by Calculated Risk on 12/08/2009 01:47:00 PM

In a research note titled: "The Fed Will Exit in 2010", Morgan Stanley's Richard Berner and David Greenlaw forecast that the Fed will raise the Fed Funds rate in the 2nd half of 2010 to 1.5%.

They are forecasting GDP to increase 2.8% in both 2010 and 2011, and for unemployment to peak in Q1 2010 at 10.3%, and decline to 9.5% in 2011.

The GDP and unemployment rate forecasts are consistent with each other (see my post: Employment and Real GDP), but the real question is why do they expect the Fed to raise rates in the 2nd half of 2010 with a sluggish recovery?

The reason is they expect inflation expectations to pickup, and the Fed to react by raising rates (to 1.5% by the end of 2010, and 2.0% by the end of 2011). That would be unusually since the Fed historically waits until sometime well after the unemployment rate peaks.

The following graph is from I post I wrote in September: Fed Funds and Unemployment Rate

Click on graph for larger image in new window.

This graph shows the effective Fed Funds rate (Source: Federal Reserve) and the unemployment rate (source: BLS)

In the early '90s, the Fed waited more than a 1 1/2 years after the unemployment rate peaked before raising rates. The unemployment rate had fallen from 7.8% to 6.6% before the Fed raised rates.

Following the peak unemployment rate in 2003 of 6.3%, the Fed waited a year to raise rates. The unemployment rate had fallen to 5.6% in June 2004 before the Fed raised rates.

Here is more from Paul Krugman: When should the Fed raise rates? (even more wonkish)

Goldman Sachs recently forecast that the Fed will be on hold through 2011:

The key features of our 2011 outlook: (1) a strengthening in growth from 2.1% on average in 2010 to 2.4% in 2011, with real GDP rising at an above-potential 3½% pace in late 2011; (2) a peaking in unemployment in mid-2011 at about 10¾%; (3) extremely low inflation – close to zero on a core basis during 2011; and (4) a continuation of the Fed’s (near) zero interest rate policy (ZIRP) throughout 2011.

Although there are other considerations - such as inflation expectations, I don't expect the Fed to raise rates until late in 2010 at the earliest - and more likely sometime in 2011 or even later.

by Calculated Risk on 12/08/2009 10:53:00 AM

From Bloomberg: Most Targeted for Mortgage Relief Don’t Qualify, Official Says

A majority of the 3.2 million borrowers targeted by the U.S. Treasury Department for mortgage relief under the administration’s foreclosure prevention program are unlikely to qualify, an agency official said.
...
Although we know that not every borrower will qualify for a permanent modification, we are disappointed in the permanent modification results so far,” said Allison, who is the former chief executive officer for federally controlled mortgage- finance giant Fannie Mae.

Testimony from Treasury Assistant Secretary for Financial Stability Herbert Allison: “The Private Sector and Government Response to the Mortgage Foreclosure Crisis”

The Home Affordable Modification Program (HAMP), which provides eligible homeowners the opportunity to significantly reduce their monthly mortgage payment, is a key part of this effort, designed to help millions of homeowners remain in their homes and prevent avoidable foreclosures. As of November 17, over 680,000 borrowers are in active modifications, saving an average of over $550 a month on their monthly mortgage payments. Servicers report that over 900,000 borrowers have received offers to begin trial modifications.
...
Our most immediate and critical challenge is converting trial modifications to permanent modifications. All mortgage modifications begin with a trial phase to allow borrowers to submit the necessary documentation and determine whether the modified monthly payment is sustainable for them.
...
Currently servicers report that about 375,000 trial modifications will have finished a three month trial period with timely payments before 12/31/2009. Informal survey data from servicers indicate receipt of complete documents in about 30% of active trial modifications – these modifications where borrowers have returned all required documents need to be decisioned by servicers as quickly as possible. For other borrowers, servicers report that the large majority are current on their payments, but have some of the required documentation missing from applications. Housing counselors and homeowners report that servicers are losing documents, while servicers report that homeowners are not providing documents despite repeated outreach. Thousands of borrowers have successfully converted trial modifications to permanent modifications – but this is a low number compared to the total number of trial modifications.

Only "thousands" of borrowers? Ouch. The actual data should be released this week.

by Calculated Risk on 12/08/2009 09:48:00 AM

From CNBC: Government 'Out of Bullets,' Consumers in Trouble: Whitney

Primary among her concerns is the lack of credit access for consumers who she said are "getting kicked out of the financial system." She said that will be the prevailing trend in 2010.
...
"You're going to get a situation where you revert from a consumer standpoint," she added, "where those that had bank accounts for the first time, credit cards for the first time, homes for the first time get kicked out of the system and then fall prey to real predatory lenders."
...
"I have 100 percent conviction that the consumer is not getting any better and there's not more liquidity," Whitney said. ... "For a 2010 prediction, which is so disturbing on so many levels to have so many Americans be kicked out of the financial system and the consequences both political and economic of that, it's a real issue. You can't get around it. This has never happened before in this country."

Ms. Whitney makes me look like an optimist!

by Calculated Risk on 12/08/2009 08:39:00 AM

From Jeff Zeleny at the NY Times: Obama Announces New Jobs Programs

President Obama on Tuesday will announce three proposals intended to turn around the nation’s beleaguered job market ...

The speech, according to a senior administration official, will outline a series of steps to help small businesses grow and hire new staff. The president also will call for increasing the investment in infrastructure through building and modernizing highways, railways, bridges and tunnels. He also will propose a new program that provides rebates for consumers who retrofit their homes to become more energy efficient.
...
The president also will call for using some of the $200 billion in Troubled Asset Relief Program to help pay down the $1.4 trillion budget deficit.

So there are three parts: 1) apparentaly a tax credit for businesses to hire new employees, 2) more infrastructure investment, 3) and a cash-for-caulkers program.

by Calculated Risk on 12/07/2009 09:26:00 PM

From Thomas Corfman at Crain's Chicago Business: Zombie fears stalk Tishman in the Loop (ht David)

Corfman describes properties where the owners owe far more than the buildings are worth, and can't refinance, as "zombie buildings". The owners "can't compete for new tenants because they lack the money to cover brokers' commissions and interior office reconstruction."

"Virtually all the assets bought between '05 and '07 cannot be refinanced today without a significant capital infusion," says Shawn Mobley, executive vice-president at real estate firm Grubb & Ellis Co. "These buildings need to be recapitalized to get back in the business of being active real estate."
...
The number of zombie buildings in the Chicago area is likely to grow in 2010 ... For landlords, the trend means even top-quality office properties are likely to divide themselves into "haves" and "have-nots," with the latter seeing their vacancy rates worsen because of the lack of financing.
...
Many tenants won't consider zombie buildings because they need landlords' cash [for tenant improvements].

An "extend and pretend" loan modification will just let the zombie building live longer with deferred maintenance and few tenant improvements.

Although Corfman is discussing commercial office buildings, the same idea applies to residential real estate and loan modifications. Homeowners with significant negative equity own zombie houses - the "owners" are really renters and will defer maintenance as long as possible.

by Calculated Risk on 12/07/2009 06:35:00 PM

From NY Fed President William Dudley: Still More Lessons from the Crisis

The entire speech is worth reading. Dudley discusses a number of topics including his economic outlook, how the Fed should respond to bubbles, and why he believes the Fed should retain supervisory authority.

Dudley offers a mea culpa for the Fed:

With the benefit of hindsight, it is clear that the Fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and the large number of self-amplifying mechanisms that were embedded within the system. Likewise, we did not appreciate all the ramifications of the growth of the shadow banking system and its linkage back to regulated financial institutions until after the crisis began.

It didn't take "hindsight" to see that the Fed was failing to properly regulate the financial system - many people were pointing out the problems in real time, and the Fed simply chose to ignore the warnings.

On bubbles:

[I]dentifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable. Presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a bubble were to burst. This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst.

Turning to ... how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process. ...

Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.
emphasis added

We are making progress on bubbles.

And on the economic outlook:

My views about the outlook have not changed much recently and do not differ much from the consensus. The situation is slowly improving. We are having a recovery in terms of output and the pace of job losses has slowed substantially. In the second half of this year, real GDP growth will likely fall in a 3 percent to 3.5 percent annualized range. 2010 will probably be slightly weaker than that, mostly because some of the current sources of strength are temporary. The inventory cycle is providing lots of support right now and the fiscal stimulus—which is very powerful right now — will abate as we go through 2010.

2010 is also likely to be a more moderate growth period because we still face quite a few headwinds generated by the hangover of the financial crisis. ...

If growth is subdued, this implies that the unemployment rate will stay high and inflation will stay low. If this outlook is broadly correct, this suggests that it will be appropriate to keep the federal funds rate target exceptionally low for an extended period.

It is very unlikely that the Fed will raise the Fed funds rate in 2010.

by Calculated Risk on 12/07/2009 05:02:00 PM

From Diana Olick at CNBC: Bank of America: 2/3 of Borrowers May Lose Mods (ht montas ankle)

[Jack Schakett, credit loss mitigation strategies executive at B of A.] told me that of the 65 thousand trial modifications set to expire Dec. 31st with B of A, a full two thirds of the borrowers, while current on their payments, have not submitted the full documentation required to turn a trial mod permanent under the HAMP guidelines.

"We don't really know the major reason why the customers are not returning the documentation," Schakett claims.

Borrowers are complaining that the banks are losing documentation and that they have to submit it multiple times. Ms. Olick also suggests the possibility that some borrowers can't document their income.

BofA's Mr. Schakett said it was too soon to know why the documentation is incomplete, but this suggests that the number of permanent modifications announced this week will be very low (in the 10s of thousands).

by Calculated Risk on 12/07/2009 03:00:00 PM

The Federal Reserve reports:

Consumer credit decreased at an annual rate of 3-1/4 percent in the third quarter of 2009. Revolving credit decreased at an annual rate of 7-1/4 percent, and nonrevolving credit decreased at an annual rate of 1 percent. In October, consumer credit decreased at an annual rate of 1-3/4 percent.

Click on graph for larger image in new window.

This graph shows the year-over-year (YoY) change in consumer credit. Consumer credit is off 3.6% over the last 12 months - and falling fast. The previous record YoY decline was 1.9% in 1991.

Consumer credit has declined for a record 9 straight months - and declined for 12 of the last 13 months. It is difficult to get a robust recovery without an expansion of consumer credit - unless the recovery is built on business spending and exports (seems unlikely).

Note: The Fed reports a simple annual rate (multiplies change in month by 12) as opposed to a compounded annual rate. Consumer credit does not include real estate debt.

by Calculated Risk on 12/07/2009 12:45:00 PM

From Fed Chairman Ben Bernanke: Frequently Asked Questions. Dr. Bernanke discusses four questions:

1. Where is the economy headed?
2. What has the Federal Reserve been doing to support the economy and the financial system?
3. Will the Federal Reserve's actions lead to higher inflation down the road?
4. How can we avoid a similar crisis in the future?

On inflation, Bernanke says he expects "inflation to remain subdued for some time." On the economy:

Where Is the Economy Headed?
... Recently we have seen some pickup in economic activity, reflecting, in part, the waning of some forces that had been restraining the economy during the preceding several quarters. The collapse of final demand that accelerated in the latter part of 2008 left many firms with excessive inventories of unsold goods, which in turn led them to cut production and employment aggressively. This phenomenon was especially evident in the motor vehicle industry, where automakers, a number of whom were facing severe financial pressures, temporarily suspended production at many plants. By the middle of this year, however, inventories had been sufficiently reduced to encourage firms in a wide range of industries to begin increasing output again, contributing to the recent upturn in the nation's gross domestic product (GDP).

Although the working down of inventories has encouraged production, a sustainable recovery requires renewed growth in final sales. It is encouraging that we have begun to see some evidence of stronger demand for homes and consumer goods and services. In the housing sector, sales of new and existing homes have moved up appreciably over the course of this year, and prices have firmed a bit. Meanwhile, the inventory of unsold new homes has been shrinking. Reflecting these developments, homebuilders have somewhat increased the rate of new construction--a marked change from the steep declines that have characterized the past few years.

Consumer spending also has been rising since midyear. Part of this increase reflected a temporary surge in auto purchases that resulted from the "cash for clunkers" program, but spending in categories other than motor vehicles has increased as well. In the business sector, outlays for new equipment and software are showing tentative signs of stabilizing, and improving economic conditions abroad have buoyed the demand for U.S. exports.

Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining. Also at issue is whether the recovery will be strong enough to create the large number of jobs that will be needed to materially bring down the unemployment rate. Economic forecasts are subject to great uncertainty, but my best guess at this point is that we will continue to see modest economic growth next year--sufficient to bring down the unemployment rate, but at a pace slower than we would like.

A number of factors support the view that the recovery will continue next year. Importantly, financial conditions continue to improve: Corporations are having relatively little difficulty raising funds in the bond and stock markets, stock prices and other asset values have recovered significantly from their lows, and a variety of indicators suggest that fears of systemic collapse have receded substantially. Monetary and fiscal policies are supportive. And I have already mentioned what appear to be improving conditions in housing, consumer expenditure, business investment, and global economic activity.

On the other hand, the economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate. Despite the general improvement in financial conditions, credit remains tight for many borrowers, particularly bank-dependent borrowers such as households and small businesses. And the job market, though no longer contracting at the pace we saw in 2008 and earlier this year, remains weak. Household spending is unlikely to grow rapidly when people remain worried about job security and have limited access to credit.

Inflation is affected by a number of crosscurrents. High rates of resource slack are contributing to a slowing in underlying wage and price trends, and longer-run inflation expectations are stable. Commodities prices have risen lately, likely reflecting the pickup in global economic activity and the depreciation of the dollar. Although we will continue to monitor inflation closely, on net it appears likely to remain subdued for some time.

by Calculated Risk on 12/07/2009 11:55:00 AM

From Professor Duy: Structural and Cyclical

For several months, I have been telling stories that decompose US economic activity into what I think of as cyclical and structural dynamics. I believe the distinction is very important to firms, markets, and policymakers who need to be aware when one dynamic is clouding their view of the other.

The cyclical dynamics, in my opinion, are the most spectacular, the most visible. The real cyclical fireworks began in the second half of [2008], as the energy price shock decimated household budgets, quickly followed by a financial shock that triggered an additional pullback in demand. Firms unexpectedly found they had far too much excess capacity in this environment, and began the process of "rightsizing." [Job] losses mounted even as falling energy costs and lower interest rates for those not credit constrained began to put a floor under spending.

Eventually, firms would realign capacity with the new level of demand, and job losses would taper off. That would mark the early stages of the cyclical bottom, the point at which growths returns. The initial growth spurt could be very rapid, as firms restock inventory and pent-up demand comes into play. The additional of government stimulus will add additional fuel to the fire.

Once the early stages of recovery are complete, the story shifts from cyclical to structural. The boost from inventory correction, pent-up demand, and government stimulus fade, and the underlying growth rate, the fundamental rates of activity, becomes evident. Now your expectations about the nation's economic direction depend on the weight you place on the structural factors. If you place nearly zero weight on those factors, then growth remains fairly high as the economy rapidly returns to potential. In effect, cyclical dynamics dominate your story; the Fed is simply flipping a switch that shifts the economy from high to low states and back again, a traditional post-WWII business cycle. If you place heavy weight on structural stories, you talk about the inability to revert to past patterns of consumer spending growth due to excessive household debt, a reversion to global imbalances that supports outsized import growth, lack of an asset bubble to compensate for these structural problems, etc. With these stories in your toolkit, you expect a low underlying growth rate - barely at potential growth - in which case the gap between actual and potential output remains distressingly high for possibly years to come.

A nice summary of the differences between those who expect a "V-shaped" recovery, and those that believe the recovery will be sluggish. I think growth will be sluggish primarily because of the overhang of excess housing inventory (slowing any recovery in residential investment), and because consumers will increase their saving rate to repair their household balance sheets. There is much more in Dr. Duy's post.