The Federal Reserve just released the minutes to their June 21-22 FOMC meeting. Below I present the section dealing with the participants (Fed Governors and Regional Fed Presidents) views and projections. In between paragraphs I comment on the relevant data that has been released since the meeting, and interpret/translate their remakes.
In their discussion of the economic situation and outlook, meeting participants agreed that the economic information received during the intermeeting period indicated that the economic recovery was continuing at a moderate pace, though somewhat more slowly than they had anticipated at the time of the April meeting.
Participants noted several transitory factors that were restraining growth, including the global supply chain disruptions in the wake of the Japanese earthquake, the unusually severe weather in some parts of the United States, a drop in defense spending, and the effects of increases in oil and other commodity prices this year on household purchasing power and spending. Participants expected that the expansion would gain strength as the influence of these temporary factors waned.
Data since the meeting indicate that the economy has not picked up, even though some of those temporary factors should have eased, most notably the oil price part. It seems likely that there will be somewhat stronger growth in the second half than in the first half. However, it appears that growth in the second quarter will be below the 1.9% rate in the first quarter.
Nonetheless, most participants judged that the pace of the economic recovery was likely to be somewhat slower over coming quarters than they had projected in April. This judgment reflected the persistent weakness in the housing market, the ongoing efforts by some households to reduce debt burdens, the recent sluggish growth of income and consumption, the fiscal contraction at all levels of government, and the effects of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest.
Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and declining prices in the housing sector, the chance of a larger-than-expected near-term fiscal tightening, and potential financial and economic spillovers if the situation in peripheral Europe were to deteriorate further.
Participants still projected that the unemployment rate would decline gradually toward levels they saw as consistent with the Committee’s dual mandate, but at a more gradual pace than they had forecast in April. While higher prices for energy and other commodities had boosted inflation this year, with commodity prices expected to change little going forward and longer-term inflation expectations stable, most participants anticipated that inflation would subside to levels at or below those consistent with the Committee’s dual mandate.
I agree with all of the slowing factors they mentioned. While eventually we will see residential investment recover, we are already seeing higher starts for Apartments and the vacancy rate for apartments has been falling nicely. Those new starts are not going to be available for people to live in until well into 2012. This year completions, both single family and multi-family, are likely to be at record lows. The rebuilding of the savings rate is needed over the long term, the rates of the middle of this decade were dangerously low. However a rising savings rate slows the economy. I would emphasize the fiscal contraction part of the story.
At the Federal level it looks like it could come two ways. If the Debt ceiling is not increased, spending will plummet, and we WILL have a new recession, nay a new depression, and one that would probably be worse than the first one. (What If There is No Debt Ceiling Increase?)
The other scenario is that the price to be paid for getting the debt ceiling increase will be very large cuts in spending over the next decade to the tune of several trillion. That would be like a cancer on the economy, instead of a massive heart attack. Given the choice between the two, I would rather have the cancer, but we don’t have to have either. As for the gradual decline in unemployment, well gradually the Pacific Ocean is becoming smaller and the Atlantic Ocean is getting bigger, and eventually, the Atlantic will be bigger than the Pacific. The unemployment rate has ticked up for three straight months now. I agree that the uptick in headline inflation is probably temporary.
Activity in the business sector appeared to have slowed somewhat over the intermeeting period. Although the effects of the Japanese disaster on U.S. motor vehicle production accounted for much of the deceleration in industrial production since March, the most recent readings from various regional manufacturing surveys suggested a slowing in the pace of manufacturing activity more broadly. However, business contacts in some sectors–most notably energy and high tech–reported that activity and business sentiment had strengthened further in recent months.
Business investment in equipment and software generally remained robust, but growth in new orders for nondefense capital goods–though volatile from month to month–appeared to have slowed. While FOMC participants expected a rebound in investment in motor vehicles to boost capital outlays in coming months, some also noted that indicators of current and planned business investment in equipment and software had weakened somewhat, and surveys showed some deterioration in business sentiment. Business contacts in some regions reported that they were reducing capital budgets in response to the less certain economic outlook, but in other parts of the country, contacts noted that business sentiment remained on a firm footing, supported in part by strong export demand.
Compared with the relatively robust outlook for the business sector, meeting participants noted that the housing sector, including residential construction and home sales, remained depressed. Despite efforts aimed at mitigation, foreclosures continued to add to the already very large inventory of vacant homes, putting downward pressure on home prices and housing construction.
Yes the Japanese disaster is being felt here, particularly in the Auto industry, and so far in this recovery, manufacturing has been (was?) a bright spot. However, the underlying problem is a lack of demand. Why invest in new machines, when the ones you have are sitting idle? One reason is that a new machine can effectively replace labor with capital. If the new machine will allow you to make the same number of widgets with five people instead of six. Productivity growth has been very robust in this recovery. All of the benefit to higher productivity has been going to capital in the form of higher profits. The S&P 500 is expected to earn over $1 Trillion in 2012, up from 544 Billion in 2009. Exports are rising, but then again, so are imports.
Meeting participants generally noted that the most recent data on employment had been disappointing, and new claims for unemployment insurance remained elevated. The recent deterioration in labor market conditions was a particular concern for FOMC participants because the prospects for job growth were seen as an important source of uncertainty in the economic outlook, particularly in the outlook for consumer spending.
Several participants reported feedback from business contacts who were delaying hiring until the economic and regulatory outlook became more certain and who indicated that they expected to meet any near-term increase in the demand for their products without boosting employment; these participants noted the risk that such cautious attitudes toward hiring could slow the pace at which the unemployment rate normalized. Wage gains were generally reported to be subdued, although wages for a few skilled job categories in which workers were in short supply were said to be increasing relatively more rapidly.
The June employment report would certainly reinforce that employment has been disappointing (see: Awful Jobs Report In Depth, pt. 1 and Awful Jobs Report In Depth, pt. 2). The basic problem as far as unemployment is concerned is a lack of aggregate demand, not any structural issues in the economy. If it were a structural issue, there would be lots of areas with worker shortages and soaring salaries, rather than just a few. While productivity growth is vital over the long term (after all it is the level of productivity that determines per capita living standards), in times of lots of high unemployment it is the enemy of strong job growth.
Changes in financial market conditions since the April meeting suggested that investors had become more concerned about risk. Equity markets had seen a broad selloff, and risk spreads for many corporate borrowers had widened noticeably. Large businesses that have access to capital markets continued to enjoy ready access to credit–including syndicated loans–on relatively attractive terms; however, credit conditions remained tight for smaller, bank-dependent firms. Bankers again reported gradual improvements in credit quality and generally weak loan demand.
In identifying possible risks to financial stability, a few participants expressed concern that credit conditions in some sectors–most notably the agriculture sector–might have eased too much amid signs that investors in these markets were aggressively taking on more leverage and risk in order to obtain higher returns.
Meeting participants also noted that an escalation of the fiscal difficulties in Greece and spreading concerns about other peripheral European countries could cause significant financial strains in the United States. It was pointed out that some U.S. money market mutual funds have significant exposures to financial institutions from core European countries, which, in turn, have substantial exposures to Greek sovereign debt.
Participants were also concerned about the possible effect on financial markets of a failure to raise the statutory federal debt ceiling in a timely manner. While admitting that it was difficult to know what the precise effects of such a development would be, participants emphasized that even a short delay in the payment of principal or interest on the Treasury Department’s debt obligations would likely cause severe market disruptions and could also have a lasting effect on U.S. borrowing costs.
While it looks like the Europeans were able to kick the Greek can down the road again, they are rapidly running out of street to do that with. Eventually, Greece will default, or restructure its debt so that bondholders have to take big haircuts, the functional equivalent of a default. When that happens it will leave a mark, both in Europe and here at home.
Lately it looks like the problem has spread to Italy. If Italy runs into serious problems, the whole world is going to have serious problems. I agree that it is impossible to know what the exact effect of a U.S. default would be due to a failure to raise the debt ceiling since it has never happened before. The same is true of global thermonuclear war, but we know enough that the effect would be so disastrous that it would be madness to try it.
Participants noted several factors that had contributed to the increase in inflation this year. The run-up in energy prices, as well as an increase in prices of other commodities and imported goods, had boosted both headline and core inflation. At the same time, extremely low motor vehicle inventories resulting from global supply disruptions in the wake of the Japanese earthquake–by contributing to higher motor vehicle prices–had significantly raised inflation, although participants anticipated that these temporary pressures would lessen as motor vehicle inventories were rebuilt.
Participants also observed that crude oil prices fell over the intermeeting period and other commodity prices also moderated; developments that were likely to damp headline inflation at the consumer level going forward. However, a number of participants pointed out that the recent faster pace of price increases was widespread across many categories of spending and was evident in inflation measures such as trimmed means or medians, which exclude the most extreme price movements in each period. The discussion of core inflation and similar indicators reflected the view expressed by some participants that such measures are useful for forecasting the path of inflation over the medium run. In addition, reports from business contacts indicated that some already had passed on, or were intending to try to pass on, at least a portion of their higher costs to customers in order to maintain profit margins.
I agree that the recent rise in inflation is temporary. Oil prices have already come down, and we are starting to see the Auto companies put incentives back on, indicating that the supply disruptions from Japan have eased a bit. Profit margins are not a problem. For the S&P 500 as a whole they should be 9.51%, rising to 10.21% in 2012, up from 6.39% in 2009. Excluding Financials, they should be 8.87% in 2011, rising to 9.36% in 2012, up from 7.08% in 2009.
Most participants expected that much of the rise in headline inflation this year would prove transitory and that inflation over the medium term would be subdued as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. Nevertheless, a number of participants judged the risks to the outlook for inflation as tilted to the upside. Moreover, a few participants saw a continuation of the current stance of monetary policy as posing some upside risk to inflation expectations and actual inflation over time.
However, other participants observed that measures of longer-term inflation compensation derived from financial instruments had remained stable of late, and that survey-based measures of longer-term inflation expectations also had not changed appreciably, on net, in recent months. These participants noted that labor costs were rising only slowly, and that persistent slack in labor and product markets would likely limit upward pressures on prices in coming quarters. Participants agreed that it would be important to pay close attention to the evolution of both inflation and 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. Another participant, however, expressed concern that the adoption of such an objective could, in effect, alter the relative importance of the two components of the Committee’s dual mandate.
I think the low-inflation-due-to-slack-in-the-economy folks have the better argument and if anything the risks in the inflation picture are tilted to the downside. To get high and persistent inflation, you need a wage price spiral, and that is not going to happen with 9.2% unemployment. Average hourly wages actually fell slightly in June. However, a weaker dollar would be very welcome in boosting exports/cutting imports, and that would help push inflation higher.
Participants also discussed the medium-term outlook for monetary policy. Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation. Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought.
Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy’s level of potential output. In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances but disagreed on the implications for future policy.
I strongly agree with the first group. Both growth and inflation are likely to stay low. So the text book would say ease up on Monetary policy. The problem is that we are in a liquidity trap, and short term rates are already near zero, and have been since 12/08. Further quantitative easing might not be all that effective, just pushing on a string. Fiscal stimulus (or at least stopping the fiscal contraction) would be much more helpful in getting the economy going again. Frankly I think the idea of withdrawing the monetary stimulus already in the system is for the lack of a more technical term, nuts. The unemployment problem is overwhelmingly cyclical, not structural.
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