Fed Watch: Living on a Knife Edge

Tim Duy with his latest Fed Watch:

Living on a Knife Edge, by Tim Duy: Big, big week for monetary policy. Today, we get the PPI figures. Tomorrow, Fed Chairman Ben Bernanke marches up to Capitol Hill for his Congressional testimony after getting a fresh reading on inflation earlier that morning. Unless the inflation numbers surprise on the downside, I am not confident that with oil staring at $80 a barrel, Bernanke can stick with a message that suggests inflation is under control. At the same time, with clear evidence of a slowdown evolving in consumer spending and a housing sector that is clearly on the rocks, Senators will want to hear that Bernanke is pulling his foot off the pedal. Financial markets are split pretty evenly between expectations of another hike or a pause next month; tomorrow’s events could shift the tide decisively in one direction or the other.

This, of course, is the proverbial rock and the hard place. Instinct tells me that the risk is that unless the inflation figures come in below expectations, Bernanke will come down sounding hawkish. He, like virtually all central bankers these days, will tend to fear inflation more than slow growth – and that would set the stage to push expectations toward another rate hike in August.

The US consumer is on the ropes. The stress was obvious in the May personal income report, which again showed households struggling to maintain spending by continuing to deplete their savings. And we have little reason to believe the situation is improving; retail sales were below expectations in July. Note that these are nominal figures – a paltry gain in prices will effectively wipe out any potential real gains. Moreover, as Calculated Risk notes, industry insiders are not expecting their customers back anytime soon, if retail sector job growth is any indicator. Notice too that Target just warned on their July same store sales; the stock slipped 3.2% in after hours trading. The future isn’t looking much brighter, with the expectations of large ARM resets looming heavily in our collective inner-bear.

But, do recessions originate in consumer spending? Or is investment spending the culprit? The Fed will side with the latter interpretation, and in looking for evidence of a recession inducing investment reversal, I suspect they will come across the following charts:

The first two are familiar indicators of core investment intentions. Orders for capital goods excluding aircraft and defense are maintaining their upward trend. Backlogs continue to grow as well, a sign that firms are struggling to keep up with demand, suggesting the need for capacity expansion via, you guessed it additional investment. In this light, yesterday’s strong industrial production report is also supportive of another rate hike.

The last chart is the ratio of corporate cash flow to nonresidential investment. Firms can satisfy all of their current investment spending, and them some, without resorting to financial markets. Under such circumstances, additional rates hikes, or market gyrations, will likely have a smaller effect on firms’ investment behavior.

But will investment hold steady if the consumer starts to fade? Plenty of cash just means firms can invest, it doesn’t mean they will. And isn’t the consumer spending slowdown enough to pull growth down to potential, thereby lessening the inflationary pressures? This was, in a nutshell, the story from the last FOMC statement, as well as the argument for a pause in August. Not a bad argument, at that, one that John Berry makes in this piece, concluding with:

Fed officials have been focused on making sure that the energy price shock doesn't spill over into core inflation, and so far they have been successful. That means that if oil prices do stabilize then headline inflation will decline. And the risk of that spill over will be gone.

Given the steady upward trend in oil prices over the past few years, one would think that we would have to sit through more than one FOMC meeting to conclusively say that oil prices are stabilizing. Not to mention that since the June FOMC meeting, oil prices have climbed higher, hitting fresh records. That may be just a knee-jerk reaction to the Middle East conflict, but I can’t help but think back to Richmond Fed President Jeffery Lacker’s comments:

“Moreover, focusing on real interest rates draws attention to how and why policy must respond; real interest rates must fluctuate to accommodate changes in the relative pressure on current versus future resources. Widespread understanding of this would have aided the market response to Katrina; the storm impaired the supply of current resources relative to the future, and so, if anything real interest rates had to rise, not fall.”

Does it matter if oil prices are higher due to a hurricane in the Gulf of Mexico or the Middle East conflict? Of course, the US economy looked healthier when the hurricanes struck last summer, and the resulting damage also knocked back refinery capacity. But this latest jump in oil prices comes at a time with elevated inflation numbers, and the expected weakening of inflationary pressures has yet to fully emerge. If the Fed holds back from another rate hike now, isn’t it the same as accommodating a fresh rise in oil prices? Will the more hawkish members of the FOMC be willing to accept that? And note that although financial markets have been agonizing over the state of the economy, Minneapolis Fed President Gary Stern is sounding rather complacent. Not surprising, considering that the economy has weathered a number of crises over the past few years.

The core of the debate continues to be the race between inflationary pressures and growth moderation. I buy the story that many FOMC members want to pause, but I think such a decision will depend more on soft inflation readings over the next three weeks rather than soft growth readings. Bernanke’s testimony will be a key is setting expectations of the next FOMC meeting. Also the Fed is likely less concerned about the health of the economy than financial market participants, suggesting that Bernanke will surprise on the hawkish side.

Comments

[save_the_rustbelt]

The ultimate irony will be this.

After watching the world go by for the past 5 years, 80% of Americans will then be beaten once again as interest rates soar.

Main Street to Wall Street - there goes the wealth of the nation.

Time to buy me a Congressman.

[hinz]

One comparison that is missing is the role of asset price inflation as the pre-cursor. A good view is provided at http://www.crbtrader.com/crbindex/futures_current.asp

Too much liquidity creates inflation which shows up first in asset and commoditity prices accompanied by one or two quarters of excessive GDP growth.

The Fed waits patiently for the inflation to show up in the PPI or a wage spiral. In the present case, the excess liquidity has enticed people to borrow for consumption. Greenspan should be taken to the wood shed for this one.

The Fed needed to normalize rates two years ago, when the housing bubble became apparrent and the commodity markets were screaming inflation.

Typically, the Fed ends up fighting an accelerating inflation which, once the expectation takes hold, is intractable and pernicious. A sledge hammer becomes necessary instead of a tack hammer.

Bernanke is faced with wringing inflationary expectations out of the market not just a short term blip in prices. If he even hints that the Fed is through, commodities will go through the roof. It has already happended to him twice in the past few months.

[spencer]

Meanwhile copper prices have retraced almost all of their correction and are appoaching new highes.
Moreover, LME copper stocks are starting to fall again
after rising in recent months.

[hj]

Typically, the Fed ends up fighting an accelerating inflation which, once the expectation takes hold, is intractable and pernicious. A sledge hammer becomes necessary instead of a tack hammer.

As G. William Miller found out; and Paul Volcker demonstrated.

[jalrin]

With the rest of the world growing, how will crushing the U.S. economy drive down commodity prices? Would it not be better to use margin requirements to destroy the speculators instead?

[js paine/slink]

right here at " the view "
i hear

the call of the inflation crows
from atop their high wire line

the slowing of the system
hasn't
produced enough real ouch yet i guess
and who knows maybe once again
like in the greenchoke of 94
it won't ever get ouchy

whatever happens
i delight in their sagacity

" gentle ben
better u hobble a zillion clowns
and ham string a few million total
wage fools
then let there be a chance
this price level rise
hits the core
and gets out of hand
like ....the 70's "

as if yankeedom
in the late 70's
was maybe only two shits
from a weimar germany

[anne]

Always work back from the bond market, for here we have a collection of institutional investors for whom the difference of a quarter percent means fist fights and more means worse. The bond market is telling us the Federal Reserve will be raising short term rates again, while the long term inflation perspective is not a problem. How far the Fed will go is not clear of course, but there is a growth cushion and remarkable international growth resilience so far in this cycle so we can hope for a moderate slowing only.

[anne]

Long term interest rates have been remarkable stable through the Fed tightening sequence, showing investor confidence in control of inflation by the Fed. Trust the bond market as an investor or analyst.

[dryfly]

With the rest of the world growing, how will crushing the U.S. economy drive down commodity prices?

There is more in that line than any of us know.

I work in the metals processing world (energy & metal price sensitive)... the run up in these areas is more than a 'monetary event'... there are real worldwide shortages relative to desired levels of demand. Copper & zinc are only the two most visible examples - others too.

China & the ROW are gobbling up an enormous supply of these materials. So raising our rates will not reduce global demand much at all, only increase our pain.

Or will it?

There is an argument that China demand isn't 'primary order' but rather 'secondary order'... that they aren't consuming to fill their own demand (primary demand) but rather are consuming to build to sell to us to fill our demand (secondary order demand)... Same thing with some (maybe a lot) of their energy use... used to move stuff around on its way to us.

If that is the case then cranking down on US rates - stifling US demand - very well could ratchet down those commodity prices. It really depends how much global demand is independent and how much is dependent on US derived demand. I'd guess knowing that ratio would tell some body smarter than me a lot.

But I have no idea what the answer to that one is. Does Benny?

[Movie Guy]

Producer Price Indexes (PPI) - June 2006
BLS
Released 18 July 2005

Percentage Change, seasonally adjusted annual rate for: 3 months ended in June 2006 as compared to three months ended in March 2006

Finished goods: 6.7% / up from (-2.2%)
...Finished consumer foods: 4.5% / up from (-8.6%)
...Finished energy goods: 22.3% / up from (-11.4%)
...Finished goods less foods and energy: 2.3% / down from 3.9%
...Finished consumer goods, excluding foods and energy: 1.9% / down from 4.4%
...Capital equipment: 3.0% / down from 3.1%

Intermediate materials, supplies, and components: 11.1% / up from 2.3%
...Intermediate foods and feeds: 0.3% / up from (-3.2%)
...Intermediate energy goods: 17.9% / up from (-7.5%)
...Intermediate materials less foods and energy: 9.8% / up from 5.7%
...Materials for nondurable manufacturing: 10.0% / up from 6.5%
...Materials for durable manufacturing: 31.7% / up from 13.0%
...Materials and components for construction: 7.8% / up from 7.7%

Crude materials for further processing: 5.7% / up from (-38.2%)
...Foodstuffs and feedstuffs: 3.9% / up from (-28.6%)
...Crude energy materials: (-12.1%) / up from (-54.8%)
...Crude nonfood materials less energy: 63.1% / up from 15.2%

Not seasonally adjusted, from June 2005 to June 2006:

Finished goods - up 4.9%
Finished energy goods - up 19.1%
Finished goods other than foods and energy - up 1.9%
Finished consumer foods - up 0.6%
Intermediate goods - up 9.3%
Crude goods index - up 8.6%

Wholesale Prices Jump in June
NY Times, 18 July 2006

"A jump in wholesale prices does not necessarily mean that prices at the retail level will rise, because corporations often absorb higher costs without passing them along to the consumer. So last month’s data may not foreshadow a rise in the government’s consumer price index, which is much more closely watched as a sign of inflation. Consumer price data for June is set to be released Wednesday."

"Some economists, however, said today’s report hinted at the beginning stages of higher consumer prices. Prices for intermediate goods excluding food and energy, which include materials used in the manufacturing process, have jumped 7.3 percent since last June. That suggests that in the coming months, manufacturers could be pressured to pass their higher production costs along to wholesalers, who in turn could pass it along to retailers."

"Seven-point-three percent is arguably blistering," said Richard Yamarone, director of economic research for Argus Research. "It could mean higher prices on the retail level. And the Fed doesn’t want to gamble with that."

U.S. June Producer Prices Rise 0.5%; Core Rate Rises 0.2%
Bloomberg, 18 July 2006

GLOBAL MARKETS-Bonds dip as US PPI rate hike risk, stocks soft
Reuters, 18 July 2006

US mortgage bonds end flat after strong PPI data
Reuters, 18 July 2006

[cm]

MG: I cannot make claims about price hikes across the board because I don't buy across the board, but in the local grocery chains I have been seeing significant price hikes for food and other staples over several years.

OTOH of late we have an increased number of "sales" (reduced price or buy one get one free). Maybe that's just because of the summer. And before we had this or that holiday. And maybe the items I buy are overweighted in the sales. Heck, maybe I'm so cheap that I'm conditioned to only look for stuff on sale.

Anyway, overall it looks like Safeway is not "absorbing" a lot.

[sharkbait]

According to your charts the fed will be tightening forever.

[ilsm]

"OTOH of late we have an increased number.........

As Truman said send me a 'one armed economist'.

Dryfly,

Good points, but if we decline in our demand maybe China and ROW consumers will grow some legs.

How about someone else's economy provide the demand side? good thing?