Saturday, September 15, 2007


It is perhaps fitting that Fed Chairman Ben Bernanke on the anniversary of 9/11 should be making a speech in Berlin that attempts to clarify why we have run up such a trade deficit—of approximately $1 trillion last year alone.

Chairman Bernanke made the speech on the 9/11 anniversary for several reasons. It is consumer spending and borrowing since 9/11—fueled by record low interest rates—that enabled the huge trade deficit, and the trade deficit in turn has enabled the huge federal budget deficit—up to $8 trillion at this writing.

Those twin deficits are a major headache for Bernanke. They happen at the same time that “the U.S. has already reached the leading edge of major demographic changes that will result in an older population and more slowly growing workforce,” said Bernanke in his speech.

This explains why the Fed has been reluctant to drop consumers’ interest rates as it finally did for its banks last month. It wants to discourage consumer spending and encourage more savings, which would reduce the twin deficits.

There is also a second reason behind the Fed’s reluctance. Too much money in consumers’ pockets tends to cause higher inflation. Bernanke and many other Fed Governors, apparently, believe that part of their mission is to discourage consumers from any inflationary tendencies. I.e., if consumers believe the Fed is hawkish and vigilant concerning any inflation, then consumers might shop more carefully. It is only if consumers believe the Fed is serious about controlling prices, in other words, that consumers will control their spending.

In fact, a famous speech Bernanke made when the Fed’s Vice Chairman in 2001 outlined this philosophy. He claimed it was the Fed’s anti-inflation vigilance in the 1980s that caused a period he called the “Great Moderation”, when inflation was subdued. Inflation began to moderate in the 1980s after such draconian Fed measures as raising their fed funds rate to 19 percent in 1981. This caused 2 recessions within 3 years, needless to say.

However, Bernanke is only giving us part of the story. Consumers are over indebted not only due to the Fed’s very accommodative credit easing, but the federal tax cuts of 2001 and 2003 put a huge amount of money back into consumers’ pockets. This encouraged the borrowing binge, and caused the dollar’s value to fall to a 15 year low. It has also caused the price of imported oil—which is paid in dollars, let us not forget—to rise to $80 per crude barrel of devalued dollars at this writing.

The influx of foreign savings also had a hand in the double-digit housing price rises of the past several years. For it is foreign savings that have been the main cause of lower long-term interest rates (i.e., bonds), at the same time the Fed was raising short-term interest rates. This became a disconnect that could not last. It is the rise of short-term, adjustable rates that has fueled the huge number of defaults, hence the current credit-crunch.

The latest news continues to be mixed. Retail sales are still growing at a 3.9 percent annual clip, but only because of deep discounts on last year’s models in August. Industrial production fell, while the U. of Michigan’s preliminary Sept. survey of sentiment edged up slightly, and inflation expectations declined. That is a good sign. There certainly is not yet a credit squeeze on credit cards or car loans. But there’s the rub, to borrow from Shakespeare. If and when the Fed does begin to drop consumers’ short-term rates, this will encourage more borrowing and spending, not more savings.

Consumers tend to save more when interest rates are higher, in other words—such as in the 1980s. But that hurts economic growth. A much better way to cure the twin deficits is to raise taxes on the wealthiest, those making more than $200,000 per year, as was done during the 1990s. Cutting taxes neither cuts deficits nor helps retirees’ benefits, period.

Copyright © 2007


The markets jitters come from more mixed news. July’s unemployment rate remained at 4.6 percent, but payrolls shrank by 4,000 for the first time in 4 years—as opposed to the 100,000 plus monthly jobs average of late. The NAR’s pending existing-home sales index fell, as did construction spending. But both manufacturing and service sector activity continue to expand. And retail sales are robust, especially at the high end.

All of this makes it virtually certain that the Federal Reserve will begin to reduce short-term interest rates sometime this month—maybe this week. Their mandate is not only to fight inflation, but nurture “sustained economic growth”. And any jobs uncertainty is a sure sign that employers are holding off on hiring until the real estate market settles down.

Lawrence Yun, NAR senior economist, said abnormal factors are clouding the existing-home sales picture. “It’s difficult to fully account for mortgage disruptions in the index, and our members are telling us some sales contracts aren’t closing because mortgage commitments have been falling through at the last moment,” he said.

These temporary problems are primarily with jumbo loans, and there are continuing issues for subprime borrowers. But new lenders are stepping into the breach to replace those who have stopped lending—contrary to the early 1980s, when the disparity between short and long term interest rates caused even the largest banks to stop mortgage lending. This is not the case today, as banks are flush with profits from the 5-year expansion.

The economy as a whole seems to be doing quite well of late, including consumers. One such indicator is consumer spending, which had declined but now is rising again along with personal incomes, as I have said. The government’s latest figures show that personal incomes jumped 0.5 percent in July, while real consumption expenditures have averaged 3 percent annually, indicating that third quarter economic growth could also be above 3 percent. Q2 GDP was revised to a 4 percent growth rate.

UNEMPLOYMENT—July’s unemployment rate was unchanged at 4.6 percent because the same number left the workforce as lost their jobs—more than 300,000 in each case, according to the telephone survey of households. There was a 68,000 plunge in construction and manufacturing employment, while education and health services’ employment rose 63,000, according to the payrolls survey. This balancing act is keeping the economy chugging along.

What about real estate sales? Interest rates are already plunging, with conforming 30-year fixed rates now at 5.875 percent for slightly more than a 1 point origination fee. And if the Fed drops its short-term fed funds rate, the Prime Rate and other ARM indexes would follow its lead.

“Some consumer concerns remain, but since mid-August the market has been stabilizing somewhat,” said the NAR’s Yun. “If lenders focus on the essentials of creditworthiness and adjusted valuations based on comparable sales, and ignore speculation on what might happen in the future, broader stabilization will come sooner rather than later,” Yun said.

By not acting sooner, the Fed seems to be trying to downsize the largest issuers of jumbo subprime and Option ARMs, who can no longer sell these loans on the secondary market. Neither consumers, nor these lenders will see any relief until the ARM indexes, including the Prime Rate at 8.25 percent, begin to decline.

Copyright © 2007