How the Fed Sees the Economy

The Federal Reserve just released the minutes to its March 15th meeting. Below, I present the minutes section on how the members of the Open Market Committee feel about the economy with my reaction/translation interspersed on a paragraph-by-paragraph basis.

“Participants’ Views on Current Conditions and the Economic Outlook

“In discussing intermeeting developments and their implications for the economic outlook, participants agreed that the information received since their previous meeting was broadly consistent with their expectations and suggested that the economic recovery was on a firmer footing.

“Looking through weather-related distortions in various indicators, measures of consumer spending, business investment, and employment showed continued expansion. Housing, however, remained depressed.

“Meeting participants took note of the significant decline in the unemployment rate over the past few months but observed that other indicators pointed to a more gradual improvement in overall labor market conditions. They continued to expect that economic growth would strengthen over coming quarters while remaining moderate.

“Participants noted that recent increases in the prices of oil and other commodities were putting upward pressure on headline inflation, but that measures of underlying inflation remained subdued. They anticipated that the effects on inflation of the recent run-up in commodity prices would prove transitory, in part because they saw longer-term inflation expectations remaining stable. Moreover, a number of participants expected that slack in resource utilization would continue to restrain increases in labor costs and prices.

“Nonetheless, participants observed that rapidly rising commodity prices posed upside risks to the stability of longer-term inflation expectations, and thus to the outlook for inflation, even as they posed downside risks to the outlook for growth in consumer spending and business investment.

“In addition, participants noted that unfolding events in the Middle East and North Africa, along with the recent earthquake, tsunami, and subsequent developments in Japan, had further increased uncertainty about the economic outlook.”

No real change in the outlook from the January meeting. The economy is expected to expand at a fairly solid pace, but given the huge amount of existing slack in the economy, it means people are going to be hurting for a long time. The direction is good; the position, not so much. Housing remains the key reason we have not had a more robust recovery so far, and recent increases in oil prices are going to be a headwind to future growth, but will not be enough to stop it in its tracks.

Higher food and energy prices are not likely to seep into core inflation. Given the amount of unused capacity (both human and physical) and anemic (to put it mildly) increases in wages, it is more likely that the effects of higher oil prices show up in decreased demand for other goods, rather than in higher core inflation.

“Participants’ judgment that the recovery was gaining traction reflected both the incoming economic indicators and information received from business contacts. Spending by households, which had picked up noticeably in the fourth quarter, rose further during the early part of 2011, with auto sales showing particular strength. Although some participants noted that growth in consumer spending so far this year had not been as vigorous as they had anticipated, they attributed the shortfall in part to unusually bad weather.

“While participants expected that household spending would continue to expand, the pace of expansion was uncertain. On the one hand, labor market conditions were improving, though gradually, and the temporary cut in payroll taxes was contributing to rising after-tax incomes. Some easing of credit conditions for households, particularly for auto loans, also appeared to be supporting growth in consumer spending.

“On the other hand, declining house prices remained a drag on household wealth and thus on consumer spending. In addition, sizable recent increases in oil and gasoline prices had reduced real incomes and weighed on consumer confidence. Business contacts in a variety of industries had expressed concern that consumers might pull back if gasoline prices rose significantly further and persisted at those elevated levels.”

Consumers are doing their part in getting the economy moving forward again, but are taking a bit of a breather relative to the very strong contribution they made in the fourth quarter. Bad weather probably kept many away from the stores in January.

Auto sales in particular have been strong, at least partly due to pent-up demand. Job growth puts more money in consumers’ pockets, as does the cut in payroll taxes, but that is being absorbed by higher prices at the pump.

The second down-leg in housing prices that is now underway is making people feel poorer and means that people will have to save more to repair their personal balance sheets. If the equity in your house was a big part of your retirement plan, or your plan for sending the kids to college, and it no longer exists, you will have to put more money aside, provided you still want your kids to go to college or you still want to be able to retire.

“A further increase in business activity also indicated that the economic recovery remained on track. Industrial production posted solid gains, supported in part by continuing growth in U.S. exports.

“Business contacts in a number of regions reported they were more confident about the recovery; a growing number of contacts indicated they were planning for an expansion in hiring and production to meet an anticipated rise in sales. Manufacturing firms were particularly upbeat. Some contacts reported they were increasing capital budgets to undertake investment that had been postponed during the recession and early stages of the recovery; in some cases, firms were planning to expand capacity.

“Consistent with the anecdotal evidence, indicators of current and planned business investment in equipment and software continued to rise and surveys showed a further improvement in business sentiment. In addition, although residential construction remained weak, investment in energy extraction was growing and spending on commercial construction projects appeared to be bottoming out.”

The industrial side of the economy is recovering nicely, in large part due to higher export orders. The weakening of the dollar is probably a large part of that story. Unfortunately, while exports are strong, imports have been rising rapidly as well. Higher oil prices mean that our imports are likely to increase sharply again over the next few months, which will be a significant drag on overall growth.

“Meeting participants judged that overall conditions in labor markets had continued to improve gradually. The unemployment rate had decreased significantly in recent months; other labor market indicators, including measures of job growth and hours worked, showed more-modest improvements.

“Several participants noted that the drop in unemployment was attributable more to people withdrawing from the labor force and to fewer layoffs than to increased hiring. Even so, participants agreed that gains in employment seemed to be on a gradually rising trajectory, although the recent data had been somewhat erratic and distorted by worse-than-usual weather in many parts of the country.

“In addition, surveys of employers showed that an increasing number of firms were planning to hire. Participants noted regional differences in the speed of improvement in labor markets; scattered reports indicated that firms in some regions were having difficulty hiring some types of highly skilled workers.

“Participants generally judged that there was still substantial slack in the labor market, though estimates of the degree of slack were admittedly imprecise and depended in part on judgments about a number of factors, including the extent to which labor force participation would increase as the recovery progresses and employment expands.”

While the participants did not have access to the March jobs report, I don’t think there was anything in it that would have changed their views on the jobs picture. We are making solid progress on jobs, but we have a very long way to go to get back to where we were before the Great Recession started.

“Credit conditions remained uneven. Bankers again reported improving credit quality and generally weak loan demand. Large firms that have access to financial markets continued to find credit, including bank loans, available on relatively attractive terms; however, credit conditions reportedly remained tight for smaller, bank-dependent firms.

“Participants noted evidence that the availability of student loans and of consumer loans — particularly auto loans — was increasing. Indeed, bank and nonbank lenders reported that terms and conditions for auto loans had returned to historical norms.

“In contrast, terms for commercial and residential real estate loans remained tight and the volume of outstanding loans continued to decline, though there was some issuance of CMBS backed by loans on high-quality properties in selected large metropolitan areas. A few participants expressed concern that the easing of credit conditions in some sectors was becoming or might become excessive as investors took on more risk in order to obtain higher yields.”

The capital position of banks has apparently improved (I say “apparently” because in the absence of mark-to-market accounting, I would not trust the published balance sheet of any of the major banks), but they would rather deplete that capital by paying it out as dividends and buying back stock than lending it out. This is a major mistake, and is likely to come back to bite us in a few years. Auto loans are back to normal, but banks still don’t want to lend to small businesses, and have very little interest in giving mortgages to any but those with the most pristine credit scores.

“Participants observed that headline inflation was being boosted by higher prices for energy and other commodities, and that prices of other imported goods also had risen by a substantial, though smaller, amount. A number of business contacts indicated that they were passing on at least a portion of these higher costs to their customers or that they planned to try to do so later this year; however, contacts were uncertain about the extent to which they could raise prices, given current market conditions and the cautious attitudes toward spending still held by households and businesses.

“Other participants noted that commodity and energy costs accounted for a relatively small share of production costs for most firms and that labor costs accounted for the bulk of such costs; moreover, they observed that unit labor costs generally had declined in recent years as productivity growth outpaced wage gains. Several participants noted that even large commodity price increases have had only limited effects on underlying inflation in recent decades.”

Businesses may try to pass along higher prices, but that does not mean that they will succeed in doing so. With people paying more at the pump, they will have less in their wallets to spend on other things. Already, Airlines have been forced to roll back their fuel surcharges because Southwest Air (LUV) refused to go along. I suspect the same thing will happen to other companies that try to jack up their prices.

Despite all the talk about higher input costs and the need to pass them along, net margins have been doing extremely well, at least for larger companies. For all of 2010, the composite net margin for the S&P 500 firms rose to 8.24% from 7.09% (excluding Financials; if they are included, the jump in net margins is even more extreme — going from 6.39% to 8.59% — but that is mostly due to lower loan loss reserve additions).

The consensus is looking for margin growth to continue, rising to 8.84% in 2011, and 9.37% in 2012 (or 9.59% and 10.31% if you include the Financials). I suspect that those who try to raise prices aggressively will simply lose significant market share.

“In contrast to headline inflation, core inflation and other measures of underlying inflation remained subdued, though they appeared to have bottomed out. A number of participants noted that, with significant slack in resource utilization and with longer-term inflation expectations stable, underlying inflation likely would remain subdued for some time.

“However, the importance of resource slack as a factor influencing inflation was debated. Some participants pointed to research indicating that measures of slack were useful in predicting inflation. Others argued that, historically, such measures were only modestly helpful in explaining large movements in inflation; one noted the 2003-04 episode in which core inflation rose rapidly over a few quarters even though there appeared to be substantial resource slack.”

I come down on the side of those who say the huge amount of slack in the economy will keep core inflation rates low. Really high inflation requires a wage-price spiral, and there is simply no evidence whatsoever of that happening on the wage side. Average hourly earnings are up just 1.7% over the last year, and the wage increases over the last two months annualize out to less than 0.03%.

“Participants expected that the boost to headline inflation from recent increases in energy and other commodity prices would be transitory, and that underlying inflation trends would be little affected as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. However, a significant increase in longer-term inflation expectations could contribute to excessive wage and price inflation, which would be costly to eradicate.

“Accordingly, participants considered it important to pay close attention to the evolution not only of headline and core inflation but also of inflation expectations. In this regard, participants observed that measures of longer-term inflation compensation derived from financial instruments had remained stable of late, suggesting that longer-term inflation expectations had not changed appreciably, although measures of one-year inflation compensation had risen notably.

“Survey-based measures of inflation expectations also indicated that longer-term expected inflation had risen much less than near-term inflation expectations. A few participants noted that the adoption by the Committee of an explicit numerical inflation objective could help keep longer-term inflation expectations well anchored.”

The bond market sure is not looking for high inflation if people are willing to lend their money for 10 years at less than 3.5%. I don’t think businesses do, either. Corporations are sitting on huge amounts of cash, and cash is a very poor investment in an inflationary environment. I continue to see slow growth and high unemployment as being a much more serious problem than the prospect of inflation (especially core inflation) taking off anytime soon.

“Participants generally judged the risks to their forecasts of growth in economic activity to be roughly balanced. They continued to see some downside risks from the banking and fiscal strains in the European periphery, the continuing fiscal adjustments by U.S. state and local governments, and the ongoing weakness in the housing market. Several also noted the possibility of larger-than-anticipated near-term cuts in federal government spending.

“Moreover, the economic implications of the tragedy in Japan — for example, with respect to global supply chains — were not yet clear. On the upside, the improvement in labor market conditions in recent months raised the possibility that household spending — and subsequently business investment — might expand more rapidly than anticipated; if so, the recovery could be stronger than currently projected.

“Participants judged that the potential for more-widespread disruptions in oil production, and thus for a larger jump in energy prices, posed both downside risks to growth and upside risks to inflation. Several of them indicated, in light of recent developments, that the risks to their forecasts of inflation had shifted somewhat to the upside.

“Finally, a few participants noted that if the large size of the Federal Reserve’s balance sheet were to lead the public to doubt the Committee’s ability to withdraw monetary accommodation when appropriate, the result could be upward pressure on inflation expectations and so on actual inflation.

“To mitigate such risks, participants agreed that the Committee would continue its planning for the eventual exit from the current, exceptionally accommodative stance of monetary policy. In light of uncertainty about the economic outlook, it was seen as prudent to consider possible exit strategies for a range of potential economic outcomes. A few participants indicated that economic conditions might warrant a move toward less-accommodative monetary policy this year; a few others noted that exceptional policy accommodation could be appropriate beyond 2011.”

I seriously doubt we will see an increase in the Fed Funds rate before the start of 2012. To the list of downside risks, I would add fiscal contraction at the Federal as well as the State and Local level. I think the oil price rise shows up more in weaker economic growth than in pass through to higher core inflation.

The increase in oil price is a change in relative prices, not an increase in the overall price level. That is a good reason to adjust your portfolio, but not a reason to tighten monetary policy. Given that demand for energy is very inelastic, particularly in the short term, oil companies like ExxonMobil (XOM) are going to have much more pricing flexibility than other firms. That is a good reason to put it, and firms like it, in your portfolio, but the spillover into higher overall inflation is going to be very modest and should not last that long.

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