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Message: The R Word (Schwab)
If anyone's interested, here's an article from Schwab about the most recent 3.5% discount rate cut. I liked the discussion about the R word and "Whether the downturn is officially labeled a recession, I believe it will feel like one."
Fed Cuts a Half Point, Downside Risks Remainby Christopher Burdick, Director, Economic Analysis, Schwab Center for Financial ResearchJanuary 30, 2008
By a 9-to-1 vote, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate half a point to 3%. The lone dissent came from Dallas Federal Reserve President Richard W. Fisher, who preferred no change. The Board of Governors also approved a half-point cut in the discount rate to 3.5%.
Key paragraphs from the Fed's statement
According to the FOMC: "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction, as well as some softening in labor markets.
"The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
"Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."
Why is the Fed being aggressive with rate cuts?
Some observers have speculated that the Fed knows something we don't that justifies its aggressive rate cuts this month. I disagree. Instead, I believe the Fed is trying to catch up to and possibly get ahead of the challenges that threaten to slow the economy further, rather than being too far behind. Federal Reserve Governor Frederic Mishkin's research advises bold rate cuts when faced with a severe decline in home prices. Today's inflation readings are old news; I believe tomorrow's will likely move lower given the economic softness already in the pipeline. In the long run, the Fed's aggressive style may either require fewer rates cuts overall or minimize the time rates are left low. In my view, that could reduce the volatility in the business cycle.
This time around, the only thing the Fed might possibly know that we don't are the results of the January labor report scheduled for release on February 1, 2008. While it's unclear whether the Fed did indeed get an early peek at the results, during the Greenspan era, the Bureau of Labor Statistics made the report available to the Fed a few days early. Even so, it's not the Fed's practice to react to just one economic report even if it is one as important as the labor report.
What ails the economy?
The challenges facing the economy are well documented:
· Housing downturn.
· Tight lending standards.
· Rising consumer debt.
· Credit crunch.
· Slowing employment growth.
· Tax-like effect of high energy prices.
· Negative wealth effect caused by falling home and stock prices.
Unfortunately, by its own admission, the Fed can't manage these challenges as well as it could in the past. At this juncture, the Fed is trying to minimize the pain and quicken the recovery. Whether the downturn is officially labeled a recession, I believe it will feel like one. That's because I expect the economy to be saddled with housing's challenges, particularly falling home prices, throughout 2008 and into 2009.
Recession: clarifying the definition
Nobody wants a recession, though most everyone seems to want to make a prediction about it. Shouldn’t we first have a clear understanding of what this economic fear looks like?
All too often the press defines the "R" word as "two straight quarterly declines in gross domestic product (GDP)." However, this is an improper oversimplification, according to the official arbiter of calling recessions known as the National Bureau of Economic Research (NBER).
According to the NBER, "A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales."
Now that we have the proper definition, let's look at the drawbacks: All of these economic variables are lagging indicators, which are subject to revision. GDP is still very important, but it's less timely because it's reported quarterly rather than monthly. As a result, an official announcement by the NBER as to when a recession began occurs several months after it actually started. In fact, if the recession is short enough, sometimes the announcement doesn't happen until the recession is already over.
Obviously, the lesson here is don't wait for the NBER. Instead, what I suggest is monitor the anecdotal, more forward-looking reports that feed into GDP—income, employment, industrial production, wholesale and retail sales—not just GDP.
Signs of hope
I'd agree that the odds of recession have increased and the economy is slowing down, but signs of hope exist. Let's start with GDP, which on the surface looked poor with a mere rise of 0.6% for the fourth quarter of 2007. That's well below the economy's sustainable growth rate, which is generally thought to be somewhere between 2.5% to 3%. Yet GDP represents output, not demand. The good news is demand grew 1.9% in the fourth quarter of 2007, thanks to a meaningful drawdown in inventories (separate from the housing industry).
With inventories (outside housing) low, that likely means less overhang for businesses to dispose of if the economy slows further. A more dynamic way of viewing this is to compare the level of inventories with sales to come up with an inventory-to-sales ratio. At 1.24 through November 2007, that ratio is lowest on record according to Census Bureau.
Although one month doesn't make a trend, durable goods orders posted a surprising 5.2% increase in December. The component gains were broad-based, supported by many upward revisions to the November data. Proxies for capital spending looked more upbeat for the first time since September 2007.
What about housing?
Although I expect this industry to hold the economy down and not allow it to grow at its potential this year, not all the news is bad. Mortgage rates have been declining since last summer. According to Freddie Mac, the national average of the 30-year fixed-rate mortgage fell to 5.48% as of January 24, 2008. That's well down from the June 14, 2007, peak of 6.74% and the lowest since March 25, 2004.
The housing affordability index from the National Association of Realtors® has risen for five consecutive months. It's up 11.3% year-over-year and 22.5% from the cycle low set back in July 2006.
Though still bloated, inventories of existing homes have fallen. The December 2007 level is down 14.4% from the July 2007 peak. And based on the current sales rate, these inventories represent a 9.6 supply in months, down from the cycle peak of 10.7 months seen in October 2007.
Refinancing activity has skyrocketed. According to the Mortgage Bankers Association, the refinance index is up 22.1% for the week ending January 25, 2008, up 215% in just the past four weeks alone and at the highest level since July 18, 2003. Granted, some of this might represent futile attempts to refinance by homeowners that are now finding it hard to qualify (income, equity, credit, etc.) before their mortgage resets. But at least this indicator is moving in the right direction in a big way, and could be further lifted if the proposed fiscal stimulus package does allow for higher loan limits.
The lag in monetary policy, which is generally considered to be within a wide range of three to 18 months, has already started to kick in for some of the rate cuts which commenced on September 18, 2007. If the fiscal stimulus package comes through with checks arriving by the summer, that could help minimize the economic slowdown. With the impact from the aggressive rate cuts to follow, the economy could be on its way to a recovery.
What's next for monetary policy?
How deep might the Fed go with rate cuts? I don't think even the Fed knows that for sure, but I do believe monitoring the yield of the two-year Treasury note could be a useful guide. When the economy is in balance, its yield tends to track slightly above the Fed's target for the fed funds rate.
But when the economy slows and the bond market anticipates rate cuts by the Fed, the yield of the two-year note typically falls to a level where the collective bond market participants believe the fed funds target should be in order to appropriately stimulate the economy. Yet this can become exaggerated on the low side if they think the Fed is way behind. During the early parts of this rate-cut campaign, it kept going down more so than the actual rate cuts by the Fed.
Lately, though, the trend seems to have improved. The yield of the two-year note appeared to have bottomed (intraday) on January 23, 2008, near 1.85%. Since then, it's moved higher and has been staying in the neighborhood of 2.2% to 2.3%. That's a good thing, in my opinion, because it shows greater faith in the Fed. To the extent that the yield can stay in this area (and possibly higher), I have more confidence in the economy's ability to show signs of a recovery. A good test will be to see how the yield behaves in response to a disappointing economic report. If the reaction is muted, that's a sign the bond market believes the Fed will likely continue to loosen monetary policy in an appropriate manner—both in terms of timing and quantity.
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