Fed Watch: Inflation Concerns Set to Trump the Slowdown?

Tim Duy with a Fed Watch in anticipation of next week's meeting:

Inflation Concerns set to Trump the Slowdown?, by Tim Duy: The intensity of disgust for the 2Q06 GDP report – documented excessively at macroblog – caught me somewhat by surprise. It probably caught the Fed by surprise, too. After all, looking at the longer term, it is hard to see a reason to panic just yet:

We should all remember that plenty of people were ready to call it quits for the current expansion after the 4Q05 GDP report, but the economy (or, more accurately, the data) rebounded strongly the following quarter. Now, I doubt we are headed for another rebound of that magnitude – there is little reason to suspect that the consumer is gaining much additional traction. But the incoming data since I last wrote are, from the Fed’s perspective, relatively more supportive of an additional rate hike than not.

As far as the GDP report is concerned, it is consistent with the Fed expectation that the economy is slowing toward potential growth, with that slowing largely driven by changes in consumption spending and residential construction. I tend to believe they will discount the most worrisome part of the report, the 1% contraction in spending on equipment and software. They will view it as largely inconsistent with higher frequency data, notably the durable goods numbers, industrial production, and the ISM report. This is not to say the investment data in the GDP report are wrong (generally, the “data are wrong” story is an unwillingness to accept reality). Instead, there can be considerable volatility in the data that masks the underlying trend. Again, look back to 4Q05. There was hand-wringing over the weak investment numbers, only to see that story reversed in 1Q06. Moreover, the Fed will refer back to the Beige Book for supportive anecdotal evidence, noting:

Among products, demand was especially vigorous for various durable goods. Substantial sales gains were reported for makers of electrical equipment and information technology products such as semiconductors, along with further increases in orders and activity for makers of commercial aircraft and products used for national defense. The reports also pointed to a further rise in demand for makers of heavy equipment, machine tools, and steel, offset in part by reduced demand for smaller equipment that is oriented towards residential construction activity.

In short, I doubt the FOMC will see an impending recession in the GDP data. What they will find in recent data is the suggestion that inflation is becoming increasingly more entrenched. Core PCE inflation in June stood at 2.4% compared to a year ago, and 2.8% annualized compared to 3 months ago. Ouch – any way you slice it, the inflation news is unsettling, running well above the supposed 2% comfort level. And, the Fed will note, wages and salaries continue to climb:

One way to look at this is that consumers are merely demanding sufficient compensation to maintain living standards. The Fed will likely take a different tack – higher wage and salary growth suggests plenty of labor market pressure. Moreover, if higher prices are matched with higher wages, doesn’t that imply that imply that inflation expectations are set to be notched higher? Further supporting the wage/inflation story is the higher than expected ECI numbers. And note that oil breached $76 today, threatening to make a fresh attempt at the previous record. The long awaited stabilization of oil prices looks still to be long awaited.

And while household spending has eased, the Fed does not want households to maintain the rate of spending growth they became accustomed to in recent years anyway; I suspect FOMC members are quite pleased to see consumption spending pull back, and won’t be interested in reversing that process by accommodating higher prices. Yes, some sectors, maybe autos, will be hurt, but any rebalancing of the economy is going to result in some unpleasantness.

The truth is, the more I look at the data, the more I am tilted toward another Fed hike next week (not unlike William Polley). Financial markets, however, are not particularly supportive of that call – the focus of the markets has shifted from inflation to slow growth. Indeed, the predominant view appears to be the next rate hike is the last. Looking at the data, I simply can’t believe this is the thinking on Constitution Ave. And, as reported by David Altig, we have heard from two Fed officials who don’t sound so convinced a pause is a sure thing, with fairly balanced remarks consistent with Fed Chairman Ben Bernanke’s recent testimony on Capitol Hill.

Where then is the case for a pause? It can be largely summarized as:

1. The Fed’s new communication strategy continues to emphasize the expected slowdown.
2. Housing is slowing, and there is considerable amount of uncertainty regarding the ultimate economic impact. The only thing we know for sure is that it won’t be pretty. It is reasonable to expect the Fed to at least slowdown the pace of rate hikes in response.
3. Likewise, the economy does appear to be slowing in line with the Fed’s forecast, maybe even more quickly, depending how you want to read the GDP report. If the economy slows, won’t inflationary pressures ease as well?
4. The view that the inflation data is tainted by aberrant owner occupied rent behavior, and thus can be discounted. See my piece last week. With the OER question eliminated, the remaining inflation can be written off as pass-through from last summer’s energy price spike. Moreover, high productivity costs will contain inflation; note the low unit labor cost growth.

If the slowdown story is the important story on Constitution Ave., then much of the incoming data is supportive of a pause next month, especially because Fed officials continue to trot out the forecast for slowing growth. Overall, as I argued last time, the Beige Book appears consistent with that story. The data on economic activity, however, are sufficiently strong to prevent the Fed from believing a pause means done.

If the inflation numbers dominate, then we have to be looking at another rate hike next week. Yes, the inflationary pressures in the Beige Book looked pretty benign, but the actual PCE inflation data is simply not pretty. Will FOMC members want to look like they are disinterested observers in the face of these numbers? It’s one thing to let inflation creep up when the economy is clearly set to run below trend. But with the economy only expected to slow to potential, it becomes likely that the more inflation-wary policymakers will start thinking that they need to pull growth BELOW potential to reverse the inflationary uptick. That would be a whole new ballgame.

In short, I want to believe the “growth slowdown means a pause” story, but the inflation numbers keep circling around me like a pack of hyenas just waiting for me to drop my guard. Central bankers tend to hold onto hawkish leanings longer than expected. I simply suspect that while financial markets appear to be more focused on the slowdown story, the Fed will focus on the inflation story. Moreover, I doubt the Fed finds the GDP report to be particularly dismal. Consequently, I think the call is much closer than the betting on Wall Street indicates, close enough for me to expect another hike next week.

Perhaps tomorrow’s employment report will help lift the cloud…

Comments

[Emmanuel]

Hmm...this is an interesting decision point for the Fed. Nouriel Roubini's take is that B-B-B-Bennie of the Feds will want to prove his mettle in spite of the considerable, ah, "downside risks" mentioned above. I don't necessarily agree 100%, but it's worth noting:

What about Bernanke and the Fed? Wouldn't they stop then ease if there is a serious US slowdown? They would if the US slowdown was only due to a housing and consumption slump. But if the US slowdown is associated with a likely increase in core inflation--as I do expect--you will see the Fed Funds rate at 6% by December or, at the latest, February 2007...

A new and untested and tentative new Fed Chair like Bernanke cannot afford to be labeled as an inflation dove or wimp; so gentle Ben will prove to the markets that he has the cojones to stamp out inflationary expectations. And with domestic demand necessary to grow below output to reduce the unsustainable US current account deficit and to slow the consumption binge of the last few years, the Fed will accept sub-par growth of 2% for a few quarters without being forced to ease, since core inflation will be rising.

[spencer]

Meanwhile July auto sales rebounded to 17.2 (SAAR) from
16.3 m in June as Detroit and the japanese as well implemented large scale discounts. Since December 2000 real retail sales have bounced around a 6% growth trend and in June they were right on that trend line and Department store type merchandise were still above the 7% trend they have been on since December 2000. The consumer is still hanging in there.

But the recent downward revision to real gdp showed capital spending to be even weaker then previously thought. Real nonresidential fixed investment is only
up 14.5% from the trough -- originally reported as 19% -- as compared to 21% in the 1980s,33% in the 1990s and some 50% in the 1960s at this point in the cycle.
Capital spending was revised down from 11% of GDP to only 10.5% of GDP as compared to just under 10% at the bottom.

Moreover, copper prices are rising again and the purchasing managers deliveries index ticked back up -- it is a great leading indicator of capacity utilization, backlogs,oil and other commodity prices and fed funds.

[Bruce Wilder]

Looking at the charts in this post, I have to wonder how the NBER arrived at its dating of the last recession.

I know there's been some silly, partisan back-and-forth on the dating of the last recession, with the Democrats taking points on the official dating of March 2001, but, really, what possible justification can there be for that dating? My eyeballs look at the charts, and I see, December 2000, at the latest.

What NBER criteria allow them to date the recession as beginning a full quarter after it, to my eyes, began? Is there an intuitive summary answer that explains the difference?

[spencer]

Bruce -- income data like in this chart is generally a lagging indicator.

Go to NBER.org and you can find a good discussion of how they date the recession. Remember, this was an unusual recession in that consumer spending stayed positive throughout and it was a capital spending recession rather then an inventory recession.

[anne]

Spencer:

"Remember, this was an unusual recession in that consumer spending stayed positive throughout and it was a capital spending recession rather then an inventory recession."

And lack of capital spending given fine corporate earnings and record or near record corporate saving, bothers me still.

[spencer]

anne -- i just looked at the newly revised real gdp and investment data. Real nonresidential fixed investment is only up 14.5% from the economic bottom -- it was originally reported to be up 19%. By comparison in the long cycles of the 1980s, 90s & 60s it was up some 21%, 33% and 50%, respectively at this point in the cycle.

It was revised down from 11% of nominal gdp to only 10.5% of gdp compared to the bottom of just under 10% of gdp.

By any rational standard capital spending is the weakest this cycle of any cycle since the depression. Part of it we are still working off some of the excess investment of the 1990s. Part of it is that the oil companies are investing a very small share of their profits -- rather they are returning it to shareholders. but clearly we are seeing no evidence that the bush supply side tax cuts are inducing greater capital spending or investments. How long can be let them get away with claiming the supply side tax cuts are working. The only part of the tax cuts to work were the traditional Keynesian parts of the package.

[anne]

Spencer:

"I just looked at the newly revised real gdp and investment data. Real nonresidential fixed investment is only up 14.5% from the economic bottom -- it was originally reported to be up 19%. By comparison in the long cycles of the 1980s, 90s & 60s it was up some 21%, 33% and 50%, respectively at this point in the cycle.

"It was revised down from 11% of nominal gdp to only 10.5% of gdp compared to the bottom of just under 10% of gdp.

"By any rational standard capital spending is the weakest this cycle of any cycle since the depression."

Nicely and importantly done, and worrisome.

[dryfly]

One explanation for why less business investment is 'Schumpeter Effect'... we are getting deeper into current innovation cycle where there is more interest in lower cost commoditization of existing products and consolidation of capacity and far less interest in new products, new processes and in general less real innovation.

I mean ask yourself? What would you invest in if you had the purse strings of a major corporation?

More & better computers? How will a slightly faster, newer computer drive your costs lower? The productivity bump from file cabinet & typewriter to computer was huge... from DOS to window-like OS big... from this window OS to that window OS marginal at best (training might cost more than the benefit).

Same story with lots of capital systems & equipment.

The only area I can think of where there still might be a big bang for the buck would be 'logistics' - getting stuff here from Asia cheaper, faster, less hassles. But even here, the supply chain & big box distribution folks have been working that angle pretty hard - maybe they too are at the marginal limits of existing technology.

So if the old stuff in the plant, warehouse, office & storefront still works... and you have enough of it to meet demand... and if you can't raise prices easily due to offshore competition to cover the investment... and the benefits from the investment don't pay for themselves with large productivity improvements.... why invest in more, better capital?

Maybe its better to just pay dividends & do stock buy backs instead?

Anecdotal bit:

I talked with a potential customer today - he buys components for a large global tier one automotive supplier. I wanted to set up an appointment to come in & discuss a large highly innovative program we have going with a sister division of his company... He said 'no - not interested right now'. Said he knew all about the program and was very impressed with the technology but that his marching orders (straight from the top) were to NOT pursue crazy new ideas but to stick to knitting & buy commonly existing commodities cheaper. Much cheaper. As a result he will be out of the country for the next six weeks sourcing in 'low cost regions of the world'.

I wish that was the only time I've heard that - it isn't. Back in the mid-90s that would have been heresy. Then folks actively courted tech of all forms to drive cost lower. But that was then.

The investment numbers aren't a fluke as far as I can tell.

[Dirk van Dijk]

Anne & Dryfly,
I second your point and let me put a little color on it by quoting from my soon to be released strategy report:

Of all the factors of production, capital is the one which can most freely cross national borders. The capital gain rate is the same if you are invested in a U.S. stock which operates totally in the U.S., a U.S. based multinational with most of its operations abroad, or an ADR with no operations in the U.S. It also makes no distinction if the capital gain was generated through a firm making profitable investments in new capacity or products, or through financial engineering. Financial engineering, such as stock buybacks, are often a very logical thing for a corporation to do. After all, the management is charged with looking after the best interests of the shareholders, and often that means buying back stock. Investors are interested in the growth of earnings per share, and that can be achieved either through increasing net income or reducing shares outstanding. In the first quarter of 2006, firms in the S&P 500 spent $100 billion on share repurchases, a pace which if maintained for the rest of the year would be double that of 2004. To put that in perspective, total operating earnings for those firms in the first quarter were $186.3 billion. Toss in $53.3 billion in dividends paid in the quarter, and it is clear that companies are more focused on returning cash to shareholders than investing in new projects. As an investor, that is often a good thing. However, $1 billion spent by a company to buy back its own stock will not have the same long term implications for economic growth that $1 billion spent on R&D will have.

[anne]

Thanks, Dirk; I will read this carefully in a little while.

[Rajesh Raut]

Even if companies return cash back to their investors, what do the investors do with the cash? The capital markets are all about transfering cash from companies with few growth oportunities (ExxonMobile) to companies with large growth opportunities (Google). If they but other stocks then the overall investment picture stays the same. If they spend it on a trip to the International Space Station, well the view is probably very lovely.

[slink/js paine]

"Core PCE inflation in June stood at 2.4%
compared to a year ago,
and 2.8% annualized compared to 3 months ago Ouch –"

ouch ?? how old is this guy

" any way you slice it, the inflation news is unsettling,"

what ???

" running well above the supposed 2% comfort level"

.5 above is big time ????

and whats this 2 % target like its a drop dead zone beyond 2

you'd imagine if this were the 80's he was talking
2 digit inflation
not 2%

" And, the Fed will note,
wages and salaries continue to climb "

ignore the hand dance except for this last bit

thats the money line
i'll repeat it even ...

"wages and salaries continue to climb "
in that light

i like that wage rate change graph
looks like a koufax curve ball

wage control policy ????

no w/p spirals in sight or prospect

ite like tornado warnings at the north pole

imagine we take a huge hit
on oil prices
and other commodity prices
and
there over now
the global system is prolly slowing

and so the fedskins are
still tightening

my dear old dad used to say

"sometimes its policy
but every cycle at least once
it's pure sadism ...."

[anne]

Dirk:

"In the first quarter of 2006, firms in the S&P 500 spent $100 billion on share repurchases, a pace which if maintained for the rest of the year would be double that of 2004. To put that in perspective, total operating earnings for those firms in the first quarter were $186.3 billion. Toss in $53.3 billion in dividends paid in the quarter, and it is clear that companies are more focused on returning cash to shareholders than investing in new projects."

A useful comment, however the impact of stock buybacks is and has been significantly overstated. A considerable portion of stock that is bought back simply covers option grants and is of no help to shareholders and possibly deceptively covers the impact of option grants. However, the relative lack of investment by corporations through this growth cycle is important and puzzling. Nice :)

[Robert]

"Toss in $53.3 billion in dividends paid in the quarter, and it is clear that companies are more focused on returning cash to shareholders than investing in new projects."

There is a certain self-serving cynicism in so many of these share buybacks. For the incremental premium to MBE (meeting or beating expectations) while myopic is meaningfully large while the penalty function for torpedoing is also of a large magnitude. So if the quarter is looking light, just buy back some shares, and maybe, hopefully, no one will notice. It's not that management wants to return cash to shareholders (they would simply pay heftier divs now that double tax is gone) nor is it that they don't have ample opps in which to invest. It's just that investing involves potentially, likely, taking a short-term hit to that most cherished & coveted by modernity's best & brightest investors: earnings consistency. So instead, they buy back shares as and when necessary, squeeze the share count and make the numbers, thereby manufacturing earnings...which it would seem is a helluva lot easier than manufacturing widgets.

[zilo]

A counter-intuitive take on the Fed policy.

If the Fed pauses, the housing deflation will be severe, a "hard landing". I believe that a pause will be read as a major dovish concession and the markets will drive long term rates higher. A pause will cause long term, and mortgage rates, to rise.

A 1/4 point, with hawkish language, will cause long term rates, and mortgage rates, to drop. ARM holders will be able to refinance at lower rates.

The problem is not the Fed funds rate level. The problem is commodity and service inflation that most people have been aware has been rising for two years. They have finally bled through to the core readings.

A pause, or dovish language, is a mistake. Commodities prices will explode upwards, the dollar will decline, and long term rates will increase. High and rising prices are causing the slow down, not interest rates.

[anne]

Thinking against the Federal Reserve is a way to become poorer, and is another reason I pay less and less attention to forever bears. Let the bond market interpret Fed policy, and the bond market is telling us inflation will be controlled through this tightening cycle and the cycle is nearing an end.