market commentary
- Week Ending: February 19th, 2010
WEEKLY ECONOMIC COMMENTARY -- WEEK OF FEBRUARY 19, 2010
The Fed's announcement of a quarter-point hike in the discount rate effective Friday should not set off alarm bells in the financial markets, although it is bound to cause jitters among analysts who fear the central bank will move too soon to tighten policy. Whether they turn out to be right remains to be seen, but the Fed did go out of its way to nip those fears in the bud. In the statement regarding the rate hike as well as the decision to shorten the maturity of discount rate loans to banks, the Federal Reserve Board noted: "Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC)."
Simply put, the moves announced after the close of trading on Thursday are part of a well telegraphed effort to normalize the extraordinary emergency lending facilities put in place to deal with the worst financial crisis since the Great Depression. This normalization effort has been signaled by chairman Bernanke and other policy officials for some time, and detailed extensively in the minutes of the latest FOMC policy meeting held in late January. Whether the action is interpreted as a negative or positive development depends on the perspective taken. The negative, of course, is contained in the fears expressed above, namely that it is the first step towards a tighter policy that could well come too early and choke off the nascent economic recovery. On the positive side, it can just as easily be seen as a reflection of improving financial market conditions, making the need for emergency lending facilities unnecessary, as well as an economy that is starting to stand on its own two feet.
We are firmly in the camp that believes the central bank is not about to tighten the credit screws any time soon. Indeed, in its statement the Fed reaffirmed its intention to remain accommodative, noting "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." If there was any surprise, it was that the discount rate hike was taken earlier than expected for reasons that are still not entirely clear. Most analysts, including us, thought it would come after chairman Bernanke delivers his semiannual monetary policy report to Congress next week. The fact that it came before may well subject him to more hostile questioning by the lawmakers than would otherwise be the case.
It is unlikely that an imminent move to tighten the monetary screws is in the cards. What's more, the exact nature of the Fed's "exit" strategy, when it finally does arrive, is open to much conjecture. Most of the speculation revolves around whether the first step will be to raise short term interest rates or to withdraw liquidity from the system by reducing the size of the Fed's balance sheet. Some combination of the two is likely, but again the timing of the potential shift towards a more restrictive policy is still a ways off. Indeed, the main argument for a tightening sooner rather than later is that the excessive monetary accommodation in place for the past year is sowing the seeds for an inflation outbreak and another asset bubble. That argument, however, is not likely to gain traction in the current environment.
For one, it is hard to justify the inflation threat when price pressures remain as are as dormant as they are. Friday's release of the consumer price index is a striking reminder of the powerful deflationary winds that continue to blow through the economy. The overall CPI did rise, as expected, by a modest 0.2% in January, driven mostly by higher energy and food prices. But the core inflation reading, which strips out volatile food and energy prices and is more reflective of underlying trends, actually fell during the month for the first time since 1982. Over the past year, the core CPI is up by only 1.6% and that metric shows every sign of receding, not accelerating. The January pace follows a 1.8% annual increase in December and is firmly at the lower end of the 1.5 - 2.5% range in place over the past several years.
True, there is always the danger that the Fed will fall behind the curve. Once inflationary expectations increase and price pressures start to build, the process is difficult to reverse, requiring a much harsher response by the Fed that could send the economy into a nosedive. That stop and go type of policy was common during the 1970s, which contributed to wide swings in economic activity, stock prices and interest rates. The Fed had little credibility among investors and inflation expectations remained high throughout most of the decade. It was not until the Volcker led Fed stepped sharply on the monetary brakes for an extended period of time during the 1980s that the back of inflation was finally broken and monetary policy earned a reservoir of credibility that remains mostly intact through today.
Although policy mistakes have clearly been made since the Volcker regime, the Fed has retained its inflation fighting credibility. The excessive monetary accommodation in place over the past year, which would have been viewed with alarm in an earlier era, is generally accepted as a necessary response to the worst financial crisis since the Great Depression. While there are more than a handful of analysts who fear the Fed will overstay the course, that fear has not yet filtered into inflation expectations, which remain solidly anchored at a low level. Admittedly, the patience manifested by these low expectations may well be tested in coming months if the Fed mishandles the timing and the method of unwinding its extraordinary policy of accommodation. For now, however, it is getting the benefit of the doubt, deservedly so.
Indeed, it is not just a leap of faith in the Fed's ability to pull the appropriate monetary levers that keeps inflation expectations anchored. A number of tangible forces strongly suggest that inflation will remain tame for some time to come. For example, the housing component, which accounts for an outsized 43% of the CPI, continues to be a major drag on the inflation rate, falling by 0.3% last month. The largest fraction of this component, owner's equivalent rent, has either declined or remained flat for a record five consecutive months. With the rental vacancy rate hovering at near record levels and apartment owners struggling to find tenants, the downward pull of rents is likely to continue in the months ahead.
That trend, in turn, will keep the downward pressure on home prices intact as well. Keep in mind that households seeking shelter always have a choice between owning a home and renting, and that decision is influenced to no small extent by the ratio of home prices to rents. The higher the ratio, the greater is the incentive to rent rather than purchase a home, reducing the demand for residential properties. No doubt, the 30% collapse in home prices over the past two plus years has lowered the ratio from its abnormally high peak reached during the housing bubble years, but it still is higher than the long term average. With rents continuing to slide, home prices are likely to follow suit to keep the ratio from rising again. Indeed, the drop in rents is contributing to the foreclosure problem, as households who purchased a home during the peak years are finding it cheaper to rent than to pay off their mortgages, which for millions of homeowners is larger than what the house is worth.
That competition from rental units is also a major obstacle in the way of a more vigorous revival in homebuilding activity. That was strikingly evident again with this week's release of the housing starts figure for January. During the month, builders broke ground on 591,000 new homes, which is up modestly from the 575,000 the previous month. But the January build rate was probably inflated by a number of spec homes that builders started, anticipating demand from the homebuyer's tax credit that expires at the end of April. To qualify for the credit, the homes must be completed before the expiration date. The fact that building permits, an indicator of future construction, tumbled during the month leads us to believe that further gains in housing starts will not take place unless they are justified by a sustained increase in sales.
As it is, the volume of new construction is just barely off the all time low reached last April, and is running at less than half the average pace of the past 40 years. At best, the homebuilding collapse has largely run its course and is no longer the powerful weight on the economy that it was in 2007 and 2008. While another asset bubble may be brewing somewhere under the radar, the Fed has little to fear that it is coming from the housing sector in the foreseeable future. Nor is the housing weakness and the slide in rents the only forces tamping down inflation. With a nearly 10% unemployment rate and the number of unemployed workers exceeding job openings by a record six to one margin, workers are hardly in a strong bargaining position to demand pay raises. What little progress on the wage front they can achieve is being more than offset by the astonishing gains in productivity that businesses are squeezing out of the workforce. Hence, unit labor costs are having little or no effect in pushing up prices.
Finally, the slack in the labor force is being matched in the product markets, where excess capacity remains exceptionally high. The fact that the impressive increases in production since last fall, thanks to inventory restocking and muscular export gains, have hardly made a dent in the amount of idle productive resources testifies to how deep a hole the Great Recession has created for manufacturers and other producers of goods in the
