Fed Watch: Game Changers?

The strong data flow continues. Following up on its manufacturing counterpart, the ISM’s service sector report extended January’s improvement. Retail sales appeared to bounce higher in February, supporting the contention that January’s weakness in retail sales was weather related. When the roads cleared, consumers realized they had a few extra dollars burning a hole in their pockets. And, most importantly, initial unemployment claims sank, bringing the 4-week average below the 400k mark. We are at levels that typically foreshadow solid labor market improvement, which is undeniably good news.

All in all, incoming data reinforce my sense that the upside and downside risks to the forecast are intensifying, which could make for a very interesting few months. I sense there is a tendency to downplay the upside risk because of the depth of the US employment and output holes. To be sure, there remains significant slack in the economy, enough so that a steady stream of good data should not induce monetary or fiscal authorities to withdraw stimulus anytime soon. This, of course, is the mistake the ECB looks likely to make:

European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month for the first time in almost three years to fight mounting inflation pressures.

An “increase of interest rates in the next meeting is possible,” Trichet told reporters in Frankfurt today after the central bank set its benchmark rate at a record low of 1 percent for a 23rd month. “Strong vigilance is warranted,” he said, adding that any move would not necessarily be the start of a “series.”

Overeager ECB policymakers aside, one can see the foundation of a shockingly sustainable recovery forming. I know, it has been so long since we saw good data that the natural inclination is to be dismissive. But at this point, all we really need is to light a little fire under the labor market to entrench a positive feedback loop. And the sharp improvement in initial claims suggests that fire has been lit. It is just a matter of time before it shows up in nonfarm payrolls.

But lighting the fire is not enough to prompt the Fed to make a rapid policy reversal. Some policymakers will focus on what they see as brewing inflation. From the Beige Book:

Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future. Homebuilders in the Cleveland and Atlanta Districts noted rising material costs, but acknowledged little ability to pass through the costs to buyers. Retailers in some Districts mentioned they had implemented price increases or were anticipating such action in the next few months.

Efforts to pass along higher prices, however, should not be enough to unsettle the Fed as a whole. Eyes should be drawn to the next sentence:

There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

Until we see enough labor demand, and reduced slack, that we see some widespread upward momentum in wages, it is tough to see how higher input cost do anything but temper demand growth.

Simply put, the baseline scenario should be that labor markets are not going to improve sufficiently quickly to unsettle the Fed’s plans. Still, there is a risk that we are underestimating the degree of slack in labor markets. I think one needs to pay more attention to that risk should we see a string of solid employment reports.

At the same time the economy is showing signs of sustained momentum, thus raising the specter of upside risks, we are faced with the downside risks from the commodity side. Undoubtedly, higher commodity prices are a drag on activity. But the last shock came in the context of waning US economic activity and rock bottom saving rates. This time, the US economy is on the upswing, with positive saving rates to provide cushion, suggesting that for now the commodity shock can be managed. Still, I can outline a scenario where low interest induces a flood of money into commodities to chase a supply induced price shock. And I am more inclined to believe that this would trigger a recessionary rather than inflationary environment.

Bottom Line: We await yet another employment report, facing intensifying risks on both sides of the forecast. The possibility of some real game changing developments is at hand. At this moment, I think the balance of risks are now on the upside, but am very, very conscious of how quickly that balance can change in the wake of a commodity price shock. I would be wary about letting the depth of this recession interfere with your read of the data, just as wary as you should be about letting the data tempt you from thinking it is time to push stimulative policies into reverse.

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