A Funny Thing Happened on the Way to a Slowdown...
The latest calibration of first-quarter 2007 GDP displayed an anemic growth rate of 1.3%. Not only was the figure well below market expectations, but it also represented a growth rate that was less than half that of one year ago. Still, levels of unemployment remain at near record lows. What could explain this counter-intuitive relationship?

Clearly, if the labor market is close to full employment and economic output is slowing, that’s not terribly good for productivity. A portion of this inconsistency could be explained by construction companies that are retaining their workers in spite of the protracted housing slump. Construction employment is typically a lagging indicator.

Not surprisingly, housing investment declined by 17% and was responsible for shaving a full percentage point off GDP growth. Nonetheless, consumer spending, having increased by 3.8%, continues to defy the pessimists. Spending was likely bolstered by strong employment and a surging stock market. Still, with the “cash-out refi” phenomenon in retreat, it remains to be seen if the consumer can continue to manage higher food and energy prices. Recent figures have shown that the pace of personal spending is trailing the rate of personal income growth.

The capital spending sector reversed its fourth-quarter 2006 decline and grew by 1.9% during the first quarter of 2007. This momentum appears to be continuing into the second quarter, as orders are increasing and inventories are working their way down. In fact, inventory reduction was responsible for erasing 0.3% from first-quarter growth. The Institute for Supply Management index of manufacturing posted a level of 54.7, its highest in over a year. The plurality of business spending, of late, has come from the transportation sector.

Inflation: In the Spotlight
“Cost-push” elements of inflation are increasingly cited in the form of rising energy and food prices. While productivity gains and continued strong corporate margins will be difficult to maintain in this environment, globalization of labor and supply sources will likely hold the traditional wage-and-price inflationary spiral in check. Indeed, the April CPI increased at a slower rate than forecast, 0.4%, versus the March level of 0.6%. Core inflation rose by 0.2%—not quite the “five-alarm” level on the inflation meter. In spite of headlines that depict gasoline prices as heading toward $4.00 per gallon in some parts of the U.S., the growth rate in energy prices during April actually moderated at 2.4%, versus 5.9% during March.

The Fed’s preferred PCE deflator, a measurement of inflation (excluding food and energy) came in at an increase of 2.2% per annum. That continues to be at the top end of the tolerance range of 1.0% to 2.0%. All told, these readings are enough to support no action on the Fed’s part in terms of changing monetary targets.

What factors tempered the latest round of inflation statistics? Slower wage growth and reduced costs of foreign-made capital goods and consumer products.

The Fed and the Dollar: The Pivot Points for Interest Rates
As expected, during the May meeting of the FOMC, the Fed left its interest-rate target unchanged and characterized the current core inflation environment as “somewhat elevated.” The implied forward curve continues to project no more than a minimal decline in short-term rates over the next 12 months. In the meantime, there is more news of short-term rate hikes in Europe.

Aside from the central banks, the key space to watch will be the currency markets, as the long end of the yield curve is increasingly influenced by international central banks and pension funds and their growing ownership share of U.S. Treasury and Agency securities.

As illustrated in Figure 1, the trade-weighted value of the U.S. dollar is at its lowest level in almost 13 years. Still the dollar has dropped by only 3.5% in the past two years. In the past (e.g., 1986 – 1988), it has seen far greater percentage declines. There is a growing list of reasons why a further decline could be in the offing, including: revaluation of the Yuan, an increasing gap between economic growth rates in the U.S. versus Europe and China, narrowing yields between U.S. fixed-income investments, and the diversification of foreign exchange reserves.

Further evidence: the smallest gap between 10-year U.S. and German treasury note yields in almost three years and a continued decline in the percentage of central bank currency reserves, 64.7% denominated in U.S. dollars at the end of fourth-quarter 2006, versus 65.8% at the end of third-quarter 2006. While a weakening dollar has improved the current account deficit (now hovering in the area of 6% of GDP and down from its peak of 7%), the deficit remains historically high on both an absolute and a proportional basis. It took a 30% slide in the value of the dollar between 1985 and 1987 to finally bring the current account back into a surplus position, which ultimately occurred in 1991.

The implication for the yield curve: If the dollar continues to weaken, there could be cause to believe in the probability of a “bear-steepener” scenario. International investors in U.S. fixed-income securities could very well request higher rates of return should they be remunerated by a continued depreciating currency.

Figure 1. Historical Trade-Weighted Value vs. Major International Currencies

Source: Federal Reserve Statistical Release May 2007

Don’t Take Any Wooden Nickels!
According to the Web site, coinflation.com, which measures the intrinsic metal value of coins around the world, the value of a modern nickel is now 9.2 cents! For the other numismatists in the room, the metallic value of a 1964 Roosevelt dime is a mere 94.9 cents. Before you consider adding a metal-melting machine as a source of fee income, recognize that under new Federal rules, it is illegal to melt coins, to carry more than $5 in equivalent one- and five-cent coins out the country, or to export more than $100 of coins unless they are designated for “legitimate and numismatic purposes.” Think five years in Leavenworth and $10,000 in fines. Yet another reason to support your local metal detector!

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

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