Andrew Duguay's blog

You may have heard that the latest report on New Home Sales in the US shows that a record low amount of new homes were sold in January.  Our own databases at ITR confirm this fact and we have data on new home sales stretching back 47 years. 

For sure, a record low number of new homes sold in the US is not a good thing for the economy.  However, I am not too worried about this record low for a few reasons. One principle reason is that January is traditionally a slow month for home sales, so the relative decline compared to previous months is nothing new.

Another reason is the homebuyer’s tax credit.  We saw the first time homebuyers tax credit increase sales in November and October when buyers where expecting the tax credits to expire.  Once Congress extended the tax credits, sales in December dropped.  January’s decline in New Home Sales is just an extension of the distortion that a large subsidy plays on a market.  I bet the closer we get to April, the higher home sales will go again as buyers rush to get the credit that is due to expire.  

The Consumer Price Index (CPI) rose to a 15-month high in January.  The cause for alarm may not seem so pertinent when you take out food and energy costs.  Core CPI barely rose at all.  However, food and energy are important factors when considering long-term inflation and with oil prices trending upward, the problems of controlling inflation become very real. 

Energy prices spiked 2.8% in the month of January and gasoline rose 4.4%.  These numbers will fluctuate from month to month, but there is no denying the overall rising trend in CPI recently.  The CPI has risen in 11 of the past 13 months. We at ITR will be watching this trend carefully for future signs of inflation as the economy recovers in 2010.

Former Federal Reserve chairman Paul Volcker recently proclaimed that big financial institutions that are in trouble need to be properly liquidated and not saved.  We at the Institute could not agree more! The perverse economic incentives that come with bailouts only encourage more risky behavior in the future.  There is a role for the government and the court system to intervene when an integrally important institution is approaching insolvency, but their task needs to be guiding that institution to non-market-crashing liquidation and not a ‘bailout’. 

Volcker has some heavy criticism for the current Federal Reserve board, saying, “I don’t think there’s any question the Federal Reserve and other regulators were not on top of the housing picture”.  The words may seem like common sense to some, but it is encouraging to see an Obama administration advisor speak clear economic sense in the face of the often economically uninformed decisions being made in Congress and at the Fed.

It is important to be well aware of the sticky situation the Federal Reserve has gotten in concerning the risk of future inflation.  Normally in a period of expanding economic activity the Fed reigns in the money supply by selling Treasuries on the open market and waiting for the short term market to respond with interest rate rise.  This strategy works well when the initial money placed in the economy is through the Fed buying US Treasuries from banks.  The Federal Reserve has built a reputation by accurate targeting of the overnight (Fed Funds Rate) money market using this method. 

However, in 2010, more than half of Federal Reserves balances are comprised of non-treasury securities.  These cannot be easily sold back on the open market to reign in inflation.  The open market for Mortgage Backed Securities (MBS) is only beginning to return and the Fed selling their share of MBS in large quantities would likely cause mortgage rates to soar and another housing crisis.  In essence, the Fed has one hand tied behind its back when dealing with inflation because they can only soak up a portion of the money they placed in to the economy in the past few years. 

And Ben Bernanke is well aware of this situation.  This is why he has proposed three different methods of draining excess money from the economy besides the usual means of selling treasuries.  One method would be to raise the interest rate paid on excess reserves held by banks at the Federal Reserve.  The other two methods are offering reverse repurchase agreements and term deposits to banks, which would essentially incentivize banks from lending for periods of time controlled by the Fed. 

These alternative approaches should all have a similar end effect as the Fed selling treasuries but have not been tested on a large scale as a way of moving short term money markets in the U.S.  This leaves some reasonable grounds for concern about the Federal Reserve’s future ability to tame inflation in the next five years.  With unprecedented monetary injection, the stakes are high.  We will have to stay tuned to see if these new methods will work as intended.

For all the news of the debt crisis in several European countries, the U.S. has relatively little direct exposure to their debt problems.  According to Barclays Capital, U.S. banks’ financial exposure to the debt of Spain, Ireland, Greece and Portugal accounts for only 5% of the total US banking industry’s foreign investment exposure and is largely concentrated in just 10 large banks.

The real impact of the European debt crisis in the near term will be felt from the declining value of the euro.  The euro has fallen 8.9% in value against the dollar since the beginning of December.  A falling euro can also drag other currencies with it that have more exposure to European markets than the US, such as the British pound and Swiss franc, leaving the US with a broad currency appreciation.  This is a potential drag on the recovering US export market.

At the Institute we encourage our clients to dismiss the common notion that the unemployment rate is a good indicator to watch pertaining to future economic conditions.  While the economy and employment are absolutely related, the unemployment rate is usually one of the last numbers to improve in an economic recovery. This is because businesses need to utilize their current capacity before they can start hiring again. 

A better employment number to watch is Average Weekly Hours of Production Workers.  This statistic is released at the same time as the unemployment numbers each month but is usually significantly less publicized. In fact, Hours Worked data has led US Industrial Production through 8 of the last 8 business cycle lows while employment led only 1 out of 8.  Average Hours Worked in the past three months is 1.4% above the year-ago level and rising; a promising sign for economic recovery in 2010.

A step forward toward carbon reduction and oil independence was made recently when the White House proposed expanding the Federal loan guarantees for nuclear power plants.  The loan guarantees are crucial in the process of attracting the necessary private start up capital for the high fixed-cost ventures and interest from energy companies to expand nuclear has been high in recent years.  So far, demand for loan guarantees has far exceeded supply (see chart) but the new proposal to triple loans is a step in the right direction.  Anyone with exposure to the power industry markets should take notice.  The stigma against funding nuclear energy in America is slowly fading.

Update:  Below is an updated chart from last week's post using the new federal budget deficit projections released in the Fiscal Year 2011 Federal Budget.  For those hoping for at least a plateau in federal debt levels (as described in the previous post as an “r” shaped exit strategy), this appears to be a bit optimistic now.  

The worrisome part for businesses is that the new budget projects come with $1.9 trillion in new taxes on individuals and businesses.  All while increasing the debt/gdp ratio for the next 10 years.  If taxes were decreasing the debt it would be one thing, but higher taxes on top of even higher fiscal outlays is a major problem. 

And the White House has a history of drastically underestimating future deficits.....

Source: White House and CBO

Source: White House and Congressional Budget Office

Even the staunchest supporter of deficit spending in the heyday of Keynesianism back in the 1940’s would be troubled by the current fiscal outlook for the US.  The difference between the current deficits and that of our fiscal policy forefathers in the 1940’s is a matter of exit strategy. 

As seen in the graph, in the 1940’s Congress, the President and the Federal Reserve wanted and implemented an “n” shaped deficit exit.  According to the latest CBO estimates, our current post-recession deficit reduction strategy looks more like an “r” than anything.  What has me worried is how an “r” shaped exit plan will effect economic growth down the road when we are still technically paying for programs such as cash for clunkers, TARP and the ARRA after the tangible benefits of the stimulus are long gone.

Democrats and Republicans can argue all day over the role of government in the marketplace but when it comes to giving another institution power…. the red flags are raised in a bipartisan manor.  Just look at the reappointment process of Federal Reserve Chairman Ben Bernanke.  You can read other economist opinions on this here.  

I will add my view that the debate over Ben Bernanke is not just about whether his actions as a Fed Chairman were beneficial to the economy.  The Fed has taken unprecedented action on the economy since the recession began and Congress does not like not holding the reigns on the recovery process; Republican or Democrat.