by Calculated Risk on 2/01/2006 03:02:00 PM

"By passing these reforms, we will save the American taxpayer another $14 billion next year, and stay on track to cut the deficit in half by 2009." George W. Bush, SOTU Address, Jan 31, 2006

After four months, Fiscal 2006 continues to set new records for the YTD increase in National Debt. For the first four months of fiscal year 2006, the National Debt increased $263.4 Billion to $8.196 Trillion as of Jan 31, 2006.


Click on graph for larger image.

The previous record for the first four months was in fiscal 2005 with an increase in the National Debt of $248.7 Billion.

Each month I will plot the YTD increase in the National Debt and compare it to the proceeding years. I expect fiscal 2006 to set a new record for the annual increase in the National Debt.

NOTE: I quoted the SOTU address last night for two reasons: first, $14 Billion is an inconsequental amount compared to the US budget, and second, there is no way the US will "cut the deficit in half" by 2009. George W. Bush has no credibility on the budget:

"... our budget will run a deficit that will be small and short-term" George W. Bush, SOTU Address, Jan 29, 2002

by Calculated Risk on 2/01/2006 11:01:00 AM

The Mortgage Bankers Association (MBA) reports: Mortgage Application Volume Declines In Latest Survey

Click on graph for larger image.

The Market Composite Index — a measure of mortgage loan application volume was 626.8 – a decrease of 5.1 percent on a seasonally adjusted basis from 660.5 one week earlier. On an unadjusted basis, the Index increased 9.1 percent compared with the previous week but was down 12.1 percent compared with the same week one year earlier.

The seasonally-adjusted Purchase Index decreased by 8.0 percent to 435.7 from 473.7 the previous week whereas the Refinance Index decreased by 1.5 percent to 1747.2 from 1773.9 one week earlier.

Rates on mortgages increased:

The average contract interest rate for 30-year fixed-rate mortgages increased to 6.20 percent from 6.04 percent one week earlier ...

The average contract interest rate for one-year ARMs increased to 5.48 percent from 5.44 percent one week earlier ...

Activity is still high, but falling again as mortgage rates are once again rising.

by Calculated Risk on 1/31/2006 05:37:00 PM

The AP is reporting:

President Bush ... [will say] Tuesday that "America is addicted to oil" and must break its dependence on foreign suppliers in unstable parts of the world.

The problem is not the source of the oil, but that America is addicted to oil in general. Oil is a global market, and to break the addiction the US needs to reduce consumption, not drill for more domestic oil. Unfortunately Bush's energy policies have been focused primarily on oil, even promoting the consumption of more oil with tax breaks for small businesses that buy large SUVs. From 2003:

This year, the perks of buying a large SUV — if you're a small business owner — got even bigger.

Congress recently passed a tax bill, as proposed in President Bush's economic stimulus plan, that offers a $100,000 tax credit for business owners who purchase any vehicle weighing 6,000 pounds or more when fully loaded.

There are several benefits of moving away from oil; economic, geopolitical and environmental. Hopefully, Bush will not call for more domestic drilling (a huge mistake), but instead call for new innovation and more conservation.

by Calculated Risk on 1/30/2006 07:27:00 PM

Dr. Altig provides the Fed Funds probabilities for the next 3 meetings:

Jan 31st:
4.5%, 97%

March 28th:
4.75%, 73%
4.5%, 20%

May 10th:
4.75%, 53%
5%, 28%
4.5% 15%

So even with the dissapointing GDP data, it appears the market expects at least two more rate hikes. Dr. Duy channels the Fed with his always insightful Fed Watch: Now It Gets Interesting...

For the Fed watcher, the 4Q05 GDP report is a real brainteaser. The central focus of the many, many blogs covering Friday’s news was the disappointing growth numbers (see William Polley’s and James Hamilton’s views, the latter including a long list of similar concerns). To be sure, the weak headline number deserved attention. But I was surprised by the relatively little attention placed on the inflation reading. I doubt the Fed is going to let that number slip by so lightly. Weak growth and higher inflation? Now that’s interesting.

And on the topic of inflation, Fed Economist Mike Bryan writes: Holding on to the Edge of Comfort

Today’s PCE inflation report for December seems to have gotten a ho-hum response in financial markets. As it should. The data were tame and not widely off expectations.

Not everyone agrees with Dr. Bryan's take on inflation (see Barry Ritholtz' Myths of the Greenspan Era). As a caveat, Dr. Bryan is writing for himself and not the Fed. Still its interesting to read his views.

by Calculated Risk on 1/30/2006 02:04:00 PM

The LA Times reports: Sales of Pleasure Boats Buoyed by Soaring Home Values

California's hot real estate market has helped power a rise in boat sales by allowing people to borrow against the soaring value of their homes to buy boats and other big-ticket items.

In California, retail sales of recreational boats — from runabouts to $4-million luxury yachts — rose about 8% last year to a record $540 million, continuing a growth trend over the last five years, according to the Southern California Marine Assn. A similar increase is expected in 2006.

Though some economists worry that too many people are overextending themselves, the boating industry considers itself lucky that business is humming despite high gasoline prices.

"A lot of people are taking money out of their homes and buying different things, and one of them — fortunately — is boats," said Dave Geoffroy, executive director of the marine association, the organizer of the L.A. Boat Show.

A couple of comments: I guess a 30 year loan on a pleasure boat is better financial planning than a 30 year loan for a hamburger!

But what happens when mortgage equity withdrawal slows?

... some dealers worry that boat sales could fall if real estate values drop, which happened in the early 1990s.

"I'm moderately concerned," said Michael Basso Jr., general manager of Sun Country Marine, which sells family boats and has locations in Castaic, Dana Point and Ontario.

He noted that half his buyers last year paid in cash, often from money they pulled out of their homes.

I wonder if the slowdown in Q4 (1.1% annualized growth in GDP) was related to a slowdown in equity extraction? The Federal Reserve's Flow of Funds report (due March 9th) will help answer that question.

by Calculated Risk on 1/27/2006 12:16:00 AM

According to the Census Bureau report, New Home Sales in December were at a seasonally adjusted annual rate of 1.269 million vs. market expectations of 1.225 million. November's sales were revised down slightly to 1.233 million from 1.245 million.


Click on Graph for larger image.

NOTE: The graph starts at 700 thousand units per month to better show monthly variation.



The Not Seasonally Adjusted monthly rate was 86,000 New Homes sold, essentially the same as the 85,000 in November.

On a year over year basis, December 2005 sales were 3.6% higher than December 2004.



The median and average sales prices are trending down.

The median sales price of new houses sold in November 2005 was $225,200; the average sales price was $283,300.



The seasonally adjusted estimate of new houses for sale at the end of December was 516,000. This represents a supply of 4.9 months at the current sales rate.

The 516,000 units of inventory is the all time record for new houses for sale. On a months of supply basis, inventory is above the level of recent years.

This report is still reasonably strong.

by Calculated Risk on 1/26/2006 01:14:00 AM

In December the FDIC, Office of the Comptroller, the Federal Reserve and other agencies issued a new proposed guidance on nontraditional mortgage products.

Now Reuters reports: US banks seek more mortgage proposal comment time

Lenders this week asked U.S. regulators to extend a comment period on a proposal that urged tighter underwriting on new mortgage products that may pose greater risks for banks and borrowers as interest rates rise.

Comments were due Feb. 27, but lenders have asked the Federal Reserve and other regulators for 30 more days.

"The proposal is extremely complex and has far-reaching consequences for our members, as well as for the nation's mortgage markets," wrote Janet Frank, director of mortgage finance in America's Community Bankers' government relations office.

"We believe that it will take an additional 30 days to complete the necessary evaluation and collect comments and data from our membership," Frank told regulators in a letter.

The Consumer Mortgage Coalition and HSBC North America Holdings Inc. also requested an additional 30 days.

Spokesmen for the Fed and Office of the Comptroller of the Currency were not immediately available to comment.

by Calculated Risk on 1/25/2006 10:46:00 AM

The Mortgage Bankers Association (MBA) reports: Mortgage Application Volume Up In Latest Survey

Click on graph for larger image.

The Market Composite Index — a measure of mortgage loan application volume was 660.5 -- an increase of 7.7 percent on a seasonally adjusted basis from 613.3 one week earlier. On an unadjusted basis, the Index decreased 0.2 percent compared with the previous week and was down 0.4 percent compared with the same week one year earlier.

The seasonally-adjusted Purchase Index increased by 6.7 percent to 473.7 from 443.9 the previous week whereas the Refinance Index increased by 7.8 percent to 1773.9 from 1645.2 one week earlier.

Rates on fixed mortgages decreased slightly again, but ARM rates increased:

The average contract interest rate for 30-year fixed-rate mortgages decreased to 6.04 percent from 6.07 percent on week earlier ...

The average contract interest rate for one-year ARMs increased to 5.44 percent from 5.39 percent one week earlier ...

The MBA survey indicates RE activity is still at a fairly high level and rebounding in January.

by Calculated Risk on 1/25/2006 10:27:00 AM

The AP reports: Existing Home Sales Set Record but Cooling

Sales of existing homes set a record for a fifth straight year in 2005 even though the year ended on a weaker note with three straight monthly declines, sending a strong signal that the nation's housing boom is beginning to cool.

The National Association of Realtors reported that sales of previously owned homes and condominiums dropped by 5.7 percent in December compared to the sales pace in November. It marked the third consecutive monthly decline, something that has not occurred in more than three years.

From the NAR:

Existing home sales fell to a 6.6 million annual rate in December, 3% lower than December 2004.

Inventories fell to 2.796 million units, from 2.924 units in November, as sellers took their houses off the market for the holidays. However, inventories are up 26.3% compared to December 2004. This represents of 5.1 months of supply at the current sales rate.

The average and median prices fell to levels not seen since May 2005. Average prices were up 7.4% for the year, and median prices up 10.5%.

by Calculated Risk on 1/24/2006 08:54:00 PM

Federal Reserve economist John Rogers (Chief, Trade and Financial Studies Section) and University of Wisconsin Professor Charles Engel, in a new paper "The U.S. Current Account Deficit and the Expected Share of World Output", Journal of Monetary Economics suggest the US Current Account Deficit may be near optimal levels.

From their conclusions:

We have asked whether the U.S. current account deficit could be consistent with expectations that the U.S. share of world GDP will increase. Under assumptions about the growth in the net GDP share that are not wildly implausible, the level of the deficit can be consistent with optimal saving behavior. But, in making this assessment, we emphasize that there are many difficult issues to deal with, and the conclusion is sensitive to how one handles these questions.

First, our findings are sensitive to how we treat two problems: the high saving rate in East Asian emerging economies, and the "exorbitant privilege" (the term used by Gourinchas and Rey (2005)) that allows the U.S. to receive a much higher return on its foreign investments than foreigners earn on their U.S. investments.

On the first point, most forecasters predict that the emerging market's share of world GDP will be increasing over time. Our empirical work does not include these countries, and if it did, the forecast path of the U.S. share of world GDP would not be as rosy. But, according to themodel, these countries ought to be borrowers in international capital markets. They are not -- they are large net lenders. It is puzzling that they are net lenders. Bernanke (2004) refers to this as a "savings glut", and hypothesizes that these countries are in essence building up a nest egg in order to protect them against a possible future international financial crisis such as the one that beset East Asia in 1997-1998.

We are not sure how to handle this in our model. It may be that these countries will continue to be high savers, in which case their saving will hold down world interest rates and the U.S. deficits will be more justifiable. On the other hand, their saving rate may fall and real interest rates may rise, which works toward the U.S. optimally having a smaller deficit.

We make the "heroic" assumption in our work that these countries are not contributing to net world saving at all. On the one hand, this is a conservative assumption (if one is trying to explain the large U.S. deficits), because the countries are in fact large net savers. On the other hand, if their net saving is reversed, the assumption is too optimistic.

It does seem like markets favor the position that these countries will maintain their positions as large savers, because long term real interest rates are very low. However, much of the recent scholarly and policy-oriented research on the U.S. current account deficit has taken the position that the markets may not be correctly foreseeing events.

Finally, it is possible that the saving rate is high in East Asian countries because of demographic factors. It has been noted that because of the one-child policy, the ratio of old to young is increasing rapidly in China. There are other countries for which demographic factors may be very important as well, and this deserves further study.

We take a similar neutral position on the exorbitant privilege. One possibility is that the U.S. will continue to receive higher returns on its foreign investments than it pays out on its foreign borrowing. On the other hand, that privilege may disappear, and worse, it may disappear not only for future borrowing but also for our outstanding debt when it is refinanced. Our work takes a somewhat neutral position by assuming future borrowing and lending takes place at the same rate of return, but that there is no additional burden to be encountered from refinancing existing debt at less favorable rates of return.

There really are a variety of scenarios that could play out. As Gourinchas and Rey (2005) demonstrate, it is not only that the return on U.S. assets within each asset class is lower than on foreign assets (implying the market views U.S. assets as less risky), but also that the mix of U.S. investments abroad favors riskier classes of assets. It is possible that the U.S. net return will fall in the future both because the risk premium on U.S. assets rises (as in Edwards (2005) or Blanchard, Giavazzi and Sa (2004)), and because foreigners shift toward investing in more risky U.S. assets. But, again, it is notable that markets do not reflect any increasing riskiness of U.S. assets.

With these major caveats in mind, we find that the size of the U.S. current account deficit may be justifiable if markets expect further growth in the U.S. share of advanced-country GDP. The growth that is needed does not appear to be implausible.
But, what the model cannot explain is why the U.S. current account deficit continues to grow. If households expect the U.S. share of world GDP to grow, they should frontload consumption. The deficits should appear immediately, not gradually.

We have allowed in our Markov-switching model for the possibility that there was a shift in regime that U.S. households only gradually learned about. But that turned out not to be able to explain the rising U.S. current account deficits. However, our simulations and estimation assumed that households understood that if a regime shift took place, the U.S. share of world GDP in the long term would be much higher than it was in the early 1980s. In practice, it may be that markets only gradually learned the U.S. long-term share. Examination of the model when there is only gradual learning about the parameters of the model will be left for future work. It is possible that because U.S. households only gradually came to the realization that their share of advanced country GDP was going to be much higher in the long run, they only gradually increased their borrowing on world markets.

This possibility is supported by our examination of the consensus long-term forecasts of U.S. GDP relative to G-7 GDP since 1993. These forecasts have consistently underestimated U.S. GDP growth relative to other countries, by wide margins. The current forecasts for the future, however, show that the markets expect a large increase in the U.S. share of GDP – almost precisely the amount that we calculate would make the current level of the deficit optimal.

There are at least two other possible explanations to explain this gradual emergence of the current account deficit. One possibility is that it takes time for consumption to adjust. This could be modeled either with adjustment costs, or, as is popular in many calibrated macro models, with habit persistence in consumption.
Another possibility is that there has been a steady relaxation of credit constraints for many U.S. households, as well as increased access to U.S. capital markets for foreign lenders. The relaxation of credit constraints was one of the possibilities that Parker (1999) explored in his study of the decline in U.S. saving. He found that it could explain at most 30% of the increase in consumption from 1959 to 1998.

The starting point of Parker's back-of-the-envelope calculation is the observation that the consumption boom is the equivalent of three-quarters of one year's GDP in present value terms. The rise in debt, as measured by the difference in ratios of household total assets to income and net worth to income, was about 20 percent over the period. Therefore, debt can explain at most .20/.75 < 30 percent of the increase in consumption. Since the time Parker wrote his paper, debt has continued to rise, by another 25% through 2005Q2 when the ratio of total assets to income exceeded the ratio of net worth to income by 1.24.

Of course, the other obvious candidate for the increasing U.S. current account deficit is through the effect of U.S government budget deficits. It is useful to note that what we are really talking about is the effects of tax cuts. In the first place, government spending as a share of GDP has not changed dramatically, so could not account for the large current account deficit. Moreover, our analysis allows for the effects of increases in government spending. An increase in current spending above the long-run spending levels would lower the U.S. share of GDP net of government spending and investment relative to future shares, thus inducing a greater consumption to net GDP ratio.

But our model assumes that the timing of taxes does not matter for household consumption -- that Ricardian equivalence holds. Obviously that might not be correct. Recent empirical studies do not show much support for Ricardian equivalence, though the point is debated.8 We note that to the extent that credit constraints have been relaxed in recent years, Ricardian equivalence becomes a more credible possibility. It may be that in more recent years, lower taxes do not boost consumption as much, and instead allow households to pay off some of their credit card debt or prepay some of their mortgage. It may be interesting to pursue empirically the hypothesis that the effects on national saving of tax varies change with the degree of credit constraints in the economy.

Another argument that needs to be explored is the distributional effects of the recent tax cuts. It has been argued that the tax cuts were less stimulative than previous cuts because they accrued mostly to wealthy individuals, who simply saved the additional after-tax income. (That is, the rich act more like Ricardian consumers.) But if that is the case, then it is more difficult to make the case that the tax cuts are responsible for the decline in U.S. national saving.

Finally, we cannot reach firm conclusions about the future path of U.S. real exchange rates. We have calibrated a model that is essentially identical to the one examined by Obstfeld and Rogoff (2004), but one in which the consumption path is determined endogenously as a function of current and expected discounted real income in each country. We found that under one set of baseline assumptions, there should not be much change in the equilibrium real exchange rate as the U.S. current account adjusts. Our model assumes the U.S. will experience higher growth in productivity in both traded and non-traded sectors, and that there is factor mobility between the traded and non-traded sector. On the one hand, if traded/non-traded productivity growth in the U.S. is slightly higher than in the rest of the world, the price of non-traded goods will rise in the U.S. from the Balassa-Samuelson effect. On the other hand, the U.S. terms of trade should fall as the supply of its exports increases. If there is home bias in consumption of tradables, that would work toward causing a U.S. real depreciation. In our baseline calibration, these two effects approximately cancel.

But as we have noted, the conclusions about the real exchange rate depend on assumptions about parameters of the model. Particularly, if the elasticity of substitution between imports and exports in consumption is much lower than our baseline simulation assumed, the U.S. could experience a substantial real depreciation over the next 25 years.

The basic message of our paper is that there are many aspects of the current account adjustment that are just not possible to predict. Under some scenarios that we do not regard as entirely unreasonable, we find that the U.S. current account deficit can be explained as the equilibrium outcome of optimal consumption decisions. But some of our modeling simplifications and assumptions might be wrong in important ways, and so it may turn out, as many have been warning, that the deficits have put the U.S. on the path to ruin.