PRINTMarket Update -- Economic Comment
June 25, 2007
When the FOMC meets next week, it will mark the one-year anniversary of a steady federal funds rate at 5.25%. Over the last year, this policy prescription proved to be the right one. As predicted by the Fed, the economy managed a moderate GDP growth rate that averaged 2.5%, while core consumer inflation came down from elevated levels to rates that are close to the Fed's comfort zone. When the Fed stopped tightening policy after the June 2006 meeting, economists had mixed opinions. Some thought the Fed stopped too soon given inflation risks, while others thought the Fed stopped too late given risks to economic growth. A few, ourselves included, thought the Fed was right to pause at this level, although our bias at that time was that the next move, when it occurred, would be a tightening rather than an easing.
Regarding risks, both camps were correct.
The economy slowed sharply in the second half of 2006 and GDP growth slipped below 1% during the first quarter of 2007. Problems in the housing market weighed most heavily on GDP growth during those quarters, but weakness was emanating from other sectors as well. Factory production was stalled as inventories in a number of non-housing related sectors, autos particularly, were being trimmed. Corporations cut back on capital goods investment. Even the government spent less. This combination, along with slower productivity growth, caused investors to worry that corporate earnings were about to slow precipitously. Similarly, economists worried about the associated risks to employment growth.
A collective sigh of relief was audible in the second quarter of 2007 when first-quarter earnings growth proved to be strong, orders for manufacturing goods rebounded, employment growth recovered, and the housing market showed more signs of stabilization. Few economists will say that there has been enough of a turnaround in the data to say that we are out of the woods, but most agree that the downside risks to economic growth have subsided. Indeed, economists looking for Fed easing in 2007 generally abandoned that view.
Inflation, meanwhile, rose sharply after the Fed stopped tightening policy last June. The consumer price index and the GDP deflator (an economy-wide measure of inflation) both rose above 4%, while core consumer inflation rose to a high near 3%. While one voting member of the FOMC (Richmond FRB President Jeffrey Lacker) voted for additional rate increases during the second-half of 2006, the rest of the FOMC voted for steady policy despite elevated inflation. Fed officials did become more vocal, however, in declaring that inflation was too high. The purpose of this rhetoric was to discourage investors from pricing in official interest rate cuts in reaction to weak economic data and encourage the population to keep their inflation expectations low despite accelerating inflation.
Whether by design or luck, the Fed's game plan worked out; inflation decelerated markedly in the second quarter. The core CPI, after reaching almost 3% last autumn slowed to just 2.2% in May, while the core personal consumer expenditure price index, the Fed's preferred inflation measure, is currently on track to drop back inside the Fed's 1-2% comfort zone with an expected 1.9% increase in May (data released on 29 June). Improvement in core consumer inflation is broad-based, although it is being led by a reduction in owner's equivalent rent, a measure designed to gauge the cost of owning a home. Rising vacancy rates in single-family homes is the cause of this improvement.
The key question now is, "Where do we go from here?" At next week's FOMC meeting, we expect the Fed to keep policy unchanged and give no indication that policy is likely to be changed one way or the other anytime soon. We expect the Fed to maintain its hawkish stance on inflation even though there has been notable improvement. It is simply too early to relax on this front given the tight labor market, high capacity utilization rates, and rising import prices. Moreover, the Fed needs to keep long-term inflation expectations steady, particularly because the one-year-ahead outlook has risen on the back of rising gasoline prices.
Our economic forecast is for continued moderate GDP growth. Economic data indicate some upside risk to our 2.5% GDP forecast for the second half of the year, but we are reluctant to raise our forecast at this time. We are cautious on a couple of fronts: the housing market is still undergoing a correction, and we think payroll data probably overstate labor market strength. Inflation is likely to improve a bit further in this environment, but a reacceleration is possible in the fourth quarter. This outlook is consistent with no change in Fed policy at next week's FOMC meeting or the foreseeable future.
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