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Commentary
"Delay is the deadliest form of denial." - C. Northcote Parkinson
The Fed: Vindicated or in Denial?
In some circles, the continued inverted shape of the yield curve (particularly at the short end) begs the question: Is the Fed in denial that the economy is softening? Clearly, there is growing evidence that economic activity is less than robust. The Fed has not yet shown any predilection toward easing, in spite of a market that appears to be discounting a reduction in short-term rates. Federal Reserve officials appear to be cautious about the risk of inflation and less concerned about downside economic risks, although core inflation indicators moderated over the past month. Indeed, during last month’s FOMC meeting, participants viewed “current rates of core inflation as uncomfortably high… all members agreed that the risks to achieving the anticipated reduction in inflation remained the greatest concern,” and “most members judged that the downside risks to economic activity had diminished a little.”
Fed Chairman Bernancke emphasized, as recently as two weeks ago, that aside from the housing and automotive sectors, most sectors of the economy are expanding at a solid rate amid a tight labor market. The unemployment rate, at 4.5%, is near a record low. That’s alongside a slower annualized GDP growth rate (which was 2.2% during the third quarter). While a declining economic growth rate was probably on the Fed’s radar, a continued low unemployment rate was probably not. Unless the labor market shows signs of deterioration or there is significant erosion in capacity utilization, it’s unlikely that the Fed will ease up on the reins. Consumer spending, supported by a strong employment base, is showing few signs of weakness. On the inflation front, at 2.4%, the Fed’s favorite gauge, the personal consumption expenditures index, remains above the desired range of 1.0% to 2.0%.
Last Friday, the Fed’s hold-the-line posture appeared to be vindicated by a strong employment situation report. Non-farm payroll for the month of November grew by 132,000. That was higher than the expected growth figure of about 100,000 jobs. The payroll number had an immediate impact on the short-end of the fixed-income markets, with the market discounting a roughly 30% probability of Fed ease three months hence, versus a probability of roughly two-thirds just before release of the report. The market’s reaction to the strong number: (a) deeper inversion of the intermediate curve, with the two-year increasing in yield, and (b) flattening of the implied forward curve, with a reduced probability of monetary easing.
Global Economic Divergence
While the U.S. economy appears to be decelerating, the picture is quite different in other parts of the world, especially in Europe. As an example, the European Commission increased its forecast rate of annualized economic growth for the first half of 2007 to 2.4%. Unemployment in Europe is now at a five-year low. As a result, the European Central Bank increased its overnight lending rate to 3.5% on December 7. Last month, the Bank of England increased its overnight benchmark to 5.0%, a five-year high. The rationale: a growing risk that inflation could head above its target of 2.0%. With economic divergence taking place on the world stage, the currency markets have become a bit unsettled, providing the Euro and Pound Sterling with a nudge to the upside. Yield premiums on U.S. Treasuries, relative to European sovereign debt, have narrowed significantly in recent weeks. Speaking of economic divergence, housing prices are once again appreciating throughout Europe.
Housing Barometer: Still Falling?
During the third quarter, the Office of Federal Housing Enterprise Oversight (OFHEO) reported that national house price appreciation was 3.45% on an annualized basis. That’s a bit slower than the appreciation rate of 7.73% reported for the last four quarters. The highest rate of home appreciation—17.5%—occurred in Idaho. The fall 2006 edition of the PMI Housing Price Risk Index continues to show that the Seattle and Portland metropolitan areas (with respective probabilities of housing price declines within the next two years of 15.3% and 15.8%) are much less susceptible to a decline in home prices than regional markets in California, Nevada, Florida and the East Coast (where depreciation probabilities are well over 50%). The PMI index is a statistical index that measures home price decline probabilities using such variables as labor statistics, household income, home price appreciation, and interest rates.
Housing starts in October registered their weakest performance in over six years, and building permits were close to 10-year lows. Still, some encouraging (or, more appropriately, less discouraging) indicators have recently emerged on the housing front. With the average rate for a 30-year mortgage now at 5.98% (down from the year’s peak in July of 6.80%), applications for mortgage loans are now at an 11-month high, as measured by the Mortgage Bankers Association’s applications index. As Chairman Bernancke stated on November 28, “The rate of home purchase may be stabilizing, perhaps in response to modest declines in mortgage interest rates.”
Softer Manufacturing Offset by a Buoyant Service Sector
The notoriously volatile, durable-goods order number for October declined by 8.2%, pointing to a lackluster manufacturing sector. This figure may have been distorted by temporarily soft computer orders in anticipation of the release of Microsoft’s new Vista operating software. Business spending on construction was particularly weak.
In contrast, the services sector appears to be gaining strength. This month’s Institute for Supply Management survey of non-manufacturing business activity increased by 3.7% to 55.6%. Service sectors that registered particular strength were wholesale trade and information services. The weakest service sectors were represented by lodging, food service, construction, and public administration.
Stagnant Productivity Disproportionately Ascribed to GDP Rather than Labor Costs
Productivity statistics remain unimpressive. Labor productivity in the third quarter grew by 0.2% (upgraded from the preliminary indication of 0.0% growth) and continues trending downward. The bulk of the productivity decline appeared to be coming from sluggish GDP growth, as opposed to the price of labor, as labor costs for the third quarter showed a lesser-than-expected increase of 2.3%. This trend supports the notion that the Fed’s decision to rest on its oars may have been a good call. GDP may be slowing, but there has yet to be any sign that the labor market has deteriorated. Until it does, we view the Fed as having little cause to move from its present position.
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
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