Wednesday, May 09, 2007

Have the Carrot Handy, but Don't Forget the Stick

FOMC Report
May 8-9, 2007

Have the Carrot Handy,
but Don’t Forget the Stick

Martin McGuire

Executive Summary:

The Fed will soften its tone on inflation concerns in the upcoming FOMC statement. I believe the Fed will remove the words ‘predominant policy concern’ from their view on the “risk that inflation will fail to moderate as expected.” This will be a small but important step toward easing the policy rate.

Recent economic data point toward weaker consumer spending, continued weakening of the housing market and slowing employment conditions. At the same time, some surprising strength has been seen in manufacturing output. Inflation is at the doorstep of the Fed’s comfortable zone.

The growing pressures from the lagged effects of prior rate increases combined with uncharacteristically high levels of risk assumption at this point of the economic cycle give rise to a higher level of systemic risk. Despite currently high levels of excess liquidity, declining economic conditions and tamer forthcoming inflation conditions could prompt the Fed to ease as early as June.

The Statement:

The FOMC statement may take note of recent decline in inflation. Year-over-year core PCE was reported to be at 2.1% in March; which is just above the widely understood 1%-2% comfort zone to which many Fed governors refer. The readings over the next months will need to be quite elevated to keep the six month average from falling into the ‘comfort zone’. Cyclical pressures on inflation are taking hold and will push inflation lower over the intermediate term (3-9 months).

The Fed has made note of housing market conditions in the statement following each of the last eight meetings and will likely continue to do so in the statement tomorrow. In January 2007 the Fed found reason to suggest ‘some tentative signs of stabilization have appeared in the housing market.’ All other references over the last year have been with respect to the extent of the weakness in that sector.

Note that in January when the Fed saw reason for reduced concerns for housing market prospects, they also adjusted the tone they took on inflation. The statements from the meeting surrounding the January meeting said that ‘readings on core inflation have been elevated’ (December 2006 FOMC) and ‘recent readings on core inflation have been somewhat elevated (March 2007 FOMC). In January however, the Fed took the view that: ‘Readings on core inflation have improved modestly in recent months’.

There seems to have been a balancing act going on there. The Fed at that time wanted to express some support for the notion that the worst of the housing troubles were behind. At the same time, they felt it necessary to lighten up on the inflation tone in fear that market participants would otherwise interpret the statement as suggesting further restrictive measures more likely.

Remember that in early December 2006, Eurodollars were pricing in 90 basis points of easing in the rolling fifth quarterly contract (December 07 expiry Eurodollar contract). Only seven weeks later, but and before the January FOMC meeting, there were only 17 basis points of easier policy rates priced in that part of the curve. Expectations had already shifted away from easier forthcoming monetary policy conditions and the Fed did not want to risk the market pricing in the expectation for a return to a ‘restrictive policy directive’.

Given the flip/flop on the Fed stated views on housing market conditions because of the subprime problems coming to light between the January and March meetings, I knew the Fed would need to be inventive in their description the housing market conditions in the March FOMC statement. I correctly assumed they would try to lump housing and general economic growth together as much as they could and replace ‘firming growth’ with something less substantial and implying more irregularity.

I wrote in my March FOMC report: “The Fed may change the FOMC statement to suggest uneven but moderate economic growth is expected, including in the area of housing, rather than ‘firming growth’ over the coming quarters.” (The Fed and Interest Rates ). The Fed in fact stated: “Recent indicators have been mixed and the adjustment in the housing sector is ongoing.” ( ).

To the extent the Fed wishes to point toward a less worrisome inflation backdrop, as I believe they will, consistent with the approach taken in January, the Fed will likely play down the problems in the housing market. If this is the approach taken by the Fed, they could move to an easy posture in June by pointing to a renewed weakness in the housing sector while inflation conditions continue to trend in the right direction. That is my base case scenario for the next two FOMC statements.

I expect the Fed in the upcoming statement to maintain an approach consistent with the that taken in January when the Fed scaled back concerns for housing market prospects and took a decidedly more benign view of inflationary prospects (than in prior statements). This will allow tweaking of the statement on both sides (growth and inflation) following the June FOMC meeting.

Current Conditions:

Housing continues to be a drag on economic growth, but has failed thus far to reach as far as I suspect it eventually will into consumer spending behavior. I have long warned that the spring home selling season would not provide the relief many were expecting. We have seen this in the most recent housing statistics and most impressively in the ‘pending home sales’ released by the National Association of Realtors. For the month of March, pending home sales declined by 4.9%. The existing inventory is nearly eight months of sales as compared to the three months long-term historic average.

The most recent employment report is the weakest since November 04’ and the first report in a long time to show a negative revision to the prior month non-farm payroll data. I believe we are at the opposite end of the spectrum from that point in 03’ when employment statistics failed to capture the jobs from start-up concerns and consulting efforts. At this point in time, many smaller firms have already been absorbed by larger firms and these jobs are well accounted for.

There has been some very solid growth in the non-residential construction industry over the last three to six months. To the extent that resources are suited equally well for non-residential as they had been for residential construction use during the housing boom, we should expect that non-residential construction has attracted these otherwise idle resources. I expect some of the reason for only moderate increases in construction unemployment over the last five month is in part due to the portability of this skill from residential to non-residential construction.

Taken one step further, we might also expect that the input cost for some non-residential projects was lower as a result of excess capacity resulting from the housing bust. As such, there may have been and may continue to be a tendency for non-residential construction firms to focus more on the relative low cost of inputs rather than the suitability or need for additional office and factory space. The extent to which industry focus is away from the sensible deployment of available resources to fulfill a requisite amount of additional office and factory space and instead toward the relative low cost of resource deployment, we will soon (if not already) have overproduction in the non-residential construction sector. This then would be on top of the current glut of housing inventory.

Both manufacturing and non-manufacturing ISM’s were higher than expected in the last reports. These series were trending lower until the last report and it is difficult at this point to understand how lasting this unexpected strength will be. Factory orders also showed extraordinary strength in the last report (March +3.1% rather than the expected +2.2%). I have long felt and see no reason at present to adjust the view that the U.S. economy will continue to rely less, going forward, on manufacturing as a percentage of total economic output. As such, I suggest we view the recently strong manufacturing readings as a curious interruption in a trend rather than the start of something grand.

It is possible, of course, that some very smart and entrepreneurial-minded firms in the States have found new products and production techniques for making unfinished goods for resale to emerging market economies. I will dutifully monitor this development.

Inflation appears tame or taming in the inter-meeting period from the March 21-22 FOMC meeting. PPI has long shown consistently low readings as firms continue to make headway on cutting costs. The Fed, in its most recent Beige Book, indicated that ‘in response to higher input prices, some manufacturing businesses in the Boston, Cleveland, Chicago and Dallas Districts were able to raise output prices.’ This is something to watch, but certainly not a trend as the last report showed month over month three, six and twelve month averages of PPI at 0.56%, 0.43% and 0.26% respectively.

The most recent CPI report indicated that core CPI for month-over-month three, six and twelve month averages was at or below 2% in each case and all trending lower from September 2006.

Finally, Core PCE as mentioned earlier was reported in March to be 2.1% on an annualized basis. This is widely considered the Feds favored guide when looking at inflation trends. The higher reading of 2.4% in February helps keep the three and six month averages higher at 2.2% and 2.0% respectively. The 12 month average in this series is still impacted by an additional two readings at 2.4% from August and September of 2006.

In early 2006 I pointed out that the Fed took note of higher short-term three and six month inflation averages. It was my expectation then as it is now that Mr. Bernanke pointed to shorter-term inflation measures while they were problematic, so that he may have the opportunity to point to them again when they were more favorable. The time is close at hand for Mr. Bernanke to show short-term inflation readings in currently more favorable light. It may come in time for a June Fed policy shift.

Looking Well Forward:

Following the two day meeting which starts today, when the FOMC meets next, it will have been a year since the Fed had last raised the policy rate. It will then be nearly twice the 6.2 month average which lay between the last rate rise and the first lowering in the prior three policy cycles.

I have largely considered the Fed neutral in their policy directive for many months and in word only has the Fed professed a more restrictive stance. This Fed posture has helped keep a tight lid on inflation expectations. The longer-lasting benefits from containment of inflation expectations, while recently debated, are still widely believed to have a profound impact on forward-dated actual inflation.

The Fed has had to maintain their decidedly hawkish inflation rhetoric longer than they have had to in previous rate cycles because the most recent restrictive policy directive failed to remove liquidity to the extent normally achieved in a less transparent operating environment. See (The Fed and Interest Rates) for further discussion on the topic for which I coined the phrase: “path-dependent restrictive monetary policy directive”.

The Fed is expected to lower target policy rates soon because of economic slowing resulting from the removal of liquidity from the housing market. The repercussions from a slowing housing market have not fully worked through to consumer spending, but the last personal spending report (March +0.3% rather than the expected +0.5%) might be an indication that the consumer is starting to react to weaker housing prices.

As we consider the course of consumer spending habits resulting from a removal of liquidity from the housing market, we would do well also to note the latest ‘safe haven’ for these fickle funds and the possible implications for Fed policy. As the subprime market was having some widely reported problems (and I am not saying they are over yet), the global equity market took note and gave some considerable ground. However, when some small sense of normality returned to the markets in general, and there was reduced concerns that the subprime industry was going to drag the rest of the financial world down the drain; liquidity, if you would, looked around and spied the equity market as a better spot certainly than housing to ‘invest’/park funds.

As such, equity markets have advanced quite smartly since mid-March. To the extent to which this development continues, the Fed will find it difficult to initiate an easier monetary policy even if growth continues to deteriorate. Classic economic reasoning would be to expect that the equity market is indicating what will happen in the economy some six to twelve months in the future. However, to that point where excess liquidity is using a very liquid global equity market to park funds which cannot otherwise find economically viable investment alternative; we should expect that recent and subsequent index gains are not instructive toward forward economic prospects.

Indeed, should there come the day when this excess in liquid funds collectively decide to find safer pastures than the equity market, consumers already struggling from the weight of weaker home prices and the resultant lower wealth effect could get the double-whammy from a rapid decline in equity indices.

While an imaginative insurance policy to protect against systemic risk should carry a higher premium today than it did only months ago, I suspect in this current liquid environment that my imaginary insurance policy would actually cost less.

The Fed has failed to remove liquidity in its most recent ‘path-dependent restrictive monetary policy directive’ as a result of excessive transparency. Market participants knew well the timing and extent of Fed ‘restrictive’ policy intentions and stayed one step ahead. The lagged effects from prior rate increases are finally coming to bear on the financial system. This is most visibly apparent in the adjustable mortgage market. Narrow credit spreads point toward continued excess risk appetite. This, then, is the recipe for systemic risk. There is no law which states that the excess liquidity in the system must make itself available for falling asset prices. We might rather expect that this liquidity may exacerbate falling asset prices at some point.

So to the Fed I would advise that the transparency which you so desperately want to operate under be used more thoroughly in an easy monetary policy directive rather than in a restrictive one. Our real time case study on the most recent Fed policy mistake shows quite clearly that transparency in monetary policy serves the Fed mandate of ensuring maximum economic growth and employment, and does little or nothing to ensure stable inflation. Sure have the carrot handy, but don’t forget the stick.

Finally, I would look far enough out to recognize that should the Fed ease the policy rate at some point over the coming months, they may not remain on an ‘easy monetary policy directive’ as long as they might have on average over prior policy cycles. The Fed will have some work left unfinished from the last ‘restrictive’ effort.


The Fed is expected to change the FOMC statement toward the recognition that inflation prospects are less worrisome, which will allow the Fed further room to ease policy rates in the near term. Economic and inflationary developments are largely supportive of an easier monetary policy. The Fed failed to remove liquidity in their last ‘restrictive’ policy effort and this has resulted in greater systemic risk and will shorten any easier monetary policy directive forthcoming.

FOMC Date | Funds Target | Risk Assessment

May 9, 2007 | 5.25% | Balanced
June 27-28, 2007 | 5.00% | Slow Eco-Low Infla
August 7, 2007 | 4.75% | Slow Eco-Low Infla
September 18, 2007 | 4.50% | Bal-Low Inflation
October 30-31, 2007 | 4.50% | Balanced
December 11, 2007 | 4.50% | Balanced


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