Fed Watch: Looking for a Reason to Worry…

Here's Tim Duy's latest Fed Watch:

I am not prone to excessive optimism or pessimism, but I think you have to go out of your way to belittle the economic data of the past week. Yes, if you dig into the details, you can find trends that are important and in some cases worrisome (see for example William Polley’s concerns about unemployment among teenage African Americans). But by in large, the economy looks to have shaken off the impact of this summer’s hurricanes, exhibiting a remarkable resilience in the process.

In my mind, the data clearly point to a continuation of the Fed’s measured pace policy – the headline GDP numbers alone would easily justify another two 25bp doses of tightening at this stage of the business cycle. Moreover, the economy has enough momentum that one would expect additional hikes on top of that.

But my thoughts on the latter are not unqualified; a few things are nagging at me. One is a few bits of anecdotal evidence I will talk about later. It appears consistent with a softening of the Fed statement to increase the emphasis on incoming data. Another is the stubborn refusal of long term rates to move higher – 4.5% rates on the ten year simply do not appear consistent with the growth outlook and the likely Fed response to that outlook. I strongly agree with David Altig on this point. Something doesn’t fit. Are Treasuries reading the anecdotal evidence as the important variable in the outlook? Or is it simply with inflation low, the Fed will find that pausing in the near term is the appropriate policy? Or both?

Looking at the data, it is hard to begin anywhere but the 3Q05 GDP revision. Growth accelerated to a 4.3% rate during the quarter, up from 3.3% the previous quarter. Consumption was revised upward. Investment in equipment and software posted a double digit gain. Yes, the trade deficit was a drag on growth. But that also means the headline number – and the stress on domestic resources ­ would only be higher without that drag. (Note: I am not downplaying the deficit, just telling another version of a widely accepted story: Eliminating the deficit will entail a possibility painful structural shift as the consumption is brought in line with the productive possibilities of the nation). Core inflation is tame. And final sales grew at a 4.7% rate, the second quarter in which sales grew faster than the 3.9% pace of 2004.

Note that growth accelerated by a full percentage point during a period in which the US faced what many would say was its worst environmental disaster. Accelerated during a disaster that many predicted would trigger the next recession. Without Katrina and Rita to erode consumer spending via higher energy costs, this number would almost certainly be even higher. The economy was hot in Q3, plain and simple.

And the fourth quarter is shaping up to be pretty solid as well. Data last week revealed that the beleaguered manufacturing sector looks pretty solid, suggesting that the travails of GM and Ford are industry specific. The ISM report held strong at 58.1. Durable goods orders posted a rebound. And looking beyond the headline numbers, nondefence, nonaircraft capital goods orders and shipments both rebounded from September’s loss. And unfilled orders continued to pile up, despite a drop in inventories. The jobs report even revealed a rare hiring gain in this sector. It sure seems that many of the nation’s factories are humming along.

Likewise, the November employment situation was solid. The economy added 215,000 jobs across a wide swath of industries. Wages continued to climb and stand 3.2% over a year ago, helping to support consumer spending in the months ahead. Manufacturing hours and overtime slipped, but the sector added workers as well – perhaps signaling that the nation’s factories are having trouble squeezing more work from the existing labor force. Sure, hiring over the past three months looks a bit tepid, but again you have to take this in context of the hurricane activity. The recovery in the affected areas will be slower going than many believed – see official attempts to lure residents back to New Orleans.

And, last but not least, even the imminent demise of the housing market looks in doubt. The 13% gain in new home sales in October offsets the more bearish existing home sales reports. Some have questioned the integrity of this data point, but until more data arrives, I have to agree with Calculate Risk’s assessment on this one.

So where can we turn for a bit of bearish news? As far as hard data is concerned, the consumer is looking a little spent. Yes, the GDP report showed an upward revision in consumer spending for Q3, but it is worth repeating that the gains were attributable to a surge in durable goods sales in July. Both August and September were down months, and October’s real gain was a paltry 0.1%. And the Wall Street Journal reports early signs of tepid spending this holiday season, despite falling gas prices and rising wages.

Of course, I am not ready to take this story too far just yet – many have fallen on their swords predicting the demise of the American consumer. Early reports might be a bit pessimistic. Analysts always fret about holiday sales. And it may be that households really, really want to purchase a new SUV, but know if they hold out a little longer, the incentives will be back (a solid bet). Still, three weak months in a row is something to note.

As far as housing in concerned, the Wall Street Journal offered a couple of cautionary tales last Tuesday, perhaps explaining some of the softness in spending. One describes the declining popularity of option ARMs, a shift that may force some marginal buyers out of the market, or at least down a notch. Higher short term rates should be squeezing this market, and limiting this source of consumer financing. Another article reports on tighter lending conditions in the market for condo construction loans. Note that these are tighter conditions for the builders, not the buyers. Still, if banks are worried about lending to builders, tighter conditions for buyers might not be far behind.

The Beige Book also points to a softening of consumer spending and housing. To be sure, there was plenty of strength reported in the Book, with overall activity expanding in most districts, including the manufacturing sectors, tightening labor markets, higher wages, and pressure to increase prices. Sounds like a recipe for higher interest rates. But consumer spending looked a bit tepid, seemingly in line with reports of cooling housing markets and mortgage activity.

What does all this translate into for the Fed? The strong data all point to additional hikes at the next two meetings. They paint the picture of a swiftly expanding economy with ongoing incipient inflationary pressures and appear to play into the more hawkish sentiments I opined on last week.

Still, the anecdotal and hard data on housing and consumer spending are sufficient to justify the concerns of many Fed officials that the statement needs to be modified (see last week’s post again). I still believe the Fed expects that their actions will work to slow the economy via housing and the consumer. There are indications that events are unfolding accordingly. Moreover, the incipient inflation pressures do not appears to be translating into actual inflation. This combines with the above to yield San Francisco Fed President Janet Yellen’s position that:

Two phrases in particular are at issue: "remove accommodation" and "at a measured pace." While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate, and other changes to the statement may be needed as well.

On the other hand, Fed Chair Alan Greenspan himself briefly passed judgment on economic performance as he began his comments on the budget deficit:

The U.S. economy has delivered a solid performance thus far in 2005. And, despite the disruptions of Hurricanes Katrina, Rita, and Wilma, economic activity appears to be expanding at a reasonably good pace as we head into 2006.

This struck a chord with me. “Reasonably good pace” seems a bit understated given the data. Is Greenspan going soft? But a quick Google search brought me around - Greenspan has used identical language in the past. From this past February:

All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored, ...

Apparently Greenspan sees 4+% growth as only reasonably good. Good enough that it justified a continuation of rate hike when inflation expectations were well contained. But Greenspan dropped the inflation praise this time around, despite a solid deceleration in core-PCE. Are we to conclude that the Big Man no longer believes that inflation is under control? I would have to say “yes,” and that at least he is not ready to shift to pull his foot off the brake just yet. Of course, one can read too much into a quick word by Greenspan. But he chooses his words carefully, and appears wary of sounding the all clear on inflation just yet. Not in his final months as Chairman.

In sum, tightening during at least the next two meetings will likely be required (from the perspective of Fed officials), but caution will be in order as well; the Fed does not want to overplay their hand, especially with so much tightening in the pipeline. This creates uncertainty about Bernanke’s first move. As I noted last week, data will be increasingly important – if the anecdotal data on consumer and housing pass through to the data and inflation stays tame, the implied message from the bond markets, Bernanke & Co. will feel comfortable standing pat in March. But if the data of recent weeks continues to mount, expect the new Chair to come to the table looking for another 25bp.  [All Fed Watch posts.]