Beige Book: Bad, Not Worse

Below are some of the key sections of the Summary of the Fed Beige Book and my reaction to it interspersed. I have also bolded what I consider to be remarks worthy of emphasis in the report.

“Reports from the 12 Federal Reserve Districts suggest that economic activity continued to be weak going into the summer, but most Districts indicated that the pace of decline has moderated since the last report or that activity has begun to stabilize, albeit at a low level…”

In other words, the economy is no longer falling off a cliff, but it has not started to climb back either. This is consistent with most of the other economic data we have been getting recently.

“Most Districts reported sluggish retail activity…Manufacturing activity showed some improvement in the Richmond, Chicago and Kansas City Districts; while St. Louis and Dallas reported some moderation of declines, Philadelphia and Minneapolis saw activity decrease and most other Districts indicated that manufacturing activity continued at low levels.

“Boston, Richmond, St. Louis, Minneapolis and San Francisco reported contractions in services industries. Banking sectors in the New York, Cleveland, Richmond, St. Louis, Kansas City and San Francisco Districts experienced weaker demand for some categories of loans. Residential real estate markets stayed soft in most Districts, although many noted some signs of improvement. By contrast, commercial real estate markets weakened further in recent months in two-thirds of the Districts and remained slow in the others.”

A very mixed picture, but that mixed picture represents a substantial improvement over the extremely dire presentation in previous months. Again, sort of what you would expect when we are bumping along the bottom.

“Districts reported varied — but generally modest — price changes across sectors and products, with competitive pressures damping increases; however, Boston, Cleveland, Chicago, Minneapolis and Dallas noted that some metals prices have increased in recent months. Most Districts indicated that labor markets were extremely soft, with minimal wage pressures, and cited the use of various methods of reducing compensation in addition to, or instead of, freezing or cutting wages.”

Inflation is not a problem at this time (but could become a more serious one in the future). The increase in metals prices is interesting, but most metals are easily traded goods, and the pick up in prices could be due to stronger demand abroad, particularly in China.

This is good news for the big mining firms like Freeport McMoran (FCX: 55.51 -3.06 -5.22%) and BHP Billiton (BHP: 59.83 0.00 0.00%). It will be hard to get an old fashioned wage-price spiral going with the wage side having no traction whatsoever.

To the extent inflation does show up, it will be on the food and energy side, not core inflation. The end result will be a reduction in the real standard of living of the average American, not a runway inflationary cycle like in the 1970’s.

“Consumer Spending and Tourism

“Consumer spending in the early summer remained below previous-year levels in most Districts, as households continued to be price conscious. Boston, Kansas City and San Francisco experienced either modest sales increases or less negative sales results than in recent reporting periods. Philadelphia, Atlanta, St. Louis, New York and Dallas cited flat or mixed sales, while sales in the remaining Districts remained soft.

“Several Districts noted that consumers focused on purchasing less expensive necessities, while sales of big-ticket items languished. Retailers in Boston, Philadelphia and Dallas characterized their outlook as ‘cautious.’

“Auto sales were mixed across the country. Chicago, Minneapolis and Kansas City saw modest increases in car sales, while New York, Philadelphia, Cleveland and Atlanta continued to experience subdued sales. The exception was sales of used vehicles, which continued to be strong or were strengthening, according to Philadelphia, Cleveland, Atlanta, Kansas City and San Francisco.

“Travel and tourism declined in the majority of Districts. The San Francisco District observed a sharp drop in luxury and business travel, while tourism activity in New York City was weak but stable since the last Beige Book report. Tourism contacts along the Atlantic coast reported that with the exception of July 4th holiday bookings, business was generally weaker than a year ago. Hotel room rates have declined in several Districts.”

People are reacting to substantially reduced wealth from both housing and the stock market, as well as slowing incomes due to layoffs and reduced hours or wages. They need to rebuild their balance sheets by increasing savings or paying down debts. As a result, they are keeping their wallets shut as much as they can.

Discretionary spending is, well, discretionary — at least in the short term. As such it is the hardest hit. Tourism is sort of the ultimate in discretionary spending, so it is among the hardest hit areas. I would expect the major hotel companies like Starwood (HOT: 22.37 -0.46 -2.01%) and Marriott (MAR: 20.46 -0.60 -2.85%) face a tough intermediate-term future.

Auto sales got down to an unsustainably low level, well below the normal rate at which cars go to the scrap heap. Thus it not surprising to see some rebound, but it is doubtful we will see the over 15 million a year rate that was the norm earlier this decade and in the 1990’s for quite awhile.

“Nonfinancial Services

“District reports regarding nonfinancial services industries were largely negative, although they included a few bright spots. The Minneapolis, St. Louis, and Dallas Districts indicated that demand for professional services such as business support, architecture and legal services continued to decline or remained soft. By contrast, reports from the health care sector were largely positive, with the San Francisco, Minneapolis and Richmond Districts citing steady-to-increased demand for medical services, and the Atlanta, Cleveland, Chicago and Dallas Districts reporting hiring activity in health care.

“Technology-related firms in the Kansas City District also reported heightened activity, especially in the clean technology and defense-driven aerospace markets. Richmond and Minneapolis noted increased demand for information technology workers, and Atlanta saw hiring activity in the defense and aerospace industry.

“Staffing industry contacts in numerous Districts suggested a higher demand for temporary or part-time workers over permanent hires, and Atlanta noted that employers were taking advantage of a higher supply of skilled labor to improve the quality of their workforces.

“Nearly all Districts reporting on transportation services observed continued weakness. Freight transport respondents from the Atlanta, Dallas and Cleveland Districts noted that cargo volumes remain below year-earlier levels. While Cleveland contacts reported that competitive shipping rates are being maintained, trucking contacts from the Atlanta District noted that an oversupply of trucks relative to demand has exerted downward pressure on rates. A few Districts also reported reduced airline traffic, especially amongst business travelers.”

Well there is a surprise — health care is still growing while the rest of the economy is shrinking. This has been a pretty consistent pattern for…oh, the last 30 years or so…as health care becomes an ever larger part of the economy.

It would be nice if there were some evidence that such spending were making us healthier, but there isn’t that much, especially relative to other countries that spend far less on health care and where the spending is growing more slowly. The weakness in freight traffic is a pretty key metric of how the overall economy is doing, and it is worthwhile to note that while they say it is below year-ago levels, they do not mention further deterioration in volumes, just that the oversupply of trucks is putting downward pressure on prices.

One more factor on the side of deflation currently — the pick up in temp hires might be a positive straw in the wind. It shows some more demand, but businesses are not sure if it is permanent yet.

“Manufacturing

“Reports on the manufacturing sector remained subdued but were slightly more positive than in the previous Beige Book. Many Districts characterized manufacturing activity as remaining depressed but with selected signs of modest improvement…albeit chiefly in nondurables industries. Districts attributed some of the recent increases in production to replenishment of finished-goods or customer inventories.

“Chicago indicated that the quick resolutions of the Chrysler and GM bankruptcies have boosted business confidence, and that automakers were scheduling a pickup in production for July…Steel production remained depressed but has leveled off or increased somewhat…Refineries increased their capacity utilization slightly over the past six weeks, but overall industry conditions remain weak because of low demand for fuels.

“Various District reports noted cancellations of orders for commercial aircraft and continued weak demand for most types of equipment and machinery. Among the positive developments in manufacturing, several Districts mentioned pickups in technology sectors, or cited strong or rising sales of military products or pharmaceuticals.

“Comments on the near-term outlook varied across Districts, but on the whole they appear consistent with a forecast of modest and uneven recovery in manufacturing output beginning during roughly the coming six to twelve months. New York, Philadelphia and Atlanta indicated that manufacturers have a generally positive or improved near-term outlook. Dallas reported that high-tech manufacturers ‘are seeing some upside potential in their forecasts instead of just down-side risks,’ but that construction-related manufacturers ‘expect no improvement in the near term.’

“Boston indicated that many respondents expect continued sub-par revenue numbers for the remainder of the year, but ‘look forward to slowly improving business in 2010,’ while Cleveland and Kansas City reported that manufacturing contacts expect little or no change in demand through the end of 2009.”

It looks like we might be on the cusp of an improvement in manufacturing, but just to replenish inventories that have gotten down to very low levels. That would be welcome, but is not sustainable unless final demand also picks up, and with incomes under pressure and a desire to save a bigger proportion of that income, demand is likely to remain soft for the foreseeable future. The improvement in Tech is consistent with what we have been seeing in the estimate revisions data, where analysts have been generally raising their sights lately for Tech firms earnings.

“Real Estate and Construction

“Commercial real estate leasing markets were described as either ‘weak’ or ’slow’ in all 12 Districts, although the severity of the downturn varied somewhat across Districts…resulting in sizable leasing concessions and/or declines in asking rents. Significant weakness in the retail leasing sector was reported for the Boston, Minneapolis and New York Districts, and industrial vacancy increased in the Atlanta, Dallas, Minneapolis and St. Louis Districts.

“Commercial real estate sales volume remained low, even ‘non-existent’ in some Districts, reportedly due to a combination of tight credit and weak demand. Construction activity was limited and/or declining in most Districts, although exceptions were noted for health and institutional construction in the St. Louis District, public sector construction in the Chicago District, and the reconstruction of the World Trade Center in Manhattan. Tight credit was cited as an ongoing factor in the dearth of new construction activity.

“The commercial real estate outlook was mixed, both within and across Districts. Some contacts expect commercial real estate markets to improve within two quarters, and others predict further market deterioration for the remainder of 2009 and possibly through late 2010.”

Commercial Real Estate is proving to be to late 2009 and 2010 what residential real estate was to 2008 and early 2009. It is going to be the major source of new headaches for the banks. With rents falling and vacancies rising, declining construction activity is a good thing, although I am sure that construction workers do not agree with me on that.

Most of the non-residential construction activity that is going on appears to be tied to the stimulus package or related to health care. Given the weakness for architects services noted above, commercial construction activity is likely to remain depressed for awhile.

“Residential real estate markets in most Districts remained weak, but many reported signs of improvement. The Minneapolis and San Francisco Districts cited large increases in home sales compared with 2008 levels, and other Districts reported rising sales in some submarkets.

“Of the areas that continued to experience year-over-year sales declines, all except St Louis — where sales were down steeply –  also reported that the pace of decline was moderating. In general, the low end of the market, especially entry-level homes, continued to perform relatively well; contacts in the New York, Kansas City and Dallas Districts attributed this relative strength, at least in part, to the first–time homebuyer tax credit. Condo sales were still far below year-before levels according to the Boston and New York reports.

“In general, home prices continued to decline in most markets, although a number of Districts saw possible signs of stabilization. The Boston, Atlanta and Chicago Districts mentioned that the increasing number of foreclosure sales was exerting downward pressure on home prices. Residential construction reportedly remains quite slow, with the Chicago, Cleveland and Kansas City Districts noting that financing is difficult.”

The housing market is awful, but has stopped getting worse. Sales are starting to pick up, but it is going to be awhile before prices start to recover. Foreclosures will continue to weigh on the market for at least the next few quarters. The first-time homebuyer tax credit program appears to be a success, and inventories are coming down to more manageable levels.

“Banking and Financial Services

“In most reporting Districts, overall lending activity was stable or weakened further for most loan categories. In contrast, Philadelphia reported a slight increase in business, consumer and residential real estate lending. As businesses remained pessimistic and reluctant to borrow, demand for commercial and industrial loans continued to fall or stay weak in the New York, Richmond, St. Louis, Kansas City, Dallas and San Francisco Districts. Consumer loan demand decreased in New York, St. Louis, Kansas City and San Francisco, stabilized at a low level in Chicago and Dallas, and was steady to up in Cleveland.

“Residential real estate lending decreased in New York, Richmond, and St. Louis. Dallas reported steady but low outstanding mortgage volumes, while Kansas City noted that the rise in mortgage loans slowed. Refinancing activity fell dramatically in Richmond, decreased in New York and Cleveland, and maintained its pace in Dallas. Bankers in the New York District indicated no change in delinquency rates in all loan categories except residential mortgages, while Cleveland, Atlanta and San Francisco reported rising delinquencies on loans linked to real estate.

“Banks continued to tighten credit standards in the New York, Philadelphia, Richmond, Chicago, Kansas City, Dallas and San Francisco Districts, and some have stepped up the requirements for the commercial real estate category, in particular, due to concern over declining loan quality. Meanwhile, Cleveland and Atlanta reported that higher credit standards remained in place, with no change expected in the near term. Credit quality deteriorated in Philadelphia, Cleveland, Kansas City and San Francisco, while loan quality exceeded expectations in Chicago and remained steady in Richmond.”

In an overleveraged country, I am not sure that the decline in lending activity is such a bad thing from a long-term point of view, however it does slow down economic growth. Given how fast public debt is growing, if loan demand were also strong in the private sector it is likely that interest rates would rise, perhaps rather sharply.

We saw the same pattern in terms of lending activity with residential mortgages that is now happening on the commercial side. As prices fall, the bankers are not as sure about the value of the collateral and become more reluctant to lend. Then again, those falling prices are evidence of a glut of available resources, so adding to the inventory of unused offices and strip malls is probably not a good thing to do in any case.

The decline in residential mortgage activity is probably a reflection of the recent rise in mortgage rates (relative to April and May). It does call into question the sustainability of the recent pick-up we saw in home sales (both new and used).

“Employment, Wages and Prices

“All Districts indicated that labor markets remain slack, with most sectors either reducing jobs or holding steady, and aggregate employment continuing to decline, on net. However, Boston, Cleveland, Richmond, Atlanta, Chicago, St. Louis and Minneapolis noted selective hiring, including attempts by some firms to take advantage of layoffs elsewhere to pick up experienced talent.

“Richmond, Chicago, St. Louis and Dallas cited moderation in the pace of manufacturing employment decline since the last report, and New York noted some signs of labor market stabilization. But Atlanta reported further deterioration in labor market conditions and additional job cuts already planned for coming months.

“The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs and unpaid vacations.

“Most Districts reported that upward price pressures were minimal. Manufacturers in the Boston, Philadelphia, Atlanta, Minneapolis, Kansas City and Dallas Districts indicated that most materials costs were flat or down; however, several Districts mentioned price increases for some metals, petrochemicals and building materials.

“While the Boston, New York and Kansas City reports say a few firms are making modest price increases stick, selling prices of most manufacturers and retailers were reportedly held down by competitive pressures. Services firms have increased discounting and/or cut fees, according to contacts in Boston, Philadelphia, Atlanta, Dallas and San Francisco, while Richmond indicated price increases for services were mild.”

The current economic environment is by its nature deflationary, which tends to raise real interest rates and further slow economic activity. The private sector is attempting to deleverage and repair balance sheets. The policy responses to this have been explicitly inflationary to counteract the natural deflation.

For the time being, it looks like the forces of deflation continue to have the upper hand. I don’t see where the increasing prices for building materials are coming from given the weak construction markets, unless they are being exported. I suspect the strength in metals prices is also mostly coming from China.

Core inflation is likely to remain subdued, and businesses will have trouble making any attempted price increase stick. If inflation shows up, it is likely to first show up on the food and energy side, and will cause headline inflation to outpace the rate of compensation growth. Given the cutting or freezing of wages, etc. it will not take much in the way of headline inflation to reduce the real standard of living of most people.

Overall, this was a downbeat report, but not as downbeat as we have seen in recent months. The picture is one of an economy stuck in the mud, not one falling off a cliff. For now, deflation remains a more significant threat than inflation, but given the increase in the size of the Fed balance sheet, it is not time to forget about potential inflation down the road.

Unemployment is going to be a very big problem for quite awhile. That slack in the economy will make it hard for inflation to gain traction. People are not going to be seeing their incomes go up, and will want to save more of what they do earn.

This will be a double-whammy on consumption. Over the long term, this is not a bad thing, since at over 70% consumption is a far bigger share of our economy than it is for most of our competitors. But at 70% of the economy, if consumption is weak, there is no way for the economy as a whole to avoid being weak.