Notwithstanding some important steps forward, however, as we return once again to Jackson Hole I think we would all agree that, for much of the world, the task of economic recovery and repair remains far from complete… Central bankers alone cannot solve the world’s economic problems.

Had the chairman stopped right there, not just for dramatic pause, but for good, and dramatically stepped down from the podium, boldly walking off stage in front of his brethren from the world’s monetary policy elite, he would have qualified for a Cuban cigar, a Nobel Prize and an early all-expense-paid retirement. Not necessarily in that order, but you get the picture.

No such luck – the truth could not be told, at least not this year at the Jackson Hole confab of the global monetary policy cabal. But never one to disappoint, the chairman did open up yet another opportunity to clarify the situation when he noted:

At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily. For a sustained expansion to take hold, growth in private final demand – notably, consumer spending and business fixed investment – must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.

Now much of this statement strikes us as backward or just plain wrong. Of course, final demand is important, it is the actions of innovators, entrepreneurs and managers responding to either existing profit signals, or anticipated or perceived profit opportunities, that set the wheels of commerce and income-generation in motion. Without the income from the jobs created by businesses, households have nothing but past savings or credit in order to express their final demand.

But our real bone to pick with the chairman has more to do with his last sentence, about the passing of the torch. Quite simply, the torch isn’t going anywhere. Uncle Sam is still holding it and the private sector is still refusing to take it.

The torch is visibly sputtering and dimming, at least if you are paying attention to the most recent economic data flowing out of the United States. Most noticeably, the pace of advance in the monthly US private payrolls has dropped below 100,000 per month, which is about where we were in 2007, on the way into the last recession.

US growth measures are decelerating and 2011 recession probabilities are rising. Bernanke acknowledges this fact with his actions, if not with his words. In the closing paragraphs of the chairman’s Jackson Hole speech:

Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists – namely, that the FOMC increase its inflation goals.

These “policy measures” will be ineffective. First off, Bernanke openly admits in the Jackson Hole speech that the Fed has no idea what the correct size or timing of further quantitative easing measures might be. Not exactly confidence-building. Second, the Fed’s communication strategy is about words and shaping perceptions, which has not proven to be Chairman Bernanke’s particular forte. Third, the notion that cutting the interest rate on excess reserves from 0.25% to any figure below will create even a dimple of change in the real economy is truly beyond absurd.

The chairman has been clear that quantitative easing works primarily through its effect on interest rates and asset prices – he might as well make the manipulation explicit and get on with it. Then he might have a small chance of creating the “wealth effects” required to get private-sector economic activity back on an accelerating track. Clearly, his original action checklist leaves much to be desired.

At the same time, we must recognize US investors have probably overplayed the double-dip card, judging by various measures of investor sentiment and by various tools of technical analysis. The pop now under way in equity prices is likely to continue as investors recognize a double dip does not mean an imminent recession – it only means a deceleration in the rate of growth, which was subpar to begin with. But we would not expect the stock market’s pop to last very long. So if you have not done so already, we would use the bounce to lighten up on equity and risk asset exposures.

US economic growth is clearly decelerating, and Chairman Bernanke has very few rabbits left in his top hats. Sustainable economic growth will not begin until the chairman’s magic show ends and meaningful private-sector investment begins.

Rob Parentau
for The Daily Reckoning

Bernanke Drops the Ball Again originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

We are told the next big technical levels for resistance to the downward trend in the euro are at $1.23 US dollars to the euro, and then again at $1.18. With Tall Paul Volcker’s publicly aired concern of a eurozone disintegration on Friday, the $1.23 level is about to be breached. We believe currency speculators have a good shot at taking it down to the $1.18 level before the ECB drops in with a sufficiently large currency intervention measure, to effectively command the wolf pack to sit, and then stay, like the good doggies the eurocrats are trying to breed over there.

Our sense, however, is that initial efforts at currency manipulation by the ECB will fail. That means the $1.18 level will eventually fail as well, because wolf packs just do not take orders like domesticated dogs do. Consequently, we stand by our call that parity in the exchange rate between the euro and the dollar is the most likely ultimate stopping point, possibly as early as late summer.

Rob Parenteau
for The Daily Reckoning

Where Will the Euro Decline End? originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

What gives? We lay it all in the June issue of The Richebacher Letter in a section titled “Weimar 2.0.” As we point out, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well.

On the demand side, in order for households’ spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in sync with price hikes or the price hikes will not stick. Households will have to pull back in other, less-essential spending areas to afford the same quantity of goods in essential items…

That is why hyperinflation episodes need not just fiscal deficit spending, but also some sort of escalator clauses or cost-of-living adjustment mechanisms built into wage contracts… Take that element away – and it is a recurring theme in historical episodes of hyperinflation – and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.

Beyond this demand-side component, which is scarcely to be found in the U.S. wage contracts these days, there is the supply-side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip…

Suffice to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you use to pay taxes or buy Treasury bonds.

Rob Parenteau
for The Daily Reckoning

Hyperinflationists Have it Wrong originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

If we follow the financial balance approach that Dr. Kurt Richebacher employed, then we have to anticipate Greece and Ireland will face challenges on two fronts.

First, the strength of the euro is making it more difficult for nations in the eurozone to run trade surpluses. Indeed, on a trailing 12-month basis, the improvement in the U.S. trade balance has been a detriment to Europe… What was once a $150 billion leakage of income out of the United States into Europe is now closer to a $70 billion flow. Those are only the direct effects — no doubt they are multiplied through foreign economies, as businesses in the tradable goods sector have faced weaker revenues and weaker profits…

Second, in the case of the so-called peripheral states in the eurozone (Spain, Italy, Ireland, Greece and Portugal), we must add the increasing pressures to rein in fiscal deficits on top of the weaker trade balances. Unlike the United States and the United Kingdom, none of these states has a sovereign currency. They cannot use currency depreciation to regain global market share. None of these states has an independent monetary policy. They are beholden to the decisions made at the European Central Bank, which will reflect the political compromises judged adequate for the region as a whole…

We see a recipe for increasing social conflict and political instability to arise in the peripheral states of the eurozone. This is not something we state lightly, but the only other way we can see out of the quandary is if global growth takes off in early 2010 and lifts some of the pressure.

The Next Dubai originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

The dollar carry trade is surely one possible route to Marc Faber’s pinpoint prediction. Investors borrowing dollars at low interest rates (or shorting dollars) and then investing the proceeds in foreign currency-denominated assets (usually with higher yields or higher expected returns) place downward pressure on the dollar exchange rate and upward pressure on the foreign currency asset they are purchasing. As the dollar exchange rate falls, the effective cost of borrowing in dollars falls, and thus the incentive to devote more resources to the trade increases — people will tend to pile into the trade, to the point it eventually will become a ‘crowded’ trade, as the negative borrowing rate becomes recognized…

But here is the problem: As of 2008, the McKinsey Global Institute estimated the United States accounted for about 21% of global GDP, while U.S. capital market assets totaled one-third of the world’s $167 trillion in assets. In addition, roughly 65% of the total foreign exchange reserves of foreign governments are held in U.S. dollars, while the euro has the next highest share, at 25%.

Dethroning the dollar may take some time, given there is as yet no other nation in position to replace these mammoth U.S. shares of global economic activity and portfolio holdings. The euro may be the closest candidate, but there are enough questions about whether the one-size-fits-all monetary policy approach may eventually spur populist calls for the defection from the European Union of Ireland, Greece, Spain and other nations still struggling with serious economic weakness that this remains a long-shot candidate. The IMF’s special drawing rights (SDR) has been frequently named as another candidate, but the SDR is really a weighted basket of four currencies, with 44% of the weight placed on the U.S. dollar, so it is not much of a replacement for those seeking to reduce U.S dollar exposure at all…

While we recognize real GDP growth has returned to much of the world, we doubt the advances in numerous commodities through mid-November (shown above) are entirely the result of stronger end demand for the products that require these commodity inputs. Rather, the ‘flight to real values,’ as Hayek termed it, appears under way as the reserve currency status of the dollar has been put into question, but no other fiat currency can take its place.

The New Reserve “Currencies” originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

The year-over-year growth rate of October retail sales ex-gas is nearly flat from a year ago, while the overall retail sales momentum is still just shy of closing that gap. With comparisons so easy against a year ago, when the global economy was in free fall, this is not a terribly inspiring result. Excluding autos, the sequential gain in October came up short of expectations, with only a 0.2% advance… Caution is still ruling, and for good reason.

Perhaps the dollar levels of retail sales tell the story more clearly. So far, we at best have a shallow recovery in overall retail sales, while furniture and electrical appliance stores are barely scraping out a trough.

The latter categories are highly discretionary purchases, and it is these durable goods items that typically provide some of the largest thrust behind economic recoveries. So far, they have not been able to get back up off the mat. From the December 2008 lows in retail sales, the leading categories have been gas, general merchandise, motor vehicles, Internet, jewelry and health and personal care sales — not a very robust mix excluding cash for clunkers, gas price hikes and trinkets for the more discreet mistresses of Goldman partners.

Can Retail Rouse the Recovery? originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Despite all the policy machinations — from TARP capital infusions to outright asset purchases, temporary lending facilities, a near-zero fed funds rate and various guarantees on bank liabilities — loans outstanding in the commercial banking system have continued to contract. Instead, banks have preferred to accumulate securities rather than make new loans. Even those purchases have flattened in recent months as banks are back to hoarding more excess reserves.

We won’t argue with the counterfactual — without these measures, the contraction in bank loans outstanding would no doubt have been much more dramatic, as an Austrian-style simplification of balance sheets would have naturally gathered momentum following the Lehman Bros. bankruptcy. But the reality is neither the household nor business sector is eager to add to its debt, and bank loan officers are still battling rising loan loss recognition from the last private credit bulge. This is much as we anticipated — the private sector has hunkered down, is spending less money than it is earning and is paying down or liquidating existing debt loads.

Why Banks Aren’t Lending originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

As you can see from the chart below, it is usually only in the first year of recovery that year-over-year labor productivity growth breaks through 4%, as it just did in Q3. When combined with hourly labor compensation growth now screwed all the way down to a 0.5% pace, falling unit labor costs are the result.

Unquestionably, labor productivity gains are one key driver of long-term growth. But here is the hitch we see developing: Small businesses appear to be on the ropes. Large businesses have cut to the bone. Both GDP and S&P 500 profit results indicate companies that are achieving high labor productivity and lower unit labor costs have, so far, been able to hold onto these gains through higher profit margins. However, if U.S. firms do not step up the reinvestment of these profits into the real economy, by lifting production up enough to first end the inventory contraction and begin inventory rebuilding, and then also stepping up their reinvestment of profits in more efficient technology or new products, then the nascent U.S. recovery will sputter out…

To put it in the extreme, labor productivity gains will not get us very far if the profits generated from them do not start getting ploughed back into voluntary inventory rebuilding and reinvestment in capital equipment.

A Key to Escaping the Recession originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Furthermore, by adding $262 billion to Treasury holdings, $79 billion to agency holdings and $515 billion to mortgage-backed security holdings from March through mid-October, the Fed has also suppressed the yields available to households in these segments of the fixed-income market. In effect, we believe the policy gambit has been to herd investors into equities and corporate bonds by reducing yield opportunities in other asset classes. By doing so, we believe the Fed has sought to induce wealth effects designed to cushion the blow of the past year’s financial crisis on real economic activity.

Thus we face some incompatible truths. Demographically [think baby boomers], more investors should be migrating to lower-risk portfolios and looking for asset mixes that provide some combination of high-income yield, security of principal and inflation protection… Policy-wise, central banks have responded to the economic carnage wrought by a major financial crisis by lowering short-term interest rates, which reduces yields on near-cash instruments like money market funds and Treasury bills. Through quantitative easing measures, they have been bidding down yields in a variety of longer-term fixed-income classes, like government bonds, mortgage-backed securities and, in some cases (as with the Bank of Japan), even corporate bonds.

Investors who demographically are at a stage of life when they need to earn high yields with fairly secure principal while maintaining a good hedge against inflation risks are finding central banks have clipped the menu of many opportunities. We suspect this portfolio incompatibility may not end well.

The Fed’s Real Objective in Keeping Rates Near Zero originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

From a mainstream economic perspective, it should be renamed Leisure Day, as unemployment is interpreted as an individual choice of leisure over paid labor effort. Of course, only a tenured professor could be expected to come up with such a conclusion. As it stands, it is currently estimated there is one job opening for every six people looking for work.

Since employment is a lagging indicator of economic activity, we learned over the years to dig deeper than the headline figure to get a read on where labor market conditions may be going. One of the more useful, but often ignored, parts of the employment report tells us about the percent of private industries that are net offering jobs. Even when payrolls are shrinking in total, some industries are still net hiring – and, indeed, this is part of how markets facilitate the reallocation of productive resources during a recession, which, as the Austrian approach reminds us, is crucial to long term-growth prospects.

This measure is called a diffusion index, and we prefer to look at the average in this series over the past three months to avoid too many miscues. As it stands, the breadth of private industries net hiring, though still at a lower level than the last recession, has consistently climbed from the March lows. The pace of broadening is even a bit stronger than what we observed in the last exit from a recession, which, as you may recall, was followed by a jobless recovery. If the slower pace of layoffs is all a sugar high from extreme policy measures, or if a double dip is about to open up before investor eyes, this is one of the places it should show up first. So far, this diffusion index is more consistent with an unemployment rate that peaks near year-end around 10% and begins to show some improvement in Q1 2010. We would also note while survey results still report perceptions of a very difficult job market, these measures have stabilized in recent months.

When firms start shedding labor more aggressively than their production activity is contracting, labor productivity (output produced per hour of work) tends to reaccelerate as the pressure on the remaining work force intensifies. In fact, productivity growth has begun to rebound, and we believe it has a good shot at pushing through 4% year-over-year growth by year-end, from the current 2% pace in the nonfarm sector. At the same time, businesses struggling to stay alive have pressured labor compensation growth. Hourly compensation (wages and benefits) growth has been on a disinflation (that is, decelerating inflation) path through the entire recession. We suspect it will be flirting with deflation near year-end, which is something we have not seen since Q4 in 1949.

If we put these two developments together – labor compensation growth approaching deflation, while labor productivity growth reaccelerates – we get deflation in unit labor costs. Companies that can hold the line on pricing while unit labor costs are falling will tend to experience rising profit margins, and rising profit margins are generally a signal to expand production. Improving cost conditions are one benefit of recessions, and if final demand can stabilize or improve from sources other than the household sector – say, fiscal policy or an improvement in the trade balance or the onset of some replacement capital spending – then this can be a route back to economic recovery. We will have more to say about this in the next monthly letter, but for the moment, it does look like firms are successfully compressing cost conditions.

This matters because with the release of Q3 S&P 500 earnings in October, we suspect strong operating leverage will become apparent to equity investors. Earnings improvement through Q2 has been all cost cutting related in a flat or falling revenue environment for most companies. If Q3 begins to show top-line revenue improvement, as we suspect it will, then earnings will be fed by both revenue and profit margin gains. After the seasonal September jitters, the exposure of the operating leverage available to firms that have cut to the bone could very well capture the imagination of investors, leading to the next leg in the advance of US equity indexes since early March.

According to supply managers in the manufacturing sector, goods sector production has been on the rise since June, and new orders are through the roof. By way of reference, the new orders index was scraping a new historical low back in December, rivaled only by the 1980 lows following Fed credit controls. Never before in the six decades of Institute for Supply Management (ISM) records have new orders surged so dramatically in any eight-month span. Never before has the ISM new order and production indexes recorded these levels without marking an escape from recession. No doubt the “cash for clunkers” sugar high has something to do with this, but we doubt it explains away all of the dramatic reversal in supply manager perceptions, as the export indicator in this report has also improved remarkably since the December 2008 lows.

These ISM results are usually good for a three-four month lead time on government reports for industrial production, shipments and new orders. We can anticipate the rebound depicted above will now reverberate in the monthly reports from here to year-end, at a minimum. In particular, the ISM production index has provided a reasonably good guide to year-over-year momentum in manufacturing production.

The sharpest monthly contractions in industrial production began in September of last year as the credit markets went into cardiac arrest, and all parts of the economy went into a cash grab/cash conservation mode so that prior cash commitments could be met. This included dramatically reducing production and liquidating existing inventory stocks. In other words, the comparisons against year ago are about to get ridiculously easy, and a healthy 5% year-over-year manufacturing production growth rate is certainly within reach by year-end 2009.

As summer slips away into the flaming leaf show of fall, we conclude the labor market is still a mess, but we can find some broadening of hiring activity even though total payrolls are still contracting. That means the necessary reallocation of productive resources, which is part of the function of recessions, is under way. More importantly, unit labor costs are falling as the pace of layoffs has overshot the contraction in output, and labor productivity is improving as a consequence, which is a second growth encouraging outcome of recessions.

The question remains what lies ahead after the massive quantitative easing operations of the Federal Reserve have lapsed and the bulk of the fiscal stimulus is behind us. In the very near term, we can surely expect auto sales to wilt following the end of the cash for clunkers program, but we remain impressed by what supply managers in the most cyclical part of the economy, namely manufacturing, have to say about new orders, production and export conditions. Policymakers panicked and adopted a “whatever it takes” stance, one that has proven to be the most radical outside of major wartime conditions. Looks like something took – and not surprisingly, gold is taking out the $1,000 per ounce mark at the same time.

Regards,

Rob Parenteau
for The Daily Reckoning

Unlabor Day originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".