The consumer and housing markets seem to be cooling off, but the evidence is still mixed. Although car sales dipped in May, chain stores reported robust activity. It could be that consumers are switching what they are spending money on rather than spending less money.
The major question could be international. The dollar has begun to slide again, and a drop in the dollar is good for the real economy but bad for inflation. Even if the Fed doesn't care about the dollar directly (and it shouldn't), it does care about a weaker dollar causing higher inflation.
The Bernanke Code
Decoding the comments from Chairman Ben Bernanke has become the latest game on Wall Street, with markets swinging wildly on each new codex released. After more than 18 years of interpreting Alan Greenspan, adjusting to a new code takes time. So far, the problem is that observers are accustomed to trying to read between the lines of the Chairman's statements. There is much less between the lines with Chairman Bernanke; most of it is in plain text.
I think his comments have been quite clear. Chairman Bernanke has said that the Federal Reserve is likely to pause. He never said that such a pause would necessarily mark the end of tightening. The problem is that the market wants to know what the Fed doesn't yet know. The economy is approaching a decision point. The Fed has raised the funds rate at a record 16 consecutive meetings, to 5% from 1%. It is time for the Fed to pause to assess the impact of what has already been done, especially because the data suggest that the economy is beginning to slow.
Unfortunately, the incoming data also suggest that inflation is beginning to heat up. The slight acceleration in the core inflation rate in April sent a shudder through the financial markets, which are scared that the Fed is being caught once again between higher inflation and slow growth, as it was in the late 1970s. Admittedly, the level of inflation is far lower than it was at that timeùthe core consumer price index (excluding food and energy) is up 2.3% from a year ago, and the core deflator for personal consumption expenditures (PCE) is up 2.1%. The Fed has indicated that its target range (although carefully not called a target yet) for inflation is 1.5%-2% and has focused on the core PCE deflator as the most appropriate measure. The slight acceleration in this index, to 2.1% from 2.0% in March, has taken on outsized importance as a result.
The problem for the Fed, however, is that inflation is a lagging indicator. What the Fed does now affects the real economy with a "long and variable lag" of about 12-18 months, and inflation with a lag of another year. If the Fed adjusts its policies based on what is happening now to inflation, it risks chasing inflation with interest rates, and generating the economic cycles in real growth and inflation that it is trying to prevent.
Federal Reserve policy always has to be forward-looking, based on what will happen a year or two from now, not what happened last quarter. I continue to believe that the economy will slow fairly abruptly in the second half of this year, as housing cools and consumers finally realise they are spending more than they are earning. After rising 4.1% in the first half of 2006, real GDP will rise at an annual rate of only 2.4% in the second half, and 2.5% over the four quarters of 2007.
But I also expect inflation to pick up. Oil prices are being passed through, if slowly, into other prices. A declining dollar will both raise import prices and provide producers with more ability to raise prices of domestically produced goods. Wages have accelerated slightly, reflecting a tighter labour market. So far, however, that rise has been offset by a slowdown in fringe-benefit costs and continued strong productivity growth. Nevertheless, the core inflation rate is expected to edge up to 2.5% by year end, in spite of weaker economic growth.
The Federal Reserve is caught between the evidence of slower growth and higher inflation, as it reported in the minutes of the May 10 FOMC meeting: "Although the expansion appeared likely to moderate, it evidently remained solid. Inflation pressures appeared to be somewhat greater than the Committee had anticipated at the time of its March meetingà Given the risks to growth and inflation, Committee members were uncertain how much, if any, tightening would be needed after today's action."
The overall tone of the minutes and Chairman Bernanke's June 5 speech were just a bit more aggressive than expected, showing more fear of inflation and less confidence the economy is slowing. We still think that a slowing economy will convince the Fed to remain on hold, but the odds are narrowing.
Many of the financial reporters seem upset that the Fed isn't telling them what it intends to do next. The Fed doesn't know what it is going to do next. Incoming data will change the outlook for inflation and for growth. Take the Fed at its word: It is uncertain whether it will have to tighten again, and by how much.
A pause should certainly not threaten the Fed's credibility. The Fed does not normally tighten at every meeting. This cycle has been unique in the Fed's moving every six weeks like clockwork (or maybe a broken clock). In all past long tightening cycles, the Fed has taken the occasional meeting off, and moved by more than 25 basis points at other meetings. The Fed could be consistent this time in large part because inflation was so well behaved, and thus there was no urgency in tightening.
Dollars And Deficits
The dollar has begun to slip again against its major trading partners. Given the growing US trade deficit, the surprise is that it hasn't slipped faster. However, in 2005, the trade gap was offset by a decline in European bond yields, which opened up a big interest-rate differential and attracted investment funds to the US. With the Eurozone economies improving and the European Central Bank starting to raise interest rates, the European bond yields are rebounding.
The dollar is likely to drop farther. The Federal Reserve is expected to stop tightening, while the ECB is likely to continue tightening through at least year end. Growth in the US is slowing, while growth in Europe is accelerating to 2.2%. Japanese growth is expected to reach 3.2% this year, and the Bank of Japan, which has already abandoned quantitative easing, is likely to abandon its zero-rate policy by year-end.
In addition, core inflation is rising in the US. The falling dollar creates inflationary pressure, because it both raises import costs and also allows domestic manufacturers more room to raise prices. But the slowing economy will limit the extent of price hikes. In addition, the dollar will drop less against the currencies of the Asian countries, which provide most of our imports. Although the Chinese government will allow the renminbi to appreciate, they won't allow it to appreciate much.
The rising bond yields overseas will put upward pressure on bond yields in the US. We expect the yield on the 10-year Treasury note to reach 5.25% the end of this year and 5.75% by the end of 2007. Helping to offset the upward pressure of overseas rates and higher inflation will be a declining Treasury borrowing requirement. May tax receipts are coming ahead of expectations, as April's did. The budget gap in fiscal 2006 seems certain to come in below $300 billion; we have revised our estimate down to $282 billion from $307 billion in our last forecast. The budget gap is likely to narrow again in fiscal 2007, but is then expected to rise in response to increased entitlement costs, as the baby boom starts to leave the workforce. We are assuming that most of the tax cuts are extended.
The danger remains oil. Imports of petroleum accounted for $65.2 billion (31% of the total first-quarter trade gap). Continued saber rattling with Iran is keeping upward pressure on oil prices. We keep revising our price forecasts higher as the geopolitical risks continue to wax rather than wane. If Iran follows through on its threat to use oil as a weapon, oil prices could easily double from their current level. Prices have already doubled from their level of four years ago, and the world economy has absorbed it unexpectedly easily. But could it absorb a redouble?
[The article is an extract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]
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