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Monday, May 07, 2007

Tim Duy's Fed Watch: Soft Jobs Report Likely Welcomed by Fed

Tim Duy explains how the Fed will interpret the "soft jobs report" for April in his latest Fed Watch:

Soft Jobs Report Likely Welcomed by Fed, by Tim Duy: The April employment report came in on the soft side of already low expectations (and, giving credit where it is due, pretty much in line with the ADP read on private payrolls). This data, taken by itself, suggests the Fed can breathe easier on the inflation front, setting the stage for a policy shift. But the impact on Fed policy, however will depend on a.) how much it differs from policymakers’ expectations, b.) how much they view it as lagging data and c.) how they read in the rest of the week’s data. The latter point is particularly important in light of a number of more positive data released during the week. On net, Fed decision makers have reason to believe that their forecast continues to play out largely according to plan. This suggests that policy continues to remain on hold in the near future.

To date, the strength of the labor market has come as a surprise to Fed officials. I believe they (reasonably) expected numbers closer to the April figure. And policy rarely hinges on a single month’s data. The soft numbers will be viewed in light of the strong number the previous month, leading the Fed to focus on the three month average of 118k, pretty much the middle of the range consistent with a steady unemployment rate (Fed officials have said that number could be 100k, while some analysts stick the 150k figure that was once the conventional wisdom). Moreover, the Fed will likely look at numbers and conclude that negative job growth is heavily concentrated in housing related sectors (construction and financial activities). They will couple that observation with the flat trend in initial unemployment claims and conclude they are getting just what they want – a softening labor market that lacks the rapid rise in layoffs consistent with recessions.

A shorter work week and slower wages gains will also ease lingering inflationary concerns. Along those lines, the stronger than expected productivity report will ease concerns that growth in that key variable is slowing. Still, one quarter by itself is not sufficient to close the book on that story. The debate goes on, with Dean Baker looking for a reversal in Q2 while Brad DeLong says the productivity slowdown is the temporary result of lagging job destruction in the construction sector.

One would think the labor report, along with the recent readings on core inflation, would give the Fed cover to switch to a more obviously neutral bias. But these are lagging indicators, and this Fed remains committed to a forward looking policy stance. And this is where some recent data appear to stand in the way of a significant change in the policy statement. The manufacturing ISM report came in unquestionably strong across the board. Particularly notable were the 6.9pp gain in new orders and a 7.5pp gain in backlogs. Just a fluke? Perhaps – from Bloomberg:

The index is unlikely to sustain these levels in coming months, said Norbert J. Ore, chairman of ISM's manufacturing survey. Housing-related demand improved from very depressed levels, contributing to the gain, he said.

Consumer spending, business investment and government purchases are unlikely to pick up much in coming months, Ore said.

''I just don't see a driver that is going to sustain that level'' in the ISM index, he said in a conference call with reporters.

Still, contrast Ore’s comments to the anecdotal portion of the report:

"The economy seems strong, business is good here." (Fabricated Metal Products)

"Detecting contractor manpower shortages." (Chemical Products)

"High corn prices could have long-term impact on soft drink industry." (Food, Beverage & Tobacco Products)

"First quarter business was strong despite gloomy 2006 forecasts for the 2007 diesel engine industry." (Machinery)

"Business remains at or above budget in all markets." (Primary Metals)

Note also that the prices paid component of the report climbed again, with 50 percent of respondents reporting higher prices. Price increases were widespread as well, not simply energy.

The Fed will have to choose between viewing the bounce in the ISM as a fluke or as supportive of their view that the economy will accelerate. The latter will be reinforced and by the similar, albeit not as dramatic, improvement in ISM read on the service sector and the better than expected March report on manufacturing. And in either case, the Fed will note that the stubborn refusal of the manufacturing ISM to make a sustained break below 50 is not consistent with a recession in the near term. That, too, suggests stable policy.

On the other hand, the Fed will also have to factor in softening consumption growth. Households lost steam in March and likely April as well, with early signs suggesting a weak retail sales report in the making. The drop in new vehicle sales, covered by Jim Hamilton, is not encouraging, but consistent with the long standing expectations that the housing market will eventually weigh on spending. Add to that the recent rise in gas prices that wage gains aren’t matching, and you see a substantially weaker consumer in Q2. Also note that higher gas prices cut both ways; they make pain for the consumer, but no matter how much the Fed cuts rates, it won’t keep the refineries on-line. More demand will only drive energy prices higher. Knowing the Fed, however, they will match a weak Q2 against a strong read on consumption in Q1 (one of Mishkin’s “bumps in the road”).

Simply put, with the employment data just now coming in line with the Fed’s expectations, combined with stronger than expected data that supports their outlook, it is tough to see the Fed making many changes this week. The softness in the labor market will pull some FOMC members to favor a shift to a neutral bias, but the Fed will be cautious as markets will read such a move as a signal that a rate cut is imminent. And if the Fed is sticking with the acceleration story, they will hesitate before sending expectations in the other direction, especially since they have been sending pretty strong signals that policy is on hold. They will choose their words carefully (I wouldn’t be surprised to seem some soothing words on productivity).

If this middling data keeps up, one can foresee a long period of relatively weak growth, but growth that is strong enough (perhaps pulled just enough by the rest of the world) to keep the Fed on hold. This would prove to be a nerve racking period for most of us, as it suggests that the Fed is willing to hold the economy on a knife edge, looking for that acceleration while risking a fall into recession.

Note that the calls for a rate cut, and criticism of the Bernanke Fed, are beginning to grow: see Rich Miller’s Bloomberg column here. Of course, there were plenty of complaints when the Fed held at 5.25% as well – and if the Fed were to cut soon, no doubt we would hear all about “helicopter Ben” once again.

    Posted by on Monday, May 7, 2007 at 12:15 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (6)

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