by Calculated Risk on 6/28/2010 07:24:00 PM

From Jeremy Gerst and Daniel Wilson at the SF Fed: Fiscal Crises of the States: Causes and Consequences. Here is their conclusion:

The current fiscal crises that most states are facing are generally the result of a severe macroeconomic downturn combined with a limited ability of the states to respond to such shocks. States are facing increased demand for public services at the same time revenue is falling. Federal stimulus support for state budgets is winding down over the next two years. Rainy-day funds are all but exhausted. Thus, state fiscal crises aren’t likely to go away soon and will probably get worse before they get better. The solutions states employ to close projected budget gaps will have painful effects on state residents and businesses but pose a more modest risk to the national recovery. Historically, the health of the national economy determines the health of state finances, not the other way around. Sustained improvement in the national economy is essential for states to grow their way out of their current problems and improve their fiscal conditions.

Although the authors didn't quantify the impact, Mark Zandi, chief economist at Moody’s Analytics, recently estimated that state and local cutbacks may cut 0.25% from U.S. GDP in 2010 and 2011.

But this is just one drag on the economy. I've been forecasting a 2nd half slowdown in GDP growth based on:

1) less Federal stimulus spending in the 2nd half of 2010. The decline in stimulus will probably be a drag of about 0.5% on GDP growth by Q4.

2) the end of the inventory correction. The inventory adjustment contributed 3.79 percentage points in Q4 2009 of the 5.6% annualized growth rate, and 1.88 percentage points of the 2.7% GDP growth (annualized) in Q1 2010. This will probably fall close to zero in the 2nd half (maybe even slightly negative).

3) more household saving leading to slower growth in personal consumption expenditures. The personal saving rate increased to 4.0% in May, and will probably rise further in the 2nd half.

4) another downturn in housing (lower prices, less residential investment). This might subtract 0.25 to 0.5 percentage points from growth in the 2nd half.

5) slowdown and financial issues in Europe and a slowdown in China,

6) and the cutbacks at the state and local level. According the Mark Zandi, this will subtract about 0.25% from GDP growth.

As I've noted before, a quarter point here, and half point there ... and pretty soon you have some real drag.

by Calculated Risk on 6/28/2010 04:00:00 PM

The 10-year Greece-to-German bond spread has widened to over 800 bps today. This is the highest level since the the EU / ECB policy response when the spread peaked at just under 1000 bps.

And from the Financial Times: Banks in Spain hit by end of ECB offer

Spanish banks have been lobbying the European Central Bank to act to ease the systemic fallout from the expiry of a €442bn ($542bn) funding programme this week ... On Thursday, the clock runs out ... One senior bank executive said: “Any central bank has to have the obligation to supply liquidity. But this is not the policy of the ECB. We are fighting them every day on this. It’s absurd.”
excerpted with permission

This liquidity facility was put in place during the financial crisis. The ECB is offering one week and three month liquidity facilities, so there won't be any short term liquidity crisis - but there are concerns that his could lead to less lending in Spain.

And a market update from Doug Short of dshort.com (financial planner).

Click on graph for interactive version in new window.

The graph has tabs to look at the different bear markets - "now" shows the current market - and there is also a tab for the "four bears".

by Calculated Risk on 6/28/2010 12:48:00 PM

From Fed Governor Kevin Warsh: It's Greek to Me

In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny. I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility. The Fed's institutional credibility is its most valuable asset, far more consequential to macroeconomic performance than its holdings of long-term Treasury securities or agency securities. That credibility could be meaningfully undermined if we were to take actions that were unlikely to yield clear and significant benefits.

Indeed, the Federal Reserve should continue to give careful consideration to the appropriate size and composition of its existing holdings. Actual sales will not take place in the near term. But, depending on the evolution of the economy and financial markets, we should consider a gradual, prospective exit--communicated well-in-advance--from our portfolio of mortgage-backed securities. In making this judgment, we should continue to assess investor demand for these assets. Ultimately, in my view, gradual, predictable asset sales by the Fed should facilitate improvements in mortgage finance and financial markets.

Any sale of assets need not signal that policy rates are soon moving higher. Our policy tools can indeed be used independently. I would note that the Fed successfully communicated and demonstrated its ability to exit from most of its extraordinary liquidity facilities over late 2009 and early 2010, even as it continued its policy of extraordinary accommodation.

"Perceptions of monetizing indebtedness"? Although this "perception" is widespread on the internet, it isn't showing up in the bond market.

I definitely agree with Warsh on this point:

"Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world."

Tanta said it better a few years ago: "We're all subprime now!"

by Calculated Risk on 6/28/2010 10:00:00 AM

Note: This is a composite index based on a number of economic releases.

From the Chicago Fed: Index shows economic activity continued to expand in May

The index’s three-month moving average, CFNAI-MA3, rose to its highest level since March 2006, increasing to +0.28 in May from +0.05 in April. May’s CFNAI-MA3 suggests that growth in national economic activity was above its historical trend. Moving above +0.20, the index’s three-month moving average in May also reached a level historically associated with a mature economic recovery following a recession.

Click on table for larger image in new window.

This graph shows the Chicago Fed National Activity Index (three month moving average) since 1967. According to the Chicago Fed:

A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.

This is the highest level in the index since March 2006, and indicates growth slightly above trend.

by Calculated Risk on 6/28/2010 08:30:00 AM

From the BEA: Personal Income and Outlays, April 2010

Personal income increased $53.7 billion, or 0.4 percent ... Personal consumption expenditures (PCE) increased $24.4 billion, or 0.2 percent.
...
Real PCE -- PCE adjusted to remove price changes -- increased 0.3 percent in May, in contrast to a decrease of less than 0.1 percent in April
...
Personal saving as a percentage of disposable personal income was 4.0 percent in May, compared with 3.8 percent in April.

The following graph shows real Personal Consumption Expenditures (PCE) through May (2005 dollars). Note that the y-axis doesn't start at zero to better show the change.

Click on graph for large image.

The quarterly change in PCE is based on the change from the average in one quarter, compared to the average of the preceding quarter.

Even with no growth in June, PCE growth in Q2 would be 2.3% 2.5%. It looks like my earlier estimate of 3% PCE growth in Q2 will be about right.

The National Bureau of Economic Research (NBER) uses several measures to determine if the economy is in recession. One of the measures is real personal income less transfer payments (see NBER memo). This increased in May to $9,113.9 billion (SAAR) and is barely above the low of October 2009 ($8,987 billion).

This graph shows real personal income less transfer payments since 1969.

This measure of economic activity is moving sideways - similar to what happened following the 2001 recession.

This month income increased faster than spending ... meaning the saving rate increased.

This graph shows the saving rate starting in 1959 (using a three month trailing average for smoothing) through the May Personal Income report. The saving rate increased to 4.0% in April (increased to 3.7% using a three month average).

I still expect the saving rate to rise over the next couple of years slowing the growth in PCE.

The increase in income was good news, but personal income less transfer payments are still only 1.4% above the low of last year.