Monday, August 9, 2010

This pithy analysis is in from Miller Tabak's Dan Greenhaus:

Just to follow up on our last few notes, now seems an opportune time to remind clients why we think monetary policy is no longer our preferred method for stimulating growth. Simply put, and as the chart below details, despite the explosion of excess reserves in the system, the result of the Fed's balance sheet expansion, the money supply has only marginally risen as total loans in the economy continue to trend lower. Effectively, the primary channel by which monetary policy boosts output, the banking system, remains impaired. As consumers and businesses continue to delever, demand for loans and money at any interest rate is suppressed. As such, lowering interest rates further, while stimulative in theory, will have smaller and smaller effects on aggregate demand as long as the delveraging process continues. As the saying goes, you can lead a horse to water but you can't make it drink.

Source: Federal Reserve, Miller Tabak + Co. estimates

Some may look at the data and see the huge spike in excess reserves and conclude that a burst in lending is sure to follow; banks simply cannot sit on so much money without lending it out to credit worthy borrowers. But as the BIS argued and as has highlighted in the past:

The underlying premise of the first proposition, which posits a close link between reserves expansion and credit creation, is that bank reserves are needed for banks to make loans. Either bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks' willingness to lend. An extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system. In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 - by far the most common - in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively. The main exogenous constraint on the expansion of credit is minimum capital requirements.

By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.

As a result, we are right to ask whether further quantitative easing initiatives will have a substantial effect. Hiroshi Ugai (2006), in a widely cited report on the effect of QE in Japan found that:

Although the QEP generated an accommodative financial environment, it had limited effects on raising aggregate demand and prices. The factors behind these limited macro-economic effects of the QEP were the erosion of the financial intermediary functions of banks, burdened by nonperforming loans and corporate balance sheet adjustments.*

Lower interest rates, in theory, would make it more attractive for borrowers to take out new loans. However, if the United States is anything like Japan, lower interest rates won't matter. Borrowers simply do not want/need new loans, regardless of the interest rate charged. Providing the banking system with additional reserves at a time when they are already sitting on over $1 trillion worth of reserves is not likely, in our opinion, to accomplish all that much.

* Quantitative Easing versus Credit Easing, Frans H. Brinkhuis

The fact that there is a need for further easing speaks volumes on the state of the weak domestic economy.

The body of today's debate is whether quantitative easing will be reintroduced tomorrow afternoon by the Fed.

My view (and the larger picture) is the fact that there is a debate at all and that there is a need for further easing speaks volumes on the state of the weak domestic economy, which is only four quarters into recovery.

It is different this time, and an easing of monetary policy is no longer the preferred route toward an improved economy.

The jobs picture will continue to frame the weak economic outlook and will negatively impact our stock market.

For most voters, the only real issue is high unemployment, and it is here that Democrats seem to have set aside bold thinking and fallen into the Republican trap of placing deficit fears ahead of job revival. Rather than spend time during the campaign stoking anxiety over Social Security, Democrats should aggressively counter the myth that the deficit is causing unemployment, and advocate using government in ways that might re-inspire voters.

-- "In Search of a New Playbook" (op-ed), The New York Times

The Democrats have already retreated from immigration and energy reform. If they can't make the case to Americans like Alexandra Jarrin that they offer more hope for a job than a radical conservative movement poised to tear down what remains of the safety net, they deserve to lose.

-- Frank Rich, "How to Lose an Election Without Really Trying" (op-ed), The New York Times

The slow economic strangulation of the Freemans and millions of other middle-class Americans started long before the Great Recession, which merely exacerbated the "personal recession" that ordinary Americans had been suffering for years. Dubbed "median wage stagnation" by economists, the annual incomes of the bottom 90% of U.S. families have been essentially flat since 1973, having risen by only 10% in real terms over the past 37 years. That means most Americans have been treading water for more than a generation. Over the same period the incomes of the top 1% have tripled. In 1973, chief executives were on average paid 26 times the median income. Now the multiple is above 300.

The trend has only been getting stronger. Most economists see the Great Stagnation as a structural problem, meaning it is immune to the business cycle. In the last expansion, which started in January 2002 and ended in December 2007, the median U.S. household income dropped by $2,000, the first ever instance where most Americans were worse off at the end of a cycle than at the start. Worse is that the long era of stagnating incomes has been accompanied by something profoundly un-American: declining income mobility.

-- Edward Luce, "The Crisis of Middle-Class America," Financial Times

The biggest political change in my lifetime is that Americans no longer assume that their children will have it better than they did. This is a huge break with the past, with assumptions and traditions that shaped us....

Parents now fear something has stopped. They think they lived through the great abundance, a time of historic growth in wealth and material enjoyment. They got it, and they enjoyed it, and their kids did, too: a lot of toys in that age, a lot of Xboxes and iPhones. (Who is the most self-punishing person in America right now? The person who didn't do well during the abundance.) But they look around, follow the political stories and debates, and deep down they think their children will live in a more limited country, that jobs won't be made at a great enough pace, that taxes -- too many people in the cart, not enough pulling it -- will dishearten them, that the effects of 30 years of a low, sad culture will leave the whole country messed up....

But do our political leaders have any sense of what people are feeling deep down? They don't act as if they do. I think their detachment from how normal people think is more dangerous and disturbing than it has been in the past. I started noticing in the 1980s the growing gulf between the country's thought leaders, as they're called -- the political and media class, the universities -- and those living what for lack of a better word we'll call normal lives on the ground in America. The two groups were agitated by different things, concerned about different things, had different focuses, different world views.

But I've never seen the gap wider than it is now. I think it is a chasm.

-- Peggy Noonan, "America Is at Risk of Boiling Over" (op-ed), The Wall Street Journal

The aggregation of the investment shock of 2008, the accumulated 2007-2010 drop in stock and home prices, consistently disappointing growth in real incomes and inept, unfocused public policy that has not even budged the unemployment rate have generated a combination of a sense of frustration, inner pessimism and powerlessness on the part of the U.S. consumer.

Frustrated by the above factors, the Democratic Tsunami of 2008 heralded the start of a populist and anti-incumbent uprising that claims no political affiliation (as demonstrated by the popularity of the conservative Tea Party movement).

It also helps to explain the average American's continued disdain for what they see as the "fat cats" -- that is, the wealthy among us and the large, liquid and capital-rich corporations.

The jobs picture will continue to frame the weak economic outlook and will negatively impact our stock market. The consumer, after decades of being aspirational in both his consumption and investing, is likely to be less so in the years to come; he is constrained and his confidence has been subdued/spoiled.

The attitudes of tone deaf former head of the Council of Economic Advisors Christina Romer and Treasury Secretary Tim "Happy Days are Here Again" Geithner have only served to alienate the average American, who did not need to see Friday's weak jobs report to know which way the wind is blowing.

For now, the lack of response by our legislative and executive branches -- what the heck is Larry Summers thinking/doing? -- in formulating a transformative and focused strategy to address the current elevated unemployment picture remains the greatest headwind in face of economic and stock market recovery.

And with no real playbook, I am starting to see nothing at all that will change this in the near future.

The oil spill in the Gulf has been filled, but the largest spill of all, the loss of jobs, is still flowing.

Until the employment picture is seriously addressed, stock market valuations will likely remain pressured, and upside opportunity will likely remain limited....

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