Tim Duy with his latest Fed Watch:
Living on a Knife Edge, by Tim Duy: Big, big week for monetary policy. Today, we get the PPI figures. Tomorrow, Fed Chairman Ben Bernanke marches up to Capitol Hill for his Congressional testimony after getting a fresh reading on inflation earlier that morning. Unless the inflation numbers surprise on the downside, I am not confident that with oil staring at $80 a barrel, Bernanke can stick with a message that suggests inflation is under control. At the same time, with clear evidence of a slowdown evolving in consumer spending and a housing sector that is clearly on the rocks, Senators will want to hear that Bernanke is pulling his foot off the pedal. Financial markets are split pretty evenly between expectations of another hike or a pause next month; tomorrow’s events could shift the tide decisively in one direction or the other.
This, of course, is the proverbial rock and the hard place. Instinct tells me that the risk is that unless the inflation figures come in below expectations, Bernanke will come down sounding hawkish. He, like virtually all central bankers these days, will tend to fear inflation more than slow growth – and that would set the stage to push expectations toward another rate hike in August.
The US consumer is on the ropes. The stress was obvious in the May personal income report, which again showed households struggling to maintain spending by continuing to deplete their savings. And we have little reason to believe the situation is improving; retail sales were below expectations in July. Note that these are nominal figures – a paltry gain in prices will effectively wipe out any potential real gains. Moreover, as Calculated Risk notes, industry insiders are not expecting their customers back anytime soon, if retail sector job growth is any indicator. Notice too that Target just warned on their July same store sales; the stock slipped 3.2% in after hours trading. The future isn’t looking much brighter, with the expectations of large ARM resets looming heavily in our collective inner-bear.
But, do recessions originate in consumer spending? Or is investment spending the culprit? The Fed will side with the latter interpretation, and in looking for evidence of a recession inducing investment reversal, I suspect they will come across the following charts:
The first two are familiar indicators of core investment intentions. Orders for capital goods excluding aircraft and defense are maintaining their upward trend. Backlogs continue to grow as well, a sign that firms are struggling to keep up with demand, suggesting the need for capacity expansion via, you guessed it additional investment. In this light, yesterday’s strong industrial production report is also supportive of another rate hike.
The last chart is the ratio of corporate cash flow to nonresidential investment. Firms can satisfy all of their current investment spending, and them some, without resorting to financial markets. Under such circumstances, additional rates hikes, or market gyrations, will likely have a smaller effect on firms’ investment behavior.
But will investment hold steady if the consumer starts to fade? Plenty of cash just means firms can invest, it doesn’t mean they will. And isn’t the consumer spending slowdown enough to pull growth down to potential, thereby lessening the inflationary pressures? This was, in a nutshell, the story from the last FOMC statement, as well as the argument for a pause in August. Not a bad argument, at that, one that John Berry makes in this piece, concluding with:
Fed officials have been focused on making sure that the energy price shock doesn't spill over into core inflation, and so far they have been successful. That means that if oil prices do stabilize then headline inflation will decline. And the risk of that spill over will be gone.
Given the steady upward trend in oil prices over the past few years, one would think that we would have to sit through more than one FOMC meeting to conclusively say that oil prices are stabilizing. Not to mention that since the June FOMC meeting, oil prices have climbed higher, hitting fresh records. That may be just a knee-jerk reaction to the Middle East conflict, but I can’t help but think back to Richmond Fed President Jeffery Lacker’s comments:
“Moreover, focusing on real interest rates draws attention to how and why policy must respond; real interest rates must fluctuate to accommodate changes in the relative pressure on current versus future resources. Widespread understanding of this would have aided the market response to Katrina; the storm impaired the supply of current resources relative to the future, and so, if anything real interest rates had to rise, not fall.”
Does it matter if oil prices are higher due to a hurricane in the Gulf of Mexico or the Middle East conflict? Of course, the US economy looked healthier when the hurricanes struck last summer, and the resulting damage also knocked back refinery capacity. But this latest jump in oil prices comes at a time with elevated inflation numbers, and the expected weakening of inflationary pressures has yet to fully emerge. If the Fed holds back from another rate hike now, isn’t it the same as accommodating a fresh rise in oil prices? Will the more hawkish members of the FOMC be willing to accept that? And note that although financial markets have been agonizing over the state of the economy, Minneapolis Fed President Gary Stern is sounding rather complacent. Not surprising, considering that the economy has weathered a number of crises over the past few years.
The core of the debate continues to be the race between inflationary pressures and growth moderation. I buy the story that many FOMC members want to pause, but I think such a decision will depend more on soft inflation readings over the next three weeks rather than soft growth readings. Bernanke’s testimony will be a key is setting expectations of the next FOMC meeting. Also the Fed is likely less concerned about the health of the economy than financial market participants, suggesting that Bernanke will surprise on the hawkish side.