Fed Watch: The Rearview Mirror

The rearview mirror is looking pretty good this week.  The ISM manufacturing index extended January’s impressive gains, again with improving internals.  Note declines in the inventory measures, which suggests manufacturing momentum is set to continue.  One can wring their hands over the Personal Income and Outlays report, which revealed a very small 0.1 percent decrease in real spending.  This should be taken in context of likely weather-related issues rather than some impending consumer slowdown.  Bolstering that view is the 0.4 percentage point gain in the saving rate; bank accounts swelled a bit as weather restrained shopping activity.  Moreover, the February spending report will get a boost from autos, with car dealers reporting well-above-expectations sales of 13.44 million units, SAAR.   No wonder consumer confidence was up in February.  Buying new cars makes people happy.

All told, incoming data continues to be on the bright side.  To be sure, it is reasonable to complain about the depth of the hole we are in – the “real” recovery remains nascent, beginning just in the final quarter of 2010.  A handful of solid data should not be reason to abandon monetary and fiscal stimulus and threaten building momentum.  But the data is solid, so much so that it is surprising to see the comments of Harvard’s Martin Feldstein. Via Bloomberg:

“There is a mixed picture now in terms of how much the economy is on track,” Feldstein said in an interview on Bloomberg Television’s “InBusiness With Margaret Brennan.” Growth “started slowing down toward the end of the fourth quarter. The January numbers are not very good at all.”

Feldstein cited less-than-forecast consumer spending in January, continuing monthly declines in U.S. housing prices and weakness in industrial production. While fourth-quarter growth was bolstered by consumers spending more after a rise in the stock market, those gains came as the personal savings rate fell, he said.

“So this is not a strong economy,” Feldstein said. “There hasn’t been a pull-through from the fourth quarter to the first quarter.”

I disagree; the pull-through has been strong. The industrial production weakness in January was the consequence of the often-volatile mining and utility sectors.  Manufacturing production gained 0.3 percent, extending a 0.9 percent gain the previous month.  And the ISM reports promise additional strength going forward.  I already commented above on the consumer spending picture.  Feldstein, however, is correct on housing.  But this should not come as a surprise – a housing recovery figures into precious few forecasts this year.

Federal Reserve Chairman Ben Bernanke also does not side with Feldstein.  Making his semi-annual trek to Capitol Hill, Bernanke gave a relatively upbeat assessment of the economy:

More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending has grown at a solid pace since last fall, and business investment in new equipment and software has continued to expand. Stronger demand, both domestic and foreign, has supported steady gains in U.S. manufacturing output.

The combination of rising household and business confidence, accommodative monetary policy, and improving credit conditions seems likely to lead to a somewhat more rapid pace of economic recovery in 2011 than we saw last year.

Enough optimism to change policy in the near term?  No:

While indicators of spending and production have been encouraging on balance, the job market has improved only slowly… Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.

It will take a few months of solid jobs data to convince Fed officials that the economy is out of harms way – and by that time, the Fed’s current asset purchase plan will be effectively over.  Maybe we will get the first such report on Friday; I am optimistic that nonfarm payrolls will look better than the weather mangled January read.  Interestingly, Oregon reported solid numbers for January, a month that was unseasonably warm.  No snow to disrupt the jobs picture.

Given where Bernanke is today, I find it difficult to believe that he will follow the path suggested by St. Louis Fed President James Bullard.  From the Wall Street Journal:

“We are still very far away from achieving our dual mandate of maximum sustainable employment and price stability,” Dudley said. “Faster progress toward these objectives would be very welcome and need not require an early change in the stance of monetary policy,” he said.

Bullard sees things a little differently. In his television appearance he explained the Fed is “determined” to get monetary policy back to a more normal profile. He explained he saw the Fed as “possibly finishing the program a little bit shy of where we intended initially, and then go on pause for a while.”

Bullard’s comments need more clarification:

Bullard differs somewhat from that camp in that he’s been a QE2 supporter and was one of its primary advocates before it was launched. His comments Monday suggest a philosophical difference. While many in the Fed see QE2 as an extension of normal monetary policy, Bullard takes that view a step further, and would like the Fed to use bond buying in a fashion similar to the way it used to approach short-term rates. The Fed didn’t always move in a straight line with rate adjustments then, and sometimes paused to take in new data.

Bullard has been suggesting for quite some time that the Fed should use small adjustments in its bond buying program to manage expectations, and this is likely his last chance to see that idea actually implemented.  Note that it was not implemented last year; the Fed opted for the announcement of a large scale program with a $600 billion target.  The only possible reason to bring an early halt to the program given the early stage of the recovery and, as Bernanke notes, an environment of stable inflations expectations, is to hand Bullard a policy “win.”  I just don’t see that happening.  But if it does, there would be no question about Bullard’s stature within the Fed.

What could upset Bernanke’s optimism?  Commodity prices, of course.  If commodity prices work their way deep into inflation expectations in an environment of improving final demand, the Fed will be pushed to reverse policy.  And if inflation truly took hold, forget about fine-tuning and tapering; think outright reversal.  That, however, I think is less likely than the recessionary implications of a sharp run up in commodity prices, the odds of which seem more likely by the day.  For now, Bernanke can only sit on the sidelines and see how it plays out.

Bottom Line:  If the Fed continues to drive by the rear view mirror, they will happily bring the current $600 program to conclusion as expected.  Assuming the data continues to hold, and momentum builds  in the job market, they will shift to “normalizing” policy, with rate hike possible early next year.  But if they turn their attention to the front windshield, they will see the commodity price truck starting to slide out of control.  But until the slide turns into an outright wreck, they just will not know which way to swerve.

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