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Monday, September 25, 2006

"Wagner’s Music is Better Than it Sounds"

The title expresses Dallas Fed President Richard Fisher's assessment of the U.S. economy -- it's better than it sounds -- except for inflation, which he believes may be a problem. His bottom line?:

While I am well aware of the risks to economic growth, the history of inverted yield curves, and the ever present possibility of exogenous shocks in a politically hazardous world, the “balance of risk,” in my book, is still tilted to the inflation side of the equation. ... While the inflation risk ... is very much on my mind, it is my considered judgment that the recent tempering of U.S. economic growth to a more sustainable rate, combined with the lagged effects of our 17 prior quarter-point rate increases, should act to lower the inflation rate over time. However, if this proves not to be the case, appropriate action will have to be taken.

Fisher's speech is below, but first here's the national outlook from the Dallas Fed:

National Update, September 2006, by Jim Dolmas, Dallas Fed: Moderating growth and elevated inflation continue to characterize the national economy.

Second-quarter GDP growth was revised up to 2.9 percent from the Bureau of Economic Analysis’s “advance” estimate of 2.5 percent.[1] While several components were revised upward, residential investment was revised downward and is now estimated to have shaved 0.6 percentage point off second quarter growth. That -0.6 percentage point contribution from residential investment represents a swing of a full percentage point from the +0.4 that residential investment contributed, on average, over the 13 quarters from first quarter 2003 through first quarter 2006.

The drag from residential investment may yet worsen before it gets better, as Chart 1 seems to suggest. The chart shows four-quarter growth in real residential investment together with the 12-month change in the National Association of Home Builders' Housing Market Index (HMI). The HMI aggregates NAHB members’ responses to questions about current single-family sales, expectations for sales over the next six months and traffic of prospective buyers. As the chart shows, changes in the HMI tend to presage changes in residential investment. The index’s August 2005 to August 2006 decline—the last data point on the chart—is the largest 12-month decline the index has seen.


Data on employment for the month of August, which came out on September 1, showed continued moderate job gains, with nonfarm payroll employment up by 128,000. Over the past five months, payroll growth has averaged about 120,000 net new jobs per month, compared with a pace of about 170,000 per month from the start of 2004 through March of this year. The current pace is probably below what is needed to absorb normal labor force growth.[2]

The pace of consumer spending growth appeared to pick up at the start of the third quarter after modest growth of 2.7 percent, annualized, over the second quarter. Real, or inflation-adjusted, personal consumption expenditures (PCE) grew at a 6.3 percent annualized rate in July. The top contributors to July’s growth were motor vehicles and parts (which contributed 1.7 percentage points), gasoline and other motor fuel (1.3 percentage points) and—perhaps reflecting hotter-than-normal temperatures in July—electricity (0.5 percentage point).

Real PCE data for August are not yet available, but nominal retail sales grew at a 2.9 percent annualized rate during the month. Since these data are not adjusted for inflation, they incorporate the effects of changes in the prices by consumers as well as changes in the quantities purchased by consumers. For example, August saw a much smaller increase in gasoline prices than in prior months and this pulled down overall retail sales growth. Nominal retail sales excluding sales at gasoline stations grew at a 4.7 percent annualized rate.

On the inflation front, conventional “ex food and energy” measures of core consumer price inflation showed signs of deceleration in July and August. The ex food and energy inflation rate for personal consumption expenditures fell to an annualized 1.7 percent in July after posting rates above 2.5 percent for the prior four months. The Consumer Price Index (CPI) excluding food and energy grew at annualized rates of 2.4 percent and 2.9 percent in July and August, respectively, down from the 3.5–4 percent rates the index had posted over the prior few months.

Whether these two months’ worth of data signal a downshift in the rate of core consumer price inflation is unclear. Neither the Dallas Fed’s trimmed mean PCE inflation rate nor the Cleveland Fed’s median CPI showed any significant slowing in July. While the Cleveland Fed measure did decelerate in August, it still came in at an annualized 3.4 percent rate.

An analysis of the underlying components of the PCE index shows a significant fraction of “core” components experiencing price increases at annualized rates better than 3 percent. Chart 2 plots monthly data on the expenditure-weighted share of nonfood, non-energy items growing at a better than 3 percent annualized rate.[3] The raw series, shown in orange, is quite volatile; the blue line is a six-month moving average. The six-month moving average in July was at about the peak it reached in 2001, with around 60 percent of nonfood, non-energy items experiencing better than 3 percent annualized rates of price growth. Prior to 2001, one has to go back to 1993 to reach a similar level.



  1. The BEA’s “final” estimate is due out September 28.
  2. Labor force growth over the past year has been about 1.3 percent. Monthly gains would need to average about 145,000 per month to absorb labor force growth at a 1.3 percent annual rate, assuming payroll employment’s share of overall employment remains stable.
  3. Data are through July; August PCE data come out September 29.

Here's the speech by Dallas Fed President Richard Fisher:

The Current State of the U.S. and Mexican Economies: Where Do We Go From Here?, by Richard W. Fisher, President, Dallas Fed: ...This morning, I plan to talk about the economies of the United States, Mexico and Texas. ... Just last week, we had another FOMC meeting and collectively decided the best course of action was to leave the federal funds rate unchanged. ...

In roughly six weeks, the U.S. economy will celebrate the fifth anniversary of its current economic expansion. Where do we stand on the eve of this milestone? We have a serious correction taking place in the housing sector. Sales, starts and permits are all down, in a range of 10 to 25 percent over the past year. In a few local housing markets—especially in the coastal areas—home prices have peaked and are beginning to decline. This may well be the most over-anticipated and over-analyzed downturn in history. ... But it is a serious matter nonetheless, with not insignificant consequences for the economy.

Home prices in many markets ran ahead of themselves, outstripping rents, incomes and demographic trends. Cheap financing combined with mortgage finance “innovations”—another name for speculative leverage facilitated by excess liquidity—added to the fervor. Indeed, one can make a cogent argument that the housing market excesses were due as much to financial construction as to good old-fashioned physical construction, and that the spigot of liquidity that bloated the stock and prices of housing was open longer than it should have been in a world of less ingenious financial engineering. Regardless, the market for residential real estate had to adjust, and it is now doing so.

Joseph is patron saint for home buying and selling. If you were to have read yesterday’s Orlando Sentinel newspaper, you would have discovered that there has been a run on statues of St. Joseph in various states as fear of the downturn in housing markets has spread. Sellers of homes are burying his statue in their yards in hopes of luring a willing buyer! Apparently, the practice of asking intercession from the saints is alive and well in the United States.

What is happening in the U.S. housing market is hardly unique. It is the nature of almost all markets to overshoot and then be subject to correction. It can be a painful correction for those who lose track of the difference between price and value and underlying fundamentals. As long as that correction is orderly and does not threaten the economy’s financial stability, we are best advised to let it run its course, monitoring it carefully to ensure that it does not infect the rest of the economy.

We are fortunate that the rest of the economy is healthy and robust. The banking system is in good shape. There is still plenty of liquidity in the financial sector. Corporate balance sheets are strong. Investment in plant and equipment is proceeding apace. Production is being reinforced by the settling down of commodity price pressures. Consumers are getting a shot in the arm from lower gasoline and natural gas prices. And, very important, the rest of the world is growing faster than the United States, further mitigating the downside risks of a slowing U.S. economy. ...

I am hearing more and more reports about the difficulty of finding labor to work our oil fields or run our chemical plants. Bankers complain of a paucity of bank clerks and tellers. Truckers are experiencing a shortage of drivers. In Houston, we are hearing complaints about the difficulty of finding cashiers for retail establishments. A major hotelier told me last week that there is a shortage of housekeeping staff. And for those who source abroad, finding ever cheaper inputs has become noticeably more difficult as growth in sourcing countries eats up available capacity. Having achieved a considerable amount of operating leverage from outsourcing and aggressively pushing the envelope of cyberspace, companies are now voicing the kinds of complaints about labor shortages most often heard in a full employment economy. ...

Lumping it all together, I am reminded of Mark Twain’s oft-quoted quip: “Wagner’s music is better than it sounds.” The outlook for economic growth may well be better than it sounds. At the same time, the inflation dynamic may be worse than it sounds.

As I sit at the FOMC table, I continue to fret more about inflation than I do about growth. While I am well aware of the risks to economic growth, the history of inverted yield curves, and the ever present possibility of exogenous shocks in a politically hazardous world, the “balance of risk,” in my book, is still tilted to the inflation side of the equation. Let me give you some math to illustrate why. ... The latest reading of core consumer inflation was close to 3 percent...

As you may know, the Federal Reserve Bank of Cleveland does not take the reported CPI at face value. They slice and dice the CPI to get a median measurement that some of us feel provides a more accurate picture of price pressures. The Cleveland Fed’s median figure for the August CPI came in at 3.4 percent annualized. They also have a measure that lops off the most volatile and presumably least sustainable components of the CPI. For August, that number came in at 2.9 percent, which closely tracks the Dallas Fed’s latest trimmed-mean estimate or 3.1 percent for Personal Consumer Expenditures inflation.

To some, 3.1 percent does not seem all that dreadful. Let me assure you that were that level of inflation sustained, it would seriously debauch the dollar. ... I don’t know a soul on the FOMC who would accept that kind of erosion in the purchasing power of our currency.

But, ah, you ask, didn’t the Producer Price Index (PPI) that came out on Thursday exhibit considerable price restraint? Indeed it did. Excluding food and energy, it actually showed overall price deflation. But we must be careful not to grasp at straws here. The PPI is very “noisy” to economists’ ears. Historically, it has not been very useful in forecasting consumer price inflation....

So the central banker’s brow, not having access to the intellectual equivalent of Botox, begins to furrow. If you are an inflation fighter, a vague recollection of Shakespeare’s Taming of the Shrew springs to mind in Hortensio’s cry, “There’s small choice in rotten apples.” The most reliable indicators of inflationary pressure are not yet comforting. Inflation remains elevated and leaves us small choice but to remain vigilant.

The FOMC left its monetary target—the fed funds rate—unchanged last week at 5.25 percent. I accept that decision. While the inflation risk I have just elucidated is very much on my mind, it is my considered judgment that the recent tempering of U.S. economic growth to a more sustainable rate, combined with the lagged effects of our 17 prior quarter-point rate increases, should act to lower the inflation rate over time. However, if this proves not to be the case, appropriate action will have to be taken. ...

He goes on to say quite a bit about the interrelationships between the U.S. and Mexican economies.

    Posted by on Monday, September 25, 2006 at 01:46 PM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (4)


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