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Commentary
“If all the cars in the United States were placed end to end, it
would probably be Labor Day Weekend”…….Doug Larson
Cost-Push
Our monthly composite survey of select economists (taken post-Katrina)
shows a one-point downward estimate in third-quarter GDP—now an
average expectation of 3.7%, versus last month’s 4.7%. Do the revised
estimates portend an extended pause in the Fed’s march to neutrality?
The answer appears to be “possible, but not likely.” Although
we could get a deferral at the September 30 FOMC meeting, expectations
now call for a year-end funds rate of 4.0%, with an increase to 4.5% by
mid-2006. These expectations for the Fed funds rate showed little change
from last month. However, the expected year-end level for the 10-year
treasury is now 50 basis points lower than it was one month ago.
As the hurricane hit landfall, the U.S. economy was coming off of strong
economic momentum for June and July. Even in the face of rising energy
prices, retail sales had achieved their strongest back-to-back gains since
1990. Monthly job growth had been increasing at a rate of approximately
200,000 workers per month.
“Fed-speak” went into overdrive after the hurricane. Michael
Moskow, president of the Federal Reserve Bank of Chicago, stated his concern
about core inflation “…running at the upper end of the range
that I feel is consistent with price stability.” He also expressed
his concern that “…because the economy is running nearer to
potential, unfavorable cost developments are more likely to pass through
to core inflation.” Anthony Santomero, president of the Federal
Reserve Bank of Philadelphia, asserted that a “…measured pace
of rate increases will continue to be appropriate.” Bottom line:
The Fed is clearly concerned about the emergence of “cost-push”
inflation in the form of rising oil prices, which could, in turn, increase
prices of non-energy goods and services. The Fed’s bias is toward
ensuring that energy price surges are contained by reduced demand, rather
than embedded in production costs throughout the economy. This favored
scenario would most likely play out once the first of the season’s
heating bills appears in consumers’ mailboxes.
Unit Labor Costs vs. Productivity: A Preferred Fed Barometer
Last month, we discussed the Fed’s growing concern over of rising
unit labor costs and their relationship to recent decreases in productivity.
Indeed, second-quarter 2005 figures show that unit labor costs have risen
2.5%—the largest rate of increase since 2000. Labor productivity
increased by 1.8%—roughly half the rate of the increase that took
place during the first quarter.
Reversion to Inversion?
By the end of August, with oil rising over $70 per barrel, the prospect
of an inverted yield curve appeared imminent, with the spread between
two-year and 10-year treasuries dropping to a low of 11 basis points—the
slimmest spread since the 2000 – 2001 recession. With the spread,
as of this writing, having expanded to 25 basis points, it appears that
the energy prices of the past week have bolstered a steepening in the
yield curve. The financial market’s current interpretation of the
effect of rising energy prices appears to be that of a slower economy
in the longer run.
Central Banking and Asset Prices
It’s a contentious debate. Should rising housing and equity prices
be incorporated within the Fed’s view of and reaction to inflation?
The central banks of Europe, the U.K., New Zealand, and Australia have
historically forged monetary strategies designed to directly counter rising
home prices. As an example, the Bank of England increased short-term rates
on five occasions throughout 2004, directly citing inflated housing prices
as the reason; 150 basis points later, housing prices stabilized. With
the Fed’s broad mandate of wage and price stability, the Greenspan
era has heretofore addressed asset bubbles (e.g., the dot-com crash),
not through direct prevention (i.e., pre-emptive tightening), but by addressing
the after-effects of burst asset bubbles (i.e., post-bubble easing). Nevertheless,
during last month’s Federal Reserve symposium in Jackson Hole, Mr.
Greenspan appeared to acknowledge that, “Global economic activity
in recent years has been influenced by capital gains on various types
of assets, and the liabilities that finance them… Our forecasts
and hence policy are becoming increasingly driven by asset price changes.”
No doubt the issue of the Fed’s future role in addressing spiraling
asset prices will be at the forefront with next year’s appointment
of a new Chairman.
Continued Sluggish Deposit Growth
During the second quarter, the Federal Reserve reported that bank deposit
growth slowed to an annualized rate of 1.7%. The industry's loan-to-deposit
ratio increased from 91.2% to 92.7%—the highest level since the
first quarter of 2001. Facing a more competitive market for core deposits
and continued loan growth, institutions are increasingly considering wholesale
sources of funding in the context of their relative marginal cost. With
most institutions continuing to generate interest rate risk reports portraying
asset sensitivity, scenarios involving potential rate declines are bearing
more scrutiny. Reviews of contingent balance sheet structures are being
considered and include shortening deposit and funding duration, extending
loan maturities and re-sets, and purchasing or implementing rate floors.
John Biestman is assistant vice president, IMS consultative
sales advisor at the Federal Home Loan Bank of Seattle.
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