Economic Monitor Commentary
by
Dr. Scott Brown
What To Watch...
The Fed's August 22 rate decision will clearly depend on developments over the next few weeks. Let's examine the key data releases, issues, and other variables that will affect the Fed's judgment.
Growth: Rebounding, Or Not?
Unusual strength in consumer spending was the main reason the Fed raised rates in February, March, and May. Inflation-adjusted consumer spending rose 5.9% in the four quarters ending 1Q00, and ran at an amazing 7.7% annual rate in the first quarter alone (these figures may be altered slightly in this week's GDP benchmark revisions, but the magnitudes are unlikely to change much). Clearly, consumer spending growth was on an unsustainable trajectory. Early in the year, Fed Chairman Greenspan postulated a theory that technology was boosting productivity to such a point that investors were projecting future gains in earnings and were spending a portion of them now. The result was that demand appeared to outpace supply. One could see it in the tighter labor market conditions (the shrinking pool of available workers) and the widening trade deficit (proof that domestic demand was growing faster than supply). Raising rates was an easy choice. The Fed further justified the move by noting that a strong pace of investment implies a higher equilibrium interest rate.
Consumer spending moderated in 2Q00. However, was this merely a pause (perhaps mild first quarter weather "stole" some strength from the second quarter) or the beginning of a more persistent slowing of the pace of economic growth? In this Friday's GDP Report, look at the average of real consumer spending for the first and second quarters - it will probably be in the range of 5.5% to 6.0%. That may not give the Fed much comfort. Still, on a monthly basis, spending remained moderate in June, suggesting that it wasn't a weather story, and consumer spending may be on a more subdued track. Federal Reserve economists believe that consumer spending restraint will persist due to the flattening of equity prices, the increase in household debt burdens (which don't appear too troublesome), higher oil prices, and the build-up in the stock of consumer durables over the last few years. It's worth noting that the Fed has maintained this "slowdown" outlook, citing many of the same factors, in each of the past four years.
While the Fed (and the markets) debate the wealth effect, the biggest driver of spending is income. Average real wage gains, thanks to a pick-up in overall inflation, are now a bit negative year-over-year. However, should spending appear to push ahead in the data for July, the Fed would be more likely to pull the trigger in August.
Labor Tightness / Wage Pressures
Monthly labor market data have been volatile in recent months, but it's worth noting a slight pick-up in adult employment rates (males: 3.5% in June vs. 3.2% in April; females: 3.8% vs. 3.5%). Teen unemployment rates are subject to sizable seasonal adjustment and are less reliable. If adult unemployment rates continue to edge up in the July data, the Fed would be more likely to hold off. The pool of available workers, a key indicator for Greenspan, hit a cycle low in June. However, these data have been choppy and a rebound is likely in July.
Still, is the unemployment rate low enough to push inflation higher? Some Fed officials (such as Governor Meyer) think so. Yet, there's no empirical evidence that higher wages feed price inflation. At the same time, tight labor markets could facilitate a rise in inflationary expectations, perhaps kicked off by a surge in oil prices. So far, there's little evidence that firms have been able to raise prices - but the Fed is watching closely.
Inflation Trending Higher?
The June CPI Report was a mixed bag. Energy prices were sharply higher (no surprise), playing catch-up for May. While components were mixed, there was no sign of inflation in non-energy commodities. However, inflation in non-energy services has been trending higher - not terribly so, but enough to notice. The increase in inflation for non-energy services appears to have been driven mostly by feed-through effects of higher energy costs. The Fed's concern is that the run-up in oil prices, while essentially a one-time event, will kick off an acceleration in inflationary expectations - which will quickly lead to an increase in actual inflation.
In trying to glean whether inflation may be headed higher, we note that (outside of energy) commodity prices have generally fallen in the last few months. As it is, energy prices are likely to fall in the months ahead. However, don't expect oil prices to fall much in the next few months. Longer-term oil futures contracts suggest energy prices will remain relatively high for some time.
Financial Markets Helping?
Bond yields have fallen substantially in the last few months, which works against the Fed. Mortgage rates are near their lows of the year. Another leg up in equity prices would likely boost consumer spending.
The Outlook
The generally hopeful tone in Greenspan's monetary policy may have been a mistake. Part of the Fed's tool kit is managing expectations about future policy actions. Greenspan's tone suggests that the Fed is inclined to keep rates steady in August. Maintaining a more credible threat of higher rates would have been more appropriate.
July 24, 2000
Best Regards, J.T. |
