NO "MISSION ACCOMPLISHED " FOR THE FED / BARRON´S ( RECOMMENDED READING )

Wednesday, August 12, 2009

UP AND DOWN WALL STREET DAILY

No "Mission Accomplished" for the Fed

By RANDALL W. FORSYTH

While financial conditions are back to pre-Lehman levels, the economy has a long way to go before actually improving.

FINANCIAL MARKETS HAVE RETURNED to the tenor, if not the actual levels, that prevailed prior to the collapse of Lehman Brothers last September, which mainly reflects the massive full-frontal attack mounted by the Federal Reserve and the Treasury to prevent a full-scale meltdown.

But for the Fed, it's far from Mission Accomplished. In the statement following the just-concluded meeting of the Federal Open Market Committee, the panel found signs "economic activity is leveling out" -- better than the suggestions "that the pace of economic contraction is slowing" seen after the June 24 confab.

That's a far sight from any notion of real improvement in the economy. And as such, the FOMC maintained its 0%-0.25% target range for federal funds, its key interest-rate target. And the panel reiterated it "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

On the financial front, meanwhile, the Committee said it would wind down its program to purchase $300 billion in Treasury securities "by the end of October." Previously, the Fed had said it would buy up to $300 billion of Treasuries by autumn, which presumably put the end date at the time of the equinox on Sept. 21.

The practical import means the Treasury market won't face a sudden cut-off in Fed purchases but a gradual one. (The central bank's plan to buy up the $1.25 trillion of agency mortgage-backed securities of $200 billion of agency debt by year-end remains unchanged.)

While the Treasury purchase plan gets inordinate attention -- not the least because of the popular perception that it represents the Fed's use of the printing press to finance the federal budget deficit and thus puts the nation on an inevitable road to perdition -- it is a relatively small portion of the central bank's program of "quantitative easing."

Indeed, since the beginning of the year, the Fed's balance sheet actually has contracted by about $300 billion, coincidentally the same total as its Treasury purchases. The central bank's assets have shrunk in large part because of the repayment of many of the various alphabet-soup facilities established to counter the credit crisis.

The restoration of the financial system's equilibrium, which has permitted the winding down of some of those facilities, has been reflected in the reversion of many of the money and credit markets' key readings back to close to normal. Notably, the three-month London interbank offered rate, a key benchmark for the cost of many business and mortgage loans, has fallen to a record low around 0.5%--back to close to its historical alignment vis-à-vis the fed funds rate target.

Financial recovery is a necessary -- but far from sufficient -- condition for economic recovery. Yet, the financial markets are extrapolating the current slower rate of deterioration morphing into an actual improvement, evidenced not only by the bungee jump in stocks but also in the interest-rate futures markets' pricing in a full-point rate hike by June 2010.

The question is how reasonable are such expectations.

As notes Steven Blitz, chief executive of Pangea Market Advisory, the FOMC finally got around to taking note of "sluggish income growth" as a constraint on consumer spending, with job losses, shorter hours and flat wages. (The flip side of this squeeze on labor is the 6.4% surge in worker productivity in the second quarter, which was reflected in the better-than-expected corporate earnings despite weak revenues.) Adds Ian Shepherdson, chief U.S. economist at High Frequency Economics, "We dispute the Fed's view that consumption is showing 'signs of stabilization' -- ex-clunkers, it is falling relentlessly -- but the overall judgment on growth is reasonable."

The financial markets appear to assume this is just another cycle. In the past, central banks could lower rates and could expect a pick-up in borrowing and lending as reliable as the reaction of journalists finding an open bar with free drinks. But, as BCA Daily Insights points out, even as credit spreads have returned to historic norms, credit continues to contract.

Given the Fed's tendency not to tighten until unemployment is in a significant, sustained downturn (not July's 0.1 percentage point phony fall owing to labor-force dropouts), BCA thinks Fed tightening is more likely a 2011 event, not next year's.

Far from being a reason for bulls to celebrate, such a delayed restoration of normalcy will be the result of the ongoing deleveraging process to correct the egregious excesses that led to the credit crisis.

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