QE vigilantes 1, The Fed 0

Surprise! Most, including myself, had expected the Fed to announce a tapering at today's meeting. My view - likely in the $10 billion range.

Instead, there was no change in policy.

My thoughts:

1. The Fed doesn't have much confidence in its economic outlook

2. The Fed is concerned about the back-up in interest rates and the possible effect on housing

3. There is some concern about fiscal restraint and the budget battles that loom.

Much of this comes directly from the Fed's statement.

Just to illustrate: 

“The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market (italics,underlined my emphasis and a new addition to the September statement vs the July statement).

"...but mortgage rates have risen further and fiscal policy is restraining economic growth."

Stocks surged, with the Dow and the S&P hitting a new record, but the focus will shift to the upcoming budget battles. Plus, will investors get that uneasy feeling since the Fed isn't seeing the kind of economic activity they had envisioned?

For now, the QE vigilantes that drove rates skyward seem to have forced the Fed to blink, and Bernanke is no longer so focused on a jobless rate that had given him the green light to taper.

A discouraging nonfarm payrolls report

Nonfarm payrolls rose a disappointing 69k in May, less than half what was expected; June revised downward from 115k to 77k

The unemployment rate rose from 8.1% to 8.2%.

The internals of the nonfarm payrolls number were poor.

I’m hearing some chatter that this is still weather-related payback from a mild winter?  So let’s look at some of the numbers.

· The service sector produced 218k in Feb, including 89k in professional and business services in Feb.

But in May those categories fell to 97k and -1k, respectively.

It’s hard to argue that a hiring manager in a high-rise looks out the window and checks the Weather Channel before making his/her hiring decision.

If there is a silver lining, the household survey that measures the unemployment rate showed a 422k rise in employment, but a 642k increase in the labor force produced the 0.1% increase in the unemployment rate. Pick up in June activity?

This is a volatile measure of employment and markets ignored it. DJIA futures went from -100 to -200 in the blink of an eye, and the 10-year Treasury fell from 1.53 to 1.48%.

The Fed –

This raises chatter of QE3, but the 10-yr is already near 1.5%!

If the Fed wants to get rates down, Europe and economic worries are accomplishing this. However, the action in the bond market, coupled with weakness in employment and commodities is troubling. And low rates just aren’t jump-starting growth.

That a monetary policy that focuses on asset appreciation. Still, there’s only a tenuous link between higher stock prices and consumer action. And the blunt action of Fed bond buys could reignite commodity inflation.

But if the Fed moves ahead, purchases of mortgage-backed securities may be considered, as the 30-year fixed mortgage has badly lagged the drop in the 10-year Treasury.

One last point, action in commodities and the recent “collapse” in 10-year yields is worrisome. The bond market, which does a better job than the stock market in terms of future activity, is screaming the “R” word.

Bernanke’s testimony next Thursday now becomes an even bigger market event.

Bernanke acknowledges additional options on the table

Fed Chief Ben Bernanke moves to the Senate today after testifying before a House Committee on Wednesday.

Much of the prepared remarks were generally anticipated: weaker-than-expected recovery is probably temporary, spike in inflation probably transitory and weakness in job market, consumer spending and housing were all mentioned.

And of course, recent Fed actions to support the economy were a part of his written testimony.

Bernanke had recently commented that another round of easing by the Fed is unlikely, implicitly suggesting that the hurdle for QE3 or some other type of unconventional easing is quite high.

But yesterday’s comments caught the market off guard, indicating that Bernanke has lowered the bar.

The Fed Chief reiterated that he expects economic activity will pick up during the second half of the year, as factors that have dampened growth subside.

Still, policymakers at the Fed are concerned that the recent weakness could persist, as Bernanke added that the outlook is unusually uncertain.

In his own words, he said, “The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support.”

He went on to list three possible options that remain in the Fed’s arsenal.

1. Provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels.
2. Initiate more securities purchases or increase the average maturity of its holdings.
3. And finally, the Fed could cut the rate it currently pays on bank reserves held at the Fed – 25 basis points – in the hope that it might put downward pressure on short-term rates more generally.

I might add that the Fed hopes a cut in reserve balances would encourage some banks to loosen lending standards and open up to businesses and consumers.  With excess reserves at $1.6 trillion (see QE2 and its economic impact – chart 2), there’s plenty of dry powder in bank vaults to fuel economic activity.

In reality, this shouldn’t have been as surprising as it first appeared since the FOMC minutes out on Tuesday revealed the heightened level of uncertainty among Fed officials.

On the one hand, they offered up a detailed plan for an exit strategy, but some members noted, “The Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run.”

Bernanke was quick to admit that “experience with these policies remains relatively limited, and employing them would entail potential risks and costs.”

He’s right and one must ask, “Will such additional stimulus work, or are we in a liquidity trap where extra cash that’s injected into the economy does little to influence interest rates?"

Deflationary risks – extremely small
I disagree with Bernanke’s assertion that deflationary risks might re-emerge.

Oil prices are near $100 per barrel and raw materials in general, though off their highs, remain at a very elevated level. Inflation expectations, which cratered last summer, are more stable this time around, and we're still seeing solid growth coming out of China based on its latest GDP number.

Further, businesses are still grappling with higher input costs, and the uptick in core inflation bears this out.

Nonetheless, the Fed is keenly aware of the uptick in the unemployment rate and the considerable slowdown in job creation.

I had suspected it might take a month or two of weak job growth before the Fed publicly discussed the possibility of a third round of easy, but the troubling slowdown and resulting weakness in hiring has tipped the Fed’s hand.

If I had to take an educated stab at what will eventually happen, weak job creation through July and August seems to be the most obvious path. And that is going to be upper most on the Fed’s mind.

But the uptick in core inflation is troubling and further easing could quickly cause renewed speculation in commodities, putting additional pressure on core inflation.

Still, just telegraphing the possibility to the financial markets suggests at least a 50% chance of some type of shift in policy.  Look for comments from regional Fed officials in the near term for clarity.

QE, commodities and stocks

The Federal Reserve announced its first foray into QE, or quantitative easing, when it communicated to the public at the end of November 2008 – see statement – it would buy up to $100 billion in GSE obligations and up to $500 billion in mortgage-backed securities.

Falling commodities and stocks, surging unemployment and emerging fears that deflation might eventually engulf the economy led the Fed to vastly expand QE, now  referred to as the first round of quantitative easing, as it now included $1.5 trillion in agency debt and mortgage-backed securities purchases and $300 billion in Treasuries.

Initially set up to go through December 2009, the Fed decided to extend and draw out the purchases of agency and MBS until the end of Q1 of 2010 in order to smooth transition in the markets – see statement.


(click chart to enlarge)

Defined as the purchases of government debt over and above what is needed to keep short-term rates at zero, the Fed’s extraordinary action has prevented a much deeper recession from taking hold.

But the  massive purchases have had little impact stimulating a more aggressive recovery, as much of the newly created money returned to the Fed in the form of excess reserves – Economic impact of QE2 looks limited.

Nonetheless, as the chart above reveals, the implementation of both QE1 and QE2 does appear to have had a profound impact on commodities and stocks.

Commodity prices (orange), as tracked by the Thomson Reuters/Jefferies CRB Index, didn’t bottom until Q1 2009 as risk averse investors shunned all but the safest assets, while a sharp slide in global manufacturing triggered a surplus of raw materials.

The end of QE1 marked the temporary end to the rise in raw material prices. In fact, the decline during the first quarter of 2010 can probably be traced to declining purchases of government securities and the expectation new buys were about to come to an end, as Fed moneys dried up.

The blow up in Greece during the spring of 2010 and the modest impact on the credit markets encouraged investors to briefly trade their commodities and stocks for the safety of the dollar.

However, the mere mention at the end of August 2010 by Fed Chief Ben Bernanke that policymakers were considering a second round of QE2 sent astute speculators back into the commodity markets.

And the eventual implementation of $600 billion in longer-term Treasury buys has helped to fuel the dramatic rise in raw material prices.

Stocks (green), as measured by the S&P 500 Index, have tracked a similar path, with the bull market being interrupted by the end of QE1 and the negative effect of the credit crisis in Greece on economic activity and financial markets.

The avoidance of a double-dip recession last year and the favorable impact from a growing economy on corporate profits has reignited bullish sentiment; however, the flood of new Fed money has also provided a stiff tailwind for stocks, in my view.


(click chart to enlarge)

A closer look at the CRB Index and the first and second rounds of QE are available in the chart above.

Economic impact of QE2 looks limited

QE2, or the second round of the Fed’s program of quantitative easing as it is popularly called, was launched with plenty of fanfare and controversy last November, but was crafted as an insurance policy against deflation as well as a way to jump-start a sluggish recovery that had failed to create a significant number of new jobs.

Since its plan to buy an additional $600 billion in longer-term Treasuries, stocks have rallied, the economy has side-stepped a double-dip recession but inflation worries have surfaced amid soaring commodity prices.

Not surprisingly, the Fed has been content to take credit for the rally in stocks and the reinvigorated economy but not the surge in commodity prices.

Looking more closely at the data, the Fed’s actions, at best, may be having only a very limited impact on the economy as I’ll explain below.

First, let’s define quantitative easing before analyzing its effect on the economy.  Quantitative easing is a tool that a central bank uses in order to provide more liquidity, or cash, than is needed to keep short term rates at zero.

In other words, a central bank, such as the Federal Reserve or the Bank of Japan, resorts to unconventional means when conventional policies that drive short-term rates to zero fail to stimulate economic growth.



In early 2009, the Fed, in its efforts to clear the logjam in the credit markets, clarified its planned asset buys by announcing it would purchase $1.25 trillion of agency mortgage-backed securities, up to $200 billion of agency debt and $300 billion in Treasury securities by the end of the year.

How does the Fed do it? What is essentially happening is that the Fed creates cash and buys government bonds from a bond dealer.  When the Fed receives its newly purchased bond, the bond dealer receives cash, which it deposits into its bank account.

The bank now has new deposits which it can lend to businesses and consumers, after holding a small percentage in reserve.  Anything above that minimum-required reserve is called “excess reserves.”

Normally, banks minimize excess reserves because they earn nothing sitting in the vault, and a bank is in business to make a profit by paying you and I a certain return on our deposit before lending it out at a higher rate.

When late 2008 rolled around, there was absolutely nothing normal happening in the credit markets, and risk-averse banks tightened credit standards and used the extra cash to shore up balance sheets. 

As you can see from the chart above, much of the Fed’s actions in late 2008 and most of 2009 simply ended up back at the Fed in the form of these excess reserves.

A quick note: Unlike in past years the Fed began paying a very small amount, 0.25%, on excess reserves held at the Fed. That’s better than what banks can get for overnight loans on the fed funds market and better than holding it the vault. Remember, the Fed is targeting a fed funds rate at between 0 – 0.25%.

The second round of QE, or QE2, has had a similar impact, as excess reserves are up nearly $400 billion since the program was initiated (see chart above). Excess reserves now stand at almost $1.4 trillion.

What is this suggesting? Simply that banks are not lending out the extra cash to businesses or consumers and instead are holding them at the Fed in the form of excess reserves, which earn a paltry 0.25%.

 

A quick look at the second and third charts seems to confirm the newly minted Federal Reserve dollars aren’t finding their way into the real economy because lending standards remain tight and consumers, who are still reeling from the worst recession in 70 years, continue to shore up savings accounts and focus on debt.



At this point in the cycle, the Fed’s extraordinarily accommodative monetary policy does not appear to be responsible for the improvement in economic activity in recent months.

Think “liquidity trap,” where monetary policy becomes largely ineffective.

Still, the very modest uptick in consumer lending and the stabilization in commercial and industrial loans are encouraging, but we’re going to need to see a greater willingness among banks to lend before the recovery kicks into high gear.

Fed’s Beige Book sees signs of pricing power

The Federal Reserve’s Beige Book – a summary of economic activity in each of the Fed’s twelve districts, indicated that the economy continued to expand at a modest pace in January and into early February, but manufacturers in a number of districts reported having “greater ability to pass through higher input costs to customers.”

Retailers in some districts also mentioned they had implemented price increases or were anticipating such action in the next few months.

Core inflation remains very low, as evidenced by the chart provided in yesterday’s Monetary Report to the Congress.

However, commodity prices have been in a strong upward trend, and regional and national manufacturing surveys have revealed that firms are being pinched by much higher raw material prices.

Nonetheless, policymakers at the Fed still see plenty of slack in the economy, while wages, the largest expense for most businesses, have moved either sideways or marginally higher.  And yields for long-term Treasuries, which would be reacting if investors were sensing a spike in inflation, have been well-behaved.

As a result, the latest forecasts by the Fed show that core inflation is expected to creep upward but not exceed 2.0% by the year 2013.



Much of their optimism is based on the fact that longer-term inflation expectations remain anchored, but I sense their attitudes toward price stability may be too sanguine.

Still-high commodity prices and surging gasoline prices in recent weeks do threaten to undermine some of the confidence that consumers have regarding price stability.

Core inflation has likely bottomed and February’s 0.2% rise in the core rate was the fastest increase in 15 months.  By itself, a 0.2% monthly increase does not mean much, but the best news on inflation is probably behind us.

If we begin to see a modest uptick in core prices (odds, though declining, don’t favor this scenario), Fed Chairman Ben Bernanke would find himself in a very difficult predicament, having to choose between a tighter policy, even as unemployment remains high, or keeping the monetary pedal-to-the-metal in the face of rising prices.

Given current political realities, it seems unlikely the Fed would turn its guns on inflation.

Dallas Fed’s Fisher, Richmond Fed’s Lacker cautious on QE2

On Tuesday, a couple of heavy hitters from the Fed weighed in on the current round of Treasury purchases commonly known as QE2. Though known for their relatively hawkish views, it shouldn’t come as a surprise that both the Dallas Fed President Richard Fisher and Richmond Fed Chief Jeffrey Lacker urged caution.

First, let’s look at the always colorful Richard Fisher. Worried about what he sees as reckless fiscal policies put in place by the legislative branch, Fisher said in prepared remarks, “We have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise.

"There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: 'Monetary policy responsibility cannot substitute for government irresponsibility.' ”

He went on to  say that “the entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.
 
“And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream.”

Taking a shot at the last one-term Democratic president, Fisher added, “I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”

In the meantime, Lacker seemed just as aggressive in his speech, as he implied that the complete plan to buy $600 billion in longer-term Treasuries could be cut short. The FOMC has “committed to regularly review the pace and overall size of the asset-purchase program in light of incoming information and adjust the program as needed," he said.

“The distinct improvement in the economic outlook since the program was initiated suggests taking that re-evaluation quite seriously. That re-evaluation will be challenging, because inflation is capable of accelerating, even if the level of economic activity has not yet returned to pre-recession trend."

For those who see an impending wave of inflation hitting the shores of the U.S. economy compliments of an extraordinarily loose monetary policy, which is being supplemented by a powerful fiscal policy, will be disappointed if the Fed doesn’t halt QE2.

Growth is accelerating, and the economy is beginning to enter a more self-sustaining phase.  I believe we will see a more aggressive approach by the nation’s leading companies when it comes to hiring.

But it hasn’t happened yet, and with only 36,000 jobs created in January, Fed Chairman Bernanke won’t budge from the current path.

Fed mentions rising commodity prices but otherwise, only tweaks language

It was no surprise that the Fed concluded its two-day meeting without any changes in interest rates and maintained its previously-stated goal of buying $600 billion in longer-term Treasury securities. A first look and more formal review of are available at Examiner.

In this post, I’d like to compare changes, or in this case the minor tweaks to the language, with the current statement and the December statement.

So let's jump in.

Following the December 14, 2010 meeting, the Fed said: "Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment."

Not much change in today’s meeting as the Fed began the press release: "Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions."

The adjustment is likely related to the 0.4 percentage point drop in December’s unemployment rate.

Continuing, the FOMC noted that “Growth in household spending picked up late last year...” versus December’s "Household spending is increasing at a moderate pace…” The upgraded assessment reflects the rise in spending at the nation’s retailers.

In the meantime, and in another sign that the recovery is slowly accelerating, the Committee maintained its view that “business spending on equipment and software is rising,” but it removed the language stating that the pace is “less rapid that earlier in the year.”

Lastly, the Fed is finally taking note of the rise in commodity prices, which was absent last month.  But just mentioning what is going on it commodities is simply acknowledging the obvious. And failing to state the obvious might seriously bring into question the Fed's publicly-stated goal of price stability. 

Still, Committee members are not expecting any out break of inflation, as they continue to insist (and rightly so) that “longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.”

In conclusion, don't expect any changes in policy in the near term. Employment growth will have to significantly accelerate, and the rate of core inflation will have to creep higher before we hear any discussions among policymakers of an exit strategy.

If there is any question about the near-term direction, the Fed's opening sentence that the recovery continues "at a rate that has been insufficient to bring about a significant improvement in labor market conditions" should leave little doubt.

Bernanke sees evidence of a self-sustaining recovery

But expect slow progress on the job front

Fed Chairman Ben Bernanke, in his written testimony before the Senate Budget Committe, said he sees "increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold."

Bernanke pointed to a 2-1/2 percent rise in real consumer spending in Q3 and evidence that Q4 expanded at a faster pace.  He also said business investment in new equipment and software has grown robustly in recent quarters, as firms have started to replace aging equipment and make investments that had been delayed during the downturn.

However, he noted that housing remains depressed amid the "overhang of vacant houses."

Stubbornly high unemployment
Despite his belief that growth will likely be "moderately stronger in 2011 than it was in 2010," an improvement in the labor market could lag.

"After the loss of nearly 8-1/2 million jobs in 2008 and 2009, private payrolls expanded at an average of only about 100,000 per month in 2010 - a pace barely enough to accommodate the normal increase in the labor force and, therefore, insufficient to materially reduce the unemployment rate."

Furthermore, Bernanke forecasts that the unemployment rate may only dip to about "8% two years from now...and it could take four to five more years for the job market to fully normalize."

And the shortfall in job creation has to be the number one problem facing the economy today.  After a sluggish start to the recovery in the second half of 2009, the economy hit a soft patch last summer that was tied to the financial instability caused by the debt crisis in Europe.

We've managed to avoid a double-dip recession in the U.S., while spending is picking up, we're seeing a broadening of the recovery, the Leading Index is pointing to further gains, and jobless claims are in a downward trend.

Still, housing is hugging the bottom and the lack of a more robust recovery has yet to force the hand of hiring managers across the country.  Until GDP begins to consistently grow at a faster pace - somewhere between 4-5%, we're not going to see much progress on the labor front.

Fiscal insanity
In the meantime, Bernanke did not shy away from the need to talk about the nation's fiscal imbalances.

He said the current path is "unsustainable," and if government deficits grow as projected by the Congressional Budget Office, "the economic and financial effects would be severe."

So far, few in Congress have seriously talked about the president's panel that has provided a blueprint for credible deficit reduction. Waiting for a crisis to sneak up and create havoc cannot be the only option.

Fed - steady as she goes

The Fed acknowledged in its opening statement that the economic recovery "has been insufficient to bring down unemployment." That's to be expected given the uptick in the unemployment rate in November.  But other than that, there were few changes.

Much of what the Fed said was a re-cap of the recent statement: inflation is low, household spending is rising but high unemployment, slow income growth and tight credit are restraining growth.

As expected, the Committee said it will "maintain its existing policy of reinvesting principal payments from its securities holdings....and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month."

Interestingly, however, the Fed said it "decided today" to continue expanding its holdings of securities as announced in November. Just a few short weeks after making its momentous but well-telegraphed decision, policymakers already appear to be considering adjustments.

There had been some suggestions that a third round of QE might eventually be proposed. But the tax and spending deal agreed to by Congressional Republicans and the White House was quite a bit larger in terms of stimulus than many had expected - think the partial social security payroll tax holiday during 2011.

Though costly in terms of lost revenues, the extra dollars that will end up in paychecks should give the economy a boost next year.  That makes "QE3" a lot less likely.

QE all but assured?

Much has been made that the Federal Reserve will eventually announce – probably at the November meeting – that it will once again begin expanding its balance sheet via a series of bond purchases.

Known as quantitative easing, or QE for short, the bond buys are over and above what are needed to keep short term interest rates at zero, but are necessary, proponents argue, to get the economy moving and put a “deflation firewall” in place.

The Fed announced a very modest program in August, deciding to reinvest any proceeds received from maturing mortgage-backed securities.  Fed Chairman Ben Bernanke followed up with a laundry list of monetary tools the Fed still has at its disposal to support growth.

But the September 21 Fed meeting couldn’t have been clearer:

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

Debate at the Fed
Though some at the Fed, like the Minneapolis Fed chief, have expressed concern regarding how effective new bond purchases may be, others, such as the president of the New York Fed, were more blunt in their support.

His remark last Friday that “the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory” is a clear signal that the Fed will announce new measures on November 3, in my view.

At this point, the Fed would have to be persuaded by robust economic data NOT to pursue bolder options to boost the economy.

Unexpectedly strong employment, manufacturing or service sector data, combined with an impressive rise in Q3 GDP might persuade the Fed to hold off. 

But strong GDP data in itself would not keep policy makers from acting, as an unexpected build in inventory, versus stronger consumer spending, would weigh into the equation.

I’ve harped on this before but I believe that a new round of QE would likely have little impact on the economy because excess bank reserves – funds banks can lend but have not due to tight lending standards and lack of consumer interest – already stand at $1 trillion!

Any new purchases would most likely end up increasing these excess reserves, which would end up being held at the Fed.  And it could fuel a slide in the dollar and boost commodity inflation and speculative excess in emerging markets.

Falling Treasury yields
So far, the yield on the ten-year Treasury has fallen from a 2010 peak of just under 4% in April to nearly 2.4% in August, where it is currently hovering.

The debt crisis in Greece initially pressured yields,  but as the crisis faded, rates continued to descend amid weak economic data and falling inflation expectations.

Speculation that the Fed might ramp up  bond purchases also played a role, but it is difficult to quantify how much the drop in yields can be attributed to QE talk versus slower growth.

The Fed has total control over the fed funds rate, but its influence over longer-term rates is more limited, which limits the effectiveness of QE.

Although mortgage rates are at record lows, the housing market has struggled.  Rates below 4% could provide minor support, but at this point, monetary policy has lost most of its punch, suggesting we are in or are near a liquidity trap.

With fiscal policy being held captive by a large federal deficit, time may be the only option left to fix what ails the economy.

Lackluster economy, housing troubles suggest forceful action from the Fed may be in the offing

Yesterday and today, the housing industry and analysts who follow what’s happening in the economy received a batch of bad news.  Existing home sales fell to the lowest level in 15 years and the pace of new home sales set a new low.

In the meantime, orders for new durable goods managed to eke out a 0.3% rise in July; however, the gain was far shy of forecasts, and the increase occurred due to a huge rise in orders for aircraft.  Pull out transportation, and durable goods orders fell 3.8%.  More worrisome, orders for capital goods fell 8.0%.

Yes, durables are volatile on a month to month basis, and the weakness in the economy we are seeing may abate when summer ends.  But the gloomy data surely has officials must have Fed officials worried that the economy could be slipping into a new recession.

New measures

The Fed is out of bullets when it comes to lowering interest rates.  Still, expect tougher talk in the statement that emerges at the conclusion of the September 21 meeting. And the possibility is growing that monetary officials could begin more aggressive measures to stoke demand.

It seems unlikely, because traders and analysts might fret that the Fed is in panic mode, but the possibility, though remote, is growing that policymakers could put new steps in place prior to the next meeting.

Fed minutes: rate hike later rather than sooner

Fed officials indicated in the minutes from the last meeting that a rate hike is contingent upon the economic recovery. And in my view, much will depend on how quickly the economy generates new jobs.

The minutes noted that the Fed's current language that interest rates will stay low for an extended period is not designed to box policymakers in by explicitly telegraphing to the financial markets that rates will stay near zero for several more months.

"A number of members noted that the Committee's expectation for policy was explicitly contingent on the evolution of the economy rather than on the passage of any fixed amount of calendar time.

"Consequently, such forward guidance would not limit the Committee's ability to commence monetary policy tightening promptly if evidence suggested that economic activity was accelerating markedly or underlying inflation was rising notably; conversely, the duration of the extended period prior to policy firming might last for quite some time and could even increase if the economic outlook worsened appreciably or if trend inflation appeared to be declining further."

Still, despite relatively upbeat economic reports that have come out recently, most officials anticipate a modest recovery and some warned against raising rates too soon.

Fed's Beige Book suggests recovery gaining traction

The Fed's Beige Book, which is a compilation of anecdotal reports from the twelve Federal Reserve districts, indicated that economic conditions have "improved modestly" since the last report.

Consumer spending has picked up modestly, according to the report, while manufacturing was "said to be, on balance, steady to moderately improving across most of the country, while conditions in the nonfinancial service sector generally strengthened somewhat."

Home sales and construction activity improved across much of the nation, though prices were generally said to be flat or still declining somewhat. However, the level of new residential construction activity was generally characterized as weak.

No big surprise - commercial real estate conditions were widely characterized as weak and, in many cases, deteriorating further. Market conditions were reported to have weakened in virtually all districts, with rising vacancy rates, downward pressure on rents, and little, if any, new development.

The Achilles heel at this point is commercial real estate, which could put added pressures on some banks, but the recovery, for now, is moving ahead at a modest pace. An improvement in the labor market would go along way in putting the recovery on self-sustaining pace.

Fed minutes and worries about inflation, bubbles

The minutes released today from the Fed's meeting early this month made if very clear that Committee members are intent on keeping rates at rock-bottom levels for the foreseeable future. But policymakers are not operating in a vacuum and discussed risks related to the very loose monetary policy that has been in place for nearly a year.

Members are mindful that very low short-term rates could lead to "excessive risk-taking in financial markets or an unanchoring of inflation expectations."

Officials in both China and Japan have recently expressed concern that low interest rates in the U.S. could be fueling the carry trade - borrowing where rates are cheap and investing the proceeds in parts of the world that fetch higher returns - and speculative bubbles in Asia.

Although some members saw inflation risks leaning to the downside in the near term, others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits.

Moreover, these participants noted that banks might seek to appreciably reduce their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Either way, the money supply would surge.

Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation, the minutes said.

To keep inflation expectations anchored, all agreed it was important for policy to be responsive to changes in the economic outlook and for the Fed to continue to clearly communicate its ability and intent to begin "withdrawing monetary policy accommodation at the appropriate time and
pace."

In my view, a small rate hike would send a strong signal to the financial markets that the U.S. is serious about its commitment to a strong dollar and stable inflation, and it could help dampen the speculation in gold as well as curtail some of the commodity inflation we are seeing (see Rate hike: sooner rather than later?). However, a minor boost should have little negative impact on the fragile economic recovery.

With the unemployment rate now above 10% and poised to head higher, there is little likelihood that Fed will take that kind of bold action. Nonfarm payrolls, which showed no signs of stabilizing over the past three months (see Thoughts on unemployment), will need to begin evening out before the Fed signals it is in the twilight of its current policy.

Fedspeak - Why rates are expected to remain low

The FOMC's press release that accompanies a rate decision provides a quick look at what Committee members think about the economy along with where interest rates might be headed. In it's statement last week, the Fed said economic conditions are "likely to warrant exceptionally low levels of the federal funds rate for an extended period." Not a big surprise that it left the language intact.

Comments from Federal Reserve presidents in between meetings give us additional insight into FOMC decisions as well as provide us clues that might signal an impending change in policy.

First, Atlanta Fed chief Dennis Lockhart said in his prepared remarks today that he believes an economic recovery probably got underway this summer. In particular, he pointed out that housing prices appear to have bottomed and risk spreads have normalized. Both are key to self-sustaining recovery.

But he cautioned that his "baseline forecast is for a relatively subdued pace of growth beyond the current quarter and through the medium term. The potential sluggishness of the recovery partly reflects certain unique characteristics of this recession.

It was led by a crisis in banking and capital markets that was triggered by a sharp and persistent reduction in valuations of residential real estate assets."

Lockhart also said problems in commercial real estate are "very worrisome for parts of the banking industry."

San Francisco President Janet Yellin made similar comments today in a speech about the economy and real estate. Yellin reminded her audience that the economy has started to move ahead, but "the strength and durability of the expansion is in question.

Some of the rebound is due to temporary government programs and a swing in inventory investment that will not provide an ongoing source of growth."

Though we are hearing cautious optimism for the Fed, fears that a subdued recovery will not produce the jobs needed to bring down the unemployment rate implies that the fed funds rate will hover near zero for the foreseeable future.

Rate hike: sooner rather than later?

The Fed announced no changes to interest rates today and made only modest adjustments to its commentary (see No surprises from Fed...). Following in the path of former Chairman Alan Greenspan, Ben Bernanke is not one to surprise financial markets and shifts in policy tend to be telegraphed in advance.

Note that even the language that conditions "warrant exceptionally low levels of the federal funds rate for an extended period" remained in the statement despite talk from analysts that the FOMC would tweak the language as it eventually prepares to raise interest rates.

If we are going to see changes at the December meeting, we are more likely to hear talk from Fed officials in speeches in the upcoming weeks, rather than get blind-sided at a Fed meeting.

That said, it might have been beneficial for a change in the language referring to rates and an eventual hike at the December meeting to 25 bp followed by another small increase to 50 bp in January.

Yes, the economy remains in a fragile state, and the unemployment rate is probably headed higher. Moreover, political pressure from lawmakers for the Fed to continue doing much of the heavy lifting remains intense. Plus, the protests from the executive and legislative branches would probably be deafening.

However, a symbolic increase would not harm the economy, in my my view, as rates would still be near rock-bottom levels. And the emergency situation and free-fall in the economy late last year that brought about near zero interest rates has abated.

A small increase would help attract the capital needed to fund large deficits and would send a strong message to international investors that the Fed is serious about the Treasury's strong dollar policy. Furthermore, it may slow some of the asset inflation we've been seeing in the commodity markets.

Do I anticipate this will occur? Highly doubtful. Bernanke & Co. will most likely hold the fed funds rate at its current target of 0-0.25% until job creation is on a self-sustaining, upward path.

Fed's Beige Books gives reason for cautious optimism

The Fed's Beige Book, which is a summary of economic conditions in each of the Federal Reserve's 12 districts, indicated that economic activity has either stabilized or displayed modest improvements in many sectors since the last report.

"Leading the more positive sector reports among districts were residential real estate and manufacturing, both of which continued a pattern of improvement that emerged over the summer. Reports on consumer spending and nonfinancial services were mixed. Commercial real estate was reported to be one of the weakest sectors."

It is no surprise, in my view, that the Fed is detecting an improvement in manufacturing and in residential real estate given that much of the data out recently are reflecting gains. Consumer spending has been more tenuous, while commercial real estate may be the Achilles heel of the economy.

Fed gives green light to recovery

Ben Bernanke didn't say that the fragile recovery is expected to turn into a robust expansion, and few if any pundits anticipated such language. But for the first time in many Fed statements, policymakers acknowledged that "economic activity has picked up following its severe downturn."

And with "substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time," which is a clear signal that the FOMC won't be removing the massive amounts of stimulus that are supporting economic activity anytime soon.

But what the Fed did say is that it will slow its previously-announced purchases of agency-backed securities in order to promote a smooth transition in the financial markets because an abrupt end to such purchases could send bond prices much lower and force a spike in mortgage rates.

Since the housing recovery is critical to the economic recovery, the Fed would like to see mortgage rates stay near current levels. Coupled with the first-time home buyer tax credit and lower prices, the necessary ingredients are in place to further gains in housing sales and prices.

Two-day Fed meeting begins today

The Federal Open Market Committee (FOMC), the policy-making arm of the Fed, begins its two-day meeting today without any of the drama surrounding prior gatherings when a potential rate change is a possibility.

In my view, we'll have to see rising employment before the Fed takes any action on its key lending rate.

What we will be looking for is any adjustments to August's policy statement that "economic activity is leveling out." Since Fed Chief Ben Bernanke is now on record as saying that the recession is likely over, we'll probably see language reflecting his recent optimism.

Core inflation, the CPI less food and energy, is still in a downward trend and there is plenty of slack in the economy, so the Fed is not yet under pressure to tighten in order to head off rising inflation.

In the meantime, we may see more hints about how policymakers may be prepared to eventually withdraw the heavy amounts of monetary stimulus in the system. Of particular interest will be whether the Committee makes any adjustments to its plan to purchase government securities.

Data have been upbeat lately, but Treasury prices and mortgage rates have been fairly stable. Keeping rates low has lent a fair amount of assistance to the troubled housing industry, and the Fed doesn't want to see a spike in rates choke of nascent demand.