Tim Duy with his latest Fed Watch:
Finally – Some FedSpeak, by Tim Duy: Presumably, the Fed remains data dependent. Market participants, however, largely don’t see it that way. Increasingly, the view is that the Fed is done – as of today, odds for another rate hike in September stand south of 20%, and, with rates on the 10 year Treasury drifting to 4.8%, it looks like the mood has firmly swung to an expectation that the next shift in policy will be a rate cut. I doubt the Fed is ready to admit victory on the inflation front so quickly, last week’s CPI and PPI numbers not withstanding. Nor, as we have seen from recent Fedspeak, are they ready to embrace the recession story. But the slowdown in consumer spending is likely weighing heavily on their thoughts. Heavily enough that they will hold rates steady in September, while still signaling their inflation unease.
Recent Fedspeak is best described as minimal. Last week Dallas Fed President Richard Fisher stepped up to the podium, but revealed little new in Fed thinking, simply noting the tight spot between accelerating inflation and slower growth. The only new information one could glean from his speech was when he described recession-minded analysts as “Eeyores.” Such a dismissive remark can only suggest that the idea of a rate cut is furthest from his mind. That said, Fisher’s “eighth inning” remark lingers in everyone’s minds – perhaps the best strategy is to bet against Fisher, and side with the “Eeyores.” Similarly, Calculated Risk takes on Fisher’s optimistic view of the Texas housing market.
More interesting were Chicago Fed President Michael Moskow’s hawkish sounding remarks on Tuesday. Here there was a clear message: Pause does not mean done. Simply put, Moskow still sees the risks of high inflation as greater than slower growth. I can’t say I find this as a surprise, considering that Moskow sees the evolving slowdown as incredibly mild with growth sliding comfortably back to potential. Also note that he reiterates his view that potential growth is consistent with a monthly NFP gain of just 100k, and that he dismisses signs of weakness in the second quarter GDP report as “due to transitory and one-off events, such as the timing of shipments in transportation and communications equipment.” And he sounds very complacent about housing, much to CR’s displeasure. Like Fisher, Moskow is not ready to buy into the Eeyore story – keep this in mind, as I suspect the Fed will be the last people to believe the economy has turned uncomfortably slow.
On the inflation front, Moskow says something intriguing:
And perhaps most importantly, inflation expectations could rise. Indeed, in recent weeks some financial market observers have questioned what a 1 to 2 percent inflation comfort zone means when core inflation has been above 2 percent for so long.
This could be read as a thinly veiled assault on FOMC policy (and I bet the Richmond Fed’s Jeffery Lacker agrees). After all, the Fed’s forecast, which presumably they can do something about, calls for core-PCE to remain above 2% through 2007. If Fed Chairman Ben Bernanke is accepting of being above the comfort range inflation for two years, why not three? Four? And if 2.25% is acceptable, what about 2.5%? These are questions we would want answered if the Fed were to move to a more formal inflation targeting scheme.
Of course, outside of handful of die-hard inflation worriers, that issue appears to be largely academic. The bond market greeted Moskow’s remarks with what amounted to a resounding yawn. The focus has shifted to the magnitude of the slowdown, while inflation concerns are lingering in the background in the wake of relatively quiescent July CPI and PPI readings. To be sure, it is easy to argue that these numbers were not so tame on closer examination. It was widely noted that CPI inflation was kept in check by declining apparel prices, and Barry Ritholtz noted the transportation impact on the PPI. David Altig also was “not quite impressed” after digging into the data here and with a follow up here.
I tend to believe that the headlines simply give the Fed a chance to catch their breath; the interior details still argue for caution (hence the Moskow speech). But then why do the bond markets keep insisting on driving the yield on the 10 year Treasury lower? Barry Ritholtz (again), is sympathetic to the view that market participants, having been lured into complacency on the inflation front, are simply “wrong.” I hesitate to believe that market participants can be described as “wrong” in the current situation. Instead, they accept the view that the Fed will sacrifice growth to keep inflation in check. Or, as the yield curve inversion appears to indicate, that the Fed has already done so, and with the economy slowing significantly, inflation will follow.
And what about that slowdown? As we have already seen, that story is meeting resistance on Constitution Ave. Again, I am not surprised. To be sure, policymakers have an eye on the housing slowdown, but I just doubt they feel much urgency. Certainly, not as much urgency as the current archetypical Eeyore, Nouriel Roubini, whose recent writing leaves me thinking about liquidating all my assets and rebalancing into a “diversified” portfolio of dry goods, gold, guns, and ammunition (which in Oregon would not be considered out of the ordinary).
Away from the extremes of the Fed and Roubini, it is hard to ignore the deepening housing slowdown and the pain it will impose on an already overextended consumer – note today’s page one story in the WSJ. Further caution on household spending comes from the August reading on consumer confidence from the University of Michigan. The combination of a jump in inflation expectations and a slide in the index was certainly discomforting, and leaves one to believe that the July inflation reprieve will be short lived.
Moreover, I think the numbers call into question the persistence of the consumer revival seen in the July retail sales data. To be sure, the retail sales report appeared to be something of a blow to the Eeyores, and, by moving the third quarter base higher, quickly led economists to up their forecasts. But the consumer confidence report suggests the uptick in spending is likely short lived. I believe that the drop in the expectations component (from 72.5 to 64.5) indicates that consumer spending sagged in August – households simply feel miserable when they aren’t spending.
And why aren’t they spending? Don’t they want to? Are they afraid to? I don’t believe that consumer slowdowns happen because households don’t want to spend. You can never have too many plasma TVs or granite countertops. No, households stop spending when their resources are drained. With the housing market steadily becoming unglued, the easy money is drying up. And after inflation, wages gains are not accelerating fast enough to make up the difference. The consumer is on the ropes, and likely to stay there for a long time.
Outside of the housing market, the auto industry is shaping up to bear the brunt of the consumer’s misery. Sure, some retailers will disappoint, but when push comes to shove, what are you more likely to give up, a Venti latte or a new car to replace the one you just bought two years ago? The car. Ford and GM sold today’s car two year’s ago, not to mention that their product lines are sadly misaligned with a new era of higher gas prices. No surprise then that Ford is cutting fourth quarter production (which, by the way, should drag on GDP). Unfortunately for the Rust Belt, the damage to the auto industry is likely to be localized – David Altig brings us some warning signs.
But I will leave you with some more upbeat news – news that will keep the Fed second guessing about the magnitude of the slowdown. Overall indicators of manufacturing activity are looking healthy. On the back of a solid ISM report came a sunny Philly Fed manufacturing reading. Moreover, industrial production posted a 0.4% gain in July, despite the weak showing in the auto sector (no surprise). Initial unemployment claims so far are holding at low levels. And while everyone is fond of showing the latest recession indicator, I would note that the recent run of ISM readings in general is not one of them:
The Fed will be waiting for signs that the housing slowdown has spread well beyond the consumer. They will want to see that the economy is assuredly sinking below potential before they can put aside their lingering inflation concerns. That, in my opinion, puts manufacturing type data in the spotlight as the next signal of the willingness of the Fed to think that the next move should be a cut (the null remains pause with inflation bias). Next up – tomorrow’s durable goods report.