The Fed: Pause and Effect
As expected, the Federal Reserve took August off, holding the federal funds rate at 5.25% after a record 17 consecutive rate hikes. We still expect one more hike in September, because the economy looks stronger and inflation is a bit higher than the Fed seems to think it should be.
The August pause had been well telegraphed by the Federal Reserve and certainly came as no surprise to observers. The press release seemed somewhat on the dovish side of expectations, citing "economic growth has moderated" instead of June's "economic growth is moderating," (see BusinessWeek.com, 8/08/06, "The Fed Shows Its Dovish Side").
IS IT OVERREACTION?
More important, the statement on inflation now reads "inflationary pressures seem likely to moderate over time," while the June statement said "moderation in growth of aggregate demand should help to limit inflation." Overall, the statement seems to convey a bit more confidence that the Fed has already hiked rates enough to stop inflation.
The problem for the Fed is always: What it does today affects inflation about two years from now. Hence the Fed usually overreacts in the face of rising inflation. Judging where inflation will be in two years presents a difficult task, especially when inflation remains fairly close to targets.
The market was disturbed by the dissent from Richmond Fed President Jeffrey Lacker. He favored another rate hike, and the dissent suggested to the market that despite the dovish statement, the Fed might lean toward tightening at the September meeting. Dissents are unusual at the meetings but do occur, especially at the beginning and end of a new chairman's term.
The dissent usually comes from district Fed presidents rather than from the other board members, probably because the board has often argued the issues out before the Federal Open Market Committee (FOMC) meeting (and perhaps because the staff is feeding them all the same arguments).
AN ACCEPTABLE SLOWING.
Although we don't view dissent as a major sign of divergence of opinion, we think the odds still favor a rate hike in September. The Fed's decision not to hike this time was heavily influenced by the employment report, which has been weak for four consecutive months, and the July rise in the unemployment rate (see BusinessWeek.com, 8/08/06, "The Pause that Perplexes").
The other economic data has shown more strength than the employment figures have, and even within the employment report, the hours remain strong. With wages still accelerating and stronger employment data likely in the next few months, another rate hike seems probable, but timing will depend on the monthly data.
The second-quarter slowdown in productivity should not be taken too seriously. The data series suffers from volatility because the hours and production data are often a little off in their timing. Over the last four quarters, productivity remains up 2.4%, in line with the 2005 total and our estimate of a 2.5% trend. The weakness in the second quarter should just be viewed as a correction to the 4.3% surge in the first quarter. More disturbing, however, is the continued acceleration of unit labor costs, even on a year-over-year basis. Unit labor costs are up 3.2% from a year ago, compared with 2% in 2005 and 0.7% in 2004.
The U.S. economy is showing clear signs of slowing down—but to a pace the Federal Reserve will likely find acceptable. We expect growth to slow to 2.5% in 2007, from the 3.5% pace of 2005 and 2006, with the unemployment rate edging up from its current 4.8% level, to 5%.
CONSUMERS STILL SPENDING.
Growth is rotating from a consumer- and housing-led pattern to an investment-led expansion. Housing topped out last summer, though the abnormally warm winter and the rebuilding from Hurricane Katrina disguised the slowdown. Consumers are finally responding to the pinch of higher interest rates and higher energy costs. On the other hand, capital spending is speeding up, led by the energy sector, and the drag from the trade deficit has diminished.
The evidence so far indicates the consumer is not slowing down as much as we had thought. The 1.4% surge in retail sales in July was heavily influenced by the 2.5% rise in gas station sales, which simply reflects price increases. Motor vehicle sales were up 3.1%, rebounding from the recent drop. But even excluding those two unusual components, sales were up 0.7%.
But despite the slowdown, inflation is likely to continue to accelerate for a few more months, responding as usual with a lag to the tightness in markets. A falling dollar will add to inflationary pressures, keeping interest rates at current levels through at least the first half of 2007. Bond yields are actually expected to rise because of continued interest rate increases in Europe and Japan.
Of course, all of this assumes no major disaster takes place in the Middle East. A sharp drop in energy supplies could still turn the moderation the Fed is trying to engineer into an outright recession. We also assume that the decline in the dollar is orderly and that no sudden crisis of confidence is allowed to disrupt the international capital flows.