Federal Reserve & Interest Rates

Today’s Commerce Department report showed that consumer spending numbers for the month of July rose slightly by 0.2% mostly on the strength of the government’s “Cash for Clunkers” program.  It’s also fairly evident that the positive effects on consumer spending from stimulus payments are also ending.

Personal and disposable income remained flat for July and the savings rate for the past two months are higher than the 12 month average which means that consumers are still worried about spending.  It doesn’t help that job losses are expected to grow in the next few months even though economic growth is poised to turn positive once again.

For most part, it’s been the government’s fiscal spending which has brought the economy out of recession but unfortunately that’s not a long term solution.  The savings rate for July was at 4.2%, consumers are still worried about the future and have been holding back on spending with this year’s tax breaks.

Personal Consumption Expenditures, a consumer gauge for inflation was flat for the month and slightly negative for the preceding 12 months, although it should be noted that it excludes the more volatile food and energy component.  Then again food and energy prices are considerably lower than they were a year ago just when the commodity bubble started to burst.

Most economist believe spending will remain relatively flat at least until the job market starts to improve once again.  There have also been some glimmers of hope that the housing market is also starting to thaw out a bit with sales activity growing over the past three months.

A lot of uncertainty from investors were laid to rest with the announcement by the Obama administration that Ben Bernanke’s will be nominated for a second term as head of the Federal Reserve.  He may face some difficult questions during his confirmation hearings but most people feel his reappointment is a given.

It’s going to be a long road to recovery and the Fed will have a difficult task ahead as it tries to shrink it’s balance sheet as economic growth returns.  It will also have to balance it’s dual mandates of maximizing employment and price stabilization while coming to grips with the country’s mounting national debt.

The Fed has had to take a number extraordinary actions of the past year in order to avert a collapse of the financial system and being able to properly unwind those actions in a timely manner maybe just as important.  Both the economy and the banking system will be in a fragile state for years to come and avoiding a potential relapse will be the main focus.

Although the recession is expected to end soon, the Fed would like to keep rates low for an extended period of time if at all possible to stimulate growth.  There is still the employment situation to worry about and the housing market has yet to recover from it’s collapse from two years ago.

Consumer confidence is still low and until that demand returns, inflation expectations will likely remain muted for the time being.  It’s going to be a difficult juggling act once inflation rears it’s ugly head once again and it will with the national debt expected to double in the next decade.

During a speech today at an annual economic symposium, Fed Chairman Ben Bernanke reflected on the financial crisis that rocked the world over the past year.

Notwithstanding these significant concerns, however, there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts.

And in early September, when the target for the federal funds rate was 2 percent, investors appeared to see little chance that the federal funds rate would be below 1-3/4 percent six months later. That is, as of this time last year, market participants evidently believed it improbable that significant additional monetary policy stimulus would be needed in the United States.

The collapse of Lehman Brothers was the spark that set the global financial system in flames and without a trillion dollars worth of government intervention, it would probably be still burning.  As much as the government has been criticized for the disorderly breakup of Lehman, they really had little choice in the matter.

Lehman was just too highly leveraged and it’s assets paled in comparison to the amount of money that would have been needed to keep it afloat.  The government has also been criticized for the amount of money it has loaned out to other financial institutions but in those cases, they have some reasonable expectation of getting paid back.

Credit markets are slowly building back up but it is going to be a long drawn out process.  Many financial institutions are still in a fragile state and could be for years to come.  Companies are still trying to de-leverage themselves and for the time being the government is having to act as the principle in credit creation.

Toxic assets are still a big problem for many banks but it is hoped that encouraging signs in the housing market will help in that regard over the next year.  Home sales activity has grown to it’s highest level in two years and if the Fed is able to keep mortgage rates around their current level that trend is likely to continue.

The economic contraction slowed in the last quarter and many economists believe that GDP will once again turn positive by year’s end.  Of greater concern is the unemployment situation which is expected to hit double figures in the upcoming months.

With Bernanke’s term set to expire at the end of the year and no news from the Obama administration on whether he will be reconfirmed or not, investors are concerned about the future of the Fed and what it’s primary goals will be moving forward.