Fed Watch: If Not For That Pesky Sequester

Tim Duy:

If Not For That Pesky Sequester, by Tim Duy: This morning's Wall Street Journal headline on the sequester included this quote:

"If they could get this fixed, the economy is poised to take off," Bank of America Corp. Chief Executive Brian Moynihan said in an interview.

I believe this is largely correct, albeit "take off" is perhaps a bit strong. The US economy looks to have shaken off some of last year's doldrums, particularly in manufacturing and the housing recovery is set to accelerate further this year. While clearly some external headwinds remain, notably the ongoing economic disaster that is Europe, I tend to think these will have only a second-order impact on the US economy. The immediate concern is obviously the impact of the sequester and earlier tax hikes, especially considering the evolving views of the impact of fiscal policy. That said, while I find the timing of these policy changes unfortunate and believe they place an unnecessary speedbump in the recovery process, their impact should fade as the year progresses.

Also bolstering the outlook is that the Federal Reserve is most likely to continue the large scale asset purchase program throughout much of this year. That was the message of Federal Reserve Chairman Ben Bernanke this week as he minimized concerns that the risks of additional easing outweighed the benefits. I expect a similar message tonight. The initial impact of the sequestration will likely place enough downward pressure on the economy which, when coupled with still low inflation (low enough that additional easing would not be unreasonable), should be enough to keep the hawks at bay.

Earlier this week we learned that home sales continue to rise:

Yes, to be sure sales remain at very low levels. But it is the direction that matters now, and the direction is positive. In and of itself, the positive direction of housing is consistent with ongoing economic expansion (those ECRI guys are not likely to catch a break). And while there has been some commentary calling into question the quality of the January numbers, I would counter with signals from the latest ISM manufacturing report indicate that at least the underlying trend of improvement held in February:

"Business seems to be on an uptick. The normal seasonal downturn for us has been much shorter and not as severe as in the past four years." (Furniture & Related Products)

"Demand indicators are robust. Supply is constrained. Pricing is escalating." (Wood Products)

Speaking of manufacturing, that too is looking more robust. Core-manufacturing orders have staged a remarkable rebound in recent months:

Likewise, the ISM numbers were generally positive. Headline, and new orders, and production:

Moreover, even the external indicators were looking better. Most important in my mind is the improvement in new import orders, a signal of solid underlying domestic demand:

Finally, while the employment index slipped slightly, it still holds in expansion territory:

Were it not for the sequester, and the already evident impact on defense spending, manufacturing would be experiencing even stronger performance.

Changing tax laws created havoc in the personal income data, first boosting the December figure as taxpayers drew income and capital gains into the waning days of 2012 to avoid higher taxes and then dropping the January number on tax hikes, including the end of the payroll tax credit:

Still, courtesy of a drop in the saving rate as households adjusted to the tax hike, consumer spending continues to grind upward:

I anticipate the spending numbers to remain on the soft side in the near term as the impact of tighter fiscal policy continues to work its way through household budgets.

None of this is meant to imply that economics conditions are rosy, just that the economy continues to move in the right direction and was likely poised for stronger growth in 2013 if not for tighter fiscal policy. The anticipated impacts of tighter policy are expected to further widen the output gap:

And note that, still contrary to the expectations of those who believed Fed policy would send prices surging ever higher, inflation remains well under control, as would be consistent with an economy running below potential:

The challenge is not too much inflation; the challenge is too little inflation. Despite the generally positive direction of the economy, there remains room for additional monetary and fiscal stimulus. I doubt we get more of the former, and we are already seeing the opposite of the latter. Not exactly the optimal policy mix.

And I would admit to uncertainty about the sustainability the recovery over the longer term; I am still not confident we can exit smoothly from the zero bound. That, however, might not be a concern until 2016 or 2017 (assuming the Fed starts increasing rates in 2015). As far as the hear and now is concerned, I anticipate that 2013 is setting the stage for a stronger 2014.

Bottom Line: Near term trends are positive, and would be more so if not for the sequester. That said, I don't expect the near term to be sufficiently positive to derail the path of monetary policy. Fed hawks will still defer to Bernanke for the foreseeable future.