The Fed "disappoints" and that is good

Seems there were a lot of people hoping that the FOMC might decide to "do something" about the persistently weak recovery. Instead, while yesterday they acknowledged that economic growth has "decelerated somewhat over the first half of this year," they added merely that they will "closely monitor incoming information ... and provide additional accommodation as needed." That's hardly a clarion call for more aggressive monetary ease, and that's a good thing, because there's not much more they can or should do at this point.

Thanks to two Quantitative Easing programs, the Fed has already created an astounding $1.6 trillion of bank reserves—17 times the amount that existed prior—of which $1.5 trillion remain on deposit at the Fed in the form of Excess Reserves. In order to support the current level of bank deposits, banks only need about $100 billion of "required" reserves, leaving $1.5 trillion available to make new loans and otherwise expand the money supply. If banks are content to hold $1.5 trillion of excess reserves today, would they be much less willing to hold the same amount of reserves if the Fed cut the Interest on Reserves to 15 bps (from the current 25) as many have suggested they should? It's hard to believe that a 10 bps reduction in the yield on excess reserves would make a significant difference. (Going to zero might make a small difference, but it would also drive money market funds out of business or force them to pay negative interest rates.) If the banking system prefers to earn almost nothing on a mountain of excess reserves instead of making loans at a rate that is many multiples of that, then that can only mean that banks are too risk-averse to make more loans today, and/or borrowers in aggregate are too risk-averse to take on more debt.

In other words, the problem of weak growth cannot be traced to any shortage of money or lack of sufficient reserves, or to the level of short-term interest rates. Risk aversion and a lack of confidence are the most likely culprits, and it's hard to see how a Fed that repeatedly acknowledges that it is very concerned about the outlook for growth is making any positive contribution to the problem.

Should the Fed attempt to force-feed the financial markets with new lending? Argentina is trying to do this, by ordering banks to increase their lending between now and year end, and to do so by making loans with interest rates lower than the current level of inflation. Last time I checked, that move hasn't made a whit of difference to the Argentine economy, but it has helped push down the value of the peso on the black market, where pesos now trade at a 32% discount to the official exchange rate.

Should the Fed adopt negative interest rates? That's just another way of force-feeding money into the economy: encourage more borrowing by ensuring that borrowing costs will be lower than inflation and lower than nominal GDP. Borrowers are almost sure to win, but lenders are almost sure to lose. That's a zero-sum game that can't result in any positive contribution to growth. Money gets pumped into real estate and commodities (i.e., into real assets that will likely benefit from higher inflation) and into speculative (e.g., leveraged) activities, but not necessarily into productive (i.e., job-creating) activities. Indeed, the transparently inflationary nature of policies such as this can only induce greater risk-aversion. That's why Argentina's economy is sinking rather than picking up, precisely because the government is so transparently trying to goose lending.

Can the Fed do anything to reduce risk aversion and boost confidence, and thus address the real underlying problems? Well, yes: they could refrain from pumping yet more reserves into an already-over-stuffed banking system, and they could refrain from reducing already-very-low short-term interest rates to zero. And that's exactly what they did with their statement yesterday. They have reduced risk aversion because they have reduced the chances of a catastrophic error of monetary policy, in which they are slow to reverse their accommodation, thus creating a huge excess supply of money which could be very inflationary. That helps explain why the dollar today is trading at close to a two-year high against other major currencies, and why gold is down 16% from last year's high.

What the Fed has yet to do is explain in greater detail why monetary policy cannot provide a magical solution to the world's problems at this point—that fiscal policy holds the key to future progress. On that score we are still waiting to see credible attempts to rein in the size and scope of government and to minimize tax and regulatory burdens in most of the world's major economies. Draghi can't come up with a ECB program that will fix that overnight; the ECB, like the Fed, can only do so much.

Slow growth, but no signs of recession

Today's economic releases shed no new light on the state of the economy, which remains one of disappointingly slow growth. Although it's very clear the economy has slowed down, there are as yet no indications that it is going to slow further or enter a recession. 

After a month of very volatile numbers, the picture of the weekly unemployment claims has clarified: the volatility was almost entirely due to seasonal adjustment factors—which attempt to predict the timing and magnitude of scheduled layoffs in the auto industry—that did not match up with the reality. By now, however, these problems are water under the bridge, and today's release is probably an accurate reflection of the underlying realities: new claims for unemployment continue to decline. On an unadjusted basis, claims are down 9% from a year ago. This is important, since if the economic fundamentals were deteriorating, we should be seeing an increase in claims, not ongoing declines. The economy is growing slowly, but it is not deteriorating.
 

Thanks to the scheduled expiration of emergency claims beneifts, and to the ongoing decline in new layoff activity, the number of people receiving unemployment insurance continues to decline on a seasonally-adjusted basis: down over 1 million in the past year, or -15.4%. This creates important new incentives in the workforce, since more people have an incentive to find and accept job offers, even though they may not be ideal jobs. This—relocating workers to the areas of the economy where they are needed and adjusting the cost of labor to new realities—is part of the natural healing process of any recession, and it has been retarded for way too long by Congress' decision to keep extending eligibility for unemployment insurance.

Announced corporate layoffs continue to run at very low levels. Once again, here is a key indicator of underlying economic fundamentals that shows no sign of deterioration.

Nondefense factory orders declined in June, and they have fallen at a 9% annualized rate so far this year. The deterioration in factory orders and related subcomponents (e.g., capital goods orders) is mirrored in the recent decline of the ISM manufacturing index, and it reflects conditions that existed 1-2 months ago, so it is arguably not new news.

Key indicators of financial health and systemic risk, captured in Bloomberg's Financial Conditions Index (first chart above), are behaving in relatively normal fashion. The Vix index of implied equity volatility remains somewhat elevated, at 18.7, but swap spreads (second chart above) are trading at relatively low levels in the U.S. and are even down significantly from recent highs in the Eurozone. The market is still in the grips of fear, and risk aversion is still high (viz. 10-yr Treasury yields at 1.46%), but markets are liquid and functioning normally. Arguably, the illiquidity that struck markets in the wake of the Lehman collapse in late 2008 was a very important factor aggravating the recessionary conditions that had been building up to that time. With banks almost frozen, for example, letters of credit were almost impossible to get, and global trade virtually collapsed. Today's liquid and relatively tranquil market conditions show no signs of deteriorating fundamentals that might threaten the U.S. economy going forward.

Mixed economic releases

The ISM manufacturing index for July came in about as expected, and it doesn't change what we already knew: the economy is in a "slow patch" with growth likely to be between 1 and 2%, as the above chart suggests. However, there is still no sign in this indicator of a recession, and that ends up being a mild positive in my view, given how bearish the market is (e.g., 1.5% 10-yr yields). 

The ADP estimate of the change in private sector employment in July was somewhat stronger than expected (163K vs. 120K), but of course this is still a fairly weak number. However, based on the above chart, the ADP number is pointing to a stronger-than-expected payroll report this Friday. The market is expecting only 110K private sector jobs to be found in Friday's release—if it came in at or above 160K that would probably be a welcome and positive surprise for the market.

This chart from last month gives yet another reason to expect a stronger-than-expected payroll report. What stands out is the very strong gains in private sector employment that have been found in the household survey so far this year, especially when compared to the fairly weak numbers we have seen in the establishment survey. It may be time for the establishment survey to "catch up" to the household survey. 

Construction spending in June came in about as expected, and it extends the upturn in the sector which began early last year. Total construction spending is up about 13% from last year's low. That's encouraging on the margin, but nothing to write home about.

UPDATE: July auto sales were ever so slightly higher than expectations (14.05M vs. 14.0M), but this is a rounding error in a series in which monthly sales are annualized and seasonally adjusted. All we know is that the uptrend in sales, which began over three years ago, appears to remain intact: since the early 2009 low, sales are up 50%, and over the past year, sales are up 15%. Both are rather impressive figures.