So just how bad are things? U.S. retail (and food services) sales in December were down by nearly 10% from the previous year. (Yes, that partially reflects lower prices. But still, 10%!)

End-of-year sales around the holiday season represent a disproportionate percentage of retailers’ annual sales and profits, so the poor performance to end 2008 has left many limping into 2009 and is expected to eventually force more into bankruptcy, particularly if poor sales continue.

Bankrupt electronics retailer Circuit City Stores Inc., was auctioning itself on Wednesday after reporting that it may have to liquidate if it can’t find a buyer by Friday.

Other companies are reporting continued sales weakness. On Wednesday, jeweler Tiffany & Co said it experienced a 35% drop in holiday sales at US stores open at least one year, and was therefore cutting its profit forecast. It also said it was exploring ways to slash costs. “We believe these conditions will continue well into 2009,” the company’s chief executive, Michael J. Kowalski, said in a statement.

Another hard-hit company, upscale retailer Neiman Marcus Group Inc., revealed in a regulatory filing Tuesday that it is planning to lay off 375 people, or 3% of its workforce.

Matthew Bordwin, a managing director of KPMG Corporate Finance LLC, which counsels distressed companies and helps them reorganize, said he expected many more retailers to falter as 2009 progresses.

“I think the goal for most retailers will be to just make it through,” Mr. Bordwin said. “It’s survival of the fittest now, and the weaker retailers are going to be falling by the wayside.”

Ricardo S. Chance, another managing director at KPMG Corporate Finance, said three factors were weighing on retailers and would surely drive more out of business: a continuing decline in consumer spending, pressure from suppliers who are tightening credit terms, and loan terms that are proving difficult to meet.

Some retailers that likely would have declared bankruptcy years ago were rescued by private-equity firms tapping cheap capital, he noted. But many of those companies are now struggling to pay off those debts, or maintain the revenues the loans called for.
“There is no doubt, given the performance of many retailers, that they are going to be breaking some of the minimum covenants they need to achieve to avoid a default with their lenders,” Mr. Chance said. –Miguel Bustillo and Kelly Evans

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The Federal Reserve released its beige book report today on regional economic conditions, and the news continues to be grim as broad weakness was recorded throughout the country. The financial sector remains in particularly bad shape.

The New York Fed reported that “a contact monitoring the financial sector maintains that the industry is still far from hitting bottom.” As the failure of Lehman Brothers continues to work its way through the industry, and Citigroup stands on the precipice of being split up, there appears to be more pain to come.

“At the larger institutions, a substantial number of job reductions in the pipeline have yet to show up in the payroll statistics, due to ongoing severance payouts,” the beige book said. “Moreover, year-end bonuses are seen falling 20%-30% from last year at some of the smaller, healthier firms but more substantially at the larger establishments.”

The struggles of the labor market aren’t limited to the financial sector, as most Fed districts reported a general weakening of conditions. Job losses in the manufacturing sector were reported by contacts in the Cleveland, Richmond, Chicago, St. Louis, Minneapolis, Kansas City, and Dallas districts.

However, there were some growth areas, especially for skilled workers. “Richmond noted that demand was strongest for workers providing professional and support services, workers with high-level technical skills, and workers proficient in computer software,” the beige book said. “Chicago noted employment growth in the education, government, and health-care fields.” Cleveland also reported continued hiring in the health-care industries. –Phil Izzo

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With interest rates coming down to rock-bottom levels, Europe’s central banks are having to look at alternative policy tools, but implementing them will be easier for some than others.

The lack of a centralized euro-zone government may make it harder for the European Central Bank than other central banks to expand its tool kit to stem a slumping economy.

The ECB has cut interest rates by 175 basis points since October, and boosted its balance sheet by around 55% compared with a year ago. The bank is widely expected to ease rates by another 50 basis points Thursday.

The Bank of England, meanwhile, has slashed rates by 350 basis points since October, and its monetary base rose by more than a quarter during the final four months of 2008 as a result of its auctions of long-term cash to banks.

The two central banks may soon have to officially join the ranks of the U.S. Federal Reserve, which, in addition to setting short-term rates near zero, last month committed to keeping rates “exceptionally” low “for some time.”

The Fed signaled a new phase for policy in which its balance sheet is used to fund new lending, and purchase programs effectively replace interest rates as its primary tool.

While policymakers disagree on a precise definition of what’s known as quantitative easing, it is basically an unorthodox strategy that may come into play when interest rates have dropped close to zero, thus rendering traditional monetary-policy tools ineffective. Its objective is to increase liquidity and reduce risk in the private sector, encouraging businesses and consumers to spend.

This can be done in a variety of different ways, including the purchase by the central bank of government debt or private-sector assets, such as corporate bonds, equities or commercial paper. Central bankers are now considering the question of which of these methods would be the most effective.

The European Treaty, which prohibits member nations from doing anything to infringe competitiveness, might provide something of a legal hurdle for the BOE, with the government also saying that it would have to work “hand in hand” with the central bank were such unconventional measures to be adopted.

However, given the need to cooperate with various national governments to put a scheme into place, it seems clear the euro zone would face a much bigger challenge in agreeing on a plan than the U.K.

“As the recent political quarrels about the fiscal policy packages showed, an agreement on a pan-regional policy effort might be difficult to achieve,” said Morgan Stanley economist Elga Bartsch.

Some central bank watchers have argued that the absence of a centralized government would limit the ECB in its pursuit of quantitative easing. The ECB’s statute prohibits it from funding the governments of the euro zone’s 16 nations by directly purchasing their debt instruments.

But that wouldn’t prevent the ECB from buying up government bonds in the secondary markets and, in that manner, helping stabilize or lower bond prices when excess supply threatens to lead to an increase in governments’ borrowing costs, said Thomas Mayer, chief European economist at Deutsche Bank.

Also, rather than taking securities as collateral in its refinancing operations, the ECB could buy them outright and thus inject liquidity on a more permanent basis into the banking sector, Mayer said.

An outright purchase of securities, though, could be seen as undermining the ECB’s independence, particularly if financial losses occur.

“This obstacle could potentially be overcome if finance ministers provided an ex-ante guarantee to cover potential losses,” Morgan Stanley’s Bartsch said.

What’s more, neither banking supervision nor insolvency legislation falls into the ECB’s remit, and the ECB would hence need to rely on governments and regulators to provide an adequate framework for quantitative easing, Bartsch cautioned.

Willem Buiter, a former member of the BOE’s Monetary Policy Committee, and now a professor at the London School of Economics, suggests that the governments of the euro-zone member states should create a special fund that can be tapped to recapitalize the ECB, if needed.

But that could be a mean task for even the most talented diplomat, analysts said. –Nina Koeppen and Natasha Brereton

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Economists and others weigh in on the larger-than-expected drop in retail sales.

Compiled by Phil Izzo

Offer your reactions in the comments section.

Dig into an interactive summary of economists’ forecasts for the coming year from the latest WSJ.com survey.

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Federal Reserve Bank of Philadelphia President Charles Plosser spoke at the 2009 Economic Panel Outlook, held at the University of Delaware, in Newark, Del., presenting economic outlook and his views on Fed policy amid near-zero interest rates. The official, who will end his voting status on the interest-rate setting Federal Open Market Committee when that body holds its first meeting of the year, said he expects some return to normalcy this year as housing hits bottom. But he played down fears of double-digit unemployment and persistent deflation. On the policy-making front, he backed a central bank inflation target and warned the Fed must closely monitor its balance sheet in an effort to avoid inflation when the economy improves. Some highlights of the speech:

Plosser

I and others have long proposed establishing an explicit inflation target as one way to signal the FOMC’s commitment to price stability and help anchor expectations. Such a commitment not only helps prevent inflation expectations from rising to undesirable levels, but it can also help prevent expectations from falling to undesirable levels…

Since we are in uncharted territory, I believe we must proceed with caution. While the lending programs are designed to improve the flow of credit, they are currently injecting enormous amounts of liquidity into the system. I believe we need to monitor that liquidity and its composition closely so that we are able to withdraw it when the time comes or else we risk fueling inflation in the future. Thus, it is not appropriate to ignore quantitative metrics in this new policy environment.

We must remember that to successfully deliver on its goal of price stability, monetary policy must establish a nominal anchor for the economy. In practice, that anchor can be the path of either a nominal interest rate or a nominal quantity of some measure of money.

In the current environment, with the targeted funds rate effectively at zero, it cannot serve as a nominal anchor. On the other hand, quantitative measures — such as the stock of money, reserves, or the monetary base — have a long and venerable tradition in monetary theory and policy. Indeed, many countries have used quantitative targets quite successfully over the years, including Germany and Switzerland. However, these metrics do not assess the distribution of Federal Reserve assets across its lending programs, a focus of credit policy.

Nonetheless, while traditional measures of money may not be the best metrics for policy in this zero interest rate environment, the size of the balance sheet does offer a possible nominal anchor for monitoring the volume of our liquidity provisions. While attention is currently focused on credit policy, ignoring or failing to take into account the consequences of unconstrained growth in our balance sheet could be costly down the road in terms of our ability to ensure price stability or support a credible commitment to that goal.

…

We must create an exit strategy from these various [lending] facilities. They were created for extraordinary times and involve significant intervention in the credit markets. They are not part of the normal operation of a central bank and should not be expected to continue.

As I have indicated, some of our new lending facilities were created to replace impaired or poorly functioning private credit markets. We must consider the possibility that our presence in these credit markets will deter private-sector participants from returning to and restoring these markets. To prevent our policies from having these perverse effects, we should consider a gradual increase in the cost of borrowing from these facilities to discourage their use and encourage other participants to return to these markets. This should be an important element of our exit strategy.

Unfortunately, simply terminating the special lending programs is not enough to avoid some knotty problems. The mere act of creating the programs has created moral hazard. To the extent that market participants now feel more comfortable asking for the central bank’s support when they get into trouble, they may be inclined to take on more risk than would otherwise be prudent — thus sowing the seeds for the next crisis. In exiting such programs, it will be important for the Fed to develop clear objectives and boundaries for lending that we can commit to follow in the future. Clarifying the criteria under which we will intervene in markets or extend credit, including defining what constitutes the “unusual and exigent” circumstances that form the legal basis for the Fed’s nontraditional lending, will be essential if we are to mitigate the moral hazard we have created.

In general, our aggressive lending, while intended to help the economy and financial markets recover, poses its own set of challenges. We must develop a well-articulated exit strategy if we are to maintain control of monetary policy and encourage the revival of strong and disciplined credit markets.

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A roundup of economic news from around the Web.

Compiled by Phil Izzo

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Sometimes what a person doesn’t say is as important as what he does say.

In comments today at the London School of Economics, Fed Chairman Ben Bernanke gave a detailed description of Fed policy in the new era of near-zero interest rates. The discussion included a long discourse on how the Fed is managing its balance sheet as it battles the financial crisis.

In recent months, officials have considered whether they should seek congressional authority for the central bank to issue its own debt. Such a step would help the Fed better manage its balance sheet and the fed funds rate, particularly when the economy starts to heal and it seeks to drain the financial system of cash it has pumped into banks in recent months. Mr. Bernanke made no mention of the idea Tuesday – a signal that it is low on the Fed’s wish list.

He did resurface another idea for balance sheet management which is an alternative to the Fed issuing its own debt. Mr. Bernanke said the Treasury could at some point resume its recent practice of issuing bills and depositing the funds with the Fed. The Treasury had been doing this last year, but began to unwind the program as its own borrowing needs exploded.

One of two things would need to happen for the Treasury to go back to depositing funds at the Fed: Either the federal debt limit would need to be raised substantially, or debt left on deposit with the Fed would have to be made exempt from the limit. Either step would require congressional action.

–Jon Hilsenrath

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The size of the Federal Reserve’s interest-rate reduction last month surprised markets. But the large cut, lowering the central bank’s rate target to a range of zero to 0.25% from 1%, appears to have been sought by at least six Federal Open Market Committee members ahead of the December 15-16 meeting.

The boards of six reserve banks — New York, Cleveland, Richmond, Atlanta, Minneapolis and San Francisco — voted December 11 to lower the discount rate (for direct Fed lending) by 0.75 percentage point, as the Fed ultimately did five days later, according to minutes of the central bank’s discount-rate meetings released Tuesday. Directors at the six reserve banks “viewed the severe strains in financial markets as exerting increased restraint on economic activity and the outlook for activity as having deteriorated notably,” the minutes said. They “concluded that monetary policy makers should act decisively to stimulate aggregate demand.”

Directors of the dozen regional Fed banks, which make direct loans to commercial banks in their districts, vote periodically on where they’d like the discount rate to be set. The requests can offer clues to the thinking of each bank president ahead of the FOMC meeting to set the federal funds rate. The Fed’s governors in Washington meet to consider the regional boards’ requests, and the central bank usually raises and lowers the discount rate — after FOMC meetings — in lockstep with the federal funds rate. (The discount rate, now at 0.5%, is a quarter percentage point above the ceiling for the federal funds rate’s target range.)

The varied schedules for the regional boards’ meetings sometimes prevent firm conclusions on the meaning behind discount rate requests. But this time the minutes showed that amid the deep economic deterioration, three FOMC participants probably preferred to leave the federal funds rate target unchanged. Directors of the reserve banks in St. Louis, Kansas City and Dallas voted December 11 to maintain the existing discount rate. They “agreed that the outlook for economic activity had weakened further,” the discount minutes said. “Rather than change the stance of monetary policy, they preferred for now to use other Federal Reserve tools to stimulate the economy.” The Fed, of course, is now moving down that path — after having used up all of its interest-rate ammunition.

The other three banks — Philadelphia, Boston and Chicago — sought a half-point cut in the discount rate (to 0.75%), presumably preferring a federal funds rate of 0.5%. They “also saw economic prospects as weaker and inflation pressures as diminishing but concluded that a 50-basis-point decrease in the primary credit rate would provide the appropriate amount of stimulus at this time,” the minutes said.

A half-point cut would have been in line with what many economists had expected. Nobody predicted the Fed, for the first time, would establish a trading range — rather than a hard target — for the federal funds rate. But the minutes suggest that the final sizable cut was contemplated even by the reserve bank presidents ahead of the two-day meeting to discuss the central bank’s options. –Sudeep Reddy

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Maybe the original financial bailout plan to have the government buy or back the toxic debt on banks’ balance sheets isn’t dead after all.

Key Federal Reserve officials Tuesday resuscitated the idea, pointing out that financial markets are still facing severe challenges.

Despite the fact that most of the first half of the $700 billion financial bailout has already been allocated for banks, the soured debt weighing on financial firms’ balance sheets continues to pose a problem, the officials said in separate remarks Tuesday.

“A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets,” Fed Chairman Ben Bernanke said in a speech Tuesday to the London School of Economics. “The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending.”

Fed Vice Chairman Donald Kohn plans to repeat that quote to lawmakers later Tuesday, according to a copy of his written testimony. Additionally, the Fed officials said asset purchases could compliment efforts to ease the pain in the housing market because government purchases of mortgage-related debt could be combined with steps to restructure some mortgages.

Bernanke, in his speech, said more needs to be done to strengthen the financial system and the Treasury could purchase troubled assets or even provide asset guarantees to reduce the uncertainty surrounding asset values. Under a third option he outlined, the Treasury could set up and capitalize so-called bad banks, which would purchase assets from financial firms in exchange for cash and equity in the bad bank, he said.

Addressing banks’ troubled assets was supposed to be the centerpiece program under the bailout, which is officially referred to as the Troubled Asset Relief Program, or TARP.

In September, Bernanke and outgoing Treasury Secretary Henry Paulson told lawmakers the aim of TARP would be to purchase toxic mortgage-related assets from banks. In fact, Paulson had described the asset purchases as “the single most effective thing we can do to help homeowners, the American people and stimulate our economy.”

But in November, Treasury did a controversial about-face and signaled that program had been shelved.

Paulson said Treasury’s initial idea to purchase firms’ illiquid assets didn’t seem like it would be very effective.

“Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending,” said Paulson.

Still, the Securities Industry and Financial Markets Association – a group representing hundreds of securities firms, banks and asset managers — has been holding out hope that Treasury would revive its original asset-purchase plan in some fashion.

Speaking to reporters last month, David Resler, who heads Sifma’s economic advisory roundtable, noted then that he believed the Treasury was still quietly considering asset purchases.

“I think that is still under study and whether it’s likely or not, I don’t know,” he said at a press briefing, during which Sifma released a report on its latest projections for the U.S. economy.

The report noted most Sifma members that participated in the study agreed a government program to purchase or insure troubled assets “would have a significant impact on bank balance sheets, and to a slightly lesser degree, on credit availability.” Meanwhile two-thirds of respondents characterized the purchase of troubled assets as important or very important to addressing the credit crisis, according to the report.

“Over 90% of respondents identified price transparency as a critical factor to the health of the credit markets,” the report said.

Adding price discovery into the markets is “a very difficult issue,” but one that goes to the heart of the current financial crisis, added Resler, also a chief U.S. economist with Nomura.

Still, if the program would be difficult to implement, Kohn and Bernanke didn’t let on that would be the case. In contrast, Kohn, suggests in his testimony Treasury has several options for reducing the uncertainty surrounding financial firms’ assets and “each approach could build on the infrastructure” Treasury already started developing when it was planning to purchase troubled assets directly. –Maya Jackson Randall

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Warning that the incoming administration is inheriting a “daunting fiscal position,” President-elect Barack Obama’s nominee to head the White House budget office pledged to tackle rising heath care costs and government inefficiencies to return the federal budget to a sustainable long-term path.

Orszag

“Even after the economy recovers from the current downturn and under current policies, the nation faces the prospect of budget deficits that, we believe, will measure about 5% of GDP over the next five to 10 years,” Peter Orszag, the former director of the Congressional Budget Office, said in testimony before the Senate Budget Committee. “Over the longer term, the situation is expected to grow even worse as health care costs continue to rise and the baby boomers retire.”

Orszag’s confirmation to become director of the Office of Management and Budget is expected to face few challenges in the Senate, where lawmakers from both parties have expressed support.

At his confirmation hearing, Orszag said the short-term economic is outlook is “bleak” and requires quick implementation of Obama’s stimulus proposals. Without action, he said the economy could lose three to four million jobs over the coming year.

The U.S. budget deficit is now expected to exceed $1 trillion in the current fiscal year, more than double the previous record set last year. And it will rise even further as a result of the stimulus effort being pushed by Obama.

Orszag said the package should bring back a period of economic growth. Once the economy recovers, he said the administration must shift its attention to medium- and long-term fiscal challenges because the budget is now on an “unsustainable path.”

Orszag said the U.S. currently has significant maneuvering room to respond to crises because its government debt is viewed as a safe investment around the world. But that situation won’t necessarily be permanent.

“Unless we change policy, however, over the long term that perception could shift — which could not only trigger a fiscal crisis, but also severely limit our ability to respond flexibly to any future economic difficulties,” he said.

On health care, he said the Obama administration needs to think about ways to slow the overall rise in health care costs, rather than just reduce the rate of growth in Medicare and Medicaid. He said the U.S. has “massive opportunities” to cut health care costs without harming health outcomes, including steps to expand health care information technology and provide incentives for prevention. The Obama administration will release its own budget and economic overview for fiscal 2010 in mid to late February, a document Orszag said will be consistent with those submitted by past new administrations. Tuesday’s hearing was free of drama, suggesting Orszag’s confirmation will be smooth.

“You’re a popular guy, people like you,” said Sen. Jeff Sessions (R., Ala.) who asked if Orszag would be comfortable in the role as “Dr. No” at OMB.

Sen. Bill Nelson (D., Fla.) tried to pin Orszag down on how the Obama administration plans to spend the final $350 billion of the Treasury Department’s Troubled Asset Relief Program, complaining that lawmakers have received “mumbo jumbo” so far. Orszag, however, deferred to Timothy Geithner, Obama’s nominee for Treasury Secretary, and Lawrence Summers, director-designate of the National Economic Council. He said it isn’t possible to give a full plan on how the TARP money will be allocated until after Jan. 20. In addition to Orszag, the Budget committee also heard testimony from Robert Nabors, Obama’s choice to be deputy director of OMB. He also vowed to reform the budget and eliminate wasteful government spending.

“These are extraordinary times,” Nabors said in prepared testimony. “In the short-term, we face the enormous challenges of reviving the economy, creating jobs, and ensuring that government investments are made wisely. In the long term, we must put the budget on a more sustainable path and gain control over our huge and rising budget deficits.” –Henry J. Pulizzi

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