Fed fiddles as America slides back into recession

Expert Albert Edwards of Societe Generale is predicting that the US economy will shrink 2 percent this year which will lead to a 40% fall in profits. According to experts, a fresh US slump is not just a risk anymore, it has already begun.

By Ambrose Evans-Pritchard
4:45PM BST 15 Jul 2012
The Telegraph

Output slowed to stall speed over the winter. The US economy tipped into outright contraction in the second quarter, even before facing the "fiscal cliff" later this year – tightening of $600bn or 4pc of GDP unless action is taken to stop it.

Nothing serious is yet being done to head off the downward slide. If ECRI is right, the implications for the global system are ugly.

It is never easy to read the signals at inflexion points. Washington is always caught off guard. As ECRI’s Lakshman Achuthan says, it took the Lehman collapse ten months into recession in September 2008 to "wake people up".

What we know is that retail sales rolled over in February and broader trade sales peaked in December. Industrial output peaked in April. The nationwide ISM index of manufacturing crashed through the break-even line of 50 in June, just as it did at the onset of the Great Recession in late 2007, but this time at a faster pace.

Job growth has slumped to 75,000 a month over the last three months, too low to stop unemployment rising again to 8.2pc, or 14.9pc on the wider U6 measure.

Albert Edwards from Societe Generale expects the US economy to shrink 2pc this year, leading to a 40pc fall in profits. He says the S&P 500 index of stocks will ultimately plumb fresh secular depths, below the 666 bottom of March 2009.

The Federal Reserve has drifted into fatalism, seeming to lose confidence in its own ability to shape events, displaying the same lack of "Rooseveltian resolve" as the Fed in the early 1930s -- to borrow an expression written years ago by a young Princeton professor, and Fed scourge, called Ben Bernanke.

There is no sign yet that the Fed is willing to launch further bond purchases before the pre-election window closes, as it did with QE2 in the summer scare on 2010.

Doves are itching to act. "We’re really right at that edge," said San Francisco Fed chief John Williams. Yet last week's Fed Minutes are a declaration of paralysis. Hawks still discern an inflation threat, even though 10-year Treasury yields have dropped to 1.49pc and the inflation-linked `TIPS' have hit minus 0.6pc. But then Fed hawks discerned inflation in 1932 aswell.

It is a form of psychosis.

The risk now is that the Fed will repeat - or has already repeated - the errors of early-to-mid 2008 when failure to respond turned a common garden recession into a disaster.

It is worth reading "The Great Recession: Market Failure or Policy Failure?" by Robert Hetzel from the Richmond Fed, the most damning critique ever published by a serving insider.

His argument – to over-simplify – is that the slump was entirely avoidable. There was no exorbitant bubble in the years before, no stretched elastic waiting to snap back.

The Fed – and the European Central Bank – caused the damage by tightening after recession had begun, ignoring frantic warnings from monetarists alert to the danger.

The sub-plot is that Paul Volcker and Alan Greenspan would never have made such a mess of affairs. They would have slashed interest rates earlier in compliance with the Fed Model as it became clear that the inventory was piling up.

The US recession began in late 2007. The slide accelerated in 2008 as the `China effect' pushed oil to $147 a barrel, with copper and corn rising in lockstep.

The Fed should have loosened monetary policy pari passu. It lost its nerve in early 2008, prisoner to old fallacies that low rates (then 2pc) signify loose money and that commodity supply shocks are inflationary. It stopped cutting, then turned hawkish, talking up rates across the yield curve.

The Fed Minutes of June 24 2008 were the coup de grace. The next policy move "could well be an increase in the funds rate," it said. By then the US economy was heading for the cliff. The collapse of Fannie, Freddie, Lehman, and AIG followed in the Autumn: symptoms of the crisis, not the cause.

Ben Bernanke bears much of the blame, though in fairness he was constrained by hawks and a nasty a dollar storm -- with veiled threats of a US bond strike by China, Russia, et al.

How could he of all people have got it wong? This was a man who once blamed the Fed's scorched earth policies for causing the Great Depression.

The answer is a Déformation professionnelle. He was blinded by own "credit channel" theory that slumps are caused by banking crises.

His theory proved to be wrong. The chain of causality was the other way round. The credit system was not flashing red warning signs in early to mid 2008.

The alert was coming from the money data. Bernanke was not paying full attention because he disdains the quantity of money theory of Milton Friedman and countless others before him -- including Keynes -- as hocus pocus. Yet the moneratists were right. They saw the steam engine coming straight down the tracks.

Bernanke did slash rates to near zero in the end and sprayed the system with $1.75 trillion of QE, but his love affair with "creditism" has muted the effects. He has been trying to drive down bond yields. This helps a little, but it is not remotely comparable to monetary stimulus a l'outrance -- the sort of action that set off a blistering recovery in 1933 .

Bernanke has bought most of the bonds from the banking system. This is a bad way to boost the broad M3 money supply. You have to go outside the banks to gain traction, buying from pension funds, life insurers, and the general public. Don't say QE has failed in the US. It has hardly been tried.

Market monetarists around the world argue that central banks can always fight off slumps, whatever is thrown at them. But to do so policy-makers must stop targeting inflation -- the wrong variable, indeed a particularly bad variable -- and instead deploy nuclear force to drive up nominal GDP to a trend line growth rate of 5pc, doing so transparently so that markets know exactly what the objective is and when the stimulus will be unwound.

I have no doubt that this would bring about a full recovery very fast if conducted with enough panache, but is it possible to marshal political consent for such revolutionary action?

The Tea Party Congress, like Europe's bourgeousie, would rather wallow in liquidation, Puritan cleansing, and mass default than tolerate the possibility of a solution.

To those who excoriate monetary stimulus as some form of devilry -- most readers it seems -- my question is whether would you rather see bigger deficits and bigger publics debts instead. Because that is exactly what you get if central banks fail to act in a slump, if you don't lose you democracy as well.

Pick your poison.

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