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Consumer confidence slowly returns

Consumer confidence has risen meaningfully from the depths of depression that prevailed in late 2008. But there is still a long way to go to get back to normal. Confidence is an important part of this recovery, because the financial panic that drove the recession also caused a major decline in money velocity. As confidence slowly returns, money velocity is beginning to rise (and money demand is beginning to fall); the money that was hoarded in the recession is beginning to be spent again. Rising confidence and rising money velocity are thus important drivers of this recovery. We're making progress, but slowly.

Retail sales: a V-shaped, but sub-par recovery

Retail sales grew at a 7.9% annualized pace in the six months ending January. That's a pretty nice recovery. However, as the second chart shows, although sales are increasing at an above-trend pace, they are still about 12-13% below the levels that would have prevailed in the absence of a deep recession. We see the same pattern in GDP, which is about 9-10% below its trend. The gaps in both of these cases are substantial, but they are narrowing. In previous deep recessions, this gap narrowed quickly, thanks to very strong growth. This time it's likely to narrow more slowly, thanks to the huge increase in the size of government and income redistribution programs and the threat of higher tax rates in the future.

If Obama were really the "fierce advocate of free markets" that he says he is, he would have done things very differently last year. Instead of counting on massive income redistribution and big increases in government spending, he would have trusted free markets to pull the economy out of recession, and lowered marginal tax rates on income, capital, and corporate profits to get things jump-started. The deficit would have been much lower, and the economy much stronger. We're at a level of deficits now that are so high they are soaking up a major portion of the world's savings. If government weren't borrowing so much, the world's savings would be used by the private sector in a much more efficient and productive manner.

It's VERY different this time

It seems I keep running across people's attempts to compare today with the Depression of the 1930s. But as I was going through and updating my charts, I ran across this one of the yield on 10-year Treasury bonds. Bond yields (the 10-year was the longest Treasury maturity available until the mid-1970s) first hit 2.0% in 1941, well after the worst of the Depression and Deflation of the 1930s, and it took until late 1958 before yields rose to the level they are trading at today. In other words, it took the U.S. economy 25 years following the Depression—the low point of the Depression occurred in 1933—to get interest rates up to where they are today. Today the bond market has only taken a little over 13 months (from the end of Dec. '08, when markets were priced to a Depression) to move yields up from 2% to today's 3.7%.

Clearly, there's no comparison between the past year or so and the Depression of the 1930s. In the old days they made Depressions that lasted a long, long time. Nowadays they're over before they even get a chance to start.

If there's anyone we have to thank for short-circuiting this recent depression, it's the Fed. It's amazing how fast a trillion dollars of new money can put an end to the threat of deflation.

The 10-yr Treasury signal

This chart should not be interpreted scientifically. It is my interpretation of what the yield on 10-year Treasury bonds reveals about the market's outlook for U.S. economic growth. It's subjective, but I think it fits with a lot of the evidence that I follow. Today it's saying that the market believes the U.S. economy is growing at a relatively unimpressive pace; the consensus of most forecasters seems to be somewhere around 2-2.5%. If yields move above 4% this will be a good sign that optimism is returning. At 5%, the bond market would be telling us that we're in for a decent recovery, which would imply growth of 4% or more. I expect to see yields moving up to at least 4.5% this year, which would be consistent with growth expectations of 3-4%.

China's imports surge

We all know that China is a prolific exporter of cheap, quality goods to the rest of the world. Given the recent recovery in the U.S. and other developed countries, I was not surprised to read last night that China's January '10 exports rose 21% from what they were in Jan. '09. But what really surprised me was to see that China's Jan. '10 imports had soared by 85% from a year ago. This may be distorted a little on the high side by the timing of the Chinese New Year, but there is no denying, as this chart shows (not seasonally adjusted), that the Chinese have been doing their best to spend as much of their export earnings as possible. In fact, China's trade surplus (the thing that they are accused of aggravating by keeping the yuan "artificially low" against the dollar) was lower last year than it was in 2007 and 2008.

Skeptics will argue that Chinese imports surged because they are mindlessly stockpiling all sorts of commodities, but I see this as a sign that one of the world's most dynamic economies has recovered rapidly from the same trade collapse shock that rocked the rest of the world. It's onward and upward from here.

Trade stages a V-shaped recovery

World trade collapsed spectacularly beginning in the summer of 2008, and it staged an impressive comeback in 2009. By the end of last year, U.S. exports of goods and services had recovered fully half of what they lost from July '08 through April '09. If this isn't a V-shaped recovery in trade—arguably the most important source of global economic growth—then I don't know what it is. The global economic engine is firing on all cylinders, and it's not going to stop anytime soon. In fact, there is still a lot of catching up to do to get back to where we were in mid-2008, which means more growth for everyone.

Copper update and other musings

Early in January I posted a chart of copper prices with the title "Dr. Copper says the patient has recovered." I noted that the huge rebound in copper prices was a good sign that the global economy had recovered from its slump and was rapidly returning to health. Since then, copper prices have fallen about 15%, commodity prices in general have slumped, and so have equity prices.

The shorthand version for what has happened in the past month is a reversal of the "carry trade:" risk assets are down, and the dollar is up. Fear is up too, with the VIX bouncing from the teens to the mid-20s. Concerns over Greece and the stability of the EU are likely catalysts for the recent bout of nerves, but so too is the sudden rise of populist attacks on big banks (see my friend Don Luskin's article in today's WSJ on the subject), concerns that Fed and some other central banks are preparing to tighten monetary policy, and the fact that numerous countries, including the U.S., are being forced to confront the problem of out-of-control budget deficits brought on by profligate public sector spending practices.

Does this selloff in risk assets mark the end of the recovery and the beginning of a renewed bout of economic weakness? Could a Greek default really bring down the EU and/or the Euro, and ultimately infect the U.S. economy with another case of the economic willies? Is the global recovery so tenuous that it can't bear interest rates that move up from zero, or that it can't survive without government spending life support?

My position for the past year or so has been that the U.S. economy has recovered in spite of all the fiscal and monetary stimulus that has been thrown at it; that in fact the recovery would be stronger if it weren't for stimulus. I think fiscal and monetary stimulus are vastly over-rated. No one can prove what the government spending multiplier is, but I'll vote for it being negative. I don't see how the act of taking money from John and giving it to Joe can result in a stronger economy, and if Joe ends up being less careful about spending the money he's been given than John (which is not a very dubious proposition), then the result is clearly a weaker economy. And since when does printing money make an economy stronger? Throwing money out of helicopters probably results in new spending, but that is much more likely to just push prices up than it is to cause anyone to build new plant and equipment.

Consequently, I can't get concerned over the approach of the end of stimulus, which I think is the dominant source of the market's fear in recent weeks. Bring it on, I say. Let's have higher interest rates right now, so we can worry less about what how high inflation might go in the future. Let's have spending freezes or outright reductions in spending right now, so we can worry less about how high future tax burdens might have to rise. Let's please return to the old-fashioned notion that people know best and government knows least about how to run our lives and our businesses. Let's hope that the Tea Party ends up throwing a bunch of misguided politicians of both parties out of Congress come this November.

If lower copper prices and a reversal of the carry trade are signaling anything, it's that the world may be stumbling its way to a better set of policies, and that is good news.

Used car price update

Here's an update to a chart I've shown several times in the past. I note the huge rebound in the prices of used cars following the recession-induced collapse of late 2008. As Manheim notes, "on a mix, mileage and seasonally-adjusted basis ... the Manheim Used Vehicle Value Index was 117.6 for January, which represented a 15.6% increase from a year ago." This strongly suggests that consumers are getting back on their feet, and that inventories of unsold cars have returned to some measure of balance. More good news.

A primer on bank reserves

The $1 trillion expansion of the Federal Reserve's Balance Sheet that occurred from Sept. '08 through late last year is arguably one of the biggest monetary events to happen in the history of the U.S. This chart puts it into perspective (note that the y-axis is a logarithmic scale). Prior to this crisis, bank reserves totaled about $96 billion and hadn't grown at all since 2003; now they stand at $1,190 billion.

I like to keep big and complex things as simple as possible in order to better understand their significance, so I offer this simple description of what has happened and what it might mean. It's not meant to be a definitive analysis of the situation, but rather something that should be understandable to those with a minimal level of knowledge of monetary matters. And at the very least it provides a basis for discussion.

The Fed, responding to a huge increase in the world's demand for money and safety in the wake of the collapse of Lehman Bros., bought a trillion dollars worth of securities (mostly Treasuries and MBS, and the exact number is closer to $1.1 trillion). The Fed paid for these purchases by crediting the accounts of its member banks with reserves, which is the type of money only the Fed can create. Buying and selling securities is the traditional way that the Fed increases or reduces the supply of money to the banking system.

In short, the Fed reacted to an explosion in the demand for money by pumping an explosion of bank reserves into the system. This was the right thing to do, since to not accommodate a surge in the demand for money with a surge in the supply of money would almost certainly have resulted in a severe shortage of money and thus a monetary deflation of the sort that exacerbated the Great Depression.

To date, banks essentially haven't used any of their extra reserves to expand their lending. The reserves are sitting idle at the Fed in the form of "excess reserves," which currently total $1.06 trillion, up from roughly zero prior to Sep. '08. The Fed has increased the lending capacity of banks by an order of magnitude, but this hasn't created a flood of extra liquidity or a burst of inflation.

There are several reasons for the lack of lending. To begin with, the demand for money and safety remains high, and thus the demand for loans is still weak. To be sure, there are lots of companies that are desperate for credit to fund startups and expansions that can't find a bank willing to lend to them, but in aggregate, bank lending is weak in part because most people these days are still trying to deleverage. At the same time, banks aren't particularly anxious to lend either. They still are suspicious of the credit quality of borrowers, which is why they have raised their lending standards, and they are more risk-averse than usual, just like almost everyone. Banks aren't anxious to change this, being quite happy to keep overall risk low even if it means earning a piddling amount on all the reserves they have at the Fed.

Banks may someday decide to use their reserves, and if and when they do, they could make tons of new loans and print tons of money in the process. (This is how the fractional reserve banking system works: if you ask the bank for a loan of $1 million, the bank sets aside about $100,000 in reserves and credits your checking with $1 million.) If this were to happen it could be very inflationary. For example: $1 trillion of excess reserves could potentially support about 10 trillion of new bank deposits--a sixfold increase in bank deposits!

The Fed is naturally quite concerned about this possibility, and the markets are too. Ideally, the Fed would just reverse what they did in late 2008, and sell Treasuries and MBS in exchange for taking back the trillion dollars of excess reserves. But everyone worries that this could push interest rates sky-high, threaten the recovery, and take away the security blanket (i.e., the tons of excess reserves) that now keeps the banks warm and happy. Alternatively, as Bernanke argued in a WSJ article last summer, the Fed could allow the reserves to gradually decline over the years as the securities it holds mature or are prepaid, but this might leave too many reserves in the system for too long.

Bernanke now says that the Fed's preferred exit strategy is to continue to pay interest on reserves (an authority first granted to the Fed in the Fall of '08), even as the Fed raises short-term interest rates. That way, the theory goes, banks won't mind holding lots of excess reserves indefinitely, or at least holding a lot more than they would under a non-interest-paying regime. Bank reserves would thus become very much like T-bills, a source of bedrock security and income for banks. As the Fed ratcheted up short-term interest rates to keep inflation pressures from rising as the economy gains strength, the income on these reserves would grow commensurately. Banks would be happy to keep holding excess reserves, and the Fed wouldn't have to sell a trillion dollars of securities. The Fed would presumably pay an interest rate on reserves equal to a bit less than the desired Fed funds target rate, which in turn is what drives interest rates all along the Treasury yield curve. Between maturing debt and mortgage prepayments, the excess reserves would gradually disappear.

Without the ability to earn interest on their reserves, reserves would act like a deadweight on bank's balance sheets. Banks would either try harder to expand their lending, which could be very inflationary, or they would sell their excess reserves on the open market. The latter would severely depress the Fed funds rate, which is something the Fed doesn't want to happen. The Fed runs monetary policy by targeting the Federal funds rate, and they are going to want to raise that rate, not watch it fall.

Alternatively, the Fed could raise reserve requirements, since that would effectively soak up some portion of the excess reserves. But raising reserve requirements can't do the heavy lifting that paying interest on reserves can accomplish, because being forced to hold a lot more non-interest-paying reserves would again be a deadweight drag on banks' balance sheets.

So Bernanke's proposal to pay interest on reserves is not completely crazy. But it could become very expensive for the Fed if interest rates rose a lot, and the whole exercise takes us into uncharted waters where unintended and unforeseen consequences lurk in the depths. It would also act to legitimize the "monetization of government debt" that is the real source of all inflation.

We can only hope that the Fed is able to navigate the turbulent and uncharted waters that lie ahead, while avoiding Scylla (inflation) and Charybdis (deflation).