Federal Reserve & Interest Rates

Federal Reserve Vice Chairman Donald Kohn gave his views on the current economic outlook in a speech on Tuesday.

In broad terms, the data that we have in hand indicate that economic activity turned up in the third quarter. To some extent, the pickup in activity in recent months reflects the dissipation of some of the forces that had been exerting downward pressure on the economy during the preceding several quarters.

Perhaps the most important of these downward forces was the turmoil in financial markets that began in late 2007, which not only tightened credit availability and reduced wealth, but also undermined confidence, especially when conditions took a decided turn for the worse in the fall of 2008.

The stabilization, and more recently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.

Although the financial system has stabilized somewhat, credit has remained tighter than they would wish.  The Fed still has extensive excess bank reserves on deposit but as economic conditions improve, it is hoped that institutions will lend more freely.

The labor market is still a hurdle that the economy has to get through and while job losses are slowing, the downward trend is expected to continue for a few more months and it could take years for it to fully recover.  Many economists feel that the unemployment rate could remain above 9% mark into 2011.

The housing market also remains a problem for the economy but hopefully as credit conditions improve, that will translate into increased sales activity.  Consumer spending will also likely remain somewhat muted until labor conditions start improving once again but demand has picked up in the past few months.

A lot of people are starting to see the light at the end of the tunnel and hopefully in the months ahead, this view will be re-enforced.

The Labor Department released it’s September job’s report on Friday which had higher than forecast job losses.  This brings the total job losses since the recession began up to 7.2 million, the highest figures since the Great Depression.

Nonfarm payroll employment continued to decline in September (-263,000), and the unemployment rate (9.8 percent) continued to trend up, the U.S. Bureau of Labor Statistics reported today. The largest job losses were in construction,manufacturing, retail trade, and government. 

Many economists feel that the labor situation won’t improve for some time and that the unemployment rate could still be above the 9% mark into 2011.  This has prompted the Obama Administration to release a statement that it will “explore any and all additional measures” to spur growth.

The report is also a sobering reminder for many investors that the recovery is likely to be slow and will have some hiccups along the way.  The Federal Reserve also appears to be committed to keeping interest rates at near zero for at least another year, as inflation forecasts remain moderate for the next two years despite the explosive growth of the nation’s debt load.

While there has been recent talk of the government’s possible exit strategy from monetary and fiscal stimulus, it is apparent that it will need to be a slow and gradual process.  The risks of a double dip recession appears to be minimal at this time but the banking system is still in a fragile state and consumer spending remains depressed.

Vice Chairman of the Federal Reserve, Donald L. Kohn, spoke briefly about the Fed’s exit strategy during a speech before the Cato Institute’s Shadow Open Market Committee meeting on Wednesday.

In its most important aspects, the decision about when to begin exiting from the unusual policies is not materially different from any decision to start tightening monetary policy. We will need to begin to remove the extraordinary degree of accommodation in its various dimensions when we judge that exiting from the current stance of policy will be necessary to preserve price stability as the economy returns to higher levels of resource utilization.

The recovery is going to be a slow process, so it’s not like the Fed will have to shrink it’s balance sheet overnight.  Even so, Kohn remarked that interest rates are expected to remain low for an “extended period of time”, echoing the sentiments of last week’s FOMC meeting which kept rates at near zero.

A lot will depend on the employment picture, the Labor Department will be releasing is job’s report for September on Friday, and many economists are predicting that the unemployment rate could stay above the 9% range into 2011.  Job losses have slowed the last few months and that trend is expected to continue, but those jobs aren’t going to be replaced anytime soon.

The Fed will finish it’s purchases of Treasuries by next month and has slowed the pace of it’s purchases of agency mortgage securities and will finish that program by next spring.  They will slowly unwind their liquidity facilities, which are still needed at the moment since lending activity has yet to return to normal.

The Fed will have to balance increasing inflation pressures as the economy improves and try to avoid a possible “double dip” recession that could occur when rates start rising once again.