Fed Watch: Devil’s Advocate

Expectations are building for Federal Reserve action next week.  Bloomberg hits on a key point:

Chairman Ben S. Bernanke told lawmakers last week the “central question” confronting the Federal Reserve at its next meeting is whether growth is fast enough to make “material progress” reducing unemployment.

The answer may well be no…

…“They’re not closing that employment gap as fast as they’d like, so I suspect it adds up to more action to get things moving again,” said Michael Feroli, chief U.S. economist at New York-based JPMorgan Chase & Co. and a former researcher for the Federal Reserve Board in Washington. “Bernanke has a clear economic mandate, and we’re still far from achieving it.”

I think there are two issues at play, the forecast itself and the risk to that forecast.  On the first point, I am not convinced that incoming data have proved sufficient to measurably change the forecast.  On the key jobs issue, I keep getting pulled back to this from Bernanke’s testimony:

This apparent slowing in the labor market may have been exaggerated by issues related to seasonal adjustment and the unusually warm weather this past winter. But it may also be the case that the larger gains seen late last year and early this year were associated with some catch-up in hiring on the part of employers who had pared their workforces aggressively during and just after the recession. If so, the deceleration in employment in recent months may indicate that this catch-up has largely been completed, and, consequently, that more-rapid gains in economic activity will be required to achieve significant further improvement in labor market conditions.

I sense a great deal of uncertainty in the paragraph, suggesting to me that Bernanke would like to see more data before committing to a new policy path.  Of course,one could point to the weak tenor of the most recent string of initial claims reports as additional evidence of a flagging job market:

That said, I am still hard-pressed to see that this is sufficient to believe the steady downtrend in claims has been disrupted:

There is also the general sense that softer inflation numbers give the Fed room to act, particularly with headline CPI inflation now down below 2% year-over-year:

On this point I would caution that the downward move in headline has yet to be confirmed by core.  This should be a symmetric game.  Just as core inflation never rose fast enough to justify concerns about headline inflation, sticky core inflation in the face of declining headline inflation would signal to the Federal Reserve that they should not yet reduce their inflation forecasts.

I would also add that the anecdotal evidence is less dire, to say the least.  The most recent Beige book:

Reports from the twelve Federal Reserve Districts suggest overall economic activity expanded at a moderate pace during the reporting period from early April to late May. …

Manufacturing continued to expand in most Districts. Consumer spending was unchanged or up modestly. New vehicle sales remained strong and inventories of some popular models were tight. Sales of used automobiles held steady. Travel and tourism expanded, boosted by both the business and leisure segments. Demand for nonfinancial services was generally stable to slightly higher since the last report, and several Districts noted strong growth in information technology services. Conditions in residential and commercial real estate improved. Construction picked up in many areas of the country. Lenders in most Districts noted an improvement in loan demand and credit conditions. Agricultural conditions generally improved, and spring planting was well ahead of its normal pace in most reporting Districts. Energy production and exploration continued to expand, except for coal producers who noted a slight slowing in activity.

Wage pressures overall were modest. Hiring was steady or increased slightly, and contacts in a number of Districts reported difficulties in finding qualified workers, particularly those with specialized skills. Price inflation remained modest across Districts, and overall cost pressures eased as the price of energy inputs declined. Economic outlooks remain positive, but contacts were slightly more guarded in their optimism.

Confirming that relatively upbeat view is this from Bloomberg:

Rising truck shipments show the U.S. economic expansion is intact, even amid concerns that a slowdown in retail sales and Europe’s sovereign-debt crisis could stall growth.

Two measures of trucking activity signal the industry remains steady and has even “firmed up” since mid-May, according to Ben Hartford, an analyst in Milwaukee with Robert W. Baird & Co. The data complement anecdotal information from carriers that freight demand ended May on a strong note after more weakness than anticipated earlier in the month, he said.

“Trucking trends are reflective of an economic environment that is stable, not deteriorating,” Hartford said.

To me, the upshot is that the data flow over the past two years has been sloppy, possibly a reflection seasonal adjustment issues, leaving the general rule of avoiding excessive optimism and excessive pessimism as the best bet.  That rule argues for a relatively limited changes to the Fed’s forecast.

If the Fed follows the above line of thinking, they will hold steady next week.  In other words, there is a nontrivial risk that financial market participants are getting ahead of the Fed.  That said, even if the forecast does not change materially, it seems pretty clear that the risks to the downside have increased.  Indeed, the ECB is working overtime to ensure the risks remain to the downside.  This argues for additional action, especially with a block of Fed officials – including Vice-Chair Janet Yellen, San Francisco Federal Reserve President John Williams, and Chicago Federal Reserve President Charles Evans – who likely already desired more easing under the most recent forecast.

Bottom Line:  I think you can tell a story that the most recent data is not sufficient to move Fed forecasts, in which case it remains possible that the Fed does not implement any changes next week.  I have to admit to being a little nervous that we get a Fed “leak” over the next few days in an effort to reset expectations ahead of the meeting.  Still, given the increased downside risks to the forecast, it is hard for me to make this my baseline scenario, especially given the very dovish Yellen/Williams/Evan contingent, which is why I expect some action next week.  But much still rests on Bernanke, who has surprised by positioning himself to the hawkish side of the center.  After all, if he believed the Yellen/Williams/Evans stories, he would have eased already.  He hasn’t, suggesting that he has a pretty high bar to additional easing, and we just might not have crossed that bar.

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