Tim Duy's latest Fed Watch:
A number of critical reports came out this week, including 2Q GDP, 2Q ECI, June durable goods orders, and the Beige Book. When Greenspan & Co. gather on August 9 to decide the path of policy, the data will indicate to them to stay the course – the path of measured tightening is working, so don’t rock the boat.
On the real side of the economy, I suspect that grins spread across the faces of Fed policymakers as they read this morning’s GDP release. To be sure, the headline figure looked a bit weak compared to Q1, and was a hair below expectations, but it is the details that matter in this case. The inventory drawdown is the first detail – it subtracted a whopping 2.32 percentage points from GDP. Consequently, a more useful indicator of demand is final sales of domestic product, which grew 5.8%, the highest rate since 3Q03. Make no mistake – this is a strong number. Fixed investment gained 9.3%, including a double digit gain in the equipment and software category. And net exports even made a positive contribution to GDP as exports gained and imports declined slightly. In short, this report will support the Fed’s contention that the economy is on solid footing.
In fact, it is likely that the GDP report will lead Fed officials to anticipate an acceleration of growth in the back half of the year, contrary to the expectations (or at least concerns) of many commentators. The acceleration will be expected as firms rebuild inventories depleted in Q2. Yes, yes, I am aware of the concerns regarding expected production cuts in the US auto industry (see James Hamilton). Such concerns will not make too much headway among Fed policymakers. A key change has happened in the US auto industry in the past 25 years – the increase of non-US auto companies producing on US soil. For example, as Ford cuts production, Toyota expands. Best guess: The Fed will view the problems at GM and Ford as industry specific, not cyclical in nature.
More evidence of strong growth will be found in the June durable goods order report. A key underlying component, nondefence, nonaircraft capital goods orders, gained 3.8%, suggesting confidence among firms and that the investment story in the 2Q GDP report will be sustained. This contention, as well as the inventory rebuilding story, find further support in today’s Chicago PMI release, which rose from 53.6 in June to 63.5 in July, the largest monthly gain since 1983.
Most of the above data is also supported anecdotally in the Beige Book. From the summary:
Reports from all twelve Federal Reserve Districts indicate that economic activity continued to expand in June and early July. Richmond and Dallas reported that the rate of economic growth increased, and Cleveland said economic growth was stronger and more balanced than in the spring. New York was the only District to report a slowing in the rate of economic growth. Among the other Districts, Atlanta, Minneapolis, Kansas City, and San Francisco characterized the pace of expansion as solid, while Chicago described the rate of economic growth as moderate. Boston, Philadelphia, and St. Louis did not characterize the overall pace of expansion, although Boston noted that locally-based retailers were not sharing in the expansion.
And, if all of that is not enough for the Fed, they can also turn to incoming earnings reports. By my count, positive surprises outweigh the negative by 2.22 to 1.
In short, while I am aware of the many more cautious economic outlooks and the calls for the Fed to pause in its tightening campaign (See Mark Thoma and James Hamilton), Greenspan & Co. have a mound of positive data on their plate that screams to them a continuation of existing policy.
What about inflation? Isn’t it under control? Why raise rates further? To be sure, inflation looks to have moderated. From the Beige Book again:
Despite generally tighter labor markets, nearly all Districts said overall wage pressures remained moderate.
Overall price pressures either eased slightly or remained unchanged in most Districts, despite substantial increases in the costs of energy and some building materials.
This anecdotal report is supported by the GDP report, which revealed a 1.8% gain in core-PCE, down from 2.4% the previous quarter. Moreover, the ECI report revealed that wages were under control, as compensation costs gained just 0.7% in Q2. Some will read these numbers and conclude that the inflation demon has vanquished, and Knight Greenspan can return to his castle on Constitution Ave.
I doubt this will be the interpretation of Fed policy makers. Instead, they will summarize the current situation as follows: “Inflation remains under control even as growth remains strong and the unemployment rate approaches 5%. This goldilocks combination is the result of our tightening campaign, which sent a signal that kept inflation expectations under control. Considering that growth is poised to remain strong, and even accelerate, we need to maintain vigilance – which means continuing our policy of measured rate hikes to keep expectations in place.”
Short story: Greenspan and Co. don’t know how much further they have to go on this trail, but they can’t see the crest of the Fed Funds mountain just yet. The crest won’t come until they see solid evidence of demand growth sputtering.