Running on Empty

By David Lereah

The Federal Reserve recently announced that it cut its target for the Federal funds rate from 1 percent to a target range of 0 to 0.25 percent, the lowest on record. Our central bank has cut the federal funds rate 10 times in the past 15 months and now has no more room to reduce the interest rate. It is running on empty.

The Fed has exhausted its most effective tool for implementing monetary policy–the Federal funds rate. The problem has been that most interest rates (e.g., corporate bonds, lending rates) have gone up due to the financial crisis rather than follow the Federal funds rate downward. So the Fed has lost its most potent tool for managing the economy.

However, the Fed has more tools in its monetary box and plans on using them. In a statement, the Fed said that it would use “all available tools” to bolster the economy. In the past, the Fed has injected money into the economy, exerting downward pressure on interest rates. But the Fed is now committed to lowering interest rates and will do it in unconventional ways. Rather than pump money into the economy which indirectly exerts downward pressure on other interest rates, the central bank is now ready to directly purchase mortgage loans, car loans and business loans in an effort to directly influence those interest rates in a downward direction.

This Fed announcement of directly providing credit to businesses and consumers was received enthusiastically by investors. The Dow Jones Industrial Average surged 360 points on the news and long-term government rates, including mortgage rates, fell dramatically in anticipation of future Fed credit market activity.

Specifically, the Fed has plans to purchase $600 billion of mortgage-related securities under a program it announced last month. The announcement of that program already has driven mortgage rates down about ½ of a percentage point. Knowing that the Fed will expand this program with additional purchases will likely exert further downward pressure on mortgage rates. The Fed also noted in a statement that a new program is being created to funnel money to¬ward credit card loans, auto loans, student loans and small business loans.

My take on the Fed’s new initiatives is favorable. At present, inflationary pressures have eased and in re¬cent months both consumer prices and producer prices are heading down, not up. That provides enough wiggle room for the Fed to pump money into the credit markets without fear of immediate inflation. And by driving the Federal funds rate close to zero, the Fed allows banks to borrow money essentially for free, helping them restructure their weak balance sheets and capital positions by borrowing at zero percent and lending those funds out at higher rates.

The bottom line is that the Fed and the Treasury are now firefighters. They have a money hose and they are using it. They have turned on the spigot and are spraying the economy and credit markets with as much money as they can, hoping to put out fires. It is a dire situation and we hope to eventually experience fewer fires so we can get on with the process of rebuilding our financial system back to working order.

This past week’s economic measures provided us with more clues about our recession. The consumer price index plunged by 1.7 percent in November, the greatest decline since the Department of Labor began publishing seasonally adjusted changes in the index in February 1947. The decline marked the second consecutive month that the index fell by a record amount. The weakness in consumer prices was led by falling energy prices but also reflects a serious drop-off in the demand for goods and services.

The Conference Board’s index of leading indicators fell 0.4 percent in November, after falling 0.9 percent in October. The leading indicator index is at levels not seen since the 1990-91 recession and is on a path to register even lower numbers. Jobless claims for the week ending December 13 decreased by 21,000 to 554,000. The level of claims still remains at serious recession levels. We also note that for the next several weeks, claims numbers could exhibit some volatility due to the holiday season.

On the real estate side, two measures were reported this past week: housing starts and mortgage applications. The new residential construction numbers were dismal. Both housing starts and housing permits fell to record lows in November. Housing starts dropped an alarming 18.9 percent to 625,000 in November on an annualized basis. Similarly, housing permits dropped by over 15 percent to an annual rate of 616,000 in November. This large drop in residential construction activity was not expected. The dismal performance of home builders reflects on economy in a deep recession. There is just no economic or business reason for builders to dig holes in the ground right now. Most of the action in home sales involves foreclosure sales. Conditions in the home-building industry are at the worst point since the Great Depression.

If there is a silver lining to all of this it is that the lack of construction activity is bringing down new home inventories. A housing recovery can only occur if inventories for both new and existing homes come back down from excessive levels.

For more information, please visit www.reeconadvisoryreport.com.

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