Bernanke and the Three BearsMichael Englund
The story about the U.S. "Goldilocks economy" -- where growth is at a pace that is "just right", neither too fast nor too slow -- is quickly approaching a new chapter. At their June meeting, Federal Reserve policymakers will need to look beyond the economic conditions bearing the curly-tressed trespasser's name to the Three Bears: the threats of rising core inflation, a falling dollar, and moderating economic growth.
It will be hard for the policy-setting Federal Open Market Committee not to focus on what Fed chairman Ben Bernanke considers Papa Bear: inflation. The U.S. consumer price index report for March, released on Apr. 18, gave the bond market a taste of Papa's wrath. We saw a surprisingly resilient core reading (which excludes food and energy prices) at 0.3% for March.
Headline CPI inflation has consistently outpaced core inflation since 1999, with the exception of the one-year period following the September 11 terrorist attacks, and core inflation has been pushing higher from its cyclical trough in late 2003 at 1.1%. The recent plateau in core inflation has been welcome at the Fed, but there is clear risk of a renewed uptrend.
We, and the markets, have consistently assumed a reprieve in the upward march of energy prices, but to no avail. Any continued headline inflation strength would just heighten existing upside risk to core CPI inflation, as it hovers just above the 1.5% to 2% rate often cited as desirable by economists.
As with CPI, headline inflation as measured by the personal consumption expenditure (PCE) chain price index from the monthly personal income report is notably troublesome, despite the fact that the core measure from this report has recently revealed rates within the seemingly comfortable 1.5% to 2% range. These leaner figures are at particular risk through the remainder of 2006, as they are now underperforming the CPI core figures as well as headline inflation.
The quarterly GDP chain price figures have registered some particularly large gains over the last five quarters of 2.6% to 3.5%, and this measure is poised for another solid gain of 2.8% in the first quarter. Though our assumption of a near-term top in energy prices leaves a projected moderation through our 2006 forecast horizon that brings the rate back toward 2%, the trend in these figures otherwise is clearly upward.
The uptrend in U.S. inflation is also evident in the monthly U.S. trade price reports, where import prices including petroleum have soared from the nearly flat figures evident through the 2002 to 2003 period. The import and export prices without oil have shown a clear upward trend as well, and have reached or exceeded their 1995 peaks.
While the Fed needs to keep a close watch on the patriarch of the ursine household, it must also remain wary of Mama Bear -- the declining value of the U.S. dollar vs. other currencies. In this regard, the dollar appears poised to resume its downward trend from the peak in February, 2002, following some reprieve in 2005. A downtrend is in place for the U.S. currency this year despite the 2005 bounce, which we attribute partly to the effects of repatriation, and partly to the mismatch of economic growth between the U.S. and the other major industrialized economies. The gap between U.S., European, and Japanese growth prospects is now narrowing.
Finally, we turn our attention to Baby Bear: the pace of U.S. economic growth. Here, the news in 2006 has been remarkably positive for the economy, and in the first quarter this may have raised suspicions that the Fed hasn't been aggressive enough. But now, a robust U.S. economic performance for the quarter will leave the monthly and quarterly data for the remainder of the year with nowhere to go but down, and this will shift attention to whether the Fed may have gone too far in its series of rate tightenings.
The expected 2006 gyration should be particularly harsh for real consumption, which likely posted a first-quarter growth surge to the 5.5% to 6% area. Soaring gasoline prices as we enter the second quarter should take a chunk out of the "real" (adjusted for inflation) figures for this quarter, and we generally expect real consumption growth to slow to the 3% to 3.5% range for the remainder of 2006.
A similar story can be told for U.S. fixed-investment growth, which likely reached a robust 11% rate in the first quarter that will be difficult to beat in the remaining quarters of the year. Large gains in U.S. corporate profits should continue to fuel big 8% to 16% gains in equipment and software spending through the remainder of 2006. And commercial construction activity is charting a solid 2006 growth path. But a cooling pace for the housing sector should allow fixed-investment growth to moderate to the 5% to 7% range through the remainder of the year.
GROWTH AS BALLAST.
U.S. and world GDP growth should remain robust enough through 2006 to continue to provide a solid floor to energy and commodity prices through the year, and hence should be solid enough to sustain an inflation threat. As we have argued in the past, we see rising energy prices more as a reflection of strong economic growth than a harbinger of weakness, as movements here have generally been positively correlated over the last two decades.
What this means is that world growth in 2006 should be sufficiently strong to sustain the U.S. inflation and currency threats to the Fed, even though the market will likely be increasingly focused on an economic deceleration.
The prospective return of the Three Bears will raise more troublesome policy discussions at the Fed, and greater political pressure on Bernanke. Perceptions that the new Fed chief is more enamored with "inflation targeting" than his predecessor, and potentially more cynical about the benefits of micromanaging economic growth, may provide some additional color to the debate at the Fed regarding the ideal point for the central bank to take a break from its series of rate hikes. We still see the Fed pausing with the Fed funds target at a 5.0% rate -- after the FOMC hikes rates a quarter-point at its June meeting.