Is the Worst Over?

The stock market has started the second quarter of 2008 with a rousing gain: as of 2:00PM, almost 300 points on the Dow, an increase of 2.5% for the day, and it closed up 391 points or 3.2%. It's still off about 4.5% so far in 2008, but this familiar measure of 30 companies is up marginally from this time a year ago, a remarkable stability if the economy is in recession. Broader stock price gauges are down several percentage points from year-earlier levels, but they are showing milder declines than during previous contractions in the economy. You perhaps get the feeling, as I do, when the market swings up and down from day to day that investors aren't sure which way things are going.

So far, measures of economic activity have behaved in a similar fashion. Today, for example, the Institute of Supply Management, an industrial trade association, reports that its index of manufacturing activity hovered just below 50% in March for a third straight month, indicating that while the sector is experiencing retrenchment, it is quite modest. Broader evidence will come Friday, when the Labor Department publishes economy-wide job and unemployment data for March.

The Federal Reserve Staves Off Panic
Part of the stock market's relatively even-handed performance is surely related to the recent decisive actions by the Federal Reserve. With the significant degree of debt in the economy, confidence is all-important. Within a few days near mid-March, Bear Stearns, a large, 85-year-old investment bank, lost the confidence of its day-to-day lenders. We often think that long-term investing is the riskiest, but in extreme situations, funders may worry that they might not get repaid even tomorrow, so overnight financing becomes next to impossible. Such a situation loomed on March 13 and 14. ["Beware the Ides of March." Haven't I heard that somewhere before?] On the morning of March 14 and again on Sunday, March 16, the Fed announced a special lending facility for Bear and the extension of its regular discount window operations to the entire network of so-called "primary dealers".

As we mentioned last time, only commercial banks have had access to the full range of Federal Reserve support activities. A select group of investment banks also participate in the Fed's "open market operations", which are the main tool for adding or draining monetary reserves. Those dealers, just 20 in all, that are chosen to conduct these monetary policy transactions are high quality institutions that must maintain specific minimum capital levels; they are obligated to trade Treasury and other securities even under adverse market conditions and they must make extensive daily and weekly reports on their financial condition and market positions to the Federal Reserve. Thus, it would have been a tremendous shock at the very core of the US financial system if a "primary dealer" were to fail.

The Fed's also brokered the sale of Bear Stearns to JP Morgan Chase; this quick commitment to ensure the continuity of business by arranging a sale of the firm surely helped to maintain the viability of US markets in general. Just as surely as time goes on, questions will be raised about whether the Fed's actions were completely legal and appropriate, but in the moment a panic was averted.

Going forward, it seems to us that financial failure is probably less a concern for the economy in general. Among its actions, the Fed cut its key short-term interest rate again, now to 2.25%. Other interest rates have eased for many borrowers. Mortgage rates, for instance, have dipped back below 6%. And rates on most corporate bonds and short-term obligations have also declined.

But Consumers' Incomes Are Squeezed
At the same time, we do have a worry about the broader economy – and it's about us. We watch with increasing nervousness as gasoline prices continue increasing. And we know we're paying more for milk and other basic food items. The Commerce Department has published data through February on consumers' wage-and-salary income and their spending on some of these necessities, so we can see how much of our income they are taking. In the graph, you can see that energy has risen to absorb more than 13% of "take-home pay" (an after-tax measure we calculated from the Commerce Department array of information), the most in 20 years, and food-at-home has started to rise again after a lengthy decline. "Financial obligations" are a Federal Reserve series encompassing mortgage payments, rents, property taxes and insurance and they too, as we might imagine, have been taking more and more of our incomes. A more thorough exploration of these consumer finance issues will surely occupy us again. But as outlays for food and energy approach 30% of our paychecks and housing expenses account for another 42%, that leaves the smallest portion of income available for discretionary spending since these data were first compiled in 1980. So some risks to the economy might be subsiding, but we're clearly not out of the woods. And all the precautionary ideas we've expressed here about seeing to your own financial health can't be repeated too often.