Fed Watch: A Week of Data That Point to More Tightening…

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.

Comments

[Mike]

Tightening IS working, but for which economy: the real economy or the financial economy? Real economy not looking so bad, but methinks that the effects of increased rates will kill the financial economy and that's the one that really matters in this unbalanced world.

[pgl]

We both noted that inventory draw down. Over at Angrybear, I also noted fixed investment demand growth was at 9.3% per year while final sales growth was at 5.8% per year. I'm usually the pessimist and I thought Hamilton was more of an optimist - and yet we reversed roles today!

[anne]

"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."

I agree completely, so does the bond market. Notice the climb in long term interest rates today.

[Movie Guy]

If there is no inflation to speak of, then under what law or regulation is the Fed assuming responsibility for stemming consumer expenditures?

[Movie Guy]

And then I read this...

American consumption has finally all but outstripped American income.

[James Hamilton]

Very nice analysis, Tim. Did you have a reaction to Barry Ritholtz's claim that autos accounted for a "huge chunk" of the inventory drawdown? I'm not sure where the data for his claim come from.

[Tim Duy]

Out of town for the weekend, so I am just getting back to this. Thank you all for the comments.

Movie Guy - I need to take another look at the look savings statistics. This is one of those topics that people keep pointing to as a problem, but hasn't been yet.

Prof. Hamilton - I probably should have dug this dug out Friday morning. Table 5.5.6b:

http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=151&FirstYear=2003&LastYear=2005&Freq=Qtr

Huge inventory drawdown in autos. Offseting gains in wholesale trade. Note also the drawdown in nondurable manufacturing.

So, this data might fit nicely with your concerns about autos, which would imply that economists are too quick to revise up the second half estimates.

On the other hand, good ISM report this morning, consistent with the more optimistic story.