Read the fine print

An otherwise fine article from the Wall Street Journal starts with this headline:

"New York Fed Starts To Unwind Stimulus"

You might casually read that headline and assume that the Federal Open Market Committee was mighty impressed by the November employment report—and quick to respond with the first stages of a reversal in the stance of monetary policy. The facts lie, however, underneath the headline.

At issue are so-called "reverse repo" operations, described in the article thus:

"In a reverse repo, the Fed sells securities with an agreement to buy them back later at a higher rate…

"Reverse repos are one tool the Fed has at its disposal when the economy and financial markets have improved enough for it to drain cash from the system. The Fed uses short-term repurchase and reverse repurchase agreements to temporarily affect the size of the Federal Reserve System's portfolio and influence day-to-day trading in the federal-funds market."

On Thursday, the New York Fed conducted $180 million worth of reverse repo transactions on, as the article points out, "the heels of a series of reverse repo tests that have been done by the bank over recent weeks." That word "tests" is the key:

"The Fed earlier this week said it would implement small-scale reverse repos over coming weeks but said the operations have no implication for monetary policy. Rather, the Fed said the operations are being conducted to ensure operational readiness at the Fed, tri-party repo clearing banks J.P. Morgan Chase and Bank of New York Mellon, and primary dealers, the lead group of banks that deal directly with the central bank…

" 'The idea is they want to get all their ducks in a row and be ready (to pull cash) when the time is necessary,' [RBC Capital Markets interest-rate-strategy group head Ira] Jersey said, adding that there's no point in doing large scale reverse repos as long as the Fed is still purchasing assets."

A better headline for the article would surely have been something like "New York Fed Starts to Lay Groundwork to Unwind Stimulus When Time Comes." It doesn't exactly sing, but it represents the facts.

By David Altig, senior vice president and research director at the Atlanta Fed

Jobs and the potential commercial real estate problem: Still keeping us up at night

In the season of good cheer, it is certainly gratifying to know that some in the economic forecasting business are actually feeling cheerier:

Reaffirming last month's call that the Great Recession is over, NABE [National Association for Business Economics] panelists have marked up their predictions for economic growth in 2010 and expect performance to exceed its long-term trend. "While the recovery has been jobless so far, that should soon change. Within the next few months, companies should be adding instead of cutting jobs," said NABE President Lynn Reaser, chief economist at Point Loma Nazarene University.

While we at the Atlanta Fed agree that the recession has likely ended, we wish we could feel as optimistic about the current jobs outlook. We've catalogued those concerns before—here, for example—but we continue to look for reasons to believe that our pessimism is unwarranted.

As was noted in a recent speech by Federal Reserve Chairman Ben Bernanke, weak bank lending remains one potentially significant headwind impeding the jobs recovery:

"… reduced bank lending may well slow the recovery by damping consumer spending, especially on durable goods, and by restricting the ability of some firms to finance their operations."

Among the factors restricting lending, "… with loan losses still high and difficult to predict in the current environment, and with further uncertainty attending how regulatory capital standards may change, banks are being especially conservative in taking on more risk," Chairman Bernanke said.

One area where bank loan losses are potentially high and uncertain is commercial real estate (CRE). As highlighted in a macroblog post from October, if the CRE problem falls disproportionately on financial institutions that also finance small business activity, we will be all the more worried that "the post-recession employment boost [small] firms typically provide may be less robust than in previous recoveries."

In fact, as Atlanta Fed President Lockhart noted in a speech last month, as of mid-2009 the banks with high exposure to CRE (relative to tier 1 capital) accounted for about 40 percent of commercial and industrial (C&I) loans to small businesses.

Underneath that statistic are a couple of additional facts that also have our attention:

1. Over time, CRE loans have become increasingly concentrated in those banks whose CRE lending activity is high relative to their available capital. As of June 2009, banks with CRE loan books more than three times their Tier 1 capital level accounted for 52 percent of the $1.6 trillion of CRE loans in bank portfolios. Though this is lower than the 2008 peak of 59 percent, it compares to just 17 percent in 1993.

2. Small businesses that rely on bank loans for credit are much more likely to be affected by a bank's CRE exposure than in the past. In 1993, banks with CRE loan books more than three times their Tier 1 capital accounted for just 11 percent of total small business C&I loans. But this share increased to 42 percent in 2008 and stood at 38 percent in June 2009 (of a total of $281 billion of C&I loans to small businesses).

The following chart summarizes these two observations.

Thus, both commercial real estate loans and small business C&I loans are much more concentrated in banks with relatively lower levels of capital than has been the case in the past. Combined with our previous observation that a relatively high fraction of small business loans sit in banks with significant exposures to commercial real estate, these facts do not strike us as a case for optimism regarding the near-term outlook for growth in small business borrowing.

Perhaps today's job summit will result in additional ideas to counter what we see as a serious drag on job creation in the near term. And, of course, tomorrow's employment report could show signs of improvement in labor markets. That would be good news.

By David Altig, senior vice president and research director, and John Robertson, vice president, both in the Atlanta Fed's research department

Interest rates at center stage

In case you were just yesterday wondering if interest rates could get any lower, the answer was "yes":

"The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end."

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. A bit more precisely, the levels of real interest rates are tied to the growth rate of the economy. When growth is slow, rates are low.

The intuition behind this point really is pretty simple. When the economy is struggling along—when consumer spending is muted and businesses' taste for acquiring investment goods is restrained—the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

"The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:

"Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

"Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

"Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad."

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:

But the quantity of bank lending is decidedly not on the rise:

There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

By David Altig, senior vice president and research director at the Atlanta Fed

Housing back in the news

Housing back in the news

Two reports released this week remind us of the difficulties still confronting the residential real estate market. First, the consumer price index (CPI) showed continued moderation. Yes, the overall number was up 3.4 percent on a monthly annualized basis, and even the core measure ticked up 2.2 percent. But over half of the core rise was related to rising new and used car prices following the expiration of the cash-for-clunkers program. The Cleveland Fed's median CPI, which isn't influenced by these outliers, was up only 1.2 percent and still suggestive of some considerable disinflationary pressure.

What does the CPI have to do with housing? Well, the shelter component of the index, which is derived largely from rents, was unchanged and has risen only 0.7 percent over the past year (see chart below). This performance represents unprecedented lows for this, the largest of the major CPI categories, and is a good indication of the downward price pressures being felt in the residential housing market.

More directly related to the state of housing was Tuesday's report on new home starts, which dropped sharply. Starts fell 10.6 percent in October, a surprising decline for a series that appeared to bottom out in April and stabilize in recent months. But perhaps a few bumps along the road to recovery are to be expected.

Some say that the falloff in new home construction last month was likely the result of uncertainty over the continuation of the first-time homebuyers program. That's a possibility, but here's something else to consider: There may be a lot more housing inventory out there than the official numbers suggest.

In recent months it appears that home prices as measured by the S&P/Case-Shiller Index have stabilized and begun to improve while home sales have picked up notably and listing inventories of new and existing homes have fallen. However, these listing inventories fail to capture a large share of the market including homes for sale by owner, potential buyers on the sideline waiting to see improvement, and foreclosure properties that have not yet made it to market but likely will eventually.

RealtyTrac reported that foreclosure activity slowed for the third straight month in October, down 3 percent from the previous month. However, those receiving notices of defaults increased 2 percent after declining 12 percent the prior month. Bottom line, foreclosure filings remain at high levels.

Amherst Securities released a report in September that took a stab at calculating the current shadow inventory of foreclosure properties using the Truilia listing database. In light of increased sales and slowing foreclosure filings, let's see how things are going:

Comparing the September report and the November numbers, we see that listing inventories declined 3 percent, which is to be expected with the pick-up in existing home sales numbers that the National Association of Realtors has been reporting in recent months. However, the shadow inventory of foreclosed homes grew by 9 percent (real estate owned, or REO, properties grew by 4 percent), helping to drive total inventory up 2 percent from September to November.

Homebuilding was a driving force in the economy in the years leading into the recession. Looking forward, though, the homebuilding industry is continuing to face significant obstacles, including inventory challenges. Those challenges translate into homebuilders being understandably wary to move ahead on new construction until foreclosures and REO inventories measurably subside. Thus, the homebuilding challenge continues.

By Whitney Mancuso, senior economic research analyst, and Mike Bryan, vice president, both in the Atlanta Fed's research department