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Separately, the Bank announced that its Board of Directors has declared a 5% stock dividend payable on July 18, 2011 to shareholders of record as of July 5, 2011.  Mr. Opatut stated that “we declared this stock dividend as a down payment on the return we intend to provide our investors and to reward  them for the faith they showed in investing in the Bank.”

First Commerce Bank is a New Jersey chartered commercial Bank with offices in Closter and Lakewood, New Jersey.  As of March 31, 2011, the Bank had total assets of $97.7 million and total deposits of $76.2 million and total loans of $63.8 million.

You would have to be a dyed-in-the-wool pessimist not to be at least somewhat encouraged by the recent spate of economic data. True, the old year didn’t exactly end with a bang. But by all accounts, the economy staged a far better performance in the closing months of the year than most expected when the fourth quarter began. Virtually all key economic indicators – from consumer spending to business output – beat forecasts, the stock market rallied strongly, and business as well as household confidence improved, sending a strong signal of even better times to come. The major weak link in this otherwise positive chain of events was the failure of the job market to fully corroborate the economy’s strengthening tendencies.

Well, as of the first Friday of the new year we are still waiting for that confirmation. Granted, this is not a “Waiting for Godot” situation. The principal character has shown up, but on a train that is arriving far too slowly to be greeted with much enthusiasm. In fact, Friday’s jobs report was met with a rather lukewarm reception in the financial markets, reflecting a mix of good and bad news that left investors feeling more confused than confident. The day began with high expectations, due primarily to a wildly optimistic forecast by ADP, a large payroll firm, of a 297 thousand increase in private sector jobs for December. The ADP tally doesn’t match up with the official employment numbers issued by the Labor Department, but the two tend to follow a similar path over time. Not surprisingly, the upbeat ADP reading for December led many economists to revise up their forecast for the month. Earlier in the week, the general consensus was that the Labor Department’s figures would show an increase of slightly more than 100 thousand jobs in December; following the ADP report on Wednesday, however, that forecast was revised up to about 150 thousand.

Sadly, the government figures did not live up to those heightened expectations. Indeed, the herd on Wall Street should have left well enough alone; as it turned out, the economy generated 103 thousand net new jobs in the final month of the year according to the Labor Department’s initial estimate released on Friday, which was spot on with the earlier forecasts. We note that this is an initial estimate because the government’s numbers are subject to significant revisions in subsequent months. That was certainly the case this time as well, as the December report added 70 thousand jobs to the previous estimate for October and November. As a result, November’s gain in nonfarm payrolls was revised up from a tepid 39 thousand to a more respectable 71 thousand, and October now shows a solid increase of 210 thousand compared to the previous reading of 172 thousand.

Simply put, the job market continues to improve at a painfully slow pace – but it is improving. After accounting for the revisions, the three-month moving average of job increases stood at 128 thousand in December, up from 86 thousand in November. Next month, the government will be releasing its benchmark revisions for the past year, which may give a much different look as to how the job market performed in 2010 than is now perceived. In recent years, the benchmark readings have cast a much harsher light on employment, revealing deeper job cutbacks than originally estimated. That’s fairly typical during recessions and their immediate aftermath. However, the revisions tend to be positive during recoveries, so the next report may reveal a stronger job market last year than is now apparent. Such a positive surprise, if it materializes, may not be priced into the financial markets. We’ll see.

Taking stock of all economic data in recent months, what stands out loud and clear is that workers are still not fully participating in the broader economy’s gathering strength. That dichotomy is dramatically captured in the ISM surveys of manufacturing and nonmanufacturing companies for December. As the chart shows, both surveys revealed a sharp improvement in activity last month, with the index of nonmanufacturing activity surging to the highest level in nearly five years. For the most part, stronger production and new orders paced the gains, but companies were still reluctant to add to payrolls. In both surveys, the employment component actually slipped in December. It seems that corporate America is still striving to squeeze as much productivity out of their existing work force as possible.

No doubt, restraining costs will be an ongoing priority in a highly competitive pricing environment. That means companies will be holding the line on pay increases, making greater use of temporary workers and retaining a flexible workweek that includes as many part-time workers as practical. All of these characteristics were evident in the December jobs report. Hourly earnings eked out a slim 0.1 percent increase, the workweek remained unchanged and the number of employees working part-time for economic reasons (meaning that they would prefer full-time jobs) remained a tad below the all time high of 9 million that has prevailed since early 2009. This is not a picture of healthy labor market that will underpin a full-fledged self-sustaining expansion.

But the painfully slow pace of job creation is also typical of a post-crisis economy that is still coping with major headwinds, including an ongoing housing correction, steep budget cuts by state and local governments and tight lending standards for small businesses. Ironically, the conventional wisdom is that the recent increases in payrolls of slightly over 100 thousand a month are barely enough to keep up with the working-age population, and certainly not fast enough to bring down the unemployment rate. But the December jobs report would seem to belie that notion, as the unemployment rate dropped unexpectedly, plunging from 9.8 percent to 9.4 percent. The brought the rate down to the lowest level since May 2009 and was clearly the shining star of an otherwise lackluster jobs report.

The markets, however, were quick to discount that headline-grabbing drop, and perhaps for good reason. For one, the unemployment rate is derived from a much smaller sample of about 60 thousand households than the employment numbers, which are derived from a much larger canvass of about 400 thousand firms. Hence, the payroll figures are considered to be a more reliable barometer of underlying labor market trends. For another, the unemployment rate can show improvement for the wrong reason, which many felt was the case in December. What the household survey revealed was that there was a big drop in the size of the labor force. The implication is that people simply stopped looking for work, discouraged by poor job prospects, and hence are no longer counted as unemployed. Indeed, total unemployment dropped by 556 thousand during the month, more than offsetting a 297 thousand increase in employment, reducing the size of the labor force by 260 thousand.

But a closer look of the underlying data doesn’t entirely support that notion. The labor force did fall, but not solely because potential job seekers just gave up the search. Indeed, the government’s broader measure of underemployment, U-6, which includes discouraged workers as well as those working part time for economic reasons, also fell in December, from 17 percent to 16.7 percent. A major reason the labor force fell by 260 thousand last month was that fully 112 thousand workers who were employed in November dropped out in December. These folks were not fired, but left their jobs either due to retirement, to return to school or attend to family matters. Indeed, the gross flow data that provide a more detailed description of unemployment show that 114 thousand workers who were unemployed in November found jobs in December. And the number of job losers – those who went from being employed in November to being unemployed in December – plunged by 220 thousand That goes a long way towards explaining the declining trend in initial claims for unemployment benefits last month.

That said, it would be a stretch to be overly positive about the December jobs report. The increase in nonfarm payrolls remains far below normal recovery yardsticks. At the current pace, it would take more than seven years to restore nonfarm payrolls to the level that existed prior to the recession. Meanwhile, the gradual improvement in the job market seems to be mostly benefiting workers who have been out of work for a short time. The plight of the long-term unemployed is as dire as ever. In December, the average duration of the unemployed rose to 34.2 weeks, about 5 weeks longer than a year earlier. And while the overall unemployment rate fell from 9.8 percent to 9.4 percent, the rate for those out of work for more than 27 weeks increased from 4.1 percent to 4.2 percent.

Keep in mind also that the much-ballyhooed renewal of extended jobless benefits does not increase the time period for which the long-term unemployed can receive payments. The maximum period is still 99 weeks. All the renewal does is enable people out of work for less than that period to continue getting their benefits until the 99 week limit is reached. But because the fraction of long-term unemployed has skyrocketed over the past year, a startling number are approaching that cut-off point. A precise breakdown on length of unemployment is not available, but 4.0 million had been out of work for more than a year in December, 30.2 percent of the 14.0 million officially classified as unemployed. A year earlier, 14.7 million were unemployed but only 3.1 million or 22.8 percent were jobless for more than a year.

Simply put, the 99-week limit is rapidly approaching for millions of workers who will soon exhaust their benefits. Not only will their purchasing power be severely cut, their skills have languished, making it even more difficult for them to find comparable jobs than what they had before. More than anything, this dramatically highlights the nature of the structural unemployment problem facing the nation. The longer this problem persists, the more difficult it will be to reverse, and the greater will be the potential harm to the overall economy – leading to lower productivity and a slower growth trajectory for GDP. This is one of the longer-term issues the U.S. will have to confront sooner or later, along with other seemingly intractable issues such as the budget deficit. But the key hurdle for the period immediately ahead is to jump-start the job-creating engine, which continues to sputter. Our sense is that it will shift into a higher gear in coming months, but it may be a while before the labor market is operating on all cylinders.

The investment group raised over $16 million in new capital for Northern State Bank, and as a result of the transaction, the Bank now has total equity of approximately $21 million.  The Bank’s capital ratios exceed, by a significant amount, all minimum capital levels required to be deemed “well capitalized” under FDIC regulations.

Under the terms of the Recapitalization Agreement, the final purchase price for stock sold in the recapitalization was to be determined based on Northern State Bank’s book value per share as of November 30, 2010, calculated under the terms of the Recapitalization Agreement.  The final purchase price in the offering was $2.63 per share.

Although the recapitalization has closed, the offering of common stock remains open until December 28, 2010.

Abraham S. Opatut, Chairman of the Board and one of the lead investors for the Recapitalization Agreement, stated: “We look forward to continuing to provide the Bergen County market with personal, highly-responsive banking solutions, while bringing hometown banking to the Lakewood, New Jersey community.  We believe that the Northern State franchise, coupled with the capital we were able to bring to the Bank, provides us a platform to build the area’s best community bank.”

Mr. Benedict Romeo, the former Chairman of Northern State Bank and a continuing member of the Board of Directors of the Bank, stated: “Our Board believes that joining our franchise with the capital and management expertise of the investor group will significantly enhance the value of our franchise, and provide Northern State shareholders with the best return on their investments.  I look forward to working with the combined teams to make the Bank a success.”

As the calendar page turns to 2011, the case for optimism is building by the day. Admittedly, we’ve been there before, only to be disappointed by unfolding events. Recall that at the start of 2010, there were compelling reasons to believe that the economy was heading towards a brighter future. Growth accelerated in the fourth quarter of 2009, hitting a robust 5 percent annual rate, before slowing to a still-solid 3.7 percent pace in the first quarter of 2010. Main Street drew encouragement from the turn in the labor market, as companies started to increase payrolls in January following 18 months of debilitating job losses. Wall Street, in turn, was celebrating an astonishing stock market rally that got underway in the spring of 2009 and was still going strong as the curtain lifted on the new year. Even the embattled Federal Reserve started to publicly discuss an “exit strategy” from its unprecedented easy policy, poised to dismantle an array of emergency lending facilities put into place during the financial crisis and siphon off some of the massive liquidity injections that propped up the financial system and lifted the economy out of the quicksand of the Great Recession.

Of course, the ebullience of twelve months ago turned out to be based on false hopes. Instead of building on the momentum that seemed to be underway in the early months of 2010, the economy suffered a relapse; growth slid to a barely perceptible 1.7 percent pace in the second quarter, and within a heartbeat the doomsayers came out of the woodworks proclaiming imminent disaster. Suddenly, a double-dip recession lurked around the corner, the deflation threat reared its ugly head again and the specter of a “lost decade” that Japan experienced in the 1990s loomed ominously for the U.S. It’s unclear what put the cork back in the champagne just as the party was heating up. The most visible shock to confidence came in the spring when the threat of a Greek debt default morphed into a widespread European debt crisis that is still reverberating through the global markets.

But the economy also deflated under its own weight, as much of the strength over the latter part of 2009 and early 2010 was built on steroids provided by Washington, particularly the tax incentives aimed at boosting demand for homes, cars and appliances. When these incentives ran out, so too did the main drivers of growth, even as the scars from the Great Recession remained opened. So, it is reasonable to ask if the recent signs of strengthening activity are once again nothing more than a head fake that will end in a veil of tears. Certainly, the economy still faces some formidable headwinds that will almost surely put a crimp on growth in the year ahead.

In recent weeks, for example, the headlines have been filled with hard-luck stories about beleaguered state and local governments. A startling number of them are in dire circumstances, saddled with huge underfunded pension obligations and unsustainable spending commitments, even as falling property values are eroding tax revenues. Federal stimulus funds that helped plug the revenue shortfall last year are running out, and there is little sentiment in Congress to replenish them. Predictably, state and local officials have responded by pursuing aggressive belt-tightening moves. Over the past year, more than a quarter-million public sector workers outside of the Federal government have lost their paychecks, even as companies in the private sector have added 1.1 million jobs. More layoffs will surely occur in the months ahead, extending a negative influence that will be amplified if job growth in the private sector does not take up the slack.

Then there is the ailing housing sector that continues to be an Achilles heel for the economy. Sales figures released this week revealed a modest uptick in November; but rather than a late-year rebound, the picture being portrayed is one of a bottoming out process in the market for new homes and a “dead-cat bounce” in the market for existing homes. New home sales edged up by 5.5 percent to an annual rate of 290 thousand units, but that’s only a tad above the all-time low of 274 thousand hit in August and a dispiriting 21 percent below the level of a year ago. Likewise, transactions in the much larger resale market for homes were nothing to write home about

Existing home sales eked out a 5.6 percent gain to an annual rate of 4.68 million units and show a stronger advance from the summer low of 3.84 million units compared to the new home market. Even so, the pace of resales remains well below the normal levels that prevailed prior to the subprime-fueled boom that began in 2003; inventories stand at a high 9.5 months supply (relative to a more normal 6 months supply) and prices continue to weaken. With a huge shadow inventory waiting to hit the market in the form of foreclosed properties and banks tightening lending standards for potential buyers, progress in redressing the supply/demand imbalance in the housing market will progress slowly, at best.

But as we noted in last week’s commentary, following the bursting of the housing bubble that left the industry in a much-diminished state, residential outlays now carry about half the weight in the overall economy than was the case prior to the bust and, hence, should not have a meaningful impact on overall economic activity. To be sure, another sharp leg down in home prices would have a negative wealth effect on household balance sheets, buffeting confidence and curtailing spending somewhat. But it does seem that the worst is over, and property values are heading for a long slog of stagnation or modest declines rather than falling off a cliff. And while about 11 million, or more than 20 percent, of homeowners owe more on their mortgages than their homes are worth, this has to be viewed against improving balance sheets in recent years. Thanks to aggressive debt paydowns, refinancing at low rates and yes, increased defaults, debt-servicing payments as a share of disposable incomes have fallen to the lowest level in more than a decade.

At the same time, an old foe is once again making its presence felt. Oil prices, an ongoing thorn in the economy’s side, are spiking higher, with spot crude prices in the U.S. surging above $90 a barrel in recent weeks. That’s a $25 increase since the end of May, pushing up gasoline and heating bills to the point that households may have to put off other purchases. This is somewhat of a wild card in the outlook. The oil price surge may reflect a temporary blast of unusually cold weather in North America along with some speculative activity among traders rather than a negative turn in fundamental influences. However, the share of household budgets going to fuel is reaching a tipping point that in the recent past has curbed spending.

These headwinds are valid reasons to question the economy’s momentum as 2010 winds down. With the disappointments of the recent past fresh in mind, only the most wild-eyed optimist would extrapolate the economy’s better tone into a turbo-charged upturn. But while caution may be justified, there are compelling reasons to feel more confident that the recent momentum will carry into 2011. For one, consumers are getting their mojo back. Granted, the revised figures on GDP released this week show that households increased spending at a slower pace than previously estimated in the third quarter. But the 2.4 percent increase in real consumption (revised from 2.6 percent) was still the strongest in nearly four years. What’s more, the holiday shopping season is firing on all cylinders, according to industry reports, which is adding considerable oomph to fourth-quarter consumption. Real personal outlays gained a respectable 0.3 percent in November, according to the latest Commerce Department release this week, following a sturdy 0.5 percent gain in October. Averaging out the two months, real consumption is on track for an impressive increase of 4 ¼ percent in the fourth quarter.

Since consumer spending accounts for an outsize 70 percent of total economic activity, that just about guarantees a fairly robust gain in GDP for the closing quarter of the year. Our tentative estimate is for an annual rate of increase of slightly above 4 percent, which is well above the consensus forecast of a few months ago. Quite possibly, consumers may pull back early in 2011 when holiday shopping bills arrive and the sting from higher fuel costs is felt. But that makes the timeliness of the recently-signed tax bill all the more relevant. True the $858 billion price tag overstates the amount of fiscal stimulus that will be forthcoming. Keep in mind that the bill mostly extends the Bush-era tax cuts scheduled to expire at the end of 2010. Hence, the major benefit is that it snuffs out another headwind that would have stifled growth, namely an increase in taxes for most Americans. But the bill also contained a few surprising features, including a 2 percent rollback in payroll taxes for one year, a 13-month extension of jobless benefits for the long-term unemployed, and more liberal depreciation allowances that companies can take on new investments made in 2011. These features will inject about $300 billion more fiscal stimulus into the economy than was generally expected a month or so ago.

What’s more, unlike the stimulus bill enacted in February 2009, this one should provide more bang for the buck. That’s because a bigger share of the tax savings will be going to lower-income households, who are more likely to spend every penny of their additional disposable incomes. Recall also that a key reason the 2009 tax cut did not boost spending as much as hoped is that a big fraction of the savings was used to pay down the excessive debt built up prior to the recession. But households have made great strides in repairing their balance sheets over the past two years, reducing debt-servicing burdens to the lowest level in more than a decade. Hence,more of the tax savings will be recycled directly into the spending stream. As much as anything, the potential thrust from the latest fiscal stimulus is what prodded most economists to ramp up their growth forecasts for the coming year.

We concur with the brighter prospects and look for the economy to expand by about a full percentage point faster than the 2 ½ – 3 percent pace it traveled in 2010. Why is that important? Simply put, a growth rate of less than 3 percent would hardly make a dent in the intolerably high 9.8 percent unemployment rate. Historically, that pace would generate just enough jobs to keep up with the working-age population. But to recover the 8.5 million jobs lost during the Great Recession, the economy needs to grow faster. To be sure, even with the growth rate we envision for the year, the decline in the jobless rate will be painfully slow, bringing it down perhaps to just under 9 percent by the end of the year. This is the “new normal” that the nation will have to live with as it slowly emerges from the worst financial crisis and recession since the 1930s. However, barring major policy mistakes (always a big if), the elements for a long self-sustaining expansion are falling into place.

Oh, the irony of it all. With Treasury bond yields hitting a seven-month high of 3.53 percent this Wednesday, Fed chairman Bernanke must be wringing his hands in despair. After all, the main purpose of QE2 was to keep long-term interest rates as low as possible, which ostensibly would spur borrowing and spending, thus speeding up the flagging economic recovery. But since the Fed’s announcement of its bond-purchase strategy on November 3, long-term yields have spiked up by roundly a percentage point; and since the 10-year Treasury rate sets the benchmark for mortgage yields, the financing costs associated with home purchases as well as refinancing have also shot up.

But the Fed chief is more likely to be toasting the unfolding developments rather than wallowing in them. True, celebrating higher interest rates would seem to be counter-intuitive, as it is hardly something that would ordinarily nurture stronger growth. Indeed, carried far enough, the increase would clearly become a major impediment to the recovery. However, the current rate level, while up sharply and swiftly over the past month, remains well below the threshold that would stifle activity. A more accurate assessment of the situation is that rates had fallen too far during the spring and summer months, reflecting exaggerated concerns over a double-dip recession and a deflation threat, reinforced by a European debt crisis. The 10-year bond had plunged to 2.38 percent on October 4, just barely above the postwar low reached in late 2008, when the nation was mired in the worst financial crisis and economic downturn since the 1930s.

With the Treasury yield receding a bit to 3.35 percent on Friday, it is now well within the range that prevailed throughout the spring, which is more reflective of underlying financial and economic conditions. More significantly, the Fed is no doubt pleased that the forces underpinning the increase are precisely what the policy of quantitative easing was designed to bring about. Fears that the economy would relapse into another recession have dissipated, investor confidence has increased, as manifested by rising stock prices and reduced risk premiums in the bond market, and the deflation threat, while not eradicated, is far less likely to become a reality.

To be sure, the Fed acknowledges that the inflation rate remains below its comfort zone of about 2 percent and the huge slack in the product and labor markets is putting a lid on price pressures. But the downward spiral in inflation has been arrested, and an array of indicators point to a pickup going forward. Several metrics of inflation expectations have moved higher since the Fed announced its asset-purchase program in early November, including a widening in the spread between nominal and inflation-indexed yields in the Treasury market. This week’s report on the consumer price index continued to portray a tame inflation picture, but it confirmed the bottoming dynamic that is unfolding. For one, the core CPI, which excludes the volatile food and energy prices, posted the first increase in four months, albeit the increase was a slim 0.1 percent.

For another, and perhaps more importantly, the major drag on the reported inflation rate over the past two years, the persistent fall in housing costs, appears to be turning the corner. Residential rents posted a solid 0.2 percent increase in November, the third consecutive monthly increase and the largest since March of 2009. Owner’s equivalent rent has increased in four of the past six months, following flat or declining readings during most of the preceding year. Both measures, which have a combined weight of more than thirty percent in the core CPI, are now registering positive on a year-over-year basis. The housing market remains under heavy pressures from a large shadow inventory of foreclosures, but demand has stabilized and a steadily improving job market should provide increasing support for sales going into 2011.

Granted, the housing sector continues to be the economy’s Achilles heel; at best, the supply/demand imbalance will narrow gradually over the next year or two as rising jobs and incomes enables more homeowners to meet their mortgage payments, reducing the hectic pace of foreclosures even as it buttresses the demand for housing. At worst, the housing sector will suffer another leg down, as the sales pulled forward earlier this year by the housing tax credit leaves a demand void that will be prolonged and perhaps intensified by expectations that the home price decline still has room to run. At the very least, residential outlays will not provide the time-honored spark that leads to several quarters of explosive growth during the early stage of cyclical upturn.

But the absence of a housing catalyst should not be a major roadblock on the recovery road. Keep in mind that the residential sector is not playing nearly as important a role in the economy as it has in the past. As the chart shows, residential outlays as a share of GDP stood at a post-war low of 2.4 percent in the third quarter. That’s less than half the weight it carried during the initial stage of past recoveries. Hence, while the housing collapse has wrought havoc with the economy, not to mention the financial markets, over the past three years, the diminished status of the sector means that it will neither cause much more damage nor provide much momentum to the recovery in the future.

That’s not to say, of course, that the economy would not benefit from a strengthening housing industry. No segment of the labor force suffered more than construction workers, whose rank among the employed has shrunk just as dramatically as has housing’s influence on the economy. Homebuilders have downsized aggressively during the slump, and are operating with a lean staff of workers until they perceive a sustainable pickup in home sales. With financing tight, they are not about to put up speculative housing but will wait to see the “whites in the eyes” of potential buyers. Not surprisingly, inventories of newly built homes are exceptionally low, which is contributing to the woefully weak job market for construction workers. On the positive side, the lean inventories of homes on the market suggest that when a perceived sustained rebound in sales does occur, the demand for construction workers will be that much stronger, both to accommodate future sales and to replenish depleted inventories. We saw the effects of a similar inventory cycle in manufacturing following the Great Recession, as the drive to rebuild inventories coupled with growing optimism over the economy’s prospects during the second half of last year spurred a rebound in factory output and hiring.

What’s more, the economy will benefit indirectly from a revival in housing activity. Keep in mind that a home is the most important asset most households own, and changes in its value has a considerable impact on the net worth of homeowners. During the worst of the housing meltdown in 2007 and 2008, for example, residential property values plunged by $6.1 trillion, which wiped out a considerable chunk of household asset values. The slump in home values, of course, took a big bite out of household net worth, reinforcing the damage caused by the stock market collapse as well as the debt build-up associated with the overspending prior to the recession. All told, the impaired state of household balance sheets intensified and prolonged the downturn in consumer spending.

Since the end of 2008, however, the strain on balance sheets has ebbed substantially, replaced by a healing process that is still underway. More than one-third of the $17 trillion in net worth that evaporated during 2007 and 2008 has been restored over the past six quarters, thanks primarily to a powerful rebound in stock prices and an aggressive paydown in debt. While home values have not recovered, the debilitating slide is nearing an end. Indeed, after plunging from over $25 trillion at the end of 2006 to $18.4 trillion in the first quarter of 2009, the value of real estate holdings by households rebounded to $19 trillion by mid-2010 before losing $750 million in the third quarter. But while home values slumped modestly in the third quarter, reflecting the end of the tax credit-induced boost to sales earlier in the year, the impact on net worth was muted by a decline in mortgage debt.

Indeed, household net worth actually rose by $1.2 trillion in the third quarter, reversing almost the entire $1.4 trillion setback in the second quarter. With stock prices posting solid gains in the fourth quarter and boosting the value of equity holdings, the healing of household balance sheets that got underway in the spring of 2009 continued apace through the end of the year. The mending process is far from over, as debt burdens are still too high relative to incomes and about a quarter of homeowners with mortgages owe more than their homes are worth. We suspect that the deleveraging process underway for the past two years will continue over the foreseeable future, and put a crimp on the growth in consumer spending.

But if asset values continue to recover, Fed chairman Bernanke will receive a nice assist from the wealth effect in the task of adding momentum to the recovery. And while the tax and spending deal signed by President Obama on Friday may have its detractors, it provides yet another modest impetus to the economy that was not expected as recently as a month ago. No doubt, the fiscal reinforcement contributed to the upswing in bond yields in recent weeks; but as we noted at the outset, if the increase is a product of a strengthening economy and an uptick in inflation expectations, monetary officials will be more inclined to hoist a toast rather than wallow in despair.

Not too long ago during the spring months, the widespread view was the Federal Reserve would soon be taking away the punch bowl before the economic party became too heated. That expectation, of course, withered as the once-promising recovery soured over the past six months, posting tepid growth rates far too weak to lower an intolerably high unemployment rate. Hence, instead of becoming party poopers, the Fed is once again spiking the punch bowl, hoping to juice the economy’s growth machine and generate enough heat so that it can return to its more familiar role of curbing exuberance.

To no one’s surprise, the Fed announced this week that it would resurrect its quantitative easing strategy put in place during the financial crisis and economic meltdown in 2008. That program, which ended in March of this year, involved $1.7 trillion of mortgage securities and Treasury bond purchases and, despite its bad reputation, did prevent a very bad situation from becoming a catastrophe. The second iteration, commonly known as QE2, will not be as large as the first, coming in at a more subdued $600 billion package of new Treasury bond purchases through June of 2011. However, the total could be larger if the economy continues to struggle and inflation remains too low for the Fed’s comfort. In other words, this is not a shock and awe approach to the nation’s economic woes, but one that gives the Fed flexibility and the time to see how things play out.

Needless to say, the debate swirling over the wisdom of the Fed’s move prior to this week’s announcement remained very much in the forefront in the days following it. The harshest critics are those who believe it will be ineffectual and, hence, diminish the Fed’s credibility as a policy force in the future; others believe that continuing to print money in vast quantities simply sows the seeds of future inflation or another asset bubble. Conversely, there are those who have faith in the power of monetary stimulus as well as the Fed’s ability to reverse course should economic activity pick up faster than expected, igniting inflation pressures. Even the more skeptical advocates of monetary stimulus agree that in the aftermath of the midterm elections, which holds out the prospect of political gridlock, the Fed remains the only player in town that has the means to jump-start growth.

We are inclined to side with the more optimistic camp, but recognize the risk that things can turn out badly down the road. The Fed’s balance sheet, which has already doubled to $2.3 trillion, is about to expand considerably more, as it intends to purchase $110 billion of Treasury securities a month through June 2011. That amount includes not only the $600 billion as part of QE2, but another $200-$300 billion to replace maturing debt in the Fed’s portfolio. For the Treasury, this massive buying makes its huge deficit-financing task much easier in coming months. The following table summarizes how much $110 billion represents of planned new Treasury coupon debt through the end of March. We stop at March because we don’t yet have precise forecasts for Treasury issuance beyond then.

The year-over-year increase in wages and salaries was the steepest since the early months of 2008. Even more impressive is that labor income has accounted for more than 40 percent of the annual increase in personal income over the past six months. That’s a significant improvement from the less than 20 percent share of personal incomes coming from wages and salaries over the first three months of the year, when the economy started to generate positive growth in jobs. Until the paychecks of households started to escalate over the past six months or so, government transfers – i.e., unemployment benefits and the like – played a critical role supporting purchasing power. That’s not a foundation for sustainable spending growth. Consumers are more likely to step up purchases of big-ticket items when they feel confident about their job and income prospects.

To be sure, household balance sheets remain tarnished by the recession and the loss of housing and stock market wealth that accompanied the financial crisis. It will be years before that financial cushion is fully restored. However, the pick-up in wages has been strong enough to allow households to spend more vigorously even as they are padding their savings accounts. In October, the personal savings rate stood at 5.7 percent, firmly within the 5.5- 6.5 percent range that has been the norm for the better part of two years. That’s close to the average savings rate of the 1990s, and represents a hefty financial cushion relative to the puny fraction set aside from paychecks in the years leading up the latest recession, when households relied solely on appreciating asset values to fill retirement nest eggs. The housing and stock-market meltdown, of course, decimated those nest eggs and prompted ageing baby boomers to rebuild wealth the old-fashioned way, through higher savings.

Quite possibly, households will feel it necessary to bolster savings even further before fully reopening their wallets and purses. However, if the job market continues to strengthen, the odds are that most of the heavy lifting towards financial security will have been accomplished. No doubt, a big assist is being provided by the impressive rally in stock prices since early 2009, which has restored about $5 ½ trillion in value to stock portfolios. While home prices remain weak amid an ongoing soft housing market, at least the free-fall in property values has slowed, if not leveled out; indeed, households have even seen a modest increase in their housing equity, which edged up to a 37.1 percent share of home values in the second quarter from an all-time low of 32.4 percent in the first quarter of 2009. That’s still a far cry from the over 50 percent equity share retained by homeowners throughout the postwar period, but at least the debilitating vanishing of housing wealth is nearing an end.

Still, the housing market is the Achilles Heel in the economy’s recovery and stands as a rude reminder not to wax too optimistically over the momentum that seems to be building. Virtually every economist will echo the notion that a full-fledged, self-sustaining recovery will not be engaged until housing has bounced off the bottom and hops on to the growth band wagon. So far, there is little or no evidence that this is happening, or is about to occur. The latest housing numbers released this week certainly reaffirm that sorry fact. In October, sales of both existing and newly-built homes remained in the doldrums, with the new-home market sounding a particularly weak note.

True, the housing market is still suffering a payback from the sales boost imparted last year by the homebuyer’s tax credit. It will be a while before the noise from this incentive works through the monthly data and a true sense of underlying demand is uncovered. What’s more, the market’s fundamentals are clearly being obscured by the foreclosure bottlenecks associated with faulty record keeping and the legal pressure being brought to bear on the mortgage industry by state attorney generals. Indeed, a good part of the recent weakness in existing homes stems from a lower volume of distressed sales and transactions involving foreclosed properties. Until this debacle is cleared up, it will be hard to see any recovery in the critical housing sector from taking root.

But signs of progress outside of the housing market are proliferating, indicating that the road ahead should be paved with more positive than negative developments. Granted, another shock to system cannot be ruled out, particularly in light of an off-again, on-again European debt crisis that seems to be on again this week, with Ireland in the headlights and Portugal and, possibly, Spain on the radar screen. Geopolitical tensions are also coming to the fore, manifested by the North Korea shelling of South Korea. But the U.S. economy appears to be on firm enough ground to withstand these shocks, assuming they do not become confidence-shattering events. Make no mistake; the Federal Reserve will be required to play a major role in the recovery’s progress, at least over the foreseeable future. It will have to do a much better job, however, of explaining its case to the army of critics that continue to unleash of a barrage of attacks, much of which is unfounded.

Not too long ago during the spring months, the widespread view was the Federal Reserve would soon be taking away the punch bowl before the economic party became too heated. That expectation, of course, withered as the once-promising recovery soured over the past six months, posting tepid growth rates far too weak to lower an intolerably high unemployment rate. Hence, instead of becoming party poopers, the Fed is once again spiking the punch bowl, hoping to juice the economy’s growth machine and generate enough heat so that it can return to its more familiar role of curbing exuberance.

To no one’s surprise, the Fed announced this week that it would resurrect its quantitative easing strategy put in place during the financial crisis and economic meltdown in 2008. That program, which ended in March of this year, involved $1.7 trillion of mortgage securities and Treasury bond purchases and, despite its bad reputation, did prevent a very bad situation from becoming a catastrophe. The second iteration, commonly known as QE2, will not be as large as the first, coming in at a more subdued $600 billion package of new Treasury bond purchases through June of 2011. However, the total could be larger if the economy continues to struggle and inflation remains too low for the Fed’s comfort. In other words, this is not a shock and awe approach to the nation’s economic woes, but one that gives the Fed flexibility and the time to see how things play out.

Needless to say, the debate swirling over the wisdom of the Fed’s move prior to this week’s announcement remained very much in the forefront in the days following it. The harshest critics are those who believe it will be ineffectual and, hence, diminish the Fed’s credibility as a policy force in the future; others believe that continuing to print money in vast quantities simply sows the seeds of future inflation or another asset bubble. Conversely, there are those who have faith in the power of monetary stimulus as well as the Fed’s ability to reverse course should economic activity pick up faster than expected, igniting inflation pressures. Even the more skeptical advocates of monetary stimulus agree that in the aftermath of the midterm elections, which holds out the prospect of political gridlock, the Fed remains the only player in town that has the means to jump-start growth.

We are inclined to side with the more optimistic camp, but recognize the risk that things can turn out badly down the road. The Fed’s balance sheet, which has already doubled to $2.3 trillion, is about to expand considerably more, as it intends to purchase $110 billion of Treasury securities a month through June 2011. That amount includes not only the $600 billion as part of QE2, but another $200-$300 billion to replace maturing debt in the Fed’s portfolio. For the Treasury, this massive buying makes its huge deficit-financing task much easier in coming months. The following table summarizes how much $110 billion represents of planned new Treasury coupon debt through the end of March. We stop at March because we don’t yet have precise forecasts for Treasury issuance beyond then.

As the table shows, Fed buying of $110 billion per month would be the equivalent of anywhere from 82.9 percent of new Treasury coupon supply this month to as much as 108.4 percent in February. For the next five months, Fed buying of $550 billion would be the equivalent of 94.2 percent of net Treasury issuance of $584 billion. By sopping up so much of the new supply, the Fed is hoping to drive down long-term interest rates, encouraging borrowing and spurring refinancing activity that would help boost spending and economic growth. The risk, of course, is that the Fed is going too far. Not only is it printing money to finance government borrowing – always a dangerous precedent – at some point it will have to unwind these holdings when the economy picks up speed. The prospect of unloading such a huge supply of Treasury securities just as private borrowing demands would probably increase could lead to an onerous spike in long-term yields, resulting in a blood bath for bond holders as well as a major deterrent to growth.

That said, the Fed is clearly more concerned with the near-term threat of stagnation and deflation than what might happen down the road. Time will tell if its approach bears results, but it is clear at least some of the objectives of pursuing more monetary stimulus have already been accomplished. Keep in mind that although the official QE2 announcement was revealed this week following the regularly scheduled policy meeting, it was well telegraphed in advance. Indeed, chairman Bernanke had essentially spelled it out at the Jackson Hole confab back on August 27. Since then, the real yield on 10-year inflation-indexed Treasury bonds (i.e. Tips) have fallen by more than half-percent, from 1.05 percent to under 0.5 percent, and the real yield on 5-year Tips actually turned negative at the latest auction last week. Nominal rates have also fallen, but not quite as much, reflecting an uptick in inflation expectations, which is precisely what the Fed is trying to bring about to counter the growing deflationary mindset.

What’s more, expectations of more quantitative easing combined with lower interest rates have filtered through to currency traders, causing the dollar to weaken by about 5 percent since late August, including a sizeable 9 percent drop against the Euro. Meanwhile, stock investors have drawn encouragement from the Fed’s more active role, sending stock prices up by more than 15 percent since the end of August. Both of these developments are deemed positive by the Fed, as they contribute to stronger growth. The weaker dollar should add vigor to exports while higher stock prices increases household wealth, which should translate into more spending. The 15 percent market rally against a $10.7 trillion portfolio of stocks and mutual funds adds roughly $1.5 trillion to household wealth.

So even if, as many contend, that the Federal Reserve’s renewed commitment to quantitative easing is already priced into the markets, the die is cast for the economy to respond. The question is: will it? It is generally believed, rightly so, that QE2 will produce less bang for the buck than QE1. Not only is its planned size smaller than the first one, it will not have the shock effect or the reinforcement from fiscal stimulus that played such a major role in 2008 and 2009. Moreover, the transmission mechanism that facilitates the impact of monetary stimulus through to the economy is not functioning properly. For example, in theory lower mortgage rates should lead to a wave of refinancing activity. In practice, however, homeowners have seen their housing equity vanish due to falling property values, making it difficult for them to refinance their mortgagers. Likewise, the financing channel for small businesses remains clogged up, although less so than a year ago. A common refrain among small and medium-sized establishments is that banks will only lend to companies that don’t need the money.

We concur that QE2 will have less of an impact than QE1 on economic activity. That said, it is also clear that less thrust is needed than was the case in 2008 and early 2009, when the economy was still mired in a pernicious downturn and the credit markets had seized up. The recovery underway since the middle of 2009 may not be living up to normal cyclical standards; but the economy is on a positive growth track and does not require the same magnitude of heavy lifting than when it was sinking in the quicksand of the Great Recession. To be sure, the downturn put the nation in a very deep hole, including a decimated labor market that is arguably the most challenging obstacle for policy makers to overcome. Indeed, the Fed cited the slow recovery in jobs and the persistent high unemployment rate as the main reason for its second round of asset purchases, along with the uncomfortably low inflation rate.

It will be a while before the closely-watched price measures, such as the CPI, respond to the latest policy initiatives, but Friday’s jobs report may be the first sign that the ailing labor market is starting to heal. In October, the economy generated 151 thousand net new jobs, about twice what economists expected, and nonfarm payrolls for the previous two months were revised up by more than 100 thousand jobs from their original estimate. The October gain comes after four consecutive monthly declines, which was dominated by the unwinding of temporary Census workers. Private companies have been adding jobs every month this year, but the 159 thousand increase in October was also considerably stronger than expected, and the largest since last April.

To be sure, the October increase hardly makes a dent in the huge losses workers have incurred during the recession, as employment is still 7.5 million below the level of December 2007. That’s the deep hole the nation still has to climb out of, and is arguably the source of anger that scorched the Democrats in the midterm elections. Although the jobs report contained many promising elements that embraced a wide swath of industries, the unemployment rate remained at a lofty 9.6 percent. The October pace of job gains is barely enough to keep the rate from rising, but not enough to bring it down. We will have to see a string of monthly job increases of 250 to 300 thousand to make a material dent in the jobless rate. While that’s fairly typical for normal cyclical recoveries, it is hard to see it happening in the near future, given the many impediments to hiring that exist.

Still, the October report has to be viewed as an encouraging omen, particularly since it included a sizeable increase in the workweek as well as higher hourly earnings. That should give a significant boost to wages and salaries, just in time for the upcoming holiday season. Indeed, major retailers are turning more optimistic, announcing plans to hire more temporary workers to accommodate a greater number of expected shoppers than last year. It would be premature to make too much out of a one-month jump in jobs, but some forward-looking indicators suggest that the pace of hiring will be picking up. For example, two major gauges of activity in the manufacturing and services sector released by the ISM this week posted solid increases in October, reversing recent declines. More significantly is that these indexes received a big lift from a spurt in new orders. These orders, in turn, will have to be filled either by new workers or by existing workers putting in longer hours. Either way, the paychecks of households should become fatter in coming months, which could be the sparkplug that sends the recovery into a higher gear. If so, the cruise on QE2 may be shortened, and the Fed may become party poopers sooner than most expect.

The resilient stock market rally hit a brief speed bump this week when China hiked interest rates and announced other measures aimed at suppressing inflation and preventing a speculative property bubble. Since China is perhaps the most powerful engine driving global growth at the present time -other emerging market nations such as India and Brazil are also growing rapidly but do not have as much clout as the Chinese economy, which is now the second largest behind the U.S. – the news understandably had an unsettling effect on investors. After all, the U.S. along with most developed economies are struggling with fragile recoveries and are counting heavily on demand from trading partners to buttress demand.

Needless to say, any weakening of one of the few sparkplugs driving global growth would not be viewed kindly by the markets and, hence, the negative reaction to the news. However, when the results of China’s third-quarter performance were released on Thursday, it became apparent that there was little reason to fret over that prospect. Yes, growth slowed, but to a still-sturdy 9.6 percent annual rate from a 10.3 percent pace in the second quarter, when the Chinese authorities actually had stimulus measures in place. While the stimulus has been removed and the authorities are leaning against the inflationary headwinds, they are hardly clamping down on growth. If that were the case, they would accede to worldwide pressure and allow its currency to rise far more dramatically than the slow upward creep that is being grudgingly permitted. If anything, evolving currency frictions are leading to heightened uncertainty and fears of competitive devaluations that may constitute a significant obstacle to growth in coming quarters.

That said, there are already more than enough uncertain elements in the economic and financial landscape to rattle markets. The foreclosure crisis, with the latest wrinkle of mortgage put-backs potentially causing significantly more damage to bank balance sheets, remains as intractable as ever. November elections are just around the corner, with uncertain outcomes in several key races that could determine which party controls Capitol Hill – and what fiscal policy will look like in the aftermath. On this score, many nations are already going down the path of fiscal austerity, which may well lead to more problems than solutions for the unpalatable mix of flagging growth and unruly deficits.

Should growth overseas continue to wither on the vine, the U.S. will feel the pain in the form of reduced exports and manufacturing activity. As it is, that influence may already be starting to unfold. In an otherwise light week for economic data, the Federal Reserve reported a surprising drop in industrial production in September. To be sure, the decline was modest – a mere 0.2 percent – but it was the first time since the recession ended last June that industrial output slipped. The reversal of fortune may be a temporary blip rather than the start of a trend, but the implications of a stalling out of the nation’s factories are ominous. Keep in mind that manufacturers generated 136 thousand net new jobs over the first nine months of the year, fully 22 percent of the 613 thousand increase in nonfarm payrolls during the period. That’s an outsized share for a sector than accounts for less than 10 percent of total employment.

Significantly, manufacturers cut jobs in September for the second consecutive month, even as they curtailed the hours worked for those drawing paychecks. As noted above, this may just be a temporary correction of a robust hiring spree underway since the end of the recession. Recall that manufacturers in a panicky response to the financial crisis, slashed payrolls far more than was justified by the reduction in output during the 2007-2009 recession. Roundly 2.2 million workers were furloughed during the downturn, fully 16 percent of the 13.7 million factory jobs held in the final month of the expansion. While the 136 increase since the recession ended accounted for a sizeable fraction of total payroll gains, it only recoups slightly more than 5 percent of the total manufacturing jobs lost during the downturn.

In all likelihood, the biggest gains in manufacturing jobs and production are behind us, if only because the inventory rebuilding cycle is largely over. Keep in mind that not only did companies slash payrolls more steeply than justified by the fall in output, the production cutbacks also exceeded the fall-off in demand. As a result, a large swath of businesses were short of merchandise when demand stabilized at the start of the recovery and frantically moved to rebuild depleted inventories when sales picked up over the second half of last year. That, in turn, jump-started the production gains that sparked the abrupt turnaround in manufacturing. At the same time, the weakening dollar coupled with sustained growth in emerging markets spurred exports, reinforcing the boost to production provided by the inventory cycle. With inventories having been replenished, exports are now playing a bigger role lifting production, at least until domestic demand revives more strongly than it has so far.

We suspect that the recovery in manufacturing remains intact, but future production gains will be more modest than they have been this year. Part of the slowdown can be attributed to the waning influence of the inventory cycle and part to a modest slowing in exports, reflecting austerity measures by overseas policy makers and the reduced influence of a weakening dollar, which may have nearly run its course. China is not the only nation striving to rein in potential inflationary excesses. Brazil and several other Latin American countries as well as Asian economies outside of Japan are also coping with steamy growth, higher inflation and surging currencies. Some, such as Brazil, have already imposed restrictions on capital inflows and others are considering similar measures.

If any proof of the beneficial impact that strong overseas growth is having on the U.S. economy, it is only necessary to look at the latest impressive earnings reports for some of the nation’s largest manufacturers. That includes the giant heavy-equipment maker, Caterpillar, which this week reported a stronger than expected gain in profits for the third quarter, thanks largely to surging sales of its equipment to Latin America. Indeed, the company’s foreign sales account for more than 60 percent of total demand, a fraction that is common among large manufacturers. To be sure, the dominant role of foreign is spurring companies such as Caterpillar to invest in plants overseas, which doesn’t directly benefit workers in the U.S. immediately. But the indirect effects are palpable, as jobs created by foreign subsidiaries of U.S. companies eventually translate into stronger demand by foreign workers for products made in the U.S.

Nonetheless, the growth trajectory in the U.S. will ultimately be determined more by domestic than foreign developments. The financial markets may be rattled by anything that threatens global demand, but they are more attuned to domestic influences on consumer and business behavior. Not surprisingly, the growing expectation that the Federal Reserve is poised to support domestic demand by injecting more liquidity into the economy via another round of quantitative easing is boosting investor spirits. In fact, financial markets have already priced QE2 into stock and bond prices, and the failure of the Fed to follow up at its next meeting on November 2 and 3 will almost surely lead to a sharp negative reaction in the financial markets. Like most, we expect the Fed to corroborate the markets’ discounting mechanism and confirm that more monetary stimulus will be provided, albeit the extent and composition of the action is still open to question.

However, it should also be noted that the Fed’s anticipated move to expand bond purchases aimed at lowering long-term interest rates does have a downside. Keep in mind that while households have run up enormous debts in recent years and are overly leveraged relative to incomes, they are collectively huge savers as well, holding more than $13 trillion in interest-bearing deposits, credit market assets and mutual fund shares. Many savers, particularly older Americans, rely heavily on the interest income from these assets to support spending. But with short-term assets yielding practically nothing and an environment of slow growth and low inflation driving down long-term yields, this income source has been in a persistent decline. Since September 2008, interest income of households has shriveled by $160 billion. As a result, the fraction of personal income provided by interest-bearing assets has plummeted from 10.8 percent to 9.4 percent over the period.

Not only is this trend crimping the purchasing power of households and, hence, spending, it also means that savers need to put aside even more of their paychecks to achieve the same return obtained when rates were higher. Simply put, savers are getting less bang for the buck and are forced to save more to reach retirement goals. This too puts a dent in spending, which offsets the very stimulative impact that the Fed’s easing moves are designed to bring about. Indeed, there are many critics of QE2, both within and outside the Fed, who assert that it will do little to further pump prime the economy, since the system is already flooded with liquidity from past Fed moves and interest rates are already at rock-bottom levels.

We agree that Fed actions are subject to the law of diminishing returns, but the central bank’s hand is being forced by market expectations as well as the risk of sitting idly by while the recovery struggles to gain traction. What’s more, the economy’s Achilles Heel, the moribund housing market, needs as much help as it can get, and lower mortgage rates would follow any reduction in bond yields that the Fed is able to produce through expanding its bond-purchase program. According to this week’s figures on starts and building permits, it does appear that housing activity has found a bottom. To be sure, with the enormous overhang of unsold properties, including the shadow inventory of foreclosures yet to come, the housing market faces severe headwinds. But if lower mortgage rates help revive sales, that overhang will diminish and accelerate the time when housing activity starts to climb off the bottom.