Fed fighting the trade drag
With no help from fiscal policy, the Fed will continue to fight alone against the headwinds of adverse net exports, which shaved off 2 percentage points (at annual rates) from the U.S. economic growth in the first half of this year.
Recent statements from various Fed officials indicate that they are aware of the difficulty posed by weak external demand. Some of them are suggesting that future interest rate hikes could be postponed if trade deficits became a serious impediment to growth and employment creation.
So far, the Fed has been gradually withdrawing excess liquidity, but its interest rate signals remained unchanged. The effective federal funds rate is still held in a 0-0.1 percent range – which is considerably below the official 0.25 percent target.
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If you are looking for the profile of the unfolding policy shift, watch the pace of contraction of the monetary base (M0), the right-hand side of the Fed's balance sheet and the only aggregate it directly controls. It seems that September marked a turning point because M0 shrank by $25.8 billion from the previous month. That brought down the growth of this key measure of money supply to an annual rate of 16 percent, compared with 20 percent in recent months.
But the conundrum of banks' huge excess reserves (i.e., loanable funds) is still there. They stood at $2.7 trillion at the last count on October 15. A slight acceleration of bank lending to households in July and August (+6.6 percent year-over-year) is still leaving an enormous lending potential intact, while nonbanks continue to do nearly two-thirds of consumer financing.
I hope that the Fed's announcement of stringent stress tests (simulating a 60 percent decline in stock prices, a 25 percent drop in real estate values, a 10 percent unemployment rate and a 4.5 percent recession) will not trigger a sharp withdrawal of banks' lending to consumers – as was the case in the run-up to similar tests in the euro area.
That would be an unfortunate turn of events. Indeed, the Fed's policy has been making a stronger contact with real economy in the first half of this year, but we are still far from the point where the economic activity could sustainably move along a path that is consistent with its physical limits to growth.
Jobs and income numbers are too weak. The actual unemployment rate in September was exactly double the reported rate of 5.9 percent. And the 2.4 percent growth of the disposable personal income (corrected for inflation) in the first half of the year is just a modest rebound from a decline during last year.
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Both of these variables lack the strength to lift private consumption and residential investments (three-quarters of the economy) to a growth rate above 2.3 percent observed in the first two quarters.