Inflation, Factory Data Squeeze Fed
A batch of economic data reports released Mar. 16 indicates that Federal Reserve policymakers may have to keep their focus on continued strength in retail prices, a still-resilient factory sector, and a slightly more cautious, though still upbeat, consumer at the Mar. 20-21 Federal Open Market Committee meeting.
These signals may drown out, at least temporarily, the concerns about subprime residential loans that have captured Wall Street's attention for the past few weeks, and have factored into market expectations that the Fed may adopt an easing stance to combat any liquidity crisis that may arise from the mortgage mess.
Here is Action Economics' rundown on the Mar. 16 reports:
Consumer price index (CPI): The U.S. February CPI report beat expectations for the headline, with a 0.4% gain, though with the expected 0.2% increase in the core index, which excludes food and energy prices, and with smaller energy and food price boosts than seen in the more troublesome 1.3% producer price index (PPI) surge for the month.
The figures partly bucked firmness in the February trade price report, where we saw hefty export price gains of 0.7% overall and 0.6% excluding food, with a more restrained import price gain of 0.2%.
Core year-over-year CPI price growth, at 2.7%, is above the Fed's preferred 2% soft target for this measure that is roughly consistent with the 1%-2% comfort zone for the core chain price index for personal consumption. And the headline year-over-year gain moved upward to 2.4% from 2.1%. The core year-over-year rate may drift down toward the 2.5% area through mid-year due to easier comparisons, but this may not suit a Fed that would probably like to see the figures "comfortably" and sustainably within the preferred range, and not just dancing at the upper end.
The headline year-over-year rates will remain restrained until August, when the commodity price peak of last year will scroll off the comparisons. At that point, the tendency—at least at current commodity price levels—will be for the headline rate to again exceed the core. And the strong start to energy prices in March suggests that the headline CPI figure will post a 0.5% March pop that will further raise the year-over-year headline increase to 2.7%.
We still expect a 0.3% headline gain in the February personal consumption expenditures (PCE) figure—an inflation gauge favored by the Fed—with a 0.2% core increase, with gasoline price strength similar to that signaled by the February retail sales report. The PCE chain price index for the first quarter is dancing around 2.6%, and the first-quarter gross domestic product (GDP) chain price gain will likely sit near 3.2%, which will both prove troublesome to the Fed.
Industrial production: February industrial production surged 1.0% (median 0.3%), which left capacity utilization at 82.0%, up from 81.4% (revised from 81.2%). Strength was paced by a hefty 6.7% surge in utilities, as a cold snap in most of the country in February followed the near-record warm January, though utility output was strong in January as well. The utilities gain marked the largest increase since December, 1989. Manufacturing rose 0.3%, led by a 3.1% gain in vehicles. Mining increased 0.1%.
The data imply a rebound in the February durable goods report, where we expect a 5% orders surge and 1.5% increase in shipments.
Industrial production growth will be close to 3% in the first quarter, following the downwardly revised figure of minus–1.2% in the 2006 fourth quarter (previously minus–0.8%). The fourth-quarter slowdown in industrial production lagged the slowdown in GDP growth, with a factory sector production overshoot in the second and third quarters that was sharply reversed in the fourth. The bounce now in the first quarter may presage a GDP bounce as well.
The February report also showed a jump in capacity utilization back near the cyclical high (82.4% in August) that will also keep inflation concerns alive at the Fed given capacity constraints.
Consumer sentiment: The preliminary University of Michigan consumer sentiment index for March revealed a correction to 88.8 from the February level of 91.3. The pullback is in line with the likely effect of falling stock prices and rising gasoline prices alone, without any excessive decline that would signal a deeper change in sentiment attributable to widespread mortgage market fears. The drop was exacerbated by the continued unwinding from the post-2004 high of 96.9 set in January.
We will set our forecast for the Conference Board's consumer confidence index for March at 106, following the hearty 112.5 reading in February, which marked the cyclical high. In total, despite March corrections, the various confidence measures still leave the array of data dancing around generally robust readings.
The Fed outlook: The February CPI made clear that the Fed will be unable to downgrade the inflation risk at next week's meeting, as was also made clear by the stronger-than-expected PPI and trade price data, and early indication that March will be a month of firm energy costs as well. Industrial production joined the employment and other indicators that show that February was a respectable month for the economy, aside from weather distortions that are plaguing many of the monthly reports. The drop in the preliminary Michigan sentiment index was manageable, and can be readily explained by the rise in gasoline prices and drop in stock prices at the start of the month, without any inordinate evidence of consumer "panic."
The Fed is in a difficult position and must choose its words carefully, but we believe the worst thing policymakers can do for the markets at the March FOMC meeting is move meaningfully away from their view that growth remains moderate and that they are remaining vigilant on inflation. We believe the Fed would lose credibility if they heightened the profile of their concern over the subprime debacle.
As such, it will be difficult for the Fed to do much to upgrade economic risks at the upcoming meeting as well, at least without the market perceiving that it reflects some internal subprime fears. We believe the central bank will leave the Fed funds target rate unchanged at 5.25% at the March meeting. The Fed is now quite likely to retain its tightening bias, and to keep policy comfortably on hold.