Tim Duy looks at the state of the economy and how the Fed is likely to respond:
Still Looking at More Easing, But…, by Tim Duy: Last week was, to say the least, interesting from a data and policy perspective. On average, incoming information points to additional easing in March – especially given the aggressiveness of the Federal Reserve in this cycle. It appears that a 50bp cut is the appropriate baseline. Still, as we are already looking at a recession-style pace of easing, I wonder if the Fed really wants to keep up this pace of easing until it is obvious the economy is out of the woods?
Best I think to start at the beginning of last week. Of course, the week began with housing data, of which I have little to add. The steady drumbeat of housing news has taken the shock value out of the data, not unlike TV violence. Suffice it to say that the housing market will continue to be a drag on overall economic activity for the foreseeable future.
More interesting was the December durable goods report. I was struck by the gains in nondefence, nonair capital goods; it is hard to ignore the 4.4% gain in new orders. Moreover, unfilled orders resumed their climb, and remain 8.6% above year-ago levels. Given the rising calls for recession, I would have expected these numbers to have rolled over more decisively by now…this data nags at me, preventing me from falling into the “recession is here” camp.
The GDP report fell largely within my expectations, with the inventory contraction being the only big surprise. I would not expect another inventory contraction in the current quarter, and while not in and of itself a panacea, that may be the decisive factor in a sub-zero growth rate. Of course, consumer spending is critically important at this juncture, and the year ended on a weak note, with a flat reading on real expenditures for the month. It is worth noting the role of inflation in restraining spending growth at this juncture – while nominal disposable income is up 4% annualized since September, real disposable income is essentially flat. It should not be a surprise, then, that slipping gasoline prices are fostering stability in consumer confidence; the University of Michigan number rose modestly to 78.4, compared to 75.5 the previous month. Despite what we now know as a flat labor market.
Last Thursday we also saw a sharp rise in initial unemployment claims, running counter to the downward trend of recent weeks. There is quite a bit of difficult to estimate seasonality in the weekly figures, but one can surmise that the recent improvements were, on average, somewhat overstated. This was substantiated with the January 2008 employment report on Friday. The fall in nonfarm payrolls came as a surprise – forecasts were pushed upward by the seemingly benign initial claims reports and the ADP release. As is typical, when the latter misses, it misses big. Use with caution.
Jim Hamilton hits the high and low points of the report. I add that an interesting detail emerges with the revisions. Average monthly payroll growth was 109k and 105k during the first two quarters of the 2007, a period associated with a relatively stable unemployment rate. The average growth in the second half of the year was 82k, slowing to a December 2007 – January 2008 average of 42k. Note that it wasn’t until the fourth quarter that the unemployment rate revealed a sustained increased. All in all, this pattern suggests that a stable unemployment rate corresponds to somewhere around the 100k a month, not the 150k a month that is commonly quoted as necessary to keep up with population growth. Indeed, the Fed has been moving in this direction for quite awhile, and the declining rate of labor force growth is one factor driving down the Fed’s estimate of potential growth. This may not seem important now, but will eventually.
Last but certainly not least, the ISM report on manufacturing, which was overshadowed by the jobs data, was clearly out of line with recession calls. Either that, or this will be the first recession without a sharp contraction in manufacturing activity (the closest example is the 1974 slowdown, and I don’t relish the idea of revisiting that era). Not only did the headline number rise above 50 (the rebound was actually foreshadowed by the durable goods report), but the details were very positive. New orders rebounded, and production jumped. Customer’s inventories shifted from too high to too low, consistent with expectations that the inventory decline of 4Q07 will not be repeated. Moreover, the export index jumped back after the December slip, suggesting that the recoupling/decoupling debate remains unresolved. On the downside, the employment component declined, sustaining the steady net loss of jobs in this sector.
Another warning sign was the jump in prices paid; 55% of respondents reported higher prices, only 3% lower. Of course, inflation pressures will follow real activity with a lag, but what if the rest of the world does not recouple with the US...will we be importing inflation, especially given an increasingly monetary policy…still worth thinking about. See also Saturday’s WSJ article detailing the Chinese demand-sustained high copper prices, and the related renewed effort of the People’s Bank of China to boost lending activity (thank you Across the Curve).
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Not unreasonable, as the typical business cycle would drive down inflation. I have the nagging feeling that this isn’t typical; the current downturn has an emerging market currency crisis coupled with global resource constraints feeling to it that I have trouble shaking. But a few solid readings on core inflation will shake me out of it, which is what the Fed anticipates, leaving them seemingly free to continue cutting rates.
I will note that this sentence has reappeared:
Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity.
This sentence has been my nemesis since last summer – it suggests that the Fed thinks the current level of rates is appropriate to meet their long run goals. It has been turned into meaningless blather, and appears to be viewed by market participants as largely a throwaway sentence. I had thought that considering that the financial markets kept slipping away from them, policymakers would abandon this line, as they did with the statement from the emergency meeting on January 21. At the least the Fed retained the following modifier:
However, downside risks to growth remain.
Note they dropped the “appreciable” modifier from the previous week. I am not sure that that much changed in a week – other than 125bp of easing, of course.
In total, I believe the Fed intends this line to provide them policy flexibility, suggesting that more rate cuts are not guaranteed while at the same time not appearing as if they have already decided to stop. In any event, few believe they intend to stop, as market participants are looking for another 50bp in March (although note that, according to the Cleveland Fed, expectations are all over the map, with roughly equal weights on 25, 50 and 75bps.) Given the fragile state of financial markets, including the uncertain future of the monoline insurers, does anyone believe the Fed will not meet expectations?
Which leads me back to the start…assume the Fed does pull the trigger on another 50bp in March, pushing the Fed Funds rate to 2.5%. Further assume that any potential signs of life in the economy are inconclusive, and that the housing market looks worse, not better at that time. Can the Fed stop at that point? Seems difficult, especially considering the degree to which the Fed has fostered easing expectations.
In other words, while I have trouble seeing the end point in this cycle (given the Fed’s aggressive push), I tend to think the Fed would like, at a minimum, to slow the pace. It does not seem likely that Bernanke & Co. want to push rates back toward 1% range in the next six months. (On the other end of the spectrum, John Berry thinks the Fed may start reversing course by the end of the summer.) If the Fed really believes that the current stance of policy is appropriate in the medium term, they will feel a need to take more control over expectations. And that effort may start happening with this week’s steady stream of Fed speeches, leaving open the risk of some unexpectedly hawkish talk this week, things like where policy is relative to neutral, the benign medium term forecast, worrisome inflation, etc.
Bottom Line: 50bp looks like the appropriate baseline for March, with 75bp seeming very unlikely. It is up to the data and the Fed to pull me to 25bp. Few are thinking no cut, which could be the surprise worth watching for.
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