Federal Reserve & Interest Rates

In a speech before the Economic Club of New York, Fed Chairman Ben Bernanke see continued growth for the economy into next year.  He admits though that growth is likely to be slow due to a number of factors.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds–in particular, constrained bank lending and a weak job market–likely will prevent the expansion from being as robust as we would hope. I’ll discuss each of these problem areas in a bit more detail and then end with some further comments on the outlook for the economy and for policy.

Many economists believe we could be entering a jobless recovery phase, as it could be quite some time before the job market begins to recover.  Some believe the unemployment rate could reach as high as 13% before job creation starts again.

With inflation concerns still minimal at this time, he states that low interest rates will likely be warranted for some time and while some critics have called for higher interest rates, it could be as much as a year or more before we see any significant rise in the federal funds rate.

With banks expecting more loan losses from a weak housing market, a number of institutions have been hoarding cash, which has constrained bank lending to a degree.  Weak consumer spending has also caused credit demand to be well below normal levels, although those who are seeking credit are finding a difficult time of it.

While the banking system hasn’t fully recovered, it has stabilized somewhat and now that banks have sufficient capital reserves, the Fed has begun to ramp down it’s liquidity programs.  Although it’s balance sheet activity has slowed of late, it would not be surprising if we were to see the Fed use this tool once again next year if inflation concerns remain muted.

The Federal Reserve issued a press release on Monday concerning the Supervisory Capital Assessment Program(SCAP).  Since the start of the financial crisis last fall, financial institutions have frantically raised their capital levels and are even now continuing to de-leverage their positions.

The Federal Reserve Board on Monday said that 9 of the 10 Bank Holding Companies (BHCs) that were determined in the Supervisory Capital Assessment Program (SCAP) earlier this year to need to raise capital or improve the quality of their capital to withstand a worse-than-expected economic scenario now have increased their capital sufficiently to meet or exceed their required capital buffers.

The one exception, GMAC, is expected to meet its remaining buffer need by accessing the TARP Automotive Industry Financing Program, and is in discussions with the U.S. Treasury on the structure of its investment.

Some economists believe the banking system may have too much liquidity at the moment.  While they are well positioned in case of a worst case scenario, the lack of credit being supplied to the market is worrisome.

Much of this may also have to do with the historically low interest rates the Fed currently has set.  Everyone knows the Fed will probably raise rates starting sometime next year and when that happens, consumer rates will rise as well.

Banks might be reluctant to start heavy lending at current interest rates when they aren’t likely to last and being locked into long term loans at low rates would be especially problematic with the lack of a secondary market to rollover those loans.  On the flip side, many Americans are also conscious of the weak labor market and have increased their savings rate over the past year, so the demand for credit is somewhat lacking as well, even with the currently low interest rates.

So even though the banking system has stabilized somewhat, the supply and demand for credit is still well below normal levels and it could remain that way for some time.

Although the economy returned to positive territory last quarter, an uncertain labor market is likely to put a damper on consumer spending and the holiday shopping season ahead.  On Friday, the Labor Department issued it’s October job’s report, which showed higher than expected job losses once again.

The unemployment rate rose from 9.8 to 10.2 percent in October, and nonfarm payroll employment continued to decline (-190,000), the U.S. Bureau of Labor Statistics reported today. The largest job losses over the month were in construction, manufacturing, and retail trade.

Now that unemployment has broken into the mythical double digit territory and slightly faster than many economists were predicting, it may give the government pause as it discusses exit strategies and an end to monetary and fiscal easing.  The labor market could very well put a damper on economic recovery over the long run and it could spur more fiscal spending into the new year.

This year’s stimulus package, while it also included tax breaks to spur consumer spending was also designed to create about 3 million jobs over a period of three to four years.  Thus far, little more than half a million jobs have been created and it pales in comparison to the over seven million jobs lost since the recession started.

Although the labor market typically lags behind the economy, some economists are predicting it could be as much as a year if not more before job creation begins again and that the unemployment rate could reach as high as 13% by then.  Even after the labor market starts to recover it liable to be a long and slow process, where we could still be over the double digit mark, two or three years down the road.