Mixed Signals Vex the Fed

Lower productivity and factory orders plus higher labor costs send mixed signals to the central bank; still, rate hikes before fall seem unlikely

Inflation—at least in the form of wage pressures—is still very much on the radar screen, according to government data for the 2006 fourth quarter released Mar. 6. And another report issued the same day detailed a big drop in U.S. factory orders for January. The reports illustrate the cross-currents faced by the Federal Reserve as it seeks to keeps prices in check while ensuring that economic growth remains on a solid track.

Here's Action Economics' rundown of the Mar. 6 releases:

Productivity and sales: Nonfarm productivity was revised down in the fourth quarter to 1.6%, from 3.0% previously (it was revised from –0.1% to –0.5% in the third quarter). Unit labor costs were revised up to a 6.6% rate, from 1.7% initially (revised from 3.2% to 1.1% in the third quarter). On a year-over-year basis, productivity slowed to a 1.4% pace (the smallest gain since 1997) from 2.1% previously, while unit labor costs are running at a 3.4% pace, vs. 2.8% previously. Real compensation per hour—i.e., as adjusted for inflation—was sharply boosted to 10.5%, from 7.1% previously, while compensation per hour was boosted to 8.2% in the fourth quarter, from 4.8% previously.

The report revealed the hefty revisions we expected, as the big downward fourth-quarter gross domestic product revision and hefty fourth-quarter wage accrual figure translated to big adjustments to productivity, compensation, and unit labor costs. The year-over-year nonfarm productivity gain of 1.4% should be followed by 1.5% to 2% figures in 2007, once the inventory adjustment works its way through the economy in the current quarter.

Compensation was boosted in the fourth quarter by the surge in financial sector bonus payments, which was captured faster this year than in the past two years, and incorporated quickly into fourth-quarter data instead of later spring or summer revisions. The big fourth-quarter compensation gain leaves the same 4.9% year-over-year increase as seen in the last fourth-quarter report, as prior quarterly compensation gains were revised downward. The 6.6% fourth-quarter unit-labor-cost gain leaves a big 3.4% year-over-year increase that's a big change from the 2.8% reported previously, however. This bump leaves a notable uptrend in the unit labor cost figures.

Factory orders: Factory orders dove 5.6% in January, more than erasing December's revised 2.6% increase (from 2.4% previously). A big 8.7% decline in durable goods orders (revised from –7.8%) was the main culprit behind the decline, which itself was largely a function of a drop in aircraft orders. Excluding transportation, factory orders were down only 2.9%. Shipments fell 1.2%, after jumping 1.3% in December (revised from 1.4%). Inventories fell 0.2% after 10 consecutive monthly increases, leaving the inventory-to-sales ratio at 1.23, from 1.22 in December.

More generally, the factory report revealed price-led weakness in the nondurable figures for January, boosts to shipments and orders in December followed by modest, downward January bumps that left bigger percentage drops for January, and a small twist in the December figures from inventories to sales.

The capital goods figures for shipments and orders were raised modestly in December and January, but remain consistent with a flat equipment and software figure in the first-quarter GDP report, following the 3.1% rate of decline in the fourth quarter that's now poised for a small $0.5 billion upward bump. The hike to fourth-quarter equipment will be offset by a similar, small, downward bump to factory inventories. The figures should leave the 2.2% fourth-quarter GDP growth clip intact, and we still project a 2.5% first-quarter GDP gain.

Our January business inventory forecast now sits at a decline of 0.1%, and we will assume a 5% bounce in the durable-goods report for February that will be led by a sharp bounce in the vehicle and aircraft figures from depressed January levels, and an associated 3.5% bounce in February factory orders.

The Fed outlook: In total, though the new lower productivity figures with higher wage and unit-labor-cost trends aren't a surprise, the figures will be troublesome to the Fed as it continues to wait for broad inflation measures to drop back into its comfort zones. Fed funds futures fell on Mar. 6 amid an equity market rebound, and are pricing in about 75% risk for a 25-basis-point rate cut in the Fed funds target rate—to 5.0%—by the end of June. August is fully priced for a 5% rate, though the hope for something more has been shed. We still look for the Fed to remain sidelined until the fall. And, in our view, the risk is still for a hike later in the year if the inflation figures remain sticky.

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