Excess reserves and quantitative easing

Why the Fed's latest plan won't have much impact

The Federal Reserve, in what had to be the most anticipated shift in monetary policy history, announced four weeks ago that it plans to buy an additional $600 billion in longer-term Treasury bonds.

Known as quantitative easing (QE) , which is defined as purchases of securities over and above what is needed to keep short term rates at zero, the new bond buys are part of the Fed’s own stimulus program that is designed, at least in theory, to boost the economy, create new jobs and prevent deflation from taking hold in the U.S. (was always just a very remote possibility in my view).



The first round of QE – about $1.8 trillion in bond buys – did help to stabilize the financial system in late 2008 and early 2009 when the implosion in credit markets threaten to send the U.S. and global economy into a worldwide depression.

The Fed did help to stave off a crippling depression, but failed to prevent the worst economic contraction in over 70 years, highlighting the limits of monetary policy.

Aversion to risk – the roadblock to recovery
Risking taking all but disappeared two years ago, as banks and just about everyone else sought safety and capital preservation. Hence, as the chart above reveals, excess reserves – defined as cash that is over and above what’s required to be held in the event of emergency customer needs – exploded.

And this aversion to risk among banks and consumers, which has played a major role in hampering the recovery, becomes clear when one sees that banks are holding nearly $1 trillion in excess reserves!

This time around, as the Fed gets set to prime the pump once again, things are a bit different.

Though the world’s largest economy and much of the developed world continue to slowly emerge from the recession, China and other emerging markets (EM) are experiencing robust growth.

With the Fed set to pump $600 billion in newly minted cash into the system - QE2 as it is commonly called, much of the new stimulus seems likely to find its way into the faster-growing economies, further propelling EM growth and risking new asset bubbles around the world.

Additionally, speculation in investments that have performed well in the last year may also be the beneficiary of this newly created cash. Think gold, oil, copper and a host of other raw materials.  That in turn is already stoking inflation in commodities.

Consequently, with the huge piles of cash still sitting on the sidelines, it seems very unlikely that new bond buys will have much of a direct and favorable impact on the U.S. economy.

Unless policymakers at the central bank are able to employ an exit strategy at just the right time, inflation could easily extend beyond commodities.

Consumer confidence hits highest level in five months

The Conference Board’s Consumer Confidence Index hit its highest level since June, rising 4.2 points in November to 54.1.

The improvement is welcome news to retailers heading into the holiday shopping season, suggesting that consumers won’t be so conservative when the search the malls for that perfect gift.

Many retailers are still offering up excellent bargains in order to attract recession-scarred shoppers, but the second-monthly increase in consumer confidence is signaling that some may go beyond sale items, which should help fatten profit margins.



Consumer confidence remains at a relatively low level and is still stuck in the narrow range it has been in for over a year.  That's not surprising given the summer slowdown and an unemployment rate that remains stubbornly above 9%.

However, the job market is slowly starting to improve, while weekly jobless claims fell to the lowest level since June 2008 last week.  Moreover, the Conference Board’s survey revealed that most consumers are feeling a little better about what’s happening to the labor market, which is aiding sentiment and appears set to support economic growth.

Falling new home sales contrasted by good news on jobless claims

New home sales plummeted a much larger-than-expected 8.1% in October to an annual rate of 283,000 units.  That bolstered the supply of homes from 7.9 months to 8.6 months.

However, the 8.6 months is based on the paltry number of sales.  With the actual supply just above 200,000, the number of homes on the market stands at the lowest reading since the late 1960s.

Still, the big drop in sales reflects the stiff headwinds the housing market continues to face in the wake of the expiration of the tax credits last spring.

Potential buyers are worried about the potential for further declines in prices, and the lack of any meaningful job creation is holding others back, offsetting record low mortgage rates.

In the meantime, weekly jobless claims tumbled  34,000 to 407,000 in the latest week, indicating that economic activity is accelerating and the job market is set to pick up.

Next week's data may be blurred by the Thanksgiving holiday, but the downward trend is definitely welcome news.

Philly Fed Index continues string of data showing improvement

The Philly Fed Index, which takes a look at manufacturing conditions in the mid-Atlantic region, is showing a noticeable improvement in economic activity, as the survey released by the Philadelphia Federal Reserve jumped from 1.0 in October to 22.5 in November, the best reading in a year.


(Source: Philadelphia Federal Reserve)

New orders moved back into positive territory, rising from –5.0 to 10.4, suggesting further gains in production, while shipments jumped for 1.5 points to 16.8.

The acceleration in activity also had favorable impact on hiring, which increased from 2.4 to 13.3.

However, rising demand around the globe, especially in China and other emerging markets, coupled with the re-introduction of quantitative easing by the Fed, is keeping upward pressure on raw material prices.

Prices paid rose 2.5 points to 34.0.  But the still-sluggish U.S. recovery is making it difficult to pass along higher commodity prices, as evidenced by a –2.1 reading on the prices received component.

Looking at the chart above, the summer soft patch has faded.  Just as important, the improvement in the Philly Fed signals that the weakness we saw in the more volatile and narrow Empire Manufacturing Index was very likely an aberration.

Expect the economy to gradually improve heading into the end of the year.

Jobless claims in process of establishing new range

Weekly initial jobless claims held below 440,000 for the third week in four, helping to confirm the recent downward trend.

Weekly claims did rise 2,000 to 439,000 in he latest week, but the 4-week moving average, which smooths out the volatility in the weekly data and is a better gauge of the market, fell 4,000 to 443,000.  Continuing claims dropped 48,000 to 4.3 million.

Jobless claims appear to be settling into a new range after hovering in a band between about 450,000 to 500,0000 for over a year.

The slight, downward trend not only suggests that that labor market may be slowly firming, but it is also an indication that economic activity is gradually picking up.  Though consumer confidence continues to languish, other data, such as retail sales, have been improving.

Nonetheless, any enthusiasm from the recent drop in jobless claims needs to be tempered by the fact that claims remain elevated and any improvement in the economy is likely to be modest.

Core CPI perilously close to zero

Fed action, recovery make deflation unlikely

The core CPI held steady for the third month in a row, and core prices slipped from 0.8% year-over-year in September to just 0.6%.

That might normally set off alarm bells at the Fed, but seasonal factors may have played a role in October’s number.



Additionally, the Fed’s latest round of quantitative easing has all but eliminated the slim chance that the U.S. will slip into deflation.

Still, at 0.6%, there is little in the way of retail inflation in the economy.

Detail available in my report at Examiner.

Tumbling multi-family starts hammer housing starts

A 47.5% drop in multi-family starts last month was responsible for a much larger-than-expected 11.7% decline in housing starts to a seasonally adjusted annual rate of 519,000.  Pull out the volatile multi-family category and housing starts were down 1.1% to 436,000 in October.

Building permits didn’t fare much better, rising 0.5% to an annual rate of 550,000, while single-family permits inched up 1% to 406,000.



Home builder confidence has been edging higher, but as the chart above reveals, single-family permits for new homes, which is a good forward-looking indicator of the industry, has been dragging along the bottom for several months.

New home sales make up less than 10% of the overall market, but residential construction feeds directly into GDP, while increased employment and the ripple effect throughout the construction industry would have a more indirect impact on GDP.

Builders must still contend with the heavy backlog of foreclosures of later model homes, and still high unemployment and depressed consumer sentiment continue to hamper the industry.