Fed Watch: Inflation Concerns Set to Trump the Slowdown?

Tim Duy with a Fed Watch in anticipation of next week's meeting:

Inflation Concerns set to Trump the Slowdown?, by Tim Duy: The intensity of disgust for the 2Q06 GDP report – documented excessively at macroblog – caught me somewhat by surprise. It probably caught the Fed by surprise, too. After all, looking at the longer term, it is hard to see a reason to panic just yet:

We should all remember that plenty of people were ready to call it quits for the current expansion after the 4Q05 GDP report, but the economy (or, more accurately, the data) rebounded strongly the following quarter. Now, I doubt we are headed for another rebound of that magnitude – there is little reason to suspect that the consumer is gaining much additional traction. But the incoming data since I last wrote are, from the Fed’s perspective, relatively more supportive of an additional rate hike than not.

As far as the GDP report is concerned, it is consistent with the Fed expectation that the economy is slowing toward potential growth, with that slowing largely driven by changes in consumption spending and residential construction. I tend to believe they will discount the most worrisome part of the report, the 1% contraction in spending on equipment and software. They will view it as largely inconsistent with higher frequency data, notably the durable goods numbers, industrial production, and the ISM report. This is not to say the investment data in the GDP report are wrong (generally, the “data are wrong” story is an unwillingness to accept reality). Instead, there can be considerable volatility in the data that masks the underlying trend. Again, look back to 4Q05. There was hand-wringing over the weak investment numbers, only to see that story reversed in 1Q06. Moreover, the Fed will refer back to the Beige Book for supportive anecdotal evidence, noting:

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 short, I doubt the FOMC will see an impending recession in the GDP data. What they will find in recent data is the suggestion that inflation is becoming increasingly more entrenched. Core PCE inflation in June stood at 2.4% compared to a year ago, and 2.8% annualized compared to 3 months ago. Ouch – any way you slice it, the inflation news is unsettling, running well above the supposed 2% comfort level. And, the Fed will note, wages and salaries continue to climb:

One way to look at this is that consumers are merely demanding sufficient compensation to maintain living standards. The Fed will likely take a different tack – higher wage and salary growth suggests plenty of labor market pressure. Moreover, if higher prices are matched with higher wages, doesn’t that imply that imply that inflation expectations are set to be notched higher? Further supporting the wage/inflation story is the higher than expected ECI numbers. And note that oil breached $76 today, threatening to make a fresh attempt at the previous record. The long awaited stabilization of oil prices looks still to be long awaited.

And while household spending has eased, the Fed does not want households to maintain the rate of spending growth they became accustomed to in recent years anyway; I suspect FOMC members are quite pleased to see consumption spending pull back, and won’t be interested in reversing that process by accommodating higher prices. Yes, some sectors, maybe autos, will be hurt, but any rebalancing of the economy is going to result in some unpleasantness.

The truth is, the more I look at the data, the more I am tilted toward another Fed hike next week (not unlike William Polley). Financial markets, however, are not particularly supportive of that call – the focus of the markets has shifted from inflation to slow growth. Indeed, the predominant view appears to be the next rate hike is the last. Looking at the data, I simply can’t believe this is the thinking on Constitution Ave. And, as reported by David Altig, we have heard from two Fed officials who don’t sound so convinced a pause is a sure thing, with fairly balanced remarks consistent with Fed Chairman Ben Bernanke’s recent testimony on Capitol Hill.

Where then is the case for a pause? It can be largely summarized as:

1. The Fed’s new communication strategy continues to emphasize the expected slowdown.
2. Housing is slowing, and there is considerable amount of uncertainty regarding the ultimate economic impact. The only thing we know for sure is that it won’t be pretty. It is reasonable to expect the Fed to at least slowdown the pace of rate hikes in response.
3. Likewise, the economy does appear to be slowing in line with the Fed’s forecast, maybe even more quickly, depending how you want to read the GDP report. If the economy slows, won’t inflationary pressures ease as well?
4. The view that the inflation data is tainted by aberrant owner occupied rent behavior, and thus can be discounted. See my piece last week. With the OER question eliminated, the remaining inflation can be written off as pass-through from last summer’s energy price spike. Moreover, high productivity costs will contain inflation; note the low unit labor cost growth.

If the slowdown story is the important story on Constitution Ave., then much of the incoming data is supportive of a pause next month, especially because Fed officials continue to trot out the forecast for slowing growth. Overall, as I argued last time, the Beige Book appears consistent with that story. The data on economic activity, however, are sufficiently strong to prevent the Fed from believing a pause means done.

If the inflation numbers dominate, then we have to be looking at another rate hike next week. Yes, the inflationary pressures in the Beige Book looked pretty benign, but the actual PCE inflation data is simply not pretty. Will FOMC members want to look like they are disinterested observers in the face of these numbers? It’s one thing to let inflation creep up when the economy is clearly set to run below trend. But with the economy only expected to slow to potential, it becomes likely that the more inflation-wary policymakers will start thinking that they need to pull growth BELOW potential to reverse the inflationary uptick. That would be a whole new ballgame.

In short, I want to believe the “growth slowdown means a pause” story, but the inflation numbers keep circling around me like a pack of hyenas just waiting for me to drop my guard. Central bankers tend to hold onto hawkish leanings longer than expected. I simply suspect that while financial markets appear to be more focused on the slowdown story, the Fed will focus on the inflation story. Moreover, I doubt the Fed finds the GDP report to be particularly dismal. Consequently, I think the call is much closer than the betting on Wall Street indicates, close enough for me to expect another hike next week.

Perhaps tomorrow’s employment report will help lift the cloud…