Fed’s High Wire Inflation Fighting Effort Risks Triggering a Recessionary Fall

Imagine a high-wire act performed without a net.  That describes the Federal Reserve’s effort to curb inflation without crashing the economy.  Success will bring applause and relief; failure, a brief downturn, at best, with a prolonged recession the worst case outcome. 

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Like a car with worn tires, the U.S. economy is struggling to gain traction. It’s not skidding off the road and it is heading generally toward recovery. But it’s not there yet. And while the forward momentum is encouraging, the slipping and sliding is making for an uncomfortable and unsettling ride.

The November labor market report provides a recent example. The unemployment rate rose unexpectedly to 9.8 percent from 9.4 percent as employers added only 39,000 workers to their payrolls for the month ¾ far below projections that the economy might gain as many as 159,000 jobs.

The housing market continued to contribute to the prevailing unease, producing another in what has been a series of disappointing reports. New home sales declined by 8.1 percent in October, putting the annual sales pace (283,000 units) near the record low reported in August. Housing starts also fell by 12 percent from the September level, mostly reflecting a 44 percent drop in multifamily construction as single-family starts declined by only 1.1 percent.

“Starts are a reminder of just how miserable the situation is in housing,” Chris Low, chief economist at FTN Financial in New York, told Bloomberg News. “Sales have been so weak for so long that we continue to see starts bouncing along the bottom,” he added.

Industry analysts blamed a combination of builder caution in the face of continuing weakness in homebuyer demand and the difficulty builders are having in obtaining credit for new projects, as lenders remain relatively tight-fisted and risk-averse.

Near Bottom -- Maybe

Building permits, an indicator of future activity, were relatively flat in October, remaining below 1 percent – about as close to the bottom (no construction activity at all) as they are likely to get. Although builder confidence improved (somewhat inexplicably, given the new home statistics), analysts pointed out that there is little basis for an optimistic near-term view.

“I don’t see much on the horizon that would give anybody a great degree of comfort on the financial condition of the country,” Donald Tomnitz, chief executive officer of D.R. Horton, the nation’s second largest home builder, told Bloomberg. “I just don’t see a lot of hope for a great spring market,” he added.

Existing home sales in October were also weaker than anticipated, declining by 2.2 percent from the September level, leaving volume nearly 26 percent below the year-ago pace. Trying to find something positive to say about statistics that are anything but, Lawrence Yun, the chief economist of the National Association of Realtors (NAR) termed the housing recovery “uneven,” which is about as euphemistic a description as one could find for a market that looks grim by any measure.

Still, Yun insisted, sales activity “is clearly off the bottom and is attempting to settle into normal sustainable levels." Given continuing improvements in employment, and significantly favorable affordability conditions, he predicts, “sales should steadily improve to healthier levels of above 5 million by spring of next year.”

An unexpected increase in the NAR’s pending sales index for October suggests that his forecast may be more than wishful thinking. But even with that 10 percent increase, the index remains nearly 22 percent below the year-ago level, with sales still facing the formidable headwinds created by a still high unemployment rate.

No Price Recovery

Home price trends provide little evidence of the market stability that analysts and prospective buyers want to see. The Standard & Poor’s/Case-Shiller index, increased by only 0.6 percent in September, its smallest gain in the past 8 months, as 15 of the 20 cities included in the survey posted year-over-year declines. After gaining ground in 4 of the previous 5 quarters, prices declined by 1.5 percent between the second and third quarters. The index is now 28 percent below its July 2006 peak and unlikely to improve any time soon, according to Karl Case, one of the founders of the closely-watched housing barometer.

“Prices are going to be flat for a while,” he told Bloomberg Radio. The outlook, he acknowledged is “a little discouraging.”

More than a little discouraging, according to a recent Zillow report, which says the nationwide decline in home values rivals the Great Depression, when values fell by 25.9 percent over a 5-year period. The report also estimates that 23.2 percent of single-family owners were “upside down” in the third quarter, with mortgages exceeding the value of their homes, up from 22.5 percent with negative equity in the second quarter.

“The high percentage of homeowners in negative equity continues to be troubling, in that it represents a huge number of people who are not only more vulnerable to foreclosure, but who are essentially trapped in their current homes and are prevented from selling and buying a new home, Stan Humphries, Zillow’s chief economist, said in a press statement. “This has profound implications for future demand and will be a millstone around the neck of the housing market,” he added.

Foreclosure Fiasco

Foreclosures, and the mess created by flawed foreclosure filings, also have achieved millstone status. Foreclosures, which set a new record in September (as 1.2 out of every 1000 homeowners lost their homes), create obvious downward pressure on prices, but they also have a positive effect – reducing inventories swollen by repossessed homes.

The foreclosure fiasco has undermined that progress, forcing financial institutions to delay foreclosure actions as they have struggled to clean up flawed paperwork, fend off a rising tide of consumer and investor lawsuits, and persuade increasingly skeptical courts that they have the right to foreclose, can document their standing, and have followed proper procedures in their foreclosure actions.

A monthly survey by Campbell/Inside Mortgage Finance found that 24 percent of short sales and 12 percent of REO sales scheduled for October were delayed or canceled because of foreclosure-related concerns. A separate report by RealtyTrac found that homes in the foreclosure process sold for 32 percent less than non-distressed properties in the third quarter, the largest discount in five years. Analysts attributed the widening gap largely to buyer demand weakened by the foreclosure problems “which could chill demand even further” in the coming months, James Saccacio, RealtyTrac’s chief executive officer, said in the report.

Employment Picture Blurred

Compared with the housing market data, labor market reports had begun to look almost rosy, until the November statistics were announced. Unemployment claims had been declining and analysts had been predicting (incorrectly, as it turned out) that the November report would show evidence of a budding employment rebound.

The Federal Reserve has remained cautions and concerned, predicting before the November labor report that the unemployment rate would decline only modestly, to around 9 percent, by the end of next year, as the economic recovery remains “disappointingly slow.”

The Fed’s most recent beige book report, released December 1, painted a somewhat brighter, or at least brightening, picture, with most of the district banks reporting stronger economic growth, “some improvement” in hiring activity and “generally positive” expectations for holiday spending.

Early indications suggest the holiday spending optimism may be justified. Retail sales for Thanksgiving weekend increased by 6.4 percent over last year, building on a 1.2 percent gain in October and fueling hopes for the best holiday shopping season since the recession began.

Improving consumer confidence is a major factor in these increasingly upbeat retail projections. The Conference Board’s confidence index and the Thomson Reuters/University of Michigan’s preliminary sentiment index both increased in October, reaching 5-month and 3-month highs, respectively.

Consumer spending also increased in October – the fifth consecutive gain for this measure – as rebounding incomes led many heretofore tight-fisted consumers to relax the grip on their wallets. Among other positive signs:

  • The consumer debt load declined by almost 1 percent in September from the June level as households continued to repair their tattered finances. The New York Fed reported that household debt has declined by $1 trillion since the third quarter of 2008, and only part of the decline is attributable to defaults or charge-offs, Donghoon Lee, a senior economist at the bank, said in his study. “This change, which we continue to study carefully, can be a result of both tightening credit standards and voluntary changes in saving behavior,” he added.
  • New bankruptcy filings declined by 16 percent between the second and third quarters – the fifth consecutive decline in business filings and the second decline in the past four quarters for personal filings.
  • Both leading and lagging economic indicators improved in October.
  • Although new factory orders declined in November, factory production levels increased, as did the Institute for Supply Management’s (ISM’s) business barometer and production gauge. The ISM’s non-manufacturing index (measuring the service sector) grew at its fastest pace in six months, while its manufacturing gauge remained firmly in positive territory for the 16th consecutive month, providing additional evidence that the economic recovery is on solid ground, many analysts agree.

“Businesses are starting to feel better about the outlook and so they’re willing to spend more on investment as well as to hire,” Stephen Stanley, chief economist at Pierpoint Securities, told Bloomberg. “We had strong growth early in the year, a little bit of a hiccup in the middle and now things are starting to come back again.”

“The soft patch is behind us,” Jonathan Basile, an economist at Credit Suisse, agreed, telling Bloomberg, “We have a little more momentum. Employers are getting a bit more optimistic about the outlook and [don’t feel the same need] to cut costs.”

Surveys confirm that corporate executives are feeling more confident about the economic outlook, but as the recent labor statistics indicate, their confidence has not as yet translated into a hiring surge, or anything close to it.

“This is still, by standards of history, only a half-speed expansion,” Avery Shenfeld, chief economist at CIBC World Markets, told Bloomberg recently – fast enough to boost the confidence and the spending of consumers who have jobs, but not nearly fast enough to reduce an unemployment rate that remains the largest impediment to a significant and sustained economic recovery.