Consumer Confidence/Sentiment indicators are considered as "soft" data in that they reflect psychology rather than actual activity, the July reading of the Conference Board's Consumer Confidence Index (Tuesday) is a little more meaningful than usual. The series showed a particularly sharp decline of nearly 10 points to 52.9 in June and the consensus seems to be looking for an additional modest drop in July. However, given the sheer magnitude of June's decline, and given that the index had also stood at more elevated 57.7 in May, the potential exists for a moderate rebound from July's level to the mid-50s area. This is not an unreasonable expectation, in view of an overall more resilient stock market this month, one of the factors- besides perceptions of labor market conditions- that tend to influence the confidence surveys.


Durable goods orders, a key but often hopelessly volatile measure of momentum in the manufacturing sector, fell 0.6% in May but is expected to rise modestly (around 1%) in June, boosted by a rebound in the transportation component and, specifically, aircraft orders for the month. If ex-transportation orders manage to eke out a gain in June, that would be fairly significant in that this will be following a 1.6% gain in such orders in May. Given some uneasiness created by an unexpectedly lower ISM reading in June, back-to-back gains in the ex-transportation durable goods orders should help restore confidence in the underlying momentum of the manufacturing sector.

It is for the same reason that Friday's Chicago PMI should be viewed as the third key economic release of the week. The series was relatively little changed in June at 59.1 vs. 59.7 in the prior month, not retreating by nearly as much as the national ISM. The consensus seems to be that the Chicago PMI will catch up with the cooling reflected in last month's ISM and retreat by an additional 2 to 3 points to the 56-57 range in July. While the broader premise of a modest interim downshifting in manufacturing activity in the midst of a waning inventory cycle is reasonable, a decline of the magnitude expected by the consensus in July is far from assured. In fact, if the Chicago PMI holds up in the vicinity of its June level, this would trigger a nearly automatic upward revision to expectations about next Monday's July ISM (currently expected to edge lower to 55 from 56.2 in June).

The Q2 GDP data on Friday are unlikely to be materially important to the market, as they will reflect the distinct softening in economic activity that had already become apparent in the partial data for the quarter and which has already been largely discounted. The directionless behavior of initial unemployment claims, and their distinctly choppy pattern in the last few weeks due to anomalies in the normal seasonal shutdown of auto plants, both have delegated the series to a second-row seat in terms of significance for the time being and this is unlikely to change with this week's number- almost irrespective of what the number actually is. It is hard to imagine the Q2 Employment Cost Index on Friday becoming any one's real focus, given that wage and price pressures are broadly viewed as a non-issue in the current environment. Finally, Friday's Reuters/University of Michigan Consumer Sentiment index for the entire month of July is likely to represent a simple, inconsequential, fine-tuning to its early-month reading of 66.5...

...and, of course, this morning's 24% jump in June's new home sales is not particularly telling of anything either, as it represents only a partial rebound from a disastrous 36.7% cratering of such sales in May.

All in all, the first three reports we identified above (Consumer Confidence, Durable Goods Orders, Chicago PMI) as standing out in this week's crowded calendar have the potential to paint a picture of a somewhat more resilient than generally assumed economic recovery, following a string of at times very disappointing data in the last several weeks.

Anthony Karydakis

Thursday, July 22, 2010

Mr. Bernanke In a Bind...(and a footnote on Europe)

Mr. Bernanke's testimony before the Senate Banking Committee yesterday has already received an abundant amount of coverage, both in the media and among market professionals- so, there is not much particularly insightful that can be added at this point.

Still, his comments with regard to a specific topic during his testimony merit a few special observations, as they also relate directly to the heart of an article we published in this space a few days ago (

During the Q&A, the Fed Chairman was asked by Senator Jim Bunning (R, Kentucky) whether the Fed is "out of bullets" to use in order to help strengthen the underwhelming economic recovery. His reply was "Well, I don't think so. We need to continue to evaluate those options. As I said, we are not prepared to take any specific steps in the near term, particularly since we're still also evaluating the recovery, the strength of the recovery. But I do think that there is some potential for some of those steps to be effective" (italics added for emphasis).

His triple-qualified answer can hardly be viewed as an expression of confidence in the Fed's ability to actually do much at this point. Gone are the days where he was vigorously emphasizing the Fed's nearly unlimited arsenal of policy-making tools, including the infamous metaphor about helicopters throwing money into the economy from the sky- already done, and it has not worked.

Mr. Bernanke proceeded to enumerate some of those options (paying less interest on bank reserves, bolstering the Fed's language committing to keep rates low for an extended period, not allowing maturing securities to run off of its balance sheet, or embark on more asset purchases), while adding conspicuously that "...they are not going to be conventional options, so we need to look at them carefully and make sure we are comfortable with any step that we take".

While the true effectiveness of some of these measures can be called into question outright (see the first of the above links to our recent article), all of them do include considerable risks for the Fed, which make these options even less appealing on a cost-effective basis. For example, if the Fed were to engage in another round of asset purchases- massive enough to have any perceptible effect, to the tune of 30-40 basis points on market rates- it would create enormously bigger complications for its ultimate exit strategy, as it would then require the absorption of a much bigger amount of liquidity than what is currently the case. Or, it would reflect a certain degree of disconnect from the reality on the ground to argue that the Fed's elimination of the interest rate it now pays banks on their excess reserves (25 basis points) would have an effect on bank lending standards and/or economic activity; bank lending standards are not so tight because there is not enough liquidity in the system. In fact, the banking system is already swimming in reserves.

The truth is that Mr. Bernanke has probably run out of credible options to activate in order to help the economy, and this was the subtext to his highly cautious answer to that question during his testimony yesterday. Any of the remaining options are of questionable effectiveness, fraught with more risks than any potential benefit they offer.

The Fed Chairman, understandably, could not acknowledge that in public. However, his appreciation of the bind the Fed is in makes it rather unlikely that the Fed will proceed with the implementation of any such additional "stimulative" measures. If the economic recovery remains stuck on a 3% path over the net few quarters, the pressure on the Fed will be building to show that it is taking some action to alleviate the stubbornly high unemployment rate. Our guess is that Bernanke will be inclined to resist the activation of such additional steps of mostly cosmetic value and will simply prescribe patience for the economic recovery's dynamic to pick up steam over time.

For now, one thing is almost certain: that the "extended period" language is safe over the coming months.

(A brief note on Europe)
Two key economic reports coming out of Europe this morning surprised with their vigor and raise some questions about the widely anticipated slowing in economic activity there due to the fiscal austerity situation.

Eurozone's industrial orders surged 3.8% (month-to-month) in May, following a 0.6% gain in April. In the three-month period to May, orders are up 8.5% versus an increase of 5.8% in the three-month period to April. ( To alleviate any skepticism that this report was for May, and therefore less relevant to the period immediately following the peak of the fiscal crisis in the spring, the Eurozone's July manufacturing PMI rose to 56.5 from 55.6 in June. The service sector PMI for the bloc also rose in July to 56.0 from 55.5 in June. The strength in both PMIs for July was particularly pronounced in the data for Germany.

It may admittedly be too soon for any slowing in economic activity in Europe, as a result of the fiscal austerity policies in place, to be reflected in the July data yet. However, what these reports show is that two months after the peak of the fiscal turmoil that shook the Eurozone countries, economic growth in the bloc still has respectable forward momentum that may withstand better than originally assumed by many the fiscal policy headwinds.

Anthony Karydakis

Tuesday, July 20, 2010

Some Silver Lining in the Housing Starts Data

The 5% decline in June's housing starts to 549,000, from a downward revised drop of 14.9% in the prior month, is a stark reminder of the still dismal state of the residential construction sector. By way of a quick comparison, starts were running in the vicinity of 1 million units in the first half of 2008 and over 2 million at the peak of the housing market in 2005.

Source: U.S. Census Bureau

In recent months, the 8,000 tax credit-induced pick-up in existing and new home sales had created the perception that the housing sector might be turning the corner. That impression was based on the blurring of the distinction between starts and sales, particularly since the latter was driven by an admittedly transient factor. The strengthening in the demand for purchases of homes since last fall mostly led to a decline in the previously massive inventory of both new and existing homes but not to a meaningful pick up in construction For housing starts to embark on an even moderate upswing from their depressed levels, it would require a reasonable degree of confidence by the construction industry that the stronger demand for housing is here to stay. We are not at that point yet.

In the meantime, starts remain trapped withing a 500,000 to 650,000 range, which, while plain dismal per se, at least indicates that the market is forming a bottom- which is, of course, by no means tantamount to a turnaround. The perception of the housing starts series forming a bottom also received some cautious support today from a 2.1% rise in building permits, although that was driven by a 20% spike in the noisy multi-family category.

A final note.

Inasmuch as a simple stabilization of housing starts at these historically very low levels is nothing to cheer about, it does imply a waning drag on GDP growth ahead and has been an instrumental factor allowing the current economic recovery to unfold so far.

Residential construction itself (without counting the adverse effect of a collapsing sector on traditional consumer spending on household-related items) subtracted one full percentage point from growth in both 2007 and 2008, and 0.7 percent last year on the whole (it did have a moderate contribution to growth in the second half of the year, which was no match for the big drag it represented in the prior two quarters). While it took out a modest less than 0.3% from growth in Q1 2010, it should be roughly neutral in the balance of the year, removing a key headwind to the halting economic recovery.

Anthony Karydakis

Thursday, July 15, 2010

The Fed Is Not Omnipotent

The softening tone of the economic data in recent weeks has turned the spotlight to the issue of what additional action the Fed may need to take to provide new fuel to the underwhelming economic recovery. This emerging debate was also highlighted in yesterday's front page Wall Street Journal article (
as well as in the release of the minutes of the June 22-23 FOMC meeting (

Although the Fed's conclusion at the late June meeting was that no additional measures were deemed necessary at that point, the ongoing weakness in the economic data- showcased again in this morning's disappointing Philly Fed and Empire Fed manufacturing surveys for July- is likely to keep the debate alive and probably intensify it.

A discussion as to what further action the Fed can take to reinvigorate the recovery is understandable but based on the premise that monetary policy-making does indeed have the power, or leeway, to achieve that goal in the current environment. With the federal funds rate close to zero and an enormous amount of liquidity slashing around in the the financial system, this is not so obvious.

The Fed has seemingly exhausted the array of the most potent tools it possesses to promote economic growth, that is short-term rates and quantitative easing. In fact the entire structure of interest rates remains extremely growth-friendly, with not only Treasury yields near record-lows but also with credit spreads at historically tight levels. The economic recovery's inability to inspire great confidence, nearly a year after its onset, is not the result of market yields that are not low enough or the financial system having inadequate liquidity. It is mostly the result of a lengthy healing process following a devastating financial crisis and recession that is preventing the low interest rates and abundant liquidity from having a more textbook-like stimulative effect on economic activity.

It would simply not be credible to argue that the Fed's facilitating of another 7 to 10 basis points decline in the federal funds rate form its recent 17 to 20 basis point average would have any effect on the economy at this point. Similarly, injecting more liquidity via the resurrection of some of the special temporary liquidity facilities that were put in place after the Lehman affair and were winded down by the beginning of this year would do nothing to promote economic activity, as those facilities were largely meant to stabilize a financial system on the brink of collapse and offset a disastrous liquidity squeeze in the aftermath of Lehman. The financial system is currently swimming in liquidity and it is far from clear that the doubling of the LIBOR rate since the beginning of the year is an issue that can be addressed with more liquidity injection by the Fed via such temporary facilities.

Against this backdrop the only possible remaining course of action for the Fed would be the resumption of the Fed's program of asset purchases, which ended in March. The objective would presumably be to help bring market yields lower, both in the Treasury and MBS markets, which would help provide a boost to the economic recovery. Appealing as this avenue may appear at first, a less impulsive, facts-based, examination of its implications raises some caution flags.

The Fed's staff has reportedly conducted some studies showing that the central bank's asset purchase program- which has led to an increase in its balance sheet by $1.5 trillion today compared to before the financial crisis- may have lowered market yield by as much as 50 basis points. The precision of those studies usually leaving a lot to be desired, and given that a 50 basis point estimate was presented as an upper limit, it is probably more realistic to assume that the effect of the Fed's asset purchases on long term yields has been somewhat smaller.

Both long-term Treasury yields and mortgage rates are lower today compared to the prevailing ones at the time when Treasury purchases and MBS purchases by the Fed ended (in October 2009 and March 2010 respectively). In the meantime, the momentum of the economic recovery has slowed. Arguing that the Fed's possible resumption of an asset purchases program could engineer another 20 to 30 basis point decline in yields that would prove to be materially helpful to economic activity is a highly questionable proposition. Besides, the idea of the Fed embarking on another massive program of asset purchases that would increase its portfolio by another $500 to $800 billion suffers from a cost-effectiveness problem. Such an additional increase in the Fed's balance sheet would complicate enormously further the Fed's ultimate exit strategy, given the bigger amount of liquidity to be absorbed at that time.

If the pace of the economic recovery slows to a disconcerting degree ahead, the Fed may be under extreme pressure to show that it is responding by taking some action and perhaps resume some asset purchases. In reality, though, the economic recovery is not suffering from interest rates that are not low enough or from a banking system that is not liquid enough and this calls into question the true effectiveness of any such action. Inasmuch as the Fed is often perceived as powerful enough to manipulate economic growth at will, the effectiveness of monetary policy is seriously compromised in the midst of circumstances like the current ones. Japan has already found that out.

Anthony Karydakis

Wednesday, July 14, 2010

Retail Sales+Trade Deficit=Lower Q2 GDP

The widening of the May trade deficit by $2.0 billion to $42.3 billion yesterday (both in nominal and real terms- the latter being the key to GDP calculations) and the somewhat disappointing retail sales for June this morning, both point to an appreciably lower Q2 GDP than previously expected.

As a result of the May trade deficit number, net exports are now expected to be a bigger drag on Q2 growth than previously thought, probably to the tune of $50 billion, subtracting more than 1 1/2 percentage point from GDP. This would be almost double the 0.83 percent net exports had subtracted from Q1 GDP growth.

In terms of the June retail sales, overall sales fell 0.5%, largely due to a 2.3% decline in vehicle sales. Excluding autos, sales were off by a more modest 0.1%. The part of the retail sales report that is most directly relevant to GDP calculations- that is, total sales less autos/gas station/building materials- was up 0.2% for the month, following a 0.1% decline in May.
These numbers are consistent with personal consumption in the 2 1/4-2 1/2% range in the second quarter, below the first quarter's 3.0% annual rate.

The net-net of these two reports is that Q2 GDP growth now looks more like a 2.5% proposition, with the pace of inventory accumulation remaining the wild card, given the limited inventory data available to date. Such a pace of growth would follow a twice-downward revised 2.7% Q1 GDP, confirming the disappointing failure of the recovery to pick up any momentum in the spring months from an already unimpressive first quarter.

Still, moving forward, a gradual- albeit, frustratingly slow- acceleration in employment growth should help sustain an improvement in income growth and consumption in the second half of the year, that would lead to a rebalancing of the growth trajectory to the 3.0-3.5% range. In fact, the seeds of this likely trend were evident in the May trade deficit data, as well in the ongoing deterioration of the international trade picture in recent months, as imports rose by a healthy 2.9%, reflecting the unfolding strengthening in consumer spending.

Anthony Karydakis

Monday, July 12, 2010

The Questionable Premise of the TIPS Market

Since the height of the sovereign debt turmoil that rocked Europe in mid-May, inflation-indexed Treasury securities (TIPS) have underperformed nominal Treasuries by a wide margin. As a result, the yield spread between the latter and TIPS for 10-year maturities (breakeven) has narrowed by about 50 basis points from its average (and close to its normal trend) of 230 basis points in the first four months of the year.

Source: Federal Reserve Board

The reason for the significant concession that the TIPS market has offered in the last eight weeks is a fairly straightforward one. The fiscal crunch that is affecting many European countries (including the non-eurozone U.K) has been widely perceived as a major headwind that is likely to affect adversely the growth prospects in the U.S. over the medium-term. As a result, the already unimpressive growth trajectory of the economic recovery is being downgraded, as is the already tame inflation outlook.

With core CPI already below 1.0% (0.9% year-on-year) and overall inflation steadily drifting lower (currently at 2.0% year-on-year), the expectation is that the renewed weakness in the economic outlook is likely to cause a further downward drift in both inflation measures ahead- with the behavior of the overall CPI being the relevant index for the pricing of TIPS. The term "disinflation" has increased in popular use recently, while, talk of a double-dip recession and an outright deflation has resurfaced more pointedly. Against that background, the primary appeal of TIPS (that is, to offer protection against inflation over the maturity of the security) naturally dissipates, which accounts for the narrowing of the breakevens.

Although there is little doubt that the recovery has experienced a modest loss of momentum in the last couple of months, the risks ahead have been somewhat exaggerated. The fiscal situation in Europe is already being addressed with reasonably credible measures, and, in any event, any moderation in growth there (still not a foregone conclusion, given the latest data coming out of Germany that suggest that growth is the biggest eurozone economy is still moving forward) is offset by a solid rebound in the emerging market economies. Furthermore, economic recoveries- particularly of the relatively halting kind, like the one in the U.S currently- are known for hitting an occasional soft patch, which is not in and of itself alarming. Lastly, the notion that an economic recovery will just roll over and fizzle, triggering a double-dip, has been generally not supported by history (see,

On some level, the premise upon which TIPS have underperformed Treasuries recently is almost undesrtandable, but, nonetheless, likely flawed. Although the narrowing of the bearkevens may, in view of an upcoming 30-year TIPS auction next month and the possibility of more softness in the economic data over the near-term, persist for a while longer, it remains particularly vulnerable to evidence that, all things considered, the U.S. economic recovery remains largely on track. Therefore, a trading bet on the restoration of more normal breakeven levels in the 10-year sector over the next few months merits consideration.

Anthony Karydakis

Thursday, July 8, 2010

The IMF's More Sanguine Take on Global Growth

Despite widespread uneasiness recently about the prospects for economic activity in the U.S. and Europe, the IMF's latest forecast that was released this morning paints a noticeably more sanguine picture for global growth, both in 2010 and 2011.

The IMF has now revised its 2010 growth estimate for the group of the so-called "advanced economies" (which does not include China or India) to 2.6%- up 0.3% from its previous estimate in April. Next year's growth forecast for those countries has been left unchanged at 2.4%.

Within the group of the "advanced economies", U.S. GDP growth has now been revised higher to 3.3% for this year (from 3.1% previously) and 2.9% in 2011 (from 2.6% before). The Japanese economy is now expected to grow by 2.4% this year (versus an earlier estimate of 1.9%), while a modestly slower pace expected in 2011 (1.8% now, compared to 2.0% before). As a whole, the growth forecast for the eurozone bloc has remained unchanged at 1.0% for this year but has been downgraded by 0.2% to 1.3% for 2011.

The basic tenor of the revised forecasts consists of a small upward revision to this year's global growth, and little overall change to next year's expected growth. However, the detailed country-by-country estimates now show a marginal softening in economic activity in most of the "advanced economies" in 2011, which is offset by a moderate upward revision to the growth estimate for the U.S. next year.

The GDP growth forecast for Asian has now been revised upward to 7 1/2% this year from 7% previously, as a result of the inventory cycles and "continued buoyancy in exports and private domestic demand", while there is no change to next year's previously published forecast for a more moderate and sustainable growth rate of about 6%.

Taken literally, the IMF's upward revisions to this year's growth forecasts, and the fairly minimal downward revisions for most countries in 2011, are counter-intuitive. They seem to run contrary to the recent perception of considerably elevated risks to global growth due to the fiscal turmoil in Europe and an ensuing wave of fiscal austerity.

There are two key elements here that can help reconcile this apparent inconsistency. a) The IMF explicitly acknowledges in its report the "markedly" escalated risks to growth ahead, stemming from the financial stress associated with the sovereign debt situation and the policy response to it. At the same time, it appears that, in formulating the revised forecasts, the IMF's operating assumption is that those challenges can still be contained reasonably well without chocking growth. In other words, it views those headwinds to growth as remaining still in the sphere of a "risk" rather than having already taken a central role in driving growth ahead or having over-run the natural growth dynamics already in place. b) Economic forecasts are, to a considerable extent, a "dry" (and highly imperfect at that) exercise, where assumptions are used as inputs and "results" are automatically generated in the form of point estimates. Revisions to the tune of 0.2%, 0.3%, or even 0.5% practically represent something less than a rounding error- therefore, their true reliability needs to be viewed with a grain of salt.

Perhaps, the key message from the IMF's revised forecasts is that, headline-grabbing as they have been lately- the sovereign market situation and fiscal policy developments should be monitored closely but not considered yet as a defining factor already shaping the growth trajectory ahead.

Anthony Karydakis

Wednesday, July 7, 2010

The Multiple Faces of the "Exit Strategy"

The term "exit strategy" has become one of the most popular in the financial lexicon over the last year or so, following the unprecedented amount of liquidity injected into the system by the Fed in the midst of the financial crisis in 2008-09. It has widely come to be viewed as referring to the process that the Fed will need to engage in at some point to start normalizing financial market conditions. In one of its most linear interpretations, the term is considered as synonymous to the beginning of the Fed's raising short-term rates. Underlying such an interpretation is the frequent misconception that the absorption of excessive liquidity is tantamount to tightening policy.

In reality though, "exit strategy" is a significantly more multi-layered enterprise than that.

The process of starting to normalize liquidity levels in the financial system is not necessarily linked to a higher federal funds rate and, in fact, the timing of the former is not likely to coincide with that of the latter, but it will most probably precede it.

In the last few months, a number of Fed officials have, in nearly explicit terms, drawn the distinction between the project of asset sales from the Fed's bloated $2.3 trillion portfolio and the prospect of rate hikes. In the most recent FOMC minutes available (April 27-28 meeting) there was a fairly extensive discussion, including a number of specific steps to be considered, regarding the gradual winding down of the Fed's portfolio in the future, while there was unwavering commitment to the "extensive period" language concerning the near-zero fed funds rate

Moreover, several FOMC members have been on record in recent weeks (including richmond Fed President Lacker, St. Louis Fed President Bullard, and others) offering their own take, and -in some cases- specific ideas, on the future of the Fed's asset sales, while, with the well-publicized exception of Kansas City Fed President Hoenig, there is essentially no questioning of the premise that the fed funds rate will remain near zero beyond the end of the year.

The reason for the dichotomy in terms of how these two tracks are treated by the Fed is that any gradual lightening up of the Fed's portfolio is highly unlikely to have any impact on the fed funds rate, the latter legitimately considered as the true barometer of the degree of tightness of monetary policy. Such transactions would mostly take the form of a steady, modest stream of outright sales out of the nearly $1.2 trillion MBS portion of the Fed's portfolio, or, (to a lesser degree over the next year or so, given the long maturities involved) simply allowing for some of those holdings to run-off slowly. In any event, such a process will not affect the fed funds rate, as the latter will require a very different, direct, set of actions by the Fed (namely, raising the interest rate paid on bank reserves from its current 0.25%, as well as an aggressive program of reverse RPs).

For simple operational as well as tactical reasons, the Fed will almost certainly activate the process of a carefully controlled downshifting of the size of its portfolio ahead of any short-term rate hikes. A slow reduction in its portfolio over a number of months will achieve the dual objective of 1) leaving a lesser, more manageable, amount of liquidity to be mopped up later by reverse RPs and higher rates offered on bank reserves when the time for "real tightening" comes, and 2) avoiding to unsettle financial markets prematurely by moving ahead with a highly emotional overt rate hike, as the winding down of its portfolio is a far more discrete- almost, behind-the-scenes process.

The various modalities that the implementation of the "exit strategy" ahead can take were highlighted in some interesting comments that Richmond Fed President Lacker made earlier this week (, where he argued that the Fed should sell MBS out of its current portfolio and buy Treasuries. Such an operation would leave the total amount of liquidity in the system intact but would start restoring the Fed's portfolio to its more traditional, pre-crisis, composition of holding mostly Treasury securities. In a way, this would be a useful preliminary move toward an eventual normalization of financial market conditions over the next couple of years.

The minutes of the June 22-23 FOMC meeting that will be released next week (July 14) may offer more of an insight into the discussion among policymakers about the issue of the Fed's portfolio ahead. Although the activation of a mechanism to alter the configuration and size of that portfolio is still some months ahead, it is important to recognize that it will likely precede- quite possibly by an appreciable margin- the timing of any actual rate hike. In other words, the "exit strategy" is not a monolithic project but more like a multi-faceted affair, not all of which need to have an overt effect on rates.

Anthony Karydakis

Friday, July 2, 2010

Employment Growth Still in Search of Momentum

The June employment report held no major surprises.

The unwinding of 225,000 census jobs last month caused a 125,000 drop in overall payrolls, leaving private sector job gains at an unimpressive 83,000. Although private employment has increased by a total of 593,000 jobs since the beginning of the year (corresponding essentially to a gain of 100,000 a month), it remains below its December 2007 level by 7.9 million.

The health care sector continues to lead, in relative terms, job creation, turning out a 17,000 increase last month, while manufacturing (a key area of strength so far) showed a somewhat moderate by recent standards gain of 9,000. Retail trade -7,000, financial industry -15,000. Temp-help services up 21,000, following increases of 31,000 and 23,000 in the prior to months.

Although it is a component with an admittedly choppy month-to-month behavior, the 0.1% decline in the average workweek to 34.1 put an end to an encouraging uptrend that had been emerging since early spring.

On the face of it, and although it is a headline-grabbing number for the broader public, the somewhat unexpected sharp drop in the unemployment rate to 9.5% is a bit of a question mark as to its true significance. The decline was not part of any underlying strength in employment (as captured in the household survey) as that part declined by 301,000 (also affected by the laid-off census workers, but not by the exact number as in the establishment survey). Instead, there was a very sizable, but not unprecedented, contraction in the civilian labor force last month by 652,000, that accounts for the decline in the unemployment rate. Still, on a trend basis, there is no question that the unemployment rate has decidedly turned the corner from its 10.1% cycle-peak reached last fall.

Unemployment Rate

Source: BLS

All things taken into account, the employment data validate the impression that labor market conditions continue to improve but remain on a somewhat lower trajectory than needed to provide fresh impetus to the economic recovery imminently. The process of reaching a solid pace of job creation that would correspond to 200,000-250,000 monthly private payroll gains is proving to be a slower one that we had anticipated. A lingering resistance on the part of the private sector to more aggressive hiring reflects ongoing underlying uneasiness over the momentum of the recovery. This caution creates an inevitable self-fulfilling prophecy, in that it impedes the very momentum that economic activity needs to acquire to convince private companies to hire more quickly.

None of this puts the future of the economic recovery at risk but the latter appears increasingly likely to remain mired in a 3 to 3 1/4% growth range in the second half of the year.

Anthony Karydakis