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Analysis: Beige Book optimism unconvincing

By MARTIN HUTCHINSON, UPI Business and Economics Editor

WASHINGTON, July 30 (UPI) -- The Fed's Beige Book, released Wednesday, attempts to paint an optimistic picture, with "additional signs that the pace of economic activity increased a notch" in June and early July, after a weak spring. But it is unconvincing in doing so.

For a start, the principal area of strength cited is residential real estate, which has been enjoying a boom for nearly 2 years now on the back of low and declining long term interest rates. This is of course quite deliberate Fed policy. Fed. Chairman Alan Greenspan lowered the Federal Funds rate repeatedly, which pulled down long term interest rates by making Treasury bonds more attractive investments; this in turn lowered home mortgage rates, which caused more people to buy houses, and refinance existing mortgages, taking out cash, which they then spent, revitalizing the economy.

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If this sounds too good to be true, it is; it's a perpetual motion machine. It can work, by keeping spending and economic activity going during a mild downturn, if there is a quick resumption of genuinely productive economic activity. However, it is very dangerous if applied to a lengthy recession with structural problems, because it postpones the solution to the problems and eventually falls of its own weight, precipitating a second, deeper recession that is exacerbated by a collapse in the housing market and in consumers' financial position.

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This is where we are now. Greenspan cannot have thought, when he muttered darkly about the prospect of "deflation" in June, that the result of his muttering would be a sharp sell-off in Treasury bonds that (even after a rebound Wednesday) has left long bonds yields more than 100 basis points (1 percent) above their lows. Home mortgage rates are now higher than at any time this year, and only slightly below the level of a year ago.

The result, the first inklings of which were announced Wednesday morning, has been to kill off the mortgage refinancing market, and cool substantially they home market itself. According to the weekly Mortgage Bankers' Association survey figures, announced Wednesday, the composite index was at 972.4, down 24.8 percent for the week, while the refinancing index was at 4,145.8, down 32.9 percent for the week and less than half its peak of late May/early June. It must be remembered, too, that these figures relate to activity in the week of July 22, so they do not cover the further rise in interest rates since Friday, and indeed take only modest account of the interest rate rise as a whole, since both mortgage interest rates and, still more, home mortgage applications, lag somewhat movements in the Treasury bond market. In other words, there is almost certain to be a further substantial fall in the index next week and, absent a sharp reversal in the Treasury bond market pushing yields down to mid-June levels, a continued weakness in the index thereafter, as higher Treasury bond rates translate slowly into the minds of the less market-savvy lenders, homebuyers and above all mortgage re-financers.

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This means that the Beige Book is already out of date. "Residential real estate activity remained strong in most districts in June and early July" doesn't mean diddley-squat; the rise in interest rates is going to make it a hell of a lot weaker in August and early September. Similarly, but at one remove the balanced report of "retail sales were mixed across districts since the last Beige Book report" is likely to give way to something significantly weaker, as mortgage re-financings, generally involving cash "takeouts" which were at record levels in May and early June, slow down to a more sustainable rate, or even enter a prolonged period of inactivity.

So what does the rise in interest rates mean? Well, for the reasons outlined above, I refuse to believe the current Wall Street line that it is "indicative of strength in the economy." For one thing, yields in the inflation-indexed Treasury bond market have risen nearly as much as those in the conventional Treasury bond market -- the 9 year TIPS bond, for example, has risen in yield from 1.66 percent to 2.31 percent since mid June.

This indicates that the market is expecting, not an up-tick in inflation, which would indeed in some circumstances be indicative of a recovery in the economy, but a sharp increase in the real (inflation-adjusted) cost of borrowing, for the U.S. government and for the nation as a whole. This in turn is heavily bearish for economic activity (particularly the housing and construction markets) and for the stock market itself, which must adjust itself sharply downwards to get even close to an appropriate valuation level.

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Gee, what could have caused such a thing? You don't think, do you, that it could have been the Federal deficit?

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