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Sunday, March 05, 2006

Fed Watch: Comfortable With Expectations

Tim Duy's Fed Watch:

Fed policymakers keep repeating that policy is now data dependent. That’s great – as long as all the policymakers agree on what the data is telling them. But what if unpredictable weather is leaving the data murky? As David Altig brings to our attention, Greg Ip of the Wall Street Journal believes that is the case, adding a bit of uncertainty into the policy making process. But I have a problem with this article – I simply don’t believe that Fed officials are worried they can’t discern the underlying state of the economy. Take for example, outgoing Vice Chair Roger Ferguson:

“Indeed, the most recent data suggest that economic activity in 2006 is off to a solid start. Payroll employment expanded briskly in January--the latest month for which figures are available--on top of sizable gains over the preceding two months. Although these increases contain some bounceback from the effects of the hurricanes, they also likely reflect underlying strength in labor demand--an impression that is corroborated by the recent low readings on initial claims for unemployment insurance. In addition, the underlying pace of activity in the industrial sector has been quite robust recently. Real household spending continued to climb in January; although unseasonably warm weather that month left an imprint on the data, the result suggests some underlying strength in this sector. Housing activity has, on balance, been a bit softer recently but still remains at a high level….Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying productivity growth remains strong, the financial positions of households and businesses remain conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher energy prices should diminish over time.”

Does he sound like he is confused about the weather? No, it sounds like he is confident that the teams of economists in the Federal Reserve System can manage this signal extraction problem. Ferguson is more concerned with reading the direction of the housing market than interpreting the data. As far as inflation is concerned, he acknowledges the relatively low pass-through of energy prices to core-inflation, and attributes it to better policymaking:

“…the Federal Reserve has been more aggressive in fighting all sources of inflationary pressures, including energy price changes. This effort appears to have paid off not only in low and stable inflation but also in a reduction in the sensitivity of long-run inflation expectations to energy prices. The reduced sensitivity is evidenced by how little movement has appeared in survey measures in response to the rise in energy prices over the past two years.”

This praise for past policy suggests that Ferguson would be willing to error on the side of additional tightening in light of his relatively solid economic outlook.

Of course, we will never know if that will be the case, as Ferguson will not be with us for the next meeting. But his thoughts remain relevant; he likely represents something close to a middle ground among remaining policymakers. For an even rosier look at the economy, read Minneapolis Fed President Gary Stern’s comments to MarketWatch. Some choice quotes include:

“I'm pretty positive about the outlook."

"At the end of the day, I think the economy really isn't fragile at all.”

"My sense of things is the attention being paid to [the housing market] may be exaggerated."

Also doesn’t sound confused about the weather. Stern is clearly less concerned about housing than Ferguson, and more concerned about the downside risks of excessive rate hikes, although a quarter point in either direction won’t make much of a difference. Stern is more dovish on inflation than Ferguson, but notably admits that he is (was) an outlier on the FOMC. So if the “outlier” would be ready to stop hiking rates, the median FOMC member is more comfortable with the expectation of two more rates hikes in this cycle.

Of course, we can guess this is fine with the Chicago Fed President Michael Moskow, whose February 10 speech is channeled via Mark Thoma:

"The economy is operating close to potential,'' he said. "We need to carefully monitor for the emergence of any economy-wide resource pressures.''

I see little to believe that he will have changed his tune since then. The tone of data and Fedspeak is consistent with additional rate hikes ahead – I simply get little sense that policymakers are unhappy with expectations of a 5% Fed Funds rate by May.

And I get little sense that the data are about to go South on us. Yes, I know that retail sales were a little sloppy in February. But I think you have to be wary about overanalyzing every blip in the consumer spending data. The most productive way to analyze this sector is on the back of a very simple assumption: Households want to spend. The desire lies at the very core of their beings. After all, you can never have too many big screen TV’s, can you? It is not the willingness to spend, it is the means to spend.

Wage and employment data suggest that the means to spend continues to grow. The latest BEA personal income release revealed that private wage and salary disbursements gained at an 8.7% annualized rate in January. True, these gains were partially eroded by inflation, but they still represent a solid base to support spending. Of course, the expectation remains that a cooling housing market will eliminate some of the means to spend. This, however, is already on the radar at the Federal Reserve. On this point, the Fed’s relatively benign outlook will not change, all else equal, until we deviate from the conventional wisdom, as reported by Kash at Angry Bear, that housing is slowing but not crashing.

Remaining data over the past couple of weeks have been, in my opinion, nothing less than solid. As reported by Econbrowser, there is no reason to panic over January’s sharp 10.2% drop in durable goods orders. The more reliable subcategory of nondefence, nonaircraft capital goods orders dropped a mere 0.4% after a blockbuster 5% gain in December. Moreover, unfilled orders continued their steady upward progression; suppliers simply cannot keep up with incoming orders for capital equipment. The pace doesn’t look likely to let up anytime soon; according to the Business Roundtable (via the Wall Street Journal) CEOs are signaling their intention to boost capital spending this year, as well as hiring.

The Institute of Supply Management reports on both the manufacturing and service sectors also reported solid economic growth. While again urging caution against reading to much into one month of data, the manufacturing sector look set for additional growth, with new orders up and the supply chain tightening with deliveries slowing, customer inventories too low, and backlogs increasing. Not surprising, then, that the Business Roundtable is expecting additional capital spending. As far as the service sector goes, the February rebound revealed that January’s drop was an aberration.

The big report this week is the February employment release. Analysts are hotly debating the impact of February’s snowstorm on the numbers. I assume the BLS will chime in on the debate when the report is released, if necessary. Again, this becomes a signal extraction problem for the Fed. Given that the tone of data has remained robust, a weaker than anticipated report will likely be seen as a weather-related aberration. This has been the Fed’s modus operandi in the past, and I see no reason for that to suddenly change this week.

Bottom line: I doubt Fed policymakers are terribly worried they have lost track of the economy. Such concerns are simply not reflected in Fedspeak; the uncertainty remains on more prosaic concerns, such as housing and energy. There is nothing to indicate that the Bernanke & Co. are unhappy with the expectations of additional tightening built into the markets. 
[All Fed Watch posts.]

Update (from Mark Thoma): John M. Berry at Bloomberg weighs in with: Fed's Stern Doesn't See Inflation Accelerating

    Posted by on Sunday, March 5, 2006 at 12:51 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (1)


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