|
|
Commentary
Fluttery Will Get You Nowhere
During uncertain times, it’s often consoling to observe the statistical probability of the outcomes of the political and economic questions of the day. Centuries ago, the British coined a phrase for it: making a “flutter,” or a small bet on almost any conceivable proposition.
As you might expect, much of this activity has gone online through such channels as the University of Iowa’s Iowa Electronic Markets and Intrade, a trade exchange network company. The contracts range from whether or not the G.O.P. will retain control of the House of Representatives (47.5% bid/50.8% ask), to whether or not bird flu (H5N!, to be specific) will be found in the U.S. on or before 12/31/06 (26.1% bid/35.0% ask), to whether or not a U.S. law allowing taxpayers to divert Social Security taxes to managed private accounts will be passed by 12/31/06 (0.1% bid, 2.5% ask).
None of these online exchanges support actively traded markets that directly assess the probability of a recession (operationally defined as two consecutive quarters of negative GDP growth). That’s probably because of the settlement issues associated with continuous after-the-fact statistical revisions. Nonetheless, the projections of economists-at-large, as well as the ever-present shape of the yield curve, are always available to help us sort out our bearings.
One of many odds-makers, Michael Mussa, former chief economist of the International Monetary Fund and now Senior Fellow at the Institute for International Economics, recently doubled the odds of a recession in 2007, to 30%, in the wake of higher energy prices. In a presentation last April dealing with global economic prospects, he projected that by June, we would start to see indications of weakening in the areas of consumer spending and residential investment (which have started to reveal themselves in the economic data). Then, for the second half of 2006 and into 2007, annualized GDP growth would slow to a rate of the order of 2%. In addition, he underscored four main global trends* that heighten concern for growth prospects in 2007:
- Increased inflationary pressures along with tightened monetary policies.
- Higher energy prices, notwithstanding that much of the recent run-up is due to a geopolitical risk premium of at least $15 per barrel of oil (not to mention an excessively corroded pipeline).
- The need for the U.S. to curb its current account deficit—now at 6.5% of GDP—through a declining dollar and/or reduced domestic demand.
- Excessive liquidity and capital that is being directed to emerging markets. Supporting evidence is taking the form of narrowing rate spreads and large run-ups in emerging market equities.
* “Global Economic Prospect 2006/2007: Continued Solid Growth in 2006, Rising Risks for Inflation, Financial Markets and Growth from 2007,” Michael Mussa, Senior Fellow, Institute for International Economics, April 2007
Mussa’s prognostications echo the sentiments of Fed Chairman Bernancke’s July 19 testimony to the Senate Banking Committee in which he stated, “As a consequence, a sustainable non-inflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past three years to a pace more consistent with the rate of increases in the nation’s underlying productive capacity. …That (moderation in economic growth) appears most evident in the household sector.”
Name Your Poison: Slower Growth or Faster Inflation
...and so it was, with economic growth in the second quarter registering an annualized rate of increase of 2.5%. That’s a far cry from first quarter’s 5.6% climb. Some contributors to decelerating growth:
- A 1.0% drop in spending for new business equipment and software
- A decline in motor vehicle production
- A 6.3% annualized decrease in residential construction—the largest quarterly decline in six years
Here’s more evidence of moderating growth:
- A 3.0% reduction in new home purchases during June, compared to May.
- An increase in the number of single-family homes available for sale to a record 3.725 million units. That’s 40% higher than one year ago.
- A pronounced decrease in the rate of growth in consumer spending—now a 2.5% annualized clip. That’s low relative to the long-term growth pace of almost 3.5%.
- A slight downtick in consumer confidence. The University of Michigan index dropped to 84.7 in July, from 84.9 in June.
- Subdued employment growth over the past four months. During July, the economy added 113,000 new jobs. This figure mirrors the average monthly gain in payrolls that occurred during the second quarter. That’s the lowest figure since the third quarter of 2003—when deflationary risk appeared to be the watchword. On the flip side, there were healthy increases in average hourly earnings, which continue to increase at slightly less than 4% per year.
Clearly the consumer is being hit with the headwinds of rising energy prices, higher interest rates, softening real estate prices, and a likely peak in employment growth. One mitigant: consumer balance sheets on the whole are strong, given the cumulative gains established in the stock and housing markets.
An additional report revealed that one of the Fed’s preferred measure of inflation, the core personal consumption expenditures index, increased at an annualized rate of 2.4%. That’s the highest monthly reading in four years. During the first six months of the year, inflation, as measured by this index, has sustained an average annual rate that is well above 4%.
The fixed-income markets rallied immediately after the GDP release, and the 10-year Treasury traded below 5.0% for the first time since early June. As such, the markets appear to believe that that the lag affects of the Fed’s tighter monetary policy will soon contain the inflationary pressures that we are seeing in the current set of statistics. With the prospect of future rate increases dimming by the day, the markets are seeing the Fed as focusing more attention on addressing slower growth, than on arresting inflation. Perhaps good work will take time!
Slow growth notwithstanding, recent inflation numbers are clearly outside of the Fed’s comfort zone. Some examples:
- The Institute for Supply Management’s gauge of factory raw materials prices, which rose in June amid market expectations that it would drop.
- Global central banks continuing to caution that accelerated commercial and consumer spending pose an inflationary threat. Indeed, the European Central Bank has increased its benchmark lending rate three times this year, and Japan is rapidly emerging out of its zero-interest rate environment.
End of the Tightening Cycle?
As anticipated, 17 successive elevations of the targeted Fed funds rate have come to a halt. The Fed has continued to make the case that two years of continued tightening are likely to present a cumulative policy effect. Although inflation appears to be on the upswing, the central bank may continue to pause (or, indeed reverse course) when presented with a leveling off of inflation and further signs of slowing economic growth, keeping in mind the effect of cumulative monetary policy. Recent “Fed-speak” seems to underscore the view that inflation readings are likely short-term and will ease once additional evidence of a slowing economy takes hold. There is clearly a desire to cease rate hikes, provided inflation does not keep edging toward the “red zone.”
It’s becoming increasingly difficult to navigate monetary policy between the forces of accelerating inflation and slower economic growth. We could take further cues from the labor markets, as Chairman Bernancke continually notes that while the cost of raw materials is a critical aspect of inflation, it is vastly superseded by the labor cost component. All the more reason to watch those productivity numbers! On that score, during the second quarter, labor productivity (the amount of production that is produced for each hour of work) increased at an annualized rate of only 1.1%. For the past five years, productivity has increased at an annual rate of 3.1%. Here’s the rub: For the last several years, the Fed has mentioned increased labor productivity as being a chief contributor to a tame inflation environment. While we finally received a pause from the Fed, as long as pernicious inflation data persists, the end of the tightening cycle cannot be set in stone.
The Rental Effect
The rental housing component—or owner’s equivalent rent of primary residence (OER)—is the assumed opportunity cost that a homeowner incurs by owning, rather than renting, a home. It comprises nearly 25% of the core Consumer Price Index. As more potential homebuyers are excluded from homeownership due to increasing interest rates, the number of renters is increasing and placing upward pressure on rental prices. In other words, when the housing market weakens, the CPI increases. This transitory and distorting effect on an inflation measure is one of the reasons that Fed policy makers favor the personal consumption expenditures index as a more appropriate inflation barometer, as its rental housing component carries far less weight than the CPI.
As a wise man once said during the dog days of summer, “You never know how many friends you have until you rent a house on the beach!”
John Biestman is director of business development at the Federal Home Loan Bank of Seattle.
Printable Version
E-mail this article
 |
|
Newsletter content is for our readers' informational purposes only.
Please refer to our Terms of Use for details. |
|