Fed Watch: A Solid Start To 2011

The ISM manufacturing number was not a blowout by any means.  Indeed, the rise to 57.0 headline number was slightly below expectations.  Still, it is a solid number and the internals were generally supportive.  New orders gained while inventory measures declined, suggesting solid sales that will sustain future production.  Not surprisingly, the pricing component remains high, consistent with rising commodity prices – indeed, according to the report, no industries reported falling prices.

The disappointment in the report was the employment measure, which fell from 57.5 to 55.7.  I am not sure this tells us much about the impending employment report for the final month of 2010 – I don’t think anyone had high hopes that the manufacturing sector would lead a jobs recovery; the minimal gains in durable goods manufacturing stalled out in the second half of 2010 while employment in nondurable goods generally continued the free fall initiated in the mid-90s.

Overall, the ISM report was generally consistent with the relatively upbeat flow of data seen in recent weeks suggesting that growth accelerated to something above trend at the end of 2010.  This, coupled with decreasing initial unemployment claims, supports the consensus expectation for 140k nonfarm payroll gain in Friday’s report.  While well above the dismal October report, it would promise persistent high unemployment, as 140k would be at the top end of estimates of natural labor force growth.

Paul Krugman worries that policymakers will ignore the depth of the recession and instead grab onto the positive data flow to press for fiscal and/or monetary consolidation.  On the latter:

I’m also worried about monetary policy. Two months ago, the Federal Reserve announced a new plan to promote job growth by buying long-term bonds; at the time, many observers believed that the initial $600 billion purchase was only the beginning of the story. But now it looks like the end, partly because Republicans are trying to bully the Fed into pulling back, but also because a run of slightly better economic news provides an excuse to do nothing.

There’s even a significant chance that the Fed will raise interest rates later this year — or at least that’s what the futures market seems to think. Doing so in the face of high unemployment and minimal inflation would be crazy, but that doesn’t mean it won’t happen.

I was not optimistic the Fed would opt to continue running the printing press once the current $600 billion of asset purchases is on the balance sheet, and even less so as the data continued to suggest above trend growth.  It was only the mid-year slowdown that forced the Fed’s hand in the first place.  Without that slowdown, the Fed would probably have sat on their hands despite high unemployment.

Will Bernanke & Co. move in reverse this year and actually raise rates?  I find that hard to believe given the likelihood growth will fall well short of that required to drive the unemployment rate significantly lower.  But I am also not surprised that future markets are pointing in that direction.  Indeed, that should be expected given the rates are effectively set near zero – traders have nothing to bet on but a rate increase!  That is simply the direction the risk lies.

I am looking for more upbeat data to influence upcoming Fedspeak, confirming expectations that the Fed is preparing to move to the sidelines.  On the other hand, I am not hopeful such talk will make its way into Federal Reserve Chairman Ben Bernanke’s upcoming Senate testimony.  He has displayed a willingness to play his cards close to the chest, not eager to stake out a policy shift in advance of other FOMC members.  I don’t expect much deviation from the message of December’s FOMC statement, with the risk being obvious – that he follows the upbeat flow of data.

Bottom Line:  More confirmation that the economy accelerated as we exited 2010, enough to justify winding down the large scale asset purchases and to push more FOMC members to once again think about the exit strategy, but not enough to justify an imminent tightening of monetary policy.

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