The Fed: Neutral, Not Idling
On February 2, the Fed stayed true to the script and completed the sixth meeting in a row with a 25-basis-point increase in the target rate for overnight funds. Although we may not yet be at the point where we could claim Fed neutrality (i.e., an overnight rate that would represent a balance between restraining inflation and allowing an economy to grow at a sustainable rate), predicting the timing of the next increase has become more challenging.

With the Fed funds rate at 2.5%, we are now 50 basis points higher than the European Central Bank’s comparable benchmark, but 225 basis points below the Bank of England’s. (Remember last month’s discussion of the consequences of an inverted yield curve?)

This round of rate increases is unique. Fed tightening is rarely conducted under a scenario of desired levels of inflation. Rather, it usually occurs with immediate signs of inflation. As such, the bias appears to be a central bank that is poised to act in the event inflationary pressures surface.

Thus far, with the exception of residential real estate, college tuition, and certain commodities at the raw material stage, inflation appears to be contained. In fact, 2004 saw the highest rate of economic growth on a worldwide basis in over 30 years. Still, price pressures at the finished goods level failed to surface. Consumer prices in the U.S., excluding food and energy, rose at a manageable rate of 2.2%. The Fed’s preferred measure of inflation, the personal consumption expenditures index, rose by 1.5%. Indeed, several weeks ago, Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, stated that “one and a half, for me, is price stability.” Still, other Fed members appear leery of a weaker dollar and rising commodity prices ultimately having an adverse effect upon inflation.

We’ll have further opportunities to view the Fed’s propensity for further increases when Alan Greenspan presents his semi-annual Humphrey-Hawkins testimony before Congress on February 16.

Labor Participation and the Unemployment Rate
We recently attended a meeting with Richard F. Hokenson, former chief economist at Donaldson, Lufkin & Jenrette and director of demographic research at Credit Suisse First Boston. Hokenson is a pension fund consultant who focuses on developing investment strategies around major demographic trends. As an interesting aside, he consults on behalf of large European and Japanese pension funds. Their major worry of late: current and projected returns on their domestic investments are falling well short of actuarial assumptions. So where are they looking for higher yielding assets? U.S. Treasury debt, agency debt, and other stateside investments. Quite possibly, support of our growing debt issuance may not simply represent the “kindness of strangers"!

In any event, one of the key elements of the discussion centered on a reversal in the social trend of increasing dual-earning families. Some interesting information from the U.S. Census:

Why do we bring up this demographic observation? It may be contributing to the lower unemployment rates that we are continually seeing, sometimes with less-than-expected increases in non-farm payroll employment. Indeed, during January, with a payroll increase of 146,000 (less than what most economists had expected), the unemployment rate fell from 5.4% to 5.2%. There has been a persistent drop in the ratio of jobholders as a percentage of the total population. That ratio presently stands at 62.4%, roughly 2% below the level that existed prior to the 2000 – 2001 recession.

Waning Productivity = A Tight Labor Market?
Labor productivity in the fourth quarter grew at an annualized rate of 0.8%, the lowest level in four years. Slower productivity typically portends higher labor costs in order to keep pace with demand. As companies are able to extract less from their existing labor pools, hiring should increase, so the story goes. In recent weeks, various Federal Reserve governors have mentioned that they will be looking at changing trends in productivity as future policy determinants.

The impact of declining productivity upon wage-induced inflationary pressure does not seem to have surfaced. The Labor Department’s employment cost index rose by 0.7% during the fourth quarter. Combined with the 0.9% increase from the third quarter, we have seen the lowest quarterly growth rate for the index in six years. January’s labor report showed average hourly wages rising by only three cents, with flat growth in average weekly wages.

Last month, Janet Yellen, president of the Federal Reserve Bank of San Francisco, voiced some concern regarding declining labor participation: “If participation does not rise or continues to fall,” said Yellen, “this will mean the remaining slack in the economy will diminish faster, creating upward pressure on inflation sooner.” That is, of course, provided that economic demand continues to participate.

Trade Winds
Following 4.0% growth in the third quarter, real GDP increased at a lower-than-expected rate of 3.1% during the fourth quarter. A record $632-billion trade deficit was responsible for subtracting 1.7% from the real GDP growth rate. The trade drag was offset by strong additions to inventories, business fixed investments, and consumer spending. The past two quarters show that consumer spending has registered the best rate of growth in five years. If it can’t come from rising hourly wages, there’s always a little help from the rising equity in one’s home!

A 32nd Here, a 64th There…
With U.S. equity markets having abandoned fractions as a means of communicating prices in 2001, some circles, including the Treasury and the Bond Market Association are reviewing a similar approach to the U.S. Treasury and agency markets. The Treasury recently opened discussions with primary dealers regarding the possibility of pricing securities in increments of .001%, in order to bring new issues as close as possible to par at auction and to reduce the possibility of auction re-openings. The NASDAQ has seen a significant reduction in spreads between “bid” and “ask” since the implementation of decimalization. This has been a windfall for portfolio managers and individual investors, but hardly a boon for the brokerage community. We’ll see if we can give our calculators a long-deserved rest!

John Biestman is assistant vice president, IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.

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