Fed Watch: Still Watching the Data

Tim Duy with a Fed Watch:

Still Watching the Data, by Tim Duy: Futures markets appear to have no clear conviction on the outcome of the next FOMC meeting. The message is that market participants are looking for one more rate hike, either in August or September. Moreover, they doubt the Fed’s position that “pause does not mean done.” That’s one of the messages from Jim Hamilton’s exposition on the yield curve. In fact, not only do market participants expect the next hike to be the last, they anticipate that the Fed will soon be rolling back the rate hikes.

The argument for another rate hike in August is straightforward – sure the economy is slowing, but is it slowing enough given that it is already bumping up against resource constraints? Moreover, with core-CPI posting four consecutive 0.3% readings, policymakers will appear to be accommodating higher inflation by failing to match it with higher interest rates, and thus will be setting the stage to fuel expectations of higher inflation. This essentially forms the backbone of my sense last week that the Fed was more likely than not to hike rates in August before pausing. The most recent employment, CPI, and industrial production reports, in my opinion are supportive of that position.

The counter-argument is that with the economy showing visible signs of slowing, particularly the combined housing/consumer sector, we are at an inflection point that calls for additional caution on the part of the Fed. Indeed, the composition of growth appears to be shifting in line with former Fed Chairman Alan Greenspan’s expectations. Consumer spending is easing, but investment spending is holding up while the external sector looks poised to contribute positively to GDP growth. The durable goods and GDP reports will help confirm or deny these trends.

Ultimately, the decision will rest on the forecast for inflation. And here, as many have pointed out, the housing story appears to cut both ways. Will the Fed be concerned about slowing housing activity, or the resulting inflationary impact via measurement issues?

I am not particularly sympathetic to the notion that the BLS consistently underestimates inflation by the use of owner occupied rent (OER) as a measure of housing costs. This would be an error if consumers thought of their homes as purely “shelter,” but they do not. If they did, they would not be so willing to pay a premium for owner-occupied housing relative to the rental alternatives. Instead, consumers view their homes as part shelter and part investment. It is perfectly reasonable for an index of consumer prices to simply focus on the shelter part of the consumer’s decision.

Of course, there is a reasonable position that argues that central banks should have a broader definition of price stability, one that includes asset prices as well as consumer prices. This would be the proper place to address the issue of house prices and monetary policy. In other words, the debate is not whether the BLS is accurately estimating inflation. The debate is really about what measure of prices the central bank should monitor, a narrowly defined consumer measure (that excludes food and energy) or a broad measure that includes asset prices.

I am also not particularly sympathetic to the latter position – I tend to believe it provides the central bank with too much influence in directing capital allocation decisions. Still, I recognize the opinions of those who believe that capital was essentially wasted during the internet bubble or, more recently, by excessive investment in residential housing. Note that the “waste” was likely greater in the former due to the more rapid depreciation of technology.

In any event, it appears clear that dynamics in the housing market helped depress measured consumer inflation until recently and now those same forces are working against the data. If the Fed were to be consistent, then they would not discount the inflationary impulse of rising OER. Indeed, they seemed perfectly happy with the inflation figures that were depressed by low OER growth. According to John Berry, however, consistency is not the order of the day:

Even if rents aren't the only issue, the causes of why they are rising so much mean that Fed officials do regard them somewhat separately from the other inflationary pressures at work. Essentially, the surge in rents is seen as a transitory phenomenon that will ease gradually.

This will appear to many to be gross cherry picking of the data, while others will be content to know that the Fed is carefully considering the data rather than reacting in a knee-jerk reaction to the inflation numbers. In any event, it would answer another question that had been posed to me: Why does the Fed expect core inflation to eventually moderate when growth is only expected to slow to potential, not below potential? They do see at least one component as separate from cyclical forces, and thus are more sympathetic to a pause in August then one would think given the recent run in the inflation figures. Still, I am not sure how far to carry this line of thought – as Berry noted, Fed Chairman Ben Bernanke clearly said that OER is not the only factor driving the rise in core inflation.

Also, John Berry describes the Fed’s thoughts about as “…probably their greatest single worry about growth right now.” I find this comforting, and would represent a clear shift in thinking at the Fed since this spring, when I noted:

From MarketWatch: “Poole said the financial press puts to much focus on "highly visible" sectors like the housing sector, even though it only amounts to a small fraction of overall GDP growth.”

In other words, I felt the Fed was discounting the housing slowdown, threatening to reveal that little had been learned from the Nasdaq meltdown. Clear evidence of a shift in consumer spending that coincides with a growing housing slowdown may be prompting a fresh look at the importance of the housing market on Constitution Ave. – another reason to look for a pause.

Likewise, on balance, I would have to place the most recent Beige Book in the “pause” column. Indeed, the collection of anecdotal evidence almost mirrors exactly the soft landing scenario: In general, economic activity is slowing on the back of weakening consumer spending and housing activity, but manufacturing activity remains solid, particularly for durable goods:

Among products, demand was especially vigorous for various durable goods. Substantial sales gains were reported for makers of electrical equipment and information technology products such as semiconductors, along with further increases in orders and activity for makers of commercial aircraft and products used for national defense. The reports also pointed to a further rise in demand for makers of heavy equipment, machine tools, and steel, offset in part by reduced demand for smaller equipment that is oriented towards residential construction activity.

In addition, intense competition and, in Dallas weaker demand, is holding back inflationary pressures. More “hawkish” FOMC members may seize upon “scattered indications of faster growth for some workers,” but their concerns will be tempered by more “dovish” members pointing out high productivity (meaning low unit labor cost growth).

Bottom line: The outcome of the August meeting still looks like a tossup, with current inflation data in competition with the magnitude of the slowdown. After being shocked by the forcefulness of the Fed’s inflation rhetoric in early June, I have been hesitant to move back to the “growth slowdown argues for a pause” story. Of course, that may be what exactly what Fed officials wanted to accomplish: To firmly establish their inflation fighting credibility before they take the long awaited pause.