Looking For Clarification
April 28 – May 2, 2008
The crystal ball had been fogged for some time, but the economic outlook grew even more uncertain following the Bear Sterns debacle in mid-March. The Federal Reserve expanded its liquidity facilities and cut the Fed funds target rate by 75 basis points to 2.25%. Since then, the economic data have been weak, but not horrible, consistent with roughly flat growth in GDP. While the news hasn’t been good, it’s not as bad as anticipated, leading to some improvement in stock market sentiment. Yet, downside risks to the growth outlook are still considerable. Inflation remains a serious concern. Fed policymakers face a number of potential perils. Most likely, the Fed will trim short-term interest rates once more. However, as it looks ahead, the Fed must remember the lessons of thirty years ago and avoid accommodating higher food and energy prices.
In the 1970s, oil price shocks had a more immediate impact on the economy. People paid for gasoline mostly with cash. Spending more to fill your tank left less money in your wallet to spend on other things. Currently, most consumers use credit cards for routine purchases. As a result, one doesn’t feel the sting of higher energy prices right away. However, consumers will adjust their spending habits over time. On the business side, there is now a well-developed futures market. Oil prices can be smoothed over time – hence, a smaller response to oil price shocks. Major energy users will hedge their energy costs, but there are limits to how long you can do this.
Union membership is a lot lower now (as a percentage of private-sector employment) than it was 30 years ago. In the 1970s, the government began indexing Social Security and other programs to the Consumer Price Index. The unions thought that was a good idea and began embedding “cost-of-living” increases into wage contracts. As oil prices spiked, the CPI rose, and so did union wages. Non-union wages followed and we were off to the races on inflation.
Still, while there are a number of reasons to expect a more muted response to energy price increases these days, pass-through effects seem likely to matter eventually. As gasoline prices began to rise a few years ago, the transportation sector was able to squeeze out efficiencies to make up for it. Yet, there are limits to those kind of efficiency gains. However, to date, energy price pressures do not appear to have bled through at all to higher prices of core consumer goods.
Yet, higher energy prices have contributed to food price increases. The production of fertilizer is energy intensive. Agricultural goods must be transported. On a positive note, higher food prices have helped revive rural communities and lifted the heartland. The economy in Kansas, for example, looks strong.
The commitment to biofuels, while well-intentioned, has helped generate a global food crisis, pushing agriculture prices sharply higher over the last several months. As farmers have shifted to corn, prices of other agriculture commodities, such as cotton, have shot higher. In hindsight, the push to ethanol is likely to be viewed as a terrible mistake for the economy as a whole. It’s unclear how the shakeout in farming will play out. None of the three presidential candidates appears likely to backtrack on ethanol commitments anytime soon and Congress isn’t about to turn the tide.
Fed policymakers had expected food and energy prices to moderate this year, pushing headline inflation down. So far, that hasn’t been the case. Higher food and energy prices have been a significant restraint on household spending growth. As such, overall economic growth is likely to be soft in the near term. If the Fed tried to counter such a slowdown, it would end up accommodating higher inflation. However, the economy also faces significant issues in the credit markets. Since mid-March, the worst of the financial problems seem to be behind us, but we’re still nowhere close to returning to normal. The Fed has to balance concerns about inflation with worries about tighter credit conditions. What makes the Fed’s task especially difficult is that it has to set monetary policy on where it expects the economy to be six to 12 months from now.
This week, we’ll get the initial look back at 1Q08 GDP along with fresh figures for April (consumer confidence, ISM manufacturing, vehicle sales, and employment). The Fed will spend part of its two-day policy meeting discussing expectations for growth and inflation. Unfortunately, despite whatever clarification we get from this week’s data, the outlook will remain highly uncertain. The stock market will look beyond near-term problems and focus on the eventual recovery, but that recovery, like the last two, may be long and gradual.
Fed Outlook: Easing Near An End?
April 21 – April 25, 2008
Federal Reserve officials will meet at the end of the month to set monetary policy. A decision to lower the Fed funds target rate further is not likely to be easy. The economic data have been consistent with roughly flat growth in GDP. While conditions are mixed across industries and regions, the economy does not appear to be falling off a cliff. However, there are clear headwinds to growth and important downside risks. Inflation pressures seem to be everywhere, but, importantly for the Fed, not in the labor market. Yet, the Fed’s prior confidence that inflation will moderate this year has to be shaken. The Fed’s extraordinary efforts to provide liquidity appear to be successful, but credit markets are still strained, and despite Fed rate cuts, bank credit is tighter. The FOMC will have to weigh the downside risks to growth against the upside risks to inflation.
Inflation is up. The Consumer Price Index rose 4.0% in the 12 months ending in March – and, depending on what you consume, your personal inflation rate could be a lot higher (drive a lot, eat lots of dairy, sending a kid to college?). The core CPI rose 2.4% y/y, at the upper end of the Fed’s comfort range (the Fed focuses on the PCE Price Index, which typically trends about 0.3% below the CPI). The Fed’s January projection of core inflation for 2010 was 1.4% to 2.0%, with a central tendency of 1.7% to 1.9%. The recent trend is not far from the Fed’s long-term goal, but the Fed isn’t worried about past inflation.
“Even with a substantial easing at this meeting, most members saw overall inflation as likely to moderate in coming quarters, reflecting a projected leveling-out of energy and commodity prices and an easing of pressures on resource utilization. However, inflation pressures had apparently risen even as the outlook for growth had weakened. With the uncertainties in the outlook for both economic activity and inflation elevated, members noted that appropriately calibrating the stance of policy was difficult, partly because some time would be required to assess the effects of the substantial easing of policy to date.” – FOMC minutes (March 18)
Clearly, the Fed has been betting that food, energy, and other commodity prices would moderate this year. However, food and energy prices have continued to rise since the March FOMC meeting. Inflation expectations have also increased, but more short term than long term. The Fed expects that slower near-term economic growth will help keep inflation pressures in check. To date, there appears to be little inflation pressure building through the labor market. Labor cost pressures depend on productivity growth as well as wage growth. Productivity growth typically slows during periods of economic weakness. However, in the current environment, slower productivity growth is likely to imply a squeeze on profits rather than a boost to inflation.
Commodity price pressures remain a concern. Ex-food and energy, prices of crude materials rose 16.8% y/y in March, intermediate materials rose 5.5%, and finished consumer goods at the wholesale level rose 2.3% y/y. However, in the CPI, prices of consumer goods ex-food & energy were unchanged from a year ago. Higher inflation has been concentrated in food and energy. There is a genuine global demand component to the rise in food and energy prices, and supply has a problem catching up in the short term. However, there is also a speculative element. A stumble in China’s economic growth rate, say after the Olympic games, could trigger a sharp decrease in the prices of several commodities. In addition, higher food and energy prices are likely to dampen global growth, leading to reduced growth in demand for energy and other commodities.
The dollar is often cited as a factor in the rise in commodity prices. However, the broad trade-weighted dollar is down 21% from where it was five years ago – meanwhile the price of oil is up four times. In truth, the causality appears to go the other way. The high price of oil has contributed to a weaker dollar, due to the large amount of petrodollars working their way back to the U.S.
Still, the weaker dollar has led directly to an increase in import prices. Imports account for about 40% of domestic goods consumption in the U.S. (according to NIPA estimates). In addition, the weaker dollar implies less competition from foreign firms – and hence, a greater ability for U.S. firms to pass higher costs along.
A soft economy, troubled credit markets, and downside risks give the Fed the leeway to cut short-term rates further. However, inflation fears are likely to have increased for many Fed officials (two FOMC members formally dissented from the 75-bp March 18 cut). The scope for further cuts in short-term interest rates beyond April 30 appears to be relatively limited.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
