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Commentary
"It's not that I am smart, it's just that I stay with problems longer." - Albert Einstein
Defying the Laws of Physics: Is the Speed Limit Still 65?
With productivity growth slowing (more people employed, notwithstanding a third-quarter GDP that appeared to be increasing at an annualized rate of just 1.6%), one question looms large: Has the non-inflationary growth rate dropped? Phrased another way: Has the sustainable rate at which the economy may grow without using its excess capacity dropped from the previously assumed level of about 3.5%?
Should productivity show further evidence of weakening, the Fed may view that sustainable growth level as being reduced to 2.5%. Beyond this sustained growth rate, it's assumed that inflationary pressures would kick in. The Fed may believe that a 1.6% growth rate would not prompt inflationary pressures, but with the backdrop of slower productivity and an unacceptably high, year-over-year inflation rate of 2.4%, the Fed is on guard.
Third-quarter productivity was unchanged from the second quarter, although it was expected to have increased on the order of 1.0%. Why the sluggish number? For the past 12 months, labor prices have increased by 5.3%—the highest rate of increase since 1982!
Although the price index for core personal consumption expenditures showed a slight downtick for September (0.2% versus 0.3% in August), on an annualized basis, inflation remains above the Fed's acceptable band of 1.0% to 2.0%. With continued wage pressures serving to increase inflation and lower the "speed limit" of economic growth, the bottom line appears to be this: Don't count on a Fed campaign of accommodation unless signs of a weaker labor market emerge.
Sustainable Growth into the Fourth Quarter?
In spite of the reported slowdown during the third quarter, our average monthly tabulation of select economists' estimates calls for fourth-quarter GDP to come in above 2.5%. These estimates are likely based on such recent positive indicators (>with mitigants italicized) as:
- October consumer confidence, which the University of Michigan index portrayed at the highest level in 15 months. (The Conference Board's confidence actually declined for the same period.)
- A low October unemployment rate of 4.4% (in spite of modest growth in non-farm payroll of 92,000).
- During September, personal incomes increased by 0.5%, on top of August's gain of 0.4%. Year-over-year, disposable income has increased by 5.9%. (The Conference Board's monthly confidence survey reflected fewer people expecting their incomes to increase over the next six months.)
- Consumer spending rose at an annual rate of 3.1% during the third quarter. Business spending rose by an astonishing 8.6%. (Much of the spending increase occurred as a result of inventory build-up, which may depress future GDP readings. Business investment in equipment and software is well off of its highs.)
An Inversion of Standards
The word, "jawboning," thought to have been coined in the '60s refers to the dialogue that takes place between government officials and financial markets vis-à-vis containment of wage and price increases. Recent Fed-speak certainly appears to highlight the Fed's persistent concern over inflation, even in a slower-growth environment. Indeed, Michael Moskow of the Chicago Fed emphasized his belief that "the risk of inflation remaining too high is greater than the risk of growth being too low." Vice Chairman Donald Kohn further cautioned that the persistence of inflation beyond current levels (2.4% annualized as measured by the Fed's preferred personal consumption expenditures index) would be "adverse" and would require policy actions in the form of tighter monetary policy.
The Fed's verbal vehemence appears to be exacerbating the yield curve's persistent inversion. The spread between two-year and 10-year Treasuries is now –19 basis points. In contrast, the long-end of the curve appears somewhat sanguine over inflationary prospects. In addition, long-term bonds continue to see strong interest from international sources. During this month's 10-year Treasury auction, 34% of bids came from "indirect bidders," a category that predominantly represents international central banks. Ten-year Treasury Inflation Protected Securities (TIPs) presently trade at 2.34% below the on-the-run 10-year Treasury, emulating the market's expected level of inflation over that same period of time.
There may be shorter-term technical forces supporting the long-end of the Treasury curve—namely, the improving fortunes of the U.S. budget deficit. The $248-million budget deficit for the fiscal year ending September 30, 2006, is at a four-year low.
The implied forward markets continue to foresee a negligible chance of a Fed ease within the next three months. However, the picture changes one year from now when the forward markets expect a funds rate in the range of 4.75% to 5.00%.
Aside from higher-than expected GDP growth, employment levels and changes in inflationary expectations, what could arrest the stubborn yield curve inversion? A slowing in the degree of "the kindness of strangers," a.k.a. foreign central bank purchases. With a weakened dollar, currency markets are increasingly reflecting the concern that foreign buyers might take fewer trips to the punchbowl. Indeed, Governor of the Bank of China Zhou Xiaochuan was quoted last week as stating that he had a clear plan to diversify that bank's currency reserves by cutting U.S. dollar allocations. He did, however, go out of his way to say that China had not yet sold dollars. With the U.S. trade deficit at an all-time high, what is the "kindness of strangers" worth? A working paper issued by the National Bureau of Economic Research last month, authored by Francis and Veronica Warnock of the University of Virginia, concluded that had there been no net foreign central bank flows into the U.S. Treasury market over the past year. The 10-year Treasury would carry a rate of 90 basis points higher than its present level.
Awash in Global Funds?
With new-home sales in the U.S. now approaching a 15-year low, we couldn't help but notice the goings-on across the pond. Housing starts and housing prices, according to Nationwide Building Society in the United Kingdom, are up 9.0% and 8.2% respectively on a year-over-year basis. Stephen Nickell of the London School of Economics and a member of Bank of England's Monetary Policy cited three factors that ascribe the country's resilient housing market: low short-term interest rates, low real long-term interest rates, and low levels of homebuilding.
With the example of a re-heated housing market in the U.K., it's interesting to consider whether or not world markets are replete with liquidity. Other examples of heady levels of global cash are found in the form of vastly oversubscribed initial public offerings in China and record spending plans in Japan.
There are reasons to suggest that the worldwide money supply is flush. Within the 12 countries within the Euro currency region, the preferred measure of money, "M3," is growing at an annualized rate of 8.5%. The UK's rate of money supply growth is the fastest it's been in over 15 years.
As long as the supply of money keeps growing around the world, all is well and good to fuel the "kindness of strangers," providing that there is the willingness to match!
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
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