Tim Duy with a Fed Watch:
For the Fed watcher, the 4Q05 GDP report is a real brainteaser. The central focus of the many, many blogs covering Friday’s news was the disappointing growth numbers (see William Polley’s and James Hamilton’s views, the latter including a long list of similar concerns). To be sure, the weak headline number deserved attention. But I was surprised by the relatively little attention placed on the inflation reading. I doubt the Fed is going to let that number slip by so lightly. Weak growth and higher inflation? Now that’s interesting.
But before I get ahead of myself on the inflation topic, we need to think about how rattled the Fed will be by the growth decline. For this slice of the data, I will concentrate on the contributions to GDP, following in Hamilton’s footsteps with a closer look at the underlying numbers. Let’s toss out the consumption side of the story:Pctg. pts. (annual): 2004 2005 05Q3 05Q4
Personal Cons. Exp. 2.71 2.49 2.85 0.79
Durable goods...... 0.51 0.37 0.76 -1.56
Motor veh./parts. 0.06 -0.04 0.45 -2.06
household equip. 0.34 0.28 0.37 0.35
Other............ 0.10 0.13 -0.06 0.14
Nondurable goods... 0.94 0.90 0.73 1.04
Food............. 0.48 0.49 0.61 0.51
Clothing/shoes... 0.17 0.17 0.08 0.28
Gas, fuel oil, and
energy goods.... 0.03 0.04 -0.11 0.07
Other............ 0.26 0.20 0.15 0.17
Services........... 1.27 1.22 1.36 1.32
Housing.......... 0.30 0.24 0.20 0.18
Household oper... 0.07 0.11 0.17 0.08
Elect./gas..... 0.03 0.06 0.10 0.02
Other.......... 0.05 0.05 0.08 0.06
Transportation... 0.03 0.04 0.05 0.11
Medical care..... 0.49 0.56 0.66 0.61
Recreation....... 0.11 0.06 0.02 0.08
Other............ 0.26 0.21 0.26 0.26
The end of the consumer? Oh, don’t get me wrong, the household spending slowdown will be coming. I am not sure how else the imbalances in the economy, summarized by the current account deficit, are resolved. But I am not so confident I see that adjustment in these numbers. No, seriously – the only component that looks out of whack is motor vehicles and parts. And none of us are really surprised too much here. Moreover, the Fed will look at that and note that if car sales simply stabilize in 1Q06, they will contribute nothing to GDP growth, about what they contributed in 2004 and 2005. This is not a make it or break it issue for Greenspan & Co.
For a very different perspective on the importance of the auto industry, see Jim Hamilton. I will only add that if you think it important that some rebalancing of economic activity occur to resolve the US current account deficit, then some category of household spending is going to have to take a hit. Perhaps others see a different way out, but I tend to think any rebalancing is going to involve some…how does one put it?...unpleasantness.
Much more important is the investment side of the story. Conventional wisdom, which I believe the Fed shares, is that investment swings drive business cycle fluctuations. And Fedspeak has clearly revealed policymaker’s expectation that investment spending will hold strong in 2006. They will be surprised if a different story evolves. More specifically, nonresidential fixed investment is the key here – the expectation at the Fed is that residential investment will ease this year. On to the tables:Pctg. pts. (annual): 2004 2005 05Q3 05Q4
Fixed investment... 1.47 1.28 1.31 0.51
Nonresidential... 0.92 0.87 0.88 0.30
Structures..... 0.06 0.05 0.06 0.02
Equip./soft.... 0.86 0.82 0.82 0.28
equip./soft. 0.49 0.48 0.42 0.34
Comp./equip. 0.19 0.24 0.11 0.26
Software... 0.11 0.17 0.14 0.13
Other...... 0.19 0.08 0.17 -0.05
Ind. equip.... 0.04 0.08 0.20 0.13
Trans. equip. 0.15 0.16 0.18 -0.27
Other equip. 0.18 0.09 0.02 0.07
Residential..... 0.55 0.42 0.43 0.21
I suspect this will puzzle policymakers more than the consumption figures. Is the weakness in nonres investment a fluke? The weakness is not widespread, and not like the massive swing in 3Q00 (was it that long ago?) in the equipment and software category. What about the transportation component? Is that related to the auto fallout we saw in consumption? Note that the Beige Book reported tight transportation markets, and expectations of more capital spending. Also, the story in the GDP report is just not consistent with last Thursday’s durable goods release, which revealed strong shipments of capital goods in 4Q and, bolstering the expectation that this was a one off event, a solid 3.5% gain in non defense, non aircraft capital goods orders in December. All in all, I think the Fed will be cautiously optimistic that the weak investment figure was an aberration. Given the other data, it won’t put them on hold this week, but they will be watching a bit more closely during the run up to the March meeting.
I will refrain from a long analysis on the inventory adjustment. If you are bearish, the inventory gain signals that the end is near with firms seriously misjudging demand. If you are more on the optimistic side, firms are confident about the future. The Fed will not likely place much emphasis on either story; instead, they will simply note that inventories were drawn down the previous two quarters, and many expected that trend would be reversed in the fourth quarter – nothing ominous, nothing exciting.
The swing in defense spending was hurricane related – see Gerald Prante via Mark Thoma. Not much policymaking meat here.
For some analysis of the trade figures, see Brad Setser and Menzie Chinn. At least one policymaker, New York Fed President Timothy Geithner, views the current situation as unsustainable (others do as well), but notes that it is not an appropriate focus of monetary policy. The solutions lie outside, far outside, those hallowed halls on Constitution Ave:
For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings, and the necessary slowing in U.S. domestic demand growth relative to growth of U.S. output, would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. Reforms to financial systems and to social safety nets over time would help reduce the need for exceptionally high levels of domestic saving we see in many countries.
The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others. If we focus adequate political capital on the factors within our control, we will have more credibility internationally in encouraging policy changes outside the United States that might reduce our collective risks in the adjustment process ahead.
Is that all?
Monetary policy doesn’t have a direct role in addressing this imbalance, according to Geithner. Of course, the Fed needs to be aware that the globalization of capital flows may be holding longer term interest rates lower than normal, complicating efforts to calibrate monetary policy (read as: the yield curve is no longer an accurate predictor of recessions). But that’s about it – policymakers are left with the chore of maintaining credibility in the event the US current account adjusts in a disruptive fashion. And maintaining credibility means keeping your eye on the prize, a focus on low and stable inflation.
(I know that many feel the Fed had a role in the creating role in creating the deficit by flooding the world with cheap money, and Geithner’s speech leaves the Fed unaccountable. I am only the messenger.)
Ah yes, it all comes down to inflation. And now, after two quarters of declining core-PCE inflation, we pop back up to an annualized 2.2% rate. If you saw weak growth in this GDP report, you should be especially unhappy with this inflation reading – it suggests that visions of a Fed pause are not quite as simple as a disappointing headline number. As Greg Ip at the WSJ notes, this is “around the top of incoming Fed chairman Ben Bernanke's comfort zone of 1% to 2%.” Are we seeing some pass through of this summer’s high energy costs? Very possibly, and policymakers will not like this, especially with oil within striking distance of $70. Firms that thought this summer’s energy surge a temporary phenomenon may start thinking that it is time to get more forceful about pushing higher prices onto customers. So far, pushing higher prices down the line hasn’t been easy, and the Fed will want to keep it that way – especially with signs that some firms, like Proctor & Gamble (WSJ subscription) are getting away with it.
I think the bond markets summed this up nicely on Friday. Interest rates ended just about where they began. Yes, headline GDP was weak, and red flags were raised, particularly in investment spending. But, from the Fed’s perspective, no smoking gun, especially when placed in light of higher frequency data. Couple that with higher inflation and the combination suggests little change in the course of policy – one more tomorrow, with slightly better than even odds on a March hike.
Hopefully the final statement of the Greenspan era will provide a clearer path to March. But I tend to think they will be waiting on data to guide them, just like the rest of us. [All Fed Watch posts.]