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Sunday, January 22, 2006

Fed Watch: Ready to Invert

Tim Duy with his latest Fed Watch:

I had previously believed that the Fed would not purposefully invert the yield curve (in this case, the spread between the 10 year and the Fed Funds rates). I had thought that whatever economic environment would drive tighter Fed policy would drive long rates higher. But it looks like inversion day is coming, barring some near term changes in the bond market. Moreover, the Fed looks to be sending a very specific signal: Even if we do pause at the March meeting, our bias remains tilted toward inflation. A solid economy and rising energy prices means it is too early to call off the dogs. In my opinion, policymakers do not want investors to get the idea that a pause in rates signals an imminent rate cut. Instead, they are signaling that without a more dramatic change in the economic environment, the odds remain tilted toward more tightening in the post-Greenspan era.

As this post kept getting longer and longer, a quick outline of my take on the Fed’s position is in order:

  1. Overall, economic activity is quite healthy.
  2. Consumer spending cooled at the end of last year, but Fed officials don’t seem particularly worried.
  3. Housing is cooling as well, but not uniformly, and not in such a way as to suggest a crash is coming.
  4. The expectation continues to be that firms will step up capex spending.
  5. Resource utilization continues to be a concern.
  6. A cessation in rates hikes should not be interpreted as the first step toward cutting rates.

The Beige Book was, in my opinion, somewhat hard to get a handle on. Mixed messages were common, leaving open the possibility of cherry picking little bits and pieces to support whatever story you want to tell. With that in mind, I concluded that the anecdotal message was that despite some cooling in housing and consumer spending, economic activity continued its solid expansion. And while prices pressures remain contained, there are enough signals of potential inflationary pressures to keep policymakers on their toes.

I was somewhat surprised by the benign impressions of consumer spending given wide expectations that Q4 GDP will look soft due to a weak household spending component. Moreover, the slowdown in the housing market appears to be evolving as planned, with pockets of cooling somewhat offset by pockets of heating up – including an acceleration in Oregon (Oregon is relatively inexpensive compared to other West Coast states). This pattern will support the underlying contention at the Fed that the housing “bubble” is not likely to pop with the same consequences as the burst of the technology bubble. The auto industries woes are still evident – no surprise here. But outside of that, not much of concern to policymakers and reflective of the quiescence we see in FedSpeak.

Consistent with the December employment and industrial production reports, manufacturing activity looked solid:

Increases in manufacturing activity were widely reported across the country. Only the St. Louis District characterized industrial activity as mixed. Elsewhere, robust expansion was reported in the San Francisco, Dallas, Kansas City, Minnesota, Chicago, New York, and Boston Districts. More moderate expansion was indicated in the Cleveland, Richmond, Philadelphia, and Atlanta Districts.

So it looks like, via both anecdotal and data evidence, that resource utilization from the physical capital side of the equation is on the rise – this is evidently important to at least one governor, as we will see a bit later. What about the labor side of the equation? Here it is worth repeating the relevant section from the Beige Book overview:

Most Districts reported signs of continued, if generally moderate, increases in employment. Cleveland, Minneapolis, and Richmond all cited moderate employment gains, with Richmond noting that its rate represented a slowdown. New York, Atlanta, Kansas City, and Dallas reported evidence of stronger employment growth. However, Boston noted that output growth had generally not translated into higher employment, while St. Louis reported a widely mixed pattern of layoffs and hiring. Hiring at financial and legal services firms is boosting the New York District's employment growth, although New York also reported some hiring in manufacturing. Atlanta reported strong demand for both skilled and unskilled labor, in part boosted by storm-recovery efforts.

Atlanta reported several locations with tight labor market conditions, while Boston, New York, Philadelphia, Chicago, Kansas City, Dallas, and San Francisco all reported specific occupations in which jobs have been difficult to fill. Several of these Districts cited trucking jobs. Skilled construction workers are relatively sought after in Dallas and San Francisco, and skilled manufacturing jobs were mentioned by Boston, Chicago, and Dallas. Atlanta listed a variety of specialties in "extreme shortage." New York and San Francisco noted that finance-industry labor markets were relatively tight. Despite reports of labor market tightness, Boston, Philadelphia, Minneapolis, Kansas City, and San Francisco all noted that wage increases have been generally moderate. However, New York, Chicago, and Dallas all reported some acceleration in compensation.

Mixed messages here – St. Louis and Atlanta appear to be on opposite ends of the spectrum – but the story seems to point to a strengthening labor market with accelerating wage gains in some locals. Will this acceleration spread? In the current environment, I would say this is a good bet. Note that jobless claims, a leading indicator, have fallen to a six year low. Will the Fed be unhappy, from an inflation perspective? Maybe. As always, the answer to this question depends on pass through. The Fed will be most concerned if they sense that pricing power is emerging that will allow firms to raise prices to offset higher wages. If not, then rising wages would reflect productivity gains. Nothing bad about that – it would simply indicate that the short run data is catching up to the long run theory.

On, then, to the inflation story. Note that the report on trucking and shipping has the feel of emerging transportation bottlenecks:

Trucking and shipping demand remained strong across the country, but companies were constrained by continuing driver shortages in the Atlanta, Cleveland, Chicago, and Philadelphia Districts. In addition, despite the ongoing use of fuel surcharges, contacts in Cleveland, Dallas, and Atlanta noted that margins tightened because of fuel-cost increases. Cleveland and Dallas reported plans for increased capital spending in the trucking industry. Dallas also reported that both railroads and airlines saw rising demand.

Would such bottlenecks, rather than the overall capacity utilization rate, both Fed officials? I think we will see the answer is yes. Moreover, the Fed appears confident that firms are in fact trying to pass on higher costs – leading one to believe that tighter labor markets would only add to such pressure. In the end, though, the inflation line is holding. For now, at least:

However, in the remaining nine Districts, nonlabor-input-cost increases continued to concern companies, particularly those in the manufacturing sector. Producers were reported to have attempted to recoup these costs, although, according to the Atlanta, Boston, San Francisco, and Dallas Districts, intense competition was thought to be holding down price increases in parts of the supply chain further "downstream."

In addition, keep watching the energy market. It is looking like the easing in the energy prices early this winter is being reversed, especially with regards to oil. It is easy to write this off to the tension with Iran, but note that commodities in general have continued to be strong – suggesting a common underlying dynamic is in play. Given the solid economic environment, the Fed will likely continue to see oil as an inflationary, not recessionary, threat.

For the FedSpeak, I want to first draw attention to Fed Governor Susan Bies speech. Notably, she touches on the bottleneck concern I alluded to earlier:

Futures markets currently expect only limited increases in the price of crude oil this year. Nevertheless, tight resource utilization is likely to put pressure on prices. The unemployment rate, at 5 percent in the second half of 2005, was down about 1 1/4 percentage points from its recent peak in early 2003 and at its lowest level in four years. Meanwhile, the factory operating rate--a measure of resource utilization in the manufacturing sector--was 79.6 percent in December, a rate that is approaching its 1972-2004 average of 79.8 percent. Within manufacturing, industries operating at utilization rates above their long-run averages include plastics and rubber products, iron and steel products, machinery, electronic products (excluding computers), and electrical equipment, appliances, and components. And although the overall high technology aggregate is below its long-run average rate of utilization, the operating rate at firms making computers and peripherals is above average, and the rate at manufacturers of communications equipment has risen significantly over the past year. As in the mid- to late-1990s, resilient productivity growth appears to be helping contain the inflationary pressures that might otherwise be expected to accompany a narrowing margin of resource slack. That said, we at the Federal Reserve will remain vigilant for any sign of a deterioration in the inflation outlook.

Clearly, she remains focused on the unemployment rate rather than other measures of the labor market, and concludes that it is sufficiently tight to keep inflation worries on the front burner. Moreover, the identification of specific industries in the speech is an important insight into Bies thinking. She is effectively saying that while overall manufacturing is just approaching its average utilization rates, specific sectors are already above average – suggesting the possibility of bottlenecks. Is overall utilization the important variable, or can bottlenecks in the supply chain be the inflationary trigger? You be the judge, but I bet the Bies shares the latter interpretation. Also note that in her speech, Bies remains optimistic that while bottlenecks imply inflationary pressures, rising utilization and healthy cash flow will support capex spending in the months ahead.

Bies appears to share the same outlook for healthy growth next year as Richmond Fed President Jeffery Lacker in his speech last week

It is a pleasure to be with you today to discuss the economic outlook for 2006 and beyond. It is a pleasure, in part, because the economic outlook is fairly encouraging. Growth is on a solid footing, despite this year’s run-up in energy prices and the disruptions of a devastating hurricane season. And after a brief pause this fall, employment is expanding again at a healthy pace, consumer spending continues to grow briskly, and business investment spending is robust. Granted, housing activity seems to be softening, and at least some potential price level pressures remain, so it may be too soon to break out the champagne. But inflation expectations remain contained, and we at the Fed are well-positioned to resist inflation pressures, should they emerge.

So all in all, it is quite a good outlook.

Wait a second, it might be too soon to break out the champagne, but he doesn’t sound too concerned about inflation. By the way, where is the inflation? David Altig’s colleague, Michael Bryan at macroblog, appears to be breathing a sigh of relief regarding the inflation outlook. And policymakers keep talking about inflation pressures (Lacker reiterates it is too early to conclude that the inflation risk is behind us), but don’t they need some evidence that the genie is actually getting out of the bottle to justify higher rates now that we are near neutral? Not so, according to Lacker:

As I have emphasized elsewhere, a real interest rate is a relative price — the price of current resources relative to the future resources one either forgoes by borrowing or obtains by investing. Real interest rates need to respond to changes in the relative pressure on current versus future resources.

Unpredicted movements in economic fundamentals, to the extent that they affect the relative pressure on current and future resources, thus will have implications for policy rates, even in situations in which inflation and inflation expectations are low and well-contained.

He reiterates this point in his conclusion

Thus, whenever the current sequence of tightening moves reaches completion, short-term interest rates should not be expected to remain constant for an extended period of time. Instead, they will likely move from time to time during the expansion ahead.

Policymakers will need to be alert for movements in economic fundamentals that shift the relative pressure on current versus future resources in ways that require changes in real interest rates, even if inflation pressures subside.

Read that again if you didn’t catch it the first time – even if inflation keeps under the radar, we need to be concerned the that future resources not be excessively drained to satisfy current wants. The Fed thus needs to keep policy aligned with the real economy even if inflation is in check. In other words, don’t expect the Fed to just sit still if rates are near “neutral” and inflation is in the target range.

Now, if all that doesn’t convince that the Fed holds an internal inflationary bias, just ask San Francisco Fed President Janet Yellen, via Mark Thoma’s report of her January 19th speech:

''I'm pretty comfortable with the inflation outlook,'' Yellen said today in response to an audience question after a speech to economists in Los Angeles. The risk of it speeding up is ''skewed slightly to the upside.'' She didn't elaborate on the risks.

More directly:

''Given what I know and what I've seen about the economy'' and ''based on the data that I'm looking at, probably, yes,'' the Fed is near the end of its current series of rate increases, Yellen said in response to a question. At the same time, she said the Fed is ''not finished'' with rate increases.


Yellen said yesterday that ''we have an economy that's operating somewhat above trend.''

Skewed slightly to the upside indeed, sounds like macroblog’s probabilities, are pretty accurate (traditionally, we get a new reading on Mondays). Next week another hike looks like a lock, and with policymakers holding the view that the economic is solid and inflation somewhat more likely than not, the risk remains better than even that Bernanke & Cos. first move is another hike. At a minimum, the Fed wants market participants to believe that even if the first Bernanke move is a pause, don’t be surprise if a hike does occur at a later meeting. From their perspective, they are not yet seeing conditions that justify sending an all’s clear signal. [All Fed Watch posts.]

    Posted by on Sunday, January 22, 2006 at 05:08 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (4)


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