United States: Too Soon for Tightening
Bottoming inflation and firmer labor markets are setting the stage for the debate about when and how the Fed should tighten monetary policy, or, in Fedspeak, should “remove its policy accommodation.” With several Fed officials recently warning that the Federal funds rate won’t stay at 1% indefinitely, additional evidence for these new developments will keep financial market participants wary that policymakers will now move sooner rather than later. But we agree with Fed officials who argue that it is still far too soon for action; low inflation and ample slack remain a recipe for patience, and the recent pickup in job growth has only begun to reverse the shortfall of the past three years. As a result, the change in our call that we made a month ago — that the Fed would first tighten in December rather than in September — still stands.
We see convincing signs that inflation has bottomed, and that it most likely will move higher in coming months. The stability in “core” consumer inflation at 1.1–1.2% over the past few months, with an acceleration in goods prices, confirms that the inflection point has arrived. So far the forecast for a rise in inflation from this point is still just that: a forecast. But there is ample evidence that our call for a rebirth in pricing power is on track: Cyclical prices are booming, “core” price gauges have accelerated at early stages of the processing pipeline, inflation expectations are rising, and a weaker dollar has lifted import prices. The fundamentals support that call: With capacity growing slowly and demand and production racing to catch up, factory operating rates have moved significantly higher and the so-called output gap has narrowed by nearly a percentage point over the past year. And on balance, monetary policy around the world remains highly reflationary (see “Inflation Has Bottomed,” Global Economic Forum, March 22, 2004).
But inflation is still extremely low, at the low end of the Fed’s presumed 1–2% target range for core consumer prices. And slack in labor and product markets suggests that the acceleration will be modest. If anything, the unemployment rate at 5.7% understates labor-market slack, given the decline in labor-force participation of the past four years. We expect unit labor costs to rise by about 1% over the four quarters of 2004, but such costs have declined for two years in a row. Thus, although the balance of inflation risks has shifted, for a Fed that only nine months ago was worried about deflation, it is still premature to consider tightening.
As for economic growth, the Fed has long seen the risks as evenly balanced, yet tepid job gains had market participants legitimately questioning whether the Fed’s central tendency forecast of 4½–5% growth over the four quarters of 2004 was too optimistic. Mixed incoming data — slippage in capital goods shipments that offset modest improvement in vehicle sales and retailing — fueled those concerns. Those concerns have begun to fade, as recently surging payrolls buttress the case for sustainable recovery, providing both wherewithal and confidence for consumer spending, and testifying to rising business confidence and pent-up demand for hiring in the face of high and rising benefit costs (see “Fixed Labor Costs, Operating Leverage and Job Growth,” Global Economic Forum, March 26, 2004). That surge adds to our confidence in our call for hearty sustainable growth, which has long been based on the notions that economic headwinds have faded further, financial conditions are still accommodative, and the last leg of fiscal stimulus has yet to end.
More broadly, we believe that labor markets have now turned the corner. Payroll gains over the past three months — a period long enough to iron out weather-related and other distortions — averaged 171,000, the strongest 3-month rise since June 2000. As important, the breadth of job gains across industries was impressive, with the 3-month diffusion index for private payrolls also rising to nearly a four-year high. That improvement and other clues suggest that the recent turnaround only marks the beginning of a labor-market recovery. Specifically, upward revisions to income imply that past job data understated job growth; the workweek is rising, hinting at demand; and quickening tax collections evince more jobs. While the overall private workweek actually fell by 6 minutes in March, the trend when adjusted for changes in industry composition has been rising (see “Employment Clues,” Global Economic Forum, April 2, 2004). Nonetheless, this labor-market improvement is very recent, and has a long way to run before it will convince the public. For example, popular gauges of consumer confidence do not yet show a parallel improvement.
In addition, two sets of downside risks still menace our call for strong growth. One set of concerns centers on the “tax” from higher energy prices in particular and rising commodity prices in general and supply bottlenecks. Higher gasoline and other energy prices are taxing consumers and businesses alike, but unless prices rise significantly further and last well beyond Memorial Day, we believe that rising tax refunds and other tax reductions and improved labor income will help keep consumers afloat. Consumers could face an energy “tax” hike in the first half of 2004 of about $40 billion annualized, or about 0.5% of disposable income, if prices rise to $1.95/gallon. Tax refunds have been far slower in coming to consumers than we’ve expected. But we estimate that the last leg of fiscal stimulus enacted in 2003, which should eventually show up in tax refunds and lower tax payments, could amount to as much as $72 billion at an annual rate, or nearly twice the magnitude of the hit to consumers from higher energy quotes (see “Energy Price Hikes Won’t Derail the Consumer,” Global Economic Forum, March 29, 2004).
Likewise, some worry that the fallout from surging commodity prices could crimp U.S. economic growth. In particular, jumps in manufacturing prices paid and supplier delivery indices could point to developing bottlenecks and a squeeze on profit margins. The ISM prices paid diffusion index jumped 4.5 points to 86.0 in March, a 24-year high. So far, companies are raising selling prices far more slowly than the hikes in the cost of key materials, with the core finished goods producer price index up 1.1% from a year ago, while the core intermediate price index has jumped by 2.5%. At the same time, the ISM supplier delivery index jumped 5.8 points to 67.9, the highest reading since 1979. Purchasing managers say that their “concerns are shifting from cost issues to availability” of materials.
We think those concerns are overblown. For example, some companies are recapturing pricing power and raising selling prices, as evidenced by the ramp in some diffusion indexes of prices paid, like those from the Philadelphia Fed. And neither purchasing managers nor their customers’ actions match their concerns; they aren’t rushing to hoard inventories in anticipation of shortages; both inventory diffusion indexes remain below the 50% breakeven threshold. That intermediate and crude price hikes are outpacing those of finished goods is in our view a time-honored cyclical response in recovery to growth in demand outstripping that of supply. Of course, the combination of surging Chinese and other Asian demand, the long period of capacity restraint in commodities following the plunges in volumes and prices in the Asian financial crisis, and a weaker dollar have exaggerated the pricing moves this time around.
But those developments raise a second set of risks, namely those surrounding the global outlook. In particular, our forecast for a slowing in China’s economy remains important for the U.S. prognosis, given that deliveries to China accounted for 13.7% of the growth in US goods exports in the year ended in January. China’s economy seems to be the one facing bottlenecks, with capacity constraints on electric power generation likely to promote such a slowdown. Our colleagues Steve Roach and our China economics team expect a soft landing for the Chinese economy — one that would ease commodity price pressures while maintaining China’s resilience as the engine of global growth that complements our own influence. By comparison, a hard landing in China would clearly pose a threat to the U.S. and global economies.
Those risks are context for the debate about the appropriate starting date for Fed tightening. More important, today’s low inflation means that the Fed can afford to be reactive rather than anticipatory, waiting until core inflation has moved higher and its ongoing direction is clear. Those considerations still point to December as the most likely date for the first move, though a faster rise in inflation and a booming economy could well accelerate that timing. For their part, officials are walking the fine line between patience and warning that low rates won’t last indefinitely. They want to be seen as symmetric on inflation: Having aggressively moved to prevent inflation from falling too low, and looking for a cushion well above zero to insure against unforeseen shocks, they are making it clear that they will be appropriately hawkish when it comes to resisting a rise in inflation that might undermine currently well-anchored long-term inflation expectations. Understandably, such symmetry isn’t yet fully folded in either to their rhetoric or to bond-market market expectations.
Beyond the first move, both the Fed and investors must also now focus on the broader strategy for the tightening cycle; specifically, what constitutes a neutral monetary policy and how fast policy should get there. Uncertainty clouds guesses about both, but in our view, the neutral Federal funds rate is probably near 4% — the product of a 2½–3% productivity trend and a 1–2% preferred range for inflation. And while a gradual pace is appropriate at first, no policymaker wants to get behind the curve of rising inflation or emerging financial imbalances. Thus, following the initial probing steps, in which policymakers wait to see how investors price an eventual series of tightening moves into the yield curve, the pace of tightening will likely quicken over the course of 2005, with short rates likely rising by 150 basis points. In our view, fixed-income market participants haven’t begun to factor in such a move. Consequently, we think that the recent rise in yields only represents the beginning of a steady upward climb over the course of 2004.
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