Tim Duy with a Fed watch:
Where’s That Recession?, by Tim Duy: Another FOMC meeting come and gone, with no change in policy and little indication that policy is about to change. Yes, the FOMC did acknowledge a “substantial” cooling of the housing market, but this was not exactly news given Fed Chairman Ben Bernanke’s October 31 speech. More important was that the FOMC explicitly noted that they intend to look through the current slowdown to the other side:
Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.
The Fed continues to view the current weakness as a transitory event related to the housing and auto slowdowns rather than a fundamental shift in cyclical activity. Simply put, this is not 2000 and the housing slowdown is not equal to the tech slowdown. In my mind, the data as a whole supports this view.
But first, I want to step back a few weeks to the data that rattled me, the advanced durable goods report for October. Yes, this is ancient history, but humor me; I have trouble jumping back in mid stream. I have been watching durable goods orders for a signal that the soft landing was turning hard, and the 5.1% drop in new orders for nondefence, nonair capital goods had that hard landing feeling about it. Still, something in the details caught my eye, the sharp drop in orders for computers and electronic products. I haven’t heard any stories that point to a tech slowdown. In fact, the opposite appears to be occurring – one contact actually described the tech environment as “frothy,” harkening back to the late 1990’s (see also this WSJ$ article). Note that employment in “computer systems designs and related services” in up 6.4% over a year ago (76.7 thousand jobs). Yes, Virginia, there is a Santa Claus, and good jobs are being created.
So why the orders drop?
The Vista issue jumped to mind; better at this point to put off computer orders until they start shipping with the new software (better yet to wait until Microsoft releases the inevitable service pack). Also, unfilled orders continued on the upswing, suggesting plenty of work to keep manufacturers busy even if orders activity slowdown (I have heard this from a number of industry contacts). In any event, we will know soon enough whether the orders drop is broader than just high tech – Friday we get the advanced numbers for November.
In the end, I was rattled but didn’t think the durable goods orders would have a big impact on monetary policy. Indeed, later that day Bernanke reiterated the Fed’s inflation concerns, and repeated the party line on capital investment:
In the business sector, capital investment has continued to expand at a healthy pace. Spending on nonresidential construction--a component of business investment--has been particularly robust, reflecting higher outlays for new office and commercial buildings as well as a rapid increase in expenditures on drilling and mining structures. Outlays for equipment and software, which grew briskly from mid-2004 through the early part of this year, have moderated somewhat, though order backlogs for capital goods such as industrial machinery and other types of heavy equipment remain substantial. Moreover, financial conditions continue to be favorable for investment spending, as profitability is high, the cost of capital is relatively low, and significant cash reserves remain on firms' books.
This is not, however, the most interesting point in Bernanke’s speech. Nor was his view on the housing market. More interesting was his clear words on potential output:
With regard to the labor force, research by the Board's staff highlights the role of demographic factors in determining the number of people available to work in the years just ahead. Most notably, the impending retirement of the baby boomers and the fact that women are no longer increasing their participation in the labor force at the rate they were in the past will tend to restrain the future growth rate of the U.S. labor force….Even if productivity growth is sustained at a reasonably good rate, the slower expansion of the labor force will imply some moderation in the rate of growth of potential output over the next few years. In the very near term, that slower growth in the labor force needs to be taken into consideration when assessing the sustainability of given rates of expansion in economic activity.
I myself am not convinced on the outlook for baby boomers. But that shouldn’t distract from Bernanke’s point that the Fed is looking at a lower level of potential output than market participants – which translates into a lower acceptable rate of growth. Of course, this point has been made before, but I don’t think the Fed believes market participants were listening. Indeed, Fed officials apparently felt a need to reiterate the point further that week. The same day, Philadelphia Fed President Charles Plosser noted:
Of course you might ask, what is trend growth? … Up until July, most economists would have said that the rate was somewhere close to 3.5 percent, assuming labor force growth of about 1 percent and productivity growth of almost 2.5 percent. However, in July, the government issued a benchmark revision to its estimates of GDP for the last three years. The fallout from that revision was that wages and employment grew somewhat faster than was previously estimated and productivity growth was slightly lower than we thought. As a result, the commonsense estimate of trend growth has now been lowered slightly. My own view is that trend growth is closer to 3 percent than 3.5 percent. Some even claim that trend growth is as low as 2.8 percent. I don’t think it is useful to quibble over two-tenths of a percentage point, since our ability to measure productivity is so fraught with problems. Nevertheless, almost everyone agrees that estimates of trend growth are now lower. Thus, when I say that growth should return to trend in 2007, I am expecting that growth will be near 3 percent. Note that this means that it should not surprise or concern us to see growth slowing from its pace of the last few years.
And later we also heard from Chicago Fed President Michael Moscow:
These developments have important implications for our benchmarks for the monthly employment statistics. Earlier in the decade, most economists estimated that job growth of about 150,000 per month was consistent with an economy expanding near potential. However, research at the Chicago Fed and elsewhere suggests that, given the slower growth in the labor force, monthly increases of roughly 100,000 are most likely consistent with potential...The changes in labor force growth also imply that, in the absence of changes in productivity trends, our estimates of potential GDP growth should be revised down somewhat to around 3 percent…Against this 3 percent benchmark, it is clear that the actual GDP growth rate of 3-1/2 percent that we experienced during the past few years is not sustainable today. A deceleration to average or even below average growth rates—as we have seen recently—is only natural.
I doubt it was coincidence that Fed officials were singing the same song all week; they were clearly signaling that the slow pace of growth is not all that slow. And certainly not slow enough for us to shift into rate cutting mode. Moreover, they will not be swayed by the volatility due to the housing market. From Moscow:
My baseline forecast is that GDP growth will pick up from the weak third quarter and average somewhat below its potential growth rate over the next year or so. Of course, that's an average—I do expect to see some volatility in the numbers.
Note how this theme appeared in the recent FOMC statement. The Fed simply does not want to overreact to the current slowdown by pumping more money into the economy. Perhaps they are trying to avoid what many believe to be the essential error of the Greenspan years, over liquefying the economy and just being lucky that Asian central banks were willing to mop up the excess (along those lines, I don’t think you can ask the Chinese to let the renmimbi slide without offering something in return, like, say, a tighter than anticipated monetary policy stance; see also Nouriel Roubini here, I agree with Nouriel that this is a two-sided issue).
But what about manufacturing? Surely the dip in the ISM below 50 is a sign the world is ending? The Fed has made it pretty clear that they see troubles in manufacturing as limited to housing and autos. On the former point, the anecdotal evidence I pick up is that any manufacturer with ties to the building industry is started seeing orders drop in September. Otherwise things are pretty solid. Moreover, the Fed doesn’t view the drop off in demand for housing/autos as fundamentally liquidity related. From a recent WSJ $ article:
Many Fed officials and private economists believe home builders and auto makers are curbing production to trim excess inventories as a temporary response to a drop-off in demand that was unsustainable -- not because climbing interest rates are eroding affordability.
From the Fed’s perspective, the stories in these sectors are straightforward. The speculators are out of housing, giving breathing room for persons who want to buy a home to actually live in. And the auto industry – or, more accurately, the US producers – sold forward gobs of demand in the past three years. And, unbelievably, they never got around to producing cars that American’s want when gas is $2.75 a gallon. More money from the Fed can’t fix that problem. It would instead just make gas prices higher.
Regarding housing, I don’t feel a need to chronicle the housing market’s decline – no need to recreate Calculated Risk’s efforts. I will only add that from the Fed’s perspective, the slide in new residential investment will not go on forever. There is a bottom. And when that bottom is reached, then the contribution to GDP growth will go from a negative 1.2% to zero. This would, for example, have made Q306 GDP growth 3.4% instead of 2.2%. And 3.4% is well above the Fed’s estimate of potential.
Now, they don’t really believe that the economy will snapback to 3.4% on average – and if it does, we should be expecting additional rate hikes. I think they believe the mortgage equity withdrawal story, and anticipate an Act II to the housing slowdown. In Act II, the drag from the consumer becomes more evident, pushing consumption growth rates to the 2-3% range.
My belief is that consumption growth will ease to the lower part of that range. Hence, I found the retail sales report to be shockingly strong. It stands in stark contrast to the view that the consumer is about to buckle under the weight of the housing slowdown. How stark? Well, let’s take the inflation adjusted estimate of real retail sales from the St. Louis Fed – last time I noted that this was a good estimate of real personal consumption expenditures. In real, annualized terms, retail sales are up 13.2% in November. And suppose real retail sales are flat in December. Then 4Q07 real sales will be up 4% over the previous quarter.
Needless to say, 4% consumption growth would pretty much put to rest any idea of a recession in 4Q, especially if trade makes a positive contribution as October’s contraction in the trade gap implies. And if 4Q comes in reasonable (consider the implication of strong consumption and a mix of other components that effectively cancel each other out), the Fed is not likely to change policy until they get 1Q07 numbers in late April.
To keep the consumer story alive, the labor market needs to hold strong. And the November employment report suggests that it is. Of course, you can say that nonfarm payrolls are a coincident indicator at best, but it looks to me that the labor market is behaving exactly the way it is supposed to, with hiring in construction and manufacturing following activity declines in these sectors. Moreover, initial unemployment claims continue to bounce around 300k – not a number consistent with a rapid deterioration in labor markets. And, as David Altig succinctly points out, if you are trying to draw similarities to 2000, the labor market is simply not the place to look. By this time in 2000, labor market weakness was already manifest.
For now, that leaves me pretty much caught up. I could also mention the strong ISM non-manufacturing report, and the softer signals from retailing as we head into the final stretch. Regarding the latter point, I am not surprised. Consumers want discounts, and at this point it is simply better to give a gift card and waiting until the after holiday sales. (Of course, this doesn’t work for all last minute shoppers, such as myself. My wife has let it be known that the giving of gift cards for Christmas will be met with swift and harsh retribution). I will leave the inflation report to David Altig as well. And I should note that if you are still predicting a bear market in US equities for 2006, time is running short for that to ring true. But on balance, these things most likely leave policy makers holding steady, with one foot still hovering over the break, not ready to shift to the accelerator.