The story of the noose that choked credit

Banks and corporations have been going through their own credit crunch which is why risk aversiveness has been an underlying theme in this recessionary charade.

Commercial Banks heavily rely on nontransaction deposits for funding.  These include small and large time deposits:

Repurchase agreements are an important source of bank funds and the most important lenders are corporations which means corporations are lacking idle funds and taking on a more defensive position:

Also Securitization made credit available on a mass scale:

Commercial Paper market had also become a major source of corporate funds:

We are not going to see any growth whatsoever unless funds get allocated from savers to borrowers, and by the looks of it our situation is morbid at best. Show me the money!

Durable Goods and Core-New Orders

So what exactly are durable goods?
They are products that have a life expectancy of at least three years (i.e. Macbook Pros, General Motors automobiles, washing machines,  hair dryers?, IPhones, Gulf Stream V's ect.)  From this we get the accurate sense that many important sectors of the economy are tied to durable goods production (i.e. employment, industrial production, profits, and productivity).  Also this report serves as a behind the scenes sneak preview to the comprehensive factory orders report, which includes both durable and nondurable goods.

This report is based on results obtained from 3,500 manufacturers representing 89 industry categories.  All the numbers are seasonally adjusted  but not annualized, and its only in nominal terms(aka the dollar amounts are not adjusted for inflation).  To estimate real changes in durable goods orders compare the growth rate over time with the performance of the producer price index.

The report can be found here.
This release is divided into 4 main sections: new orders, shipments, unfilled orders, and total inventories.

Table 1: Durable Goods Manufacturers' Shipments and New Orders

New Orders Decreased 1% or 2 billion to 190.45 billion. A persistent decline in new orders is ominous as it suggests that some factories may go unused.  But we have to keep in mind that this data can be misleading because of a single large military purchase or transportation order.  So we will also want to look at at the rows excluding defense (still a 0.7% drop in new orders) and transportation (.6% drop in new orders) and we find that the drop in new orders is less with these more volatile components removed.

Now with a little bit of common sense we can calculate new orders excluding defense and transportation.  Let's call it "Core-New Orders" which like core cpi excludes the most volatile components.

"Core-New Orders"(in millions) for June:

132,536 = 190,490 - ((190,490 - 144,571(excluding transportation)) + (190,490 - 178,455(excluding defense)))

In May they were:

132,678  = 192,455 - ((192,455 - 145,420 (excluding transportation)) + (192,455 - 179,713 (excluding defense)))

The percentage change from last month was:

(( 132536 - 132678 ) / 132678) x 100 = -.11%

Certainly this is not as dramatic of a fluctuation as the standard new orders measure.  Therefore this helps us realize that new orders hasn't fallen off the cliff and that although consumer demand is cutting back it is not as devastating as the standard number has you believe.  Something I found interesting is the two conflicting titles that WSJ put out today.  Real Time Economics highlights the positives:
Economists React: Encouraging Details in Durables

and WSJ Economy makes it clearly sound like a volatile downward turn:
Durable-Goods Orders Slide

Revised to be relevant and useful: TIPS and Inflation Expectations

In a previous post  I calculated expected inflation using some bond that was maturing in 2012 but we want to get a more accurate (and relevant) picture of expected inflation.  To do this we can go to the Federal Reserve and observe statistical release H.15 which are selected interest rates.  For example, 10 years from July 22nd expected inflation is:

E(p)= i - ir
Where E(p) is expected inflation,
i - nominal interest rate ( interest rate paid on nominal treasuries)
ir - real interest rate (remember the inflation index bonds are supposed to reflect these)

Looking at the statistical release if we want the 10 year inflation expectations we must look at the 10 yr bonds.  We will find that for July 22, 2010:

i (Nominal Treasury) = 2.9%
ir (Inflation indexed Treasury) = 1.78%

2.96% -1.78% = 1.18% 
E(p) = 1.18%
Therefore expected inflation for the next 10 years as of July 22nd is 1.18%

Initial Unemployment Claims: Still Super High

Initial claims for unemployment insurance remains super high like Oakland, California:

This is super bad. The number of people filing for unemployment benefits has remained at a high level which is a sign that our economy is still feeling the pain.  Initial claims are still above 400,000 which is indicative of an economy that's still losing steam (womp! womp!). 

TIPS: A Gauge Of Inflation Expectations

Treasury Inflation Protection Securities or TIPS, are indexed bonds or bonds whose interest and principle payment are adjusted for changes in the price level.  The interest rate on these bonds provides a direct measure of a real interest rate. 

Using the Fisher equation:

i = ir + E(P)
where:
i - nominal interest rate
ir - real interest rate
E(P) - expected inflation

We can re-arrange the terms to get:

Expected inflation rate for the next 10 years  =  ( (i) - Ten Year Treasury Constant Maturity Rate, monthly) - ((ir)- 10 Year TIPS, Monthly)

Using FRED:

So the expected inflation rate for the next 10 years is around 3.2%.

Housing Market Summary: May not be in a Depression but this is still depressing

The housing market is barely breathing with housing starts and new one family houses sold at all time lows:

The S&P/Case-Shiller Index shows a dramatic decline in home prices nationwide:

 I could not resist throwing Detroit and Cleveland on there.  It is going to be a long time before the consumer comes back in Detroit and Cleveland.  Nationwide home prices seem to be stabilizing at a level not seen since 2003.  The de-leveraging consumers that believe their home prices won't fall any further may start to feel financially healthier.  Although I don't imagine the de-leveraging ending anytime soon. 

What does a debt deflation entail and are we headed for one?

The process of debt deflation goes a little something like this:
Unemployment increases this leads to a sudden drop in income and more people filing for unemployment insurance.  Suddenly people feel poorer and both home spending and consumer spending decline.  Producer Prices then fall because business are cutting back on inventories.  Furthermore, lower import prices also puts downward pressure on consumer and producer prices.  Last but not least home prices continue to fall.  Consumer prices then decrease due to lower input costs (via producer price index declines and import price declines) -  this lower price level causes the real value of the debt burden to increase.  This increased financial strain will lead to the next round of defaults and further reduction in consumer spending. This leads to more unemployment and even worse some unemployed 27 weeks or longer are no longer eligible for unemployment insurance.  This leads to a further decline in incomes leading to more cash strapped households on the brink of desperation and another round of defaults as some (newly unemployed or uninsured laborers) are unable to make their debt payments.
                                         
Debt Deflation in the Economy:

Recession Hits ----> Unemployment (Increases) + Unemployment Insurance (Increases) ---> Income (Falls) -----> Spending (Falls)([Consumer Spending (Falls) + Home Spending (Falls)] )------>  Price Level (Falls) ([ Producer Prices (Fall) + Import and Export prices (Fall) + Home Prices (Fall)]-----> Consumer Prices (Fall)] ) --> Real Debt Burden (Increases) --> Defaults (Increase) ---> Consumer Spending (Falls) --> Further Unemployment (Increases) + Unemployment Insurance (Fall)]---> Income (Falls) ----> Defaults (Increase) + Consumer Spending (Falls)---> and on and on


Lets look at the most recent evidence:

 Unemployment has increased and those receiving unemployment insurance has decreased:

This is surely to have some more effects on the already depressed consumer and home spending:

The Producer Price Index has declined as of late to reflect the sharp cut back in production from businesses reaction to the lamesauce consumer demand:

Import prices have fallen recently:

Home spending and home prices continue to be trending downward:

Price deflation leads to an increased real debt burden and as we have seen defaults continue to be on the rise.  As we have just seen some data suggest that this may be occurring and the fact that severe financial crisis do sometimes lead to debt deflation leaves me very worried.  We would be experiencing a full-blown debt deflation right now if it wasn't for two things: sticky wages and unemployment insurance.  The inflexible nature of wages allows those who do have jobs to keep spending.  This - in addition to unemployment benefits - has prevented the severity of the crises from reaching the debt deflation stage.  The governments ballooning debt has not been the work of bailouts but of unemployment insurance payments.  This has represented a massive transfer of debt from the private to the public sector and the extension of these benefits have proved undeniably important for keeping our economy afloat.