« Does Fox News Change Votes? | Main | 60 Minutes: Bush, Cheney, Rice Told Iraq Had No WMD Program Before War »

Sunday, April 23, 2006

Fed Watch: I Need a Raise to Buy Gasoline

Tim Duy with his latest Fed Watch:

I need a Raise to Buy Gasoline, by Tim Duy: Well, maybe I don’t really need a raise just yet. I live about 4 miles from the office, and a tank of gas lasts me about three weeks of typical in-town driving. And the Department chair would probably just tell me to ride my bike, or use the free bus pass. So, while I may not be seriously looking for a raise just yet, I am willing to bet that most households are starting to get a bit more uneasy than myself. These high gas prices are looking more and more like a permanent situation, not just a temporary blip. Consequently, households will rethink their expectations. Should they seek higher wages to compensate for energy inflation (in addition, of course, to wages gains for rising productivity), or accept a reduced standard of living?

The latter choice, of course, will make households unhappy. And they don’t want to be unhappy. They would prefer that the economy remains strong enough squeeze employers for those extra wages before higher energy costs, not to mention the lagged impact of monetary tightening, become enough of a drain on economic activity, reducing their bargaining power. The race is on, and therein lays the policy dilemma for the Fed. Will the economy slow enough to offset the inflationary impact of higher energy prices in the back half of this year?

The expectation of Bernanke & Co., at least last Tuesday, was that the economy would ease back toward potential for the remainder of this year, reducing inflationary pressures. This was made clear in the minutes of the last meeting:

Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy.

Given the amount of tightening already in the system, most are becoming uneasy with blindly hiking away, especially considering the emerging evidence of a housing slowdown. Still, they recognize a need to hold inflation expectations in check, and that means a clear willingness to hike rates should inflationary pressures heighten unexpectedly. As I said last week, however, market participants were misinterpreting this vigilance for rate hike guarantees. The minutes disabused traders of that notion:

Several members were concerned that market participants might not fully appreciate the extent to which future policy action will depend on incoming economic data, especially when an end to the tightening process seems likely to be near. Some members expressed concern that retention of the phrase "some further policy firming may be needed to keep the risks...roughly in balance" could be misconstrued as suggesting that the Committee thought that several further tightening steps were likely to be necessary.

San Francisco Fed President Janet Yellen reiterated that theme with a speech the same day as the minutes were released. Most importantly, she provided us with her null hypothesis:

First, real GDP growth currently appears to be quite strong, but there is good reason to expect it to slow to around its potential rate as the year progresses. If it does, the degree of slack should remain within range of full employment and have little effect on inflation going forward. Although inflation is in the upper portion of my comfort zone, it appears to be well contained at present, and my best guess for the future is that it will remain well contained…Moreover, this desirable trajectory appears to be within reach at a time when the Fed's key policy interest rate—the federal funds rate—is close to a neutral stance, one that neither stimulates the economy nor restrains it.

She also explains how incoming data will affect the path of policy:

This phrase—"policy will be data dependent"—is all the rage right now in policy circles, but I think it's worth a moment to clarify what I mean when I use it. To me, it means that we should interpret the implications of incoming data for our forecast and evaluate whether resulting changes in the forecast call for a change in the policy path.

In other words, data should be read as to whether or not it changes the Fed’s view of output or inflation in the second half of this year.

But, the best laid plans of mice and men are so often unraveled by those small details. OK, perhaps not that small – markets were whipsawed by an ugly CPI report for March. FOMC hawks probably said a collective “I told you so.” For a minute by minute look at the fed funds action last week, you absolutely need to head to macroblog. Maybe inflation isn’t under control after all?

The CPI report itself, in my opinion, put the June rate hike back in play. And the surging oil prices further raises the stakes. I can confidently say that neither event was expected by the Fed. If they were expected, Yellen would not have gone out of her way to reinforce the minutes. All things considered, I would not be surprised to see upcoming Fedspeak sound more hawkish than the most recent minutes. And if the next CPI report supports the contention that the inflation is on a higher potential than previously thought, we will move from “possibility” to “probability” on a June rate hike.

The case for a June hike will be further supported if consumer spending looks to be holding steady, rather than easing back as the FOMC expects. The fate of consumer spending, however, depends on the path of income growth. Recall the close correlation between real personal consumption expenditures growth and real disposable income growth:

The two sharp deviations between the growth rates, in 1999-2000 and from roughly January 2005 onward, reflected the impact of rising energy costs. Arguably, households saw these episodes as temporary phenomena. Rather than adjusting spending growth downward, they held maintained spending patterns and drew down the saving rate (these periods often reflect the two sharp slides in saving rates).

Presumably, with saving rates hovering just south of zero and higher interest rates putting pressure on the ability/willingness to borrow, households will be looking to resolve this gap by adjusting spending downward (which makes them unhappy), or seeking additional wage compensation. The Fed appears to be expecting the former, that households will pull spending growth back in line with income growth. Alternatively, and just as well, that the gap closes due to productivity induced income growth.

But buying stuff is fun! And what good is a real wage increase if it can’t be matched by a real spending increase? Saving is boring. These, of course, are just alternative ways to reiterate that betting against the consumer is a dangerous play. Given that “resource utilization” gaps have closed, workers may be more eager to seek higher wages in the face of rising energy costs than we have seen in the last few years.

This latter scenario is not what the Fed is expecting, of course. Again, if they were expecting it, they would not be so eager to announce the end of the rate hike cycle is near. But the CPI report, with its jump in core inflation, and the fresh gains in energy prices will reinforce the positions of the FOMC’s more hawkish members while challenging the doves to revisit their outlook for the second half of the year.

    Posted by on Sunday, April 23, 2006 at 11:11 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (14)

    TrackBack

    TrackBack URL for this entry:
    https://www.typepad.com/services/trackback/6a00d83451b33869e200d834bbd6a869e2

    Listed below are links to weblogs that reference Fed Watch: I Need a Raise to Buy Gasoline:


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.