Yes, the financial crisis has passed and the economy is growing again, but there’s a good chance that growth will be temporary – the result of one-time events like “Cash for Clunkers”, the tax credit for first-time home buyers and the restocking of inventories allowed to dwindle during last year’s crisis. But with businesses still reducing payrolls, bank lending still contracting, and anxious consumers determined to save more and spend less, a sustained recovery in 2010 isn’t looking very likely.– “A New Bubble Of the Fed’s Creation”, Steven Pearlstein, The Washington Post, September 23It is unwise to prejudge the Federal Reserve’s policy strategy – or to declare the victor or the vanquished – by the split time, however notable it might be. We are at a critical transtion period, of still unknown duration, and we must prepare diligently for an uneven road race ahead. If policy is not implemented with skill and force and some sense of proportionality, the success of the overall endeavor could suffer.– “The Fed’s Job Is Only Half Over”, Kevin Warsh, Federal Reserve Governor, The Wall Street Journal, September 25 (Warsh was making an analogy here between Fed policy and a triathlon. Hence “the split time” and “road race ahead.”)
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Last Wednesday’s Fed Statement was very interesting (also see “Two Subtle, Significant Changes To The Fed Statement”, Top Gun FP, September 23). They upgraded the economy writing: “Economic activity has picked up following its severe downturn” (Sept 23). That compares with what they wrote in August: “Economic activity is leveling out” (Aug 12). “Picked up” implies improvement while “leveling out” implies stabilization.
The second interesting change to the statement was what they said about their $1.25 trillion Fannie and Freddie mortgage backed securities purchase program. The Fed will “gradually slow the pace of these purchases” spreading them out through the end of the first quarter of 2010 instead of completing them by year end, which was the previous plan. This is important because Fannie and Freddie are the biggest players in the mortgage game right now and the Fed is the biggest purchaser of their MBS.
On Friday, Fed Governor Kevin Warsh wrote a much discussed op-ed in The Wall Street Journal. Titled “The Fed’s Job Is Only Half Over”, Warsh cryptically argued that the success of the Fed’s endeavour is only half over because it still requires the removal of all its policy accomodation without tipping the economy back into recession. That is no easy task since, as I argued last week, the improvement in the economy is mostly due to massive government spending and stimulus.
The market seemed to grasp the meaning of the Fed Statement and Warsh’s editorial, with the S&P dropping 45 points (3.24%) after the release of the Fed Statement over the course of the rest of the week.
Last week’s Fed-related drama and the market action raise the key question: Can the economy survive without all the government spending and stimulus that have fueled its improvement over the last 6 months? Because the Fed’s Fannie and Freddie MBS purchase program isn’t the only program that is winding down.
The Cash For Clunkers program which ran from July 27 through August 24 stimulated a lot of new car buying in August. Close to 700,000 cars were sold under the program resulting in a 17% increase in August new car sales at Ford, 10% at Honda, 6% at Toyota, and 47% at Hyundia compared to the year ago period. Even the car makers who reported down sales (-15% for GM, -20% for Chrysler, -3% for Nissan) were less bad compared to previous months.
However, what will September sales look like when they are reported on Thursday? In all likelihood, the Cash for Clunkers program pulled sales forward that otherwise would have been spread out. While it might have increased overall sales, it’s likely to have cannibalized sales for the next few months.
The same kind of argument applies to the $8,000 1st Time Home Buyer Tax Credit which expires on Nov 30, 2009. The National Association of Realtors estimates that the tax credit was responsible for 350,000 of 1.4 million first time existing home sales in 2009 (see “1st Time Homebuyer Tax Credit And Fed Mortgage Security Buying Set To End”, Top Gun FP, September 17).
What happens to home sales when the credit expires? Congress is likely to extend the program, according to The Washington Post ( “Clock Is Ticking for First-Home Buyers: $8,000 Tax Credit Is Set To Expire Nov. 30 – Unless Congress Extends It”, September 25, A1), but that just puts off the dilemma until a later date.
Not all of the government stimulus programs are winding down. The massive federal stimulus, The American Recovery and Reinvestment Act, is still just warming up. For example, the widening of I-215 in San Bernadino recently received a $128 million federal stimulus grant. The FHA and Ginnie Mae appear to be continuing to ramp up mortgage production and their corresponding security guarantees.
But the point is well taken. This economy is completely dependent on all the government stimulus and can’t function without it, in the same way that a crack addict can’t function without his crack. When the government starts trying to take the punch bowl away, will the party continue?
Most likely, the government will err on the side of over-spiking the punch and keeping the party well supplied. But that has consequences as well – which I’ve written about many times before in this space.
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