FED POLICY OUTLOOK: "EVENTUALLY"
Dr. Scott Brown, Raymond James Financial, Inc.
(April 30, 2004) Chairman Greenspan and other Fed officials may disagree about the threat of inflation, but in public they have been singing from the same page of the hymnal. Growth is not the enemy. The Fed must guard against higher inflation, but there's no imminent threat. The Fed funds rate will have to be raised eventually, but not anytime soon. The focus is on evidence of slack in the economy and on inflation expectations. The Fed will certainly leave the fed funds rate unchanged on May 4, but the phrasing of the statement is likely to be altered. A word was conspicuously missing from Greenspan's testimony last week. That word was "patient."
One thing that stood out in Greenspan's testimony was his seemingly cavalier attitude on inflation. Sharp increases in prices of raw materials have a limited impact at the consumer level. The major force behind inflation is unit labor costs, which are still falling (thanks to strong productivity growth). "Pricing power is gradually being restored," said Greenspan, "and the threat of deflation is no longer an issue before us," but "monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building." That isn't to say that inflation is not an issue for the Fed--it's just not an immediate threat.
The Fed's focus is on the level of slack in the economy. Private-sector payrolls were 2.9 million lower in March than they were before the recession (and 560,000 lower than they were at the end of the recession). The employment/population ratio remains well below its pre-recession level. Capacity utilization is very low by historical standards. Improving trends in jobs and production are certainly welcome, but it will still be some time before the economy absorbs the current level of slack. The Fed is willing to let the economy run.
The Fed is also focused on inflation expectations (a key factor in the inflation process). The spread between inflation-adjusted and fixed-rate Treasuries is often viewed as an expectation of future inflation. However, that spread is widened by an inflation-risk premium embedded in TIPS and narrowed by a liquidity premium for fixed-rate Treasuries. While the spread is a distorted measure of inflation expectations, there's no suggestion that underlying expectations are getting out of hand (though the Fed will continue to watch closely).
One element of Greenspan's testimony went largely unnoticed, but it's worth pointing out:
"If history is any guide, competitive pressures, at some point, will shift in favor of real hourly compensation at the expense of corporate profits. ...Although labor costs, which compose nearly two-thirds of consolidated costs, no longer seem to be falling at the pace that prevailed in the second half of last year, those costs have yet to post a decisive upturn. And even if they do, the current high level of profit margins suggests that firms may come under competitive pressure to absorb some acceleration of labor costs. ...The initial effect of a slowing of productivity growth is more likely to be an easing of profit margins than an acceleration of prices."
Most likely, the Fed will alter the language in the May 4 FOMC statement and tweak it again in late June. By mid July, when Greenspan presents his semi-annual monetary policy testimony, a rate hike should be clear.
April 30, 2004
Dr Scott Brown
Raymond James Financial, Inc.
880 Carillon Parkway, St. Petersburg, Florida
727-567-1000
www.raymondjames.com
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