November 2, 2010
Dear Mr. Secretary:
When the Committee last met in early August, the economy was experiencing a noticeable downshift in the pace of expansion. Since that time, growth in economic activity appears to have stabilized, albeit at a modest rate, and risks of a sharper slowing look to have diminished. Despite the ebbing of downside risks, growth over the last two quarters has been somewhat below trend, and thus the elevated level of slack in labor markets has changed little in recent months. Fiscal tightening and a slowing in the pace of stock building remain as headwinds to growth, though financial conditions have turned more supportive recently, and reinforce the case for continued moderate expansion in coming quarters.
Real GDP increased at a 2.0% annual rate in the third quarter, somewhat faster than the 1.7% rate experienced the prior quarter. Domestic demand increased at a 2.5% pace last quarter, though a significant share of that demand growth continued to be met by higher imports. Inventory accumulation made a noticeable contribution to growth for the fifth straight quarter. The substantial lift to manufacturing activity from inventory accumulation now looks to have passed its peak, and recent measures of industrial output have already begun to show some slowing. However, the recent improvement in the ISM manufacturing survey up to 56.9 in October offers a hopeful sign that the slowing in the industrial sector will not be overly severe.
Real consumer spending increased at a 2.6% annual rate last quarter, a modest pace though better than preceding quarters. As has been the case throughout the recovery, consumer spending on durables grew solidly last quarter, as households satisfied pent-up demand, while real outlays for consumer services have shown more modest growth. The absence of significant growth in full-time employment continues to instill caution in household behavior, though the recent move up in equity prices may have supported retail sales as of late. The outlook for tax policy – including, but not limited to, the fate of the 2001 and 2003 income tax rate cuts – remains a significant source of uncertainty for the prospects for consumer spending.
After falling off abruptly after the end of this spring's homebuyer tax credit, housing demand appears to have steadied at subdued sales rates. Homebuilding activity has changed little and remains at depressed levels, as the inventory overhang limits the need for new housing units. Home price measures have generally been mixed, though show some evidence of slipping back a little after the end of the tax incentive.
Growth in business outlays remains very solid, though below the heady rates experienced earlier in the year. The most recent spending data, as well as recent survey measures of capital spending intentions, point to continued good growth in this sector. A low cost of capital, high levels of corporate profitability and the pent-up need to replace worn-out equipment are all supportive of capital expenditure growth. Good fundamentals for the business sector, however, have yet to translate into meaningful growth in full-time hiring by the private sector. The two labor market reports received since the last meeting point to anemic growth in private employment and wages. Soaring productivity in the first year of the recovery obviated the need for firms to increase full-time headcount. This burst of productivity now appears to be fading; whether firms respond by increasing hiring will be pivotal in assessing the vigor of the recovery.
Low levels of resource utilization continue to put downward pressure on wage and price inflation. Measures of core consumer price inflation remain very soft and the most recent reading of the core CPI has put the year-ago inflation rate convincingly below one percent. The September core PCE measure has increased only 1.2% over the past year, well below the 1.7-2.0% range that the Fed sees as consistent with their price stability mandate. While recession risks have subsided since the last meeting, deflation risks cannot be dismissed out of hand. That said, stabilizing rental measures, higher import and commodity prices, and relatively stable inflation expectations should all serve as bulwarks against the near-term prospect for an overall decline in the price level. The stability of inflation expectations is not independent of central bank actions, and recent Fed communications appear aimed, in part, at ensuring that expected inflation would not follow realized inflation lower.
Since mid-Summer, rhetoric from Fed officials has increasingly signaled the likely prospect of more asset purchases at the November FOMC meeting. The desire to provide more policy accommodation apparently has its source in a downwardly-revised outlook which foresees only grudging improvement in employment and inflation – both of which are running below the Fed's Congressional policy mandate. The prospect for more asset purchases – commonly referred to as QE2 – has been widely-anticipated by financial markets and has likely contributed to the improvement in financial conditions over the last three months.
Against this economic backdrop, the Committee's first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. In the near term, given the uncertain economic and fiscal situation, the Committee felt stabilizing nominal coupon issuance at current levels was appropriate. To the extent the Committee has greater clarity, it will likely recommend further reductions to nominal coupon issuance at the February refunding. Consistent with the August meeting, the Committee felt maintaining flexibility was necessary.
There was continued debate regarding the average maturity of outstanding Treasury debt. Although the Committee felt meaningful progress had been made, there was broad agreement that continuing down this path was appropriate. One concerning consequence of raising the average maturity of debt is the decline in T-bills as a percentage of marketable debt. A majority felt that a further lengthening of the average maturity should take precedence.
With regard to TIPS, the Committee suggested an auction every month. To accomplish this, the Committee recommended two 30-year TIPS re-openings, in June and October, and a discontinuation of the 30-year TIPS re-opening in August. Likewise, in five year TIPS, the Committee recommended two re-openings, in August and December, and a discontinuation of the October re-opening. This auction schedule should allow for growth in gross TIPS issuance to approximately $120 billion in calendar year 2011 from approximately $86 billion in calendar year 2010.
Despite the aforementioned recommendation on TIPS issuance, there was continued debate at the Committee regarding the success of the TIPS program. A number of members cited that relative to nominal issuance, TIPS issuance was more expensive, less liquid, and lacked the flight to quality aspect experienced in 2008. One Committee member recommended further detailed analysis into the costs and benefits of the TIPS program.
The second charge (presentation attached) was to discuss the current state of non-bank financial institutions and the outlook going forward. The member highlighted the remarkable decline in shadow-bank liabilities across a variety of short-term secured and unsecured money-market credit instruments. This naturally corresponds with investor preference for bank deposits and U.S. T-bills. The member conveyed that this change in preference was likely structural due to liquidity requirements in 2a-7 funds and anticipated Basel III liquidity coverage ratios.
The third charge examined the potential impacts of Basel III (presentation attached). The member documented the tighter definitions of Tier-1 capital, prescribed leverage and liquidity ratios, counter-cyclical capital buffers, additional capital requirements for systemically important firms, and new limits on counterparty credit risk. The member remarked that while institutions had years to comply, markets were pushing institutions to convey and implement adoption plans today. As a result, extension of liquidity, credit, and capital are being curtailed at a time of slow economic growth. The member included estimates of Basel III's negative impact on growth. Furthermore, members expressed concern that specific U.S. regulatory reforms in conjunction with Basel III adoption may put U.S. financial firms at a competitive disadvantage versus international peers. Lastly, the member pointed out that compliance with liquidity coverage ratios will lead to increased demand by designated institutions for U.S. Treasuries.
The fourth charge examined the effect of additional easing measures by monetary authorities on financial markets (presentation attached). The member listed market expectations for the second round of U.S. quantitative easing, the medium-term and long-term expected impacts, as well as the effect on Treasury debt issuance. The member noted concerns around the potential lack of Treasury supply, as well as how the U.S. Federal Reserve exits in the event its objectives are achieved.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the October-December quarter and the January-March quarter. The Committee's recommendations are attached.
Matthew E. Zames