Despite rampant hysterics about “runaway inflation” in recent months, core inflation has remained at a moderate level, inflation expectations remain well-anchored, and there is little inflation pressure coming through the labor market. Is it time to declare victory? Not just yet, but the inflation outlook still does not appear to be particularly troublesome.
The CPI ex-food & energy rose at a 2.1% annual rate in the first four months of 2011. That’s just a little over the Fed’s implicit goal (of 1.7% to 2.0%). Short-term inflation readings tend to be choppy (which is one reason to focus on the year-over-year trend), but the increase in core inflation is not unwelcome. It was trending too low for the Fed’s comfort last year. Remember, real (that is, inflation-adjusted) interest rates are what matters. Low inflation means (all else equal) higher real interest rates. Higher inflation reduces real interest rates, which is stimulative for the overall economy.
Note that, yes, the Federal Reserve does consider overall inflation, not just the core. Food and energy prices do count, but the increases in food and energy prices in recent months do not appear to be part of a broad inflationary trend. Rather, they are the result of short-term supply and demand effects. Most economists, including those at the Fed, have anticipated that oil and gasoline prices would stabilize or retreat. The recent drop in gasoline futures suggest that the retail prices should begin to fall (at this point suggesting about a 25-cent decline in the next few weeks, but that outlook can change quickly).
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What about commodity prices? Aren’t they signaling higher inflation? There have been three factors behind the run-up in commodity prices. One is the global growth story. Stronger demand from China, India, Latin America, and so on, will put some upward pressure on commodity prices (in addition, there have been supply concerns in oil relative to developments in the Middle East and North Africa). The second major factor has been monetary policy. Commodity prices tend to be high when interest rates are low. The third factor is the speculative element. The supply and demand fundamentals get you only so far. Commodity prices (and prices in most other markets for that matter) depend on what investors think someone else will be willing to pay. Over the long term, the fundamentals should win out, but the speculative aspects can dominate for long periods. The commodity fundamentals have not shifted dramatically in the last few weeks, suggesting that the recent correction and intraday volatility are due to a revaluation of the speculative element. Where that ends is anybody’s guess.
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For the Fed, the key concern is whether higher gasoline prices will lead to second-round inflation effects, higher wage gains, or a rise in inflation expectations. So far, the ability to pass along higher fuel prices appears limited. Some will get at least partly passed through. However, higher gasoline prices have a dampening effect on real consumer spending, as retailers will have to compete for the consumers’ dollar. There is no sign that wages are rising significantly. That’s the big difference between now and the 1970s (when OPEC oil price increases quickly led to inflation becoming embedded in the labor market). Finally, there’s no sign that inflation expectations are getting out of hand. The Philadelphia Fed’s latest quarterly Survey of Professional Forecasters has the CPI rising 2.1% over the next four quarters (3Q11 to 2Q12) and a 10-year inflation outlook of 2.5%. The Cleveland Fed’s latest estimate of 10-year expected inflation, based on surveys and market-based information, is 1.86%. Inflation expectations remain well-anchored.
Why all the inflation hysteria then? People often worry about things that they shouldn’t worry about, and don’t worry about things that they should worry about. We’ll continue this theme next week, when we discuss the federal budget deficit.
The April Employment Report was better than expected, reflecting a strong trend in private-sector job growth. That’s the good news. The bad news is that the economy continues to face a number of headwinds, which should restrain the pace of growth in the near term. The economy is improving, but it’s still not as strong as we’d like to see at this point.
The establishment survey data typically show large unadjusted increases in payrolls each spring. Prior to seasonal adjustment, the private sector added 1,159,000 jobs last month, the largest April gain since 2005. Last year, the rate of job destruction trended down to very low levels. This year, new hiring finally appears to be picking up.
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The unemployment rate rose to 9.0% in April, from 8.8% in March (it was 9.8% in November). The household survey showed a 190,000 drop in employment. Why the difference between the two surveys? There are some differences between what the two surveys measure, but the biggest reason for the discrepancy in April is simply that monthly changes in levels from the household survey are unreliable. The household survey covers about 60,000 households. You’re not going to get good estimates of levels (the size of the labor force or the level of employment), but you get reasonably good estimates of ratios (labor force participation, the employment-to-population ratio). Still, such ratios are only going to be accurate to about 0.2%, leading to some variation from month to month.
Labor force participation has drifted down over the last couple of years, making the unemployment rate look better than it really is. Unemployment insurance benefits were extended in the December tax agreement, but they still cut off after 99 weeks. One would expect labor force participation to decrease as individuals exhaust their unemployment insurance benefits. On the other hand, labor force participation will tend to increase when the job outlook improves, as more individuals on the sidelines become encouraged about finding a job. Thus, the unemployment rate can be unreliable as a month-to-month gauge of labor market strength or weakness. The employment-to-population cancels out any noise in labor force participation, giving a more realistic picture of slack in the labor market. The employment-to-population ratio has been little changed over the last year, and appears to be somewhat at odds with the stronger pace of private-sector job growth reported recently.
There was no noticeable impact from higher gasoline prices in the April jobs data. However, the impact of higher gasoline prices typically shows up with a lag. So we could still see signs of a more significant slowing in economic activity in the weeks and months ahead. Some of the speculative element was wrung out of the commodity market last week, but gasoline prices should remain relatively elevated in the near term. Average hourly earnings rose modestly in April and have failed to keep pace with inflation this year. That implies some restraint for consumer spending growth, but there is enough job growth to lift aggregate wage income, which will provide some support.
State and local government shed another 22,000 jobs in April, down by 467,000 since December 2008 (in comparison, federal government payrolls rose by 72,000 over this same period). Austerity moves are well intended, but they are a drag on overall economic activity in the near term. State and local government subtracted 0.36 percentage point from GDP growth over the last two quarters – not a huge impact, but normally this sector would be adding 0.20 to 0.30 percentage point.
In 2008, the last time gasoline prices rose above $4 per gallon, the economy was already in a recession. This time, higher gas prices are hitting when the economy has a good deal of positive momentum. We should easily avoid a recession this year, but growth will be slower than we’d like to see in the near term.
There were no fireworks at Fed Chairman Bernanke’s first post-FOMC press briefing. For the financial markets, it was a straight-forward and relatively dull outing. It reinforced prior notions, but we did learn a few things.
All five Fed governors and 12 district bank presidents contributed revised forecasts of growth, unemployment, and inflation last week. The central tendency forecasts exclude the three highest and three lowest projections. Fed officials lowered their outlook for GDP growth this year, but not by a lot, reflecting a slower than anticipated rate of growth in the first quarter. Unemployment is expected to decline gradually. Inflation will be higher this year, but the Fed continues to expect that commodity price pressures will be transitory. The Fed’s long-term goal for inflation has 2% as the upper limit.
Bernanke said “the substantial ongoing slack in the labor market and the relatively slow pace of improvement remain important reasons that the FOMC continues to maintain a highly accommodative monetary policy.” That doesn’t mean the Fed is relaxed. Officials will continue to monitor inflation expectations and possible second-round effects from higher oil prices.
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Bernanke gave no indication that short-term interest rates would be heading higher anytime soon. Asked to define what constitutes “an extended period,” he did not suggest any specific time period, but noted that it’s conditional on resource slack, a subdued trend in underlying inflation, and stable inflation expectations. “Once we move away from those conditions, that’s the time we need to begin to tighten.”
When asked about the impact of the end of the Fed’s asset purchase program, Bernanke repeated that the $600 billion program will be completed at the end of the current quarter, “without much tapering,” adding that, in the Fed’s view, “the end of the program is unlikely to have significant impacts on the financial markets or on the economy.” The end of the program has been well advertised. Moreover, the Fed has what’s called a stock view of the effects of securities purchases – “what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchases, but rather the size of the portfolio the Fed holds.” At this point the Fed intends to keep the size of its portfolio unchanged by reinvesting maturing securities into long-term Treasuries. At some point, the Fed will stop such reinvestments, which will be a tightening of monetary policy.
Asked about the impact of higher gasoline prices on growth and inflation, Bernanke admitted that there was not much the Fed could do about gasoline prices – “at least, not without derailing growth entirely, which is certainly not the right way to go.” After all, Bernanke said, “the Fed can’t create more oil.” What the Fed can do, he said, is to try to keep higher gasoline prices from passing through to other prices and wages, “creating a broader inflation which would be more difficult to extinguish.” The Fed anticipates that gasoline prices will stabilize or even come down, but will continue to watch developments carefully.
What about the possibility of further asset purchases down the road? Bernanke has been criticized by some for not doing enough to reduce unemployment. Bernanke countered that the Fed has already done a lot, including all the extraordinary policy steps it took during the financial crisis and two rounds of asset purchases. Bernanke emphasized that the Fed also has to worry about inflation. “If inflation expectations become unmoored and inflation were to rise significantly, the employment loss in the future would be quite significant.” That justification did not appease the Fed’s critics. It’s a judgment call.
The bottom line is that the Fed doesn’t expect to tighten anytime soon (hence, a softer dollar) and it doesn’t expect to ease monetary policy either (no QE3). Future monetary policy decisions will depend on the evolution of the outlooks for unemployment and inflation, but there’s nothing on the immediate horizon to trigger any change in the near term.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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