Tim Duy reviews the economy and the Fed's likely response to current and expected future economic conditions at its rate-setting meeting this week:
Anemic, by Tim Duy: Two weeks away from the blog. The first was spent dealing with a crashed computer – the technician said “your machine is sick,” which is a euphemism for “you’re screwed.” The second was spent advising incoming freshman. Still, two weeks later, the economy looks pretty much the same, and best characterized as “anemic.” Not as bad as might be expected, but clearly weak, with few signs of strength. I suspect that is what the FOMC will feel Tuesday, and consequently will find themselves with little reason to change policy or signal that a change will occur in the near future.
Working backwards through recent data brings us to the July employment report with a headline nonfarm payrolls decline of 51k, a tepid number to be sure, but not the triple digit declines normally associated with a recession. Still, this better than expected number masked a considerable array of general weakness. Teen unemployment is skyrocketing, total hours worked decline sharply, temporary employment decreased, real wages are declining, and the number of part time for economic reasons continued to climb. The latter is helping to drive up the broadest measure of unemployment, U-6, to 10.3%, up a whopping 2 percent points from last July and within striking range of the recent 10.4% high reached in 2003. It is difficult to envision Bernanke & Co. seriously entertaining the notion of a rate hike in this environment, despite the hawkish rhetoric of a few regional policymakers such as Philadelphia Fed President Charles Plosser. Such hawkishness, however, was not likely to go very far after the recent close call for Freddie and Fannie revealed the still precarious state of US financial markets.
Brad DeLong cites the U-6 unemployment rate as decisive evidence that the US economy has slipped into a recession. That sounds right from an employment perspective, but would be the oddest recession in memory. This point was driven home last Thursday with the release of the 2Q08 GDP report. I admit it is tough for me to accept a recession call when aggregate activity is growing at 1.9%, and the only quarter of negative growth was just barely negative. The recession case becomes clearer after stripping out the impact of external adjustment and turning to the persistent weakness in real gross domestic purchases:
Aggregate activity is evolving very close to my expectations, as growing exports and import compression maintain overall growth despite a contraction in domestic demand, thereby minimizing the impact of the slowdown on labor markets. The result is a recession that is not quite a recession as the overall economy continues to expand; growth that doesn’t feel quite like growth. In my mind, the current dynamic reflects a downward shift in the standard of living that Americans are enduring after a long period of debt-supported growth; it certainly feels like a recession to many, even if not technically a recession.
In a similar vein, the ISM report of manufacturing was also released last Thursday, with a headline number that continues to however around the 50 mark, a weak reading that remains well above recessionary levels. Overall, “anemic” sounds like a good description. Others might prefer the term “Purgatory.”
Is there much hope of a decisive change in the economic climate in the second half of this year? I tend to think the economy will experience more of the same; the lurch downward experienced at the end of 2007 looks likely to be followed by an extended period of persistent weakness. The ongoing impact of fiscal stimulus trickling through the economy, a stimulative monetary environment (resulting in a yield curve that has been relatively steep for months now), and rising new orders for nondefence, nonair capital goods (a bright spot in last week’s data) are all suggestive of a stabilizing economic environment. But with Detroit reeling from the impact of the oil shock and signals that global growth has eased back in recent weeks, it is difficult to see that stabilization evolving into a more dynamic pattern of growth this year.
Such a tepid outlook for growth suggests stable monetary policy. The wildcard is the inflation outlook. To be sure, recent headline and core numbers have not been inspiring (today we get the PCE report). And the ISM revealed that manufacturers remain under intense pricing pressure, with no commodities reported down in price. But, more importantly, nominal wage growth continues to fall short of consumer price inflation. And without stronger nominal wage growth, it is difficult to argue that inflation expectations can truly become embedded, regardless of the pricing pressures clearly in evidence. Moreover, the Fed will take comfort in recent significant drop in oil prices (a drop that caught me by surprise) and the stronger Dollar, the primary factors driving the case for a rate hike by the end of the year.
Still, should we entirely discount the possibility of a rate hike this year? Market participants still see a small probability of a rate hike this year; attention has to be turned in this direction as the Fed is almost certainly done cutting rates. At this point, the best bet for a rate hike hinges on a return to stronger growth abroad that fuels a reversal of recent trading patterns in oil and the Dollar and sustains the US economic growth derived from exports. Brad Setser reminds us that one of the forces propelling global growth, Dollar pegs in the Gulf, remain in play. But the bigger question is whether or not China stumbles in the quarters following the Olympics. I tend to believe that the Chinese government will act decisively in an effort to forestall a slowdown, redirecting spending toward investment and rebuilding and loosening monetary policy regardless of the inflation risk. Still, even steady, strong growth in China may be insufficient to sustain global growth given signs of slowing economies such as in Europe and Japan. In short, the case for a rate hike appears tied to continued decoupling of the US and global economies; recoupling argues for stable monetary policy.
Bottom Line: I suspect the Fed will stick with a statement that is largely neutral, indicating that there remains enough economic stimulus in play to sustain growth while showing concern about elevated inflation rates. Falling energy prices and a weak job market should be sufficient to keep the hawks largely at bay, with more than one dissent unlikely. Lacking the justification of skyrocketing energy costs, a plummeting Dollar, or clear signals that growth is set to rebound this year, it seems unlikely that the Fed will signal a rate hike is imminent.