Tim Duy's Fed Watch:
The Greenspan era ended peacefully. I somehow expected that colors would look a bit dull, or the chirping of birds would become melancholy. Things instead seemed pretty much unchanged – we slid into the Bernanke era with an FOMC statement that contained little new information. We need to assume policy continuity until the new top dog says otherwise. In my mind, I think Fed policy is running on two competing planks:
- With a full 350bp of tightening in the pipeline, and some indications of softening in housing, Fed officials would like the opportunity to pause to assess their handiwork.
- Increases in resource utilization and the omnipresent threat of higher energy price leave policymaker’s uneasy about pausing at this point.
The term “conundrum” comes to mind. My bet is that plank number 2 will be the winner – the solid economic data with the continuous threat of inflation suggests the Fed will still draw another arrow from its quiver.
Last week I said the Fed would not take such a dim view of the Q4 GDP report in light of anecdotal evidence and the higher frequency data. The statement of last week’s FOMC meeting conforms to this view:
Although recent economic data have been uneven, the expansion in economic activity appears solid.
The “uneven” data is likely a reference to the weak GDP report. Still, the Fed did not seem as concerned about the uptick in core-PCE as I thought:
Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained.
Regarding future policy:
Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.
The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.
As others have noted, the shift in language was expected and provides maximum flexibility for Bernanke & Co. to maneuver. The identification of resource utilization rates (see my Fed watch two weeks ago) and energy costs indicates the bias is to tighten further, in my view. The “may be needed” phrases indicates, however, that no tightening is guaranteed. The Fed did not send up an all’s clear signal. Instead, we need to shift through two months of data to determine the degree of resource utilization. And the tone of recent data suggests the Fed will tighten yet again when Bernanke presides over his first FOMC meeting as chairman and the end of March.
The January employment report adds another piece of evidence in favor of additional tightening. True, it was not a blockbuster report. Instead, it suggested a certain continuity – the slow gradual tightening of the labor market. Employers added just under 200k workers to the payrolls with gains well spread throughout the economy. The weak spot was retailing, and construction was an unexpected strong point considering evidence of softening in that sector. Recent months were revised higher as well.
The unemployment rate fell to 4.7%, a low enough number that some FOMC members will be getting increasingly nervous about “resource utilization.” Some will point to the slight uptick in the employment to population and low labor force participation rates as evidence that the labor market is weak. I think that is a difficult argument to make – see also David Altig’s thoughts on this point. There are likely secular trends in the labor markets that are not fully accounted for yet. Another potential weak spot in the report was the flat work week.
Overall, however, my take on the data suggests a relatively strong labor market. In addition to steady job growth and low unemployment, wages gains are accelerating, with January’s 7 cent gain pushing wages up 3.3% compared to last year (and 2 consecutive 0.4% monthly gains, or an annualized 5.3% gain in January). And buried within the data are further bright spots, such as a solid decline in long term unemployment (more than 27 weeks):
Also, the unemployment rate including marginally attached persons and those employed part time for economic reasons continued its steady march down as well:
Now, one does have to be careful with unemployment rates as they are lagging indicators. But initial jobless claims – a leading indicator – remain low (in Oregon claims have dropped to the lowest level in over 10 years). Moreover, I am picking up anecdotal evidence that employers are sensing a change as well. Paraphrasing one employer, “My employees are asking for higher wages, and actually expecting they will get them. And they do.”
When employers complain about lack of potential workers, I tell them they need to raise wages. This doesn’t make them happy, either.
Note that I am not attributing a stronger labor market to any specific economic policies. And it is true that the labor market remained lackluster for an extended period of time. But it does look like conditions have significantly improved over the past year, and the Fed will take note. For a different view, and another potential measurement problem, changes in the rates of non-responders, see Dean Baker at MaxSpeak.
In addition to the employment report, the bulk of this week’s data has also been supportive of another rate hike. Productivity growth stumbled (see David Altig) and unit labor costs gained. I would be somewhat careful about overreacting to this report. The Q4 GDP report looked weak due to a number of factors that all came together at once, but are probably not indicative of the underlying economic trend. This would of course also apply to the productivity numbers. Still, the best days of high productivity growth look behind us. The Fed will be wary that firms are having an increasingly difficult time improving productivity, providing additional incentive to push higher costs down the line.
The Institute of Supply Management also provided its snapshot of manufacturing and non manufacturing activity. In both cases, the outcome was slightly weaker than expectations, but still suggestive that the economy remains on solid footing. The details of the manufacturing report suggested the “resource utilization” in growing – inventories were contracting, customer’s inventories were too low, prices paid edged up, and the backlog of orders continued to grow. More meat to feed the inflation hawks at the FOMC. But perhaps they will be softened somewhat by the non manufacturing report, which indicated that inventories were too high. Calculated Risk provides his thoughts and points out the discontinuity of reports of a contracting construction industry with the expansion in employment in that industry.
Two weeks ago I said that barring any significant shifts in the bond markets, the Fed was ready to pull the trigger on a complete inversion of the yield curve when policymaker’s pushed the overnight rate to 4.5%. Since then, bonds have fallen substantially, with the 10 year rate currently hovering around 4.55% (the curve is inverted at the 10 year – 2 year horizon). A slim margin, to be sure, but a margin nonetheless.
Will longer term interest rates move up again? Or will the negative factors waiting on the sidelines – the lagged impact of previous rate hikes, a softening housing market, low saving rates, and possible consumer fatigue – turn against us and put the FOMC firmly into pause mode? Many, I think would prefer to see the Fed wait it out a meeting or two – see Jim Hamilton, for instance. But the steady, mostly supportive flow of data suggests not just yet, with the odds still on the Fed will raise rates to 4.75% on March 28th.
Still, two months of data is a lot to chew on, and it is likely we will all be scratching our heads between now and then. [All Fed Watch posts.]