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Thursday, October 18, 2007

Fed Watch: Absolutely Maddening

Tim Duy wishes new data would clarify the path the Fed will take at its next meeting, but so far that hasn't happened:

Absolutely Maddening, by Tim Duy: This is undeniably the most maddening array of data and anecdotes that I can remember having to sort through. Maddening enough that it makes me wonder if I am making an easy story more difficult that it has to be.

The trouble starts in housing…there is nothing good to be said about housing. Nothing at all. Now, time spent reading Calculated Risk had long ago convinced me that nothing good was going to happen until starts bottom at a million or so annual units, and that would have occurred regardless of recent credit tightening. The central delusion that propelled housing to new heights – the belief that housing prices only go up – has been dispelled.  No amount of easy credit is going to jump start the bubble now.

By all rights, or at least to the extent that we believe history should repeat itself, the housing downturn should already have tipped the economy into recession. This, however, implies a causal relationship, and the no-recession crowd, myself included, have been betting that the relationship is really driven by some third dynamic. So far, that bet has paid off – the impact of the housing downturn has been largely contained. From the most recent Beige Book:

At firms without direct ties to real estate and construction, contacts are still wary that credit tightening and slowing construction might slow activity in their industry, but there is cautious optimism because few see much evidence of such spillovers at this time.

This suggests that outside of housing related sectors, the impact of recent events has been primarily to cloud the forecast. This additional uncertainty is why the Fed cuts rates by 50bp – to get ahead of the potential damage from the credit tightening. Indeed, the broad credit tightening is likely that “third dynamic” I mentioned above, the link between a recession and falling housing markets. And is a broad credit crunch really happening?

Lenders in many Districts tightened credit standards, particularly for real estate. The majority of reports indicated an increase in business lending but a decline or slower growth in consumer lending.

This sounds as if the credit tightening is happening right where is should. Realistically, did lending standards for households have anywhere to go put up?

Interestingly, the adjustment in the economy to date is almost exactly as I would have expected. As housing turned down, consumer spending should slow as households realized that they were no longer living inside an ATM machine. A portion of the consumer slowdown would be borne by overseas producers, while domestic firms would benefit from a weaker dollar and a decoupling of the US from the global economy. Back to the Beige Book:

Consumer spending expanded, but reports were uneven and suggest growth was slower in September and early October than in August. The manufacturing and service sectors continued to expand, but growth weakened--mostly for products and services related to home construction and real estate transactions. Several manufacturing and service firms reported that weaker domestic demand was offset by strong sales to global markets.

The net impact should be a solid growth rate – like the 3% anticipated for Q3 – that feels miserable due to declining domestic demand. There should be a dichotomy within the labor market as well as the economy undergoes what is essentially a structural shift as the US weans itself from foreign production:

Job growth eased in some regions, but labor shortages were reported for many occupations in most Districts and are said to be restraining economic activity in some instances. Wages rose moderately except for workers in short supply, where sharp increases were reported for some positions. Upward pressure on input costs are reported in most Districts, but competitive pressures are restraining the ability to pass higher input costs to selling prices in many instances.

The job growth slowdown combined with stable initial unemployment claims is another reflection of that dichotomy – growth has slowed enough to dress hiring, particularly in housing related sectors and retail trade, but not enough to trigger mass layoffs.

The upshot is that the Fed is managing an economy that is on something of a knife edge. If you believe the “structural adjustment as the current account deficit improves” story, then you need to accept some degree of weakness in domestic consumption. Of course, you don’t want the economy to reach a tipping point on the downside. But, on the other hand, you want to be wary about overstimulating domestic demand, especially at a time when the falling currency is signaling a reduced willingness of the rest of the world to support that demand.

Adding to the complexity of the Fed’s challenge is what appears to be surging global demand as evidenced by, among other things, rising commodity prices. I can’t imagine that the US economy will be able to resist these increases indefinitely, although for now the Fed sees:

Upward pressure on input costs was reported by most Districts. Pushed up by strong domestic and international demand, energy and raw material costs are characterized as high by several Districts. Prices are up for a broad range of foods, including milk, corn, soybeans, wheat, beef, chicken and vegetables. Declines in the value of the dollar and high shipping costs have made imported goods more expensive…

But, critically:

The ability to pass higher input costs to selling prices was mixed.

Is this better or worse than the September Beige Book?

Most Districts reported little change in overall price pressures.

Sounds a bit worse to me, but I wouldn’t bet the farm on it. And, in any event, the Fed appears to be turning a blind eye to inflation. Indeed, the business press widely touted yesterday’s CPI release as consistent with the Fed’s expectations for slowing inflation. I can’t help but notice that the 3-month annualized core rate is now 2.5%, implying inflation has recently accelerated despite the declining year over year figures. And I did take notice of Barry Ritholtz’s catch:

Food Costs: Domino's Pizza (DPZ), the nations largest pizza chain, missed on both revenues and earnings yesterday. Why? Let's go to the company's CEO: "Unprecedented cost pressures and a weak consumer environment negatively impacted our domestic results in the quarter, which made striking the right balance between increasing prices, while operating in a period of declining traffic, very difficult."

Unprecedented. Cost. Pressures.

The firm noted that higher labor, food and packaging costs, as well as higher interest expenses, were only part of the problem: The company's own pizza price increases could not implemented fast enough by franchisees to outpace their rising input costs.

That's right, inflation has been running faster than their ability to print new menus!

Now, truth be told, I honestly doubt that Dominos is unable to print new menus fast enough. More likely is that management cannot move fast enough, more so for internal reasons than the inflationary pressures. Still, it is an interesting anecdote none-the-less.

But going back to the Fed, my concerns about inflation are irrelevant, as are Ritholtz’s. Bernanke & Co. are currently more focused on the downside risks to growth. The primary risk to growth stems from the housing market. If you focus on the housing story, then, you conclude that the Fed will cut rates at months end. If you focus on the “potential impact of housing to the broader economy” story, then the Fed was intentionally getting ahead of the curve with the 50bp cut in September, allowing them to take a pass on October unless they saw broad based weakness.

I have shifted increasingly to the latter camp. If I make an error on that call, it will be because I have focused on the externally driven growth as a real, structural shift in the US economy. In fact, the Fed may discount the external growth story, choosing instead to cut again on the basis of the housing slowdown. Simply put, their existing paradigm might not be able to incorporate that a fundamental shift in patterns of economic activity. Or that after 25 years of living off the rest of the world, it would be risky to believe that a change was soon at hand.

Or the Fed may simply believe that more easing is necessary at some point, so why not sooner than later. That is the easy answer. And maybe I should be paying more attention to the easy answer – I clearly recall a professor, just before the class was set to embark on a multi-page exercise in calculus and algebra, saying “Just substitute the constraint into the objective function. Graduate students always want to make things harder than they have to be.”

Bottom line: The flow of recent data, outside of housing, in my opinion does not suggest an immediate need for additional easing. I continue to believe that the external accounts are beginning to drive a structural shift in the US economy that is not fully appreciated by many. At the same time, this is another close call, and market participants could very well be 50-50 again on Halloween.

How many Fed posts on Halloween week will be titled “Trick or Treat?” I promise that I will not be one of them.

    Posted by on Thursday, October 18, 2007 at 12:33 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (31)

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