What the Fed Staff Really Thinks - Analyst Blog

Below are some key sections of the minutes of the Federal Reserve Board’s March 16th meeting. I have interspersed my commentary and interpretation where needed.

"The information reviewed at the March 16 meeting suggested that economic activity expanded at a moderate pace in early 2010. Business investment in equipment and software seemed to have picked up, consumer spending increased further in January, and private employment would likely have turned up in February in the absence of the snowstorms that affected the East Coast.

"Output in the manufacturing sector continued to trend higher as firms increased production to meet strengthening final demand and to slow the pace of inventory liquidation. On the downside, housing activity remained flat and the nonresidential construction sector weakened further. Meanwhile, a sizable increase in energy prices pushed up headline consumer price inflation in recent months; in contrast, core consumer price inflation was quite low."

Weak housing and low core inflation is a strong argument for keeping short-term interest rates low.  Manufacturing might be headed upwards, but it is doing so from a very low starting point, and it is unlikely that capacity utilization is going to rise to where choke points appear in the economy anytime soon.

"Available indicators suggested that the labor market might be stabilizing. Declines in private payrolls slowed markedly in recent months, and, in the absence of the snowstorms, private employment probably would have risen in February. The average workweek for production and nonsupervisory workers fell back in February after ticking up in January; however, the drop was likely due to the storms. The unemployment rate was unchanged at 9.7 percent in February, and the labor force participation rate inched up over the past two months. However, the level of initial claims for unemployment insurance benefits remained high."

Again, positive signs about the direction, but we have a very long way to go before the economy is really healthy again. The increase in the labor force participation rate is a very positive sign (and something that continued into March). However, it will have the effect of keeping the measured unemployment rate high.

Keep an eye on the employment rate, also known as the employment-to-population ratio, as well as the unemployment rate. The employment rate bottomed in December at 58.2% and in March it was at 58.6%. However, that is down from 63.4% in December 2006, the highest it reached in the prior expansion, and an all-time high of 64.7% set in April 2000.

"After increasing briskly in the second half of 2009, industrial production (IP) continued to expand, on net, in the early months of 2010, rising sharply in January and remaining little changed in February despite some adverse effects of the snowstorms. Recent production gains remained broadly based across industries, as firms continued to boost production to meet rising domestic and foreign demand and to slow the pace of inventory liquidation.

"Capacity utilization in manufacturing rose further, to a level noticeably above its trough in June, but remained well below its longer-run average. As a result, incentives for manufacturing firms to expand production capacity were weak. The available indicators of near-term manufacturing activity pointed to moderate gains in IP in coming months."

The strong ISM manufacturing numbers confirm that growth in industrial production has continued since the Fed meeting.

"Consumer spending continued to move up. Although sales of new automobiles and light trucks softened slightly, on average, in January and February, real outlays for a wide variety of non-auto goods and food services increased appreciably, and real outlays for other services remained on a gradual uptrend. In contrast to the modest recovery in spending, measures of consumer sentiment remained relatively downbeat in February and had improved little, on balance, since a modest rebound last spring.

"Household income appeared less supportive of spending than at the January meeting, reflecting downward revisions to estimates by the Bureau of Economic Analysis of wages and salaries in the second half of 2009. The ratio of household net worth to income was little changed in the fourth quarter after two consecutive quarters of appreciable gains."

Incentives caused March Auto sales to improve, but they remain -- and are likely to remain -- far below the levels that were considered normal just a few years ago. If spending is picking up but incomes are not, it means the savings rate is falling, which helps goose the economy short term, but is a long-term chronic problem.

"Activity in the housing sector appeared to have flattened out in recent months. Sales of both new and existing homes had turned down, while starts of single-family homes were about unchanged despite the substantial reduction in inventories of unsold new homes.

"Some of the recent weakness in sales might have been due to transactions that had been pulled forward in anticipation of the originally scheduled expiration of the tax credit for first-time homebuyers in November 2009; nonetheless, the underlying pace of housing demand likely remained weak. The slowdown in sales notwithstanding, housing demand was being supported by low interest rates for conforming fixed-rate 30-year mortgages and reportedly by a perception that real estate values were near their trough."

The pending home sales data indicated that there has been a pick-up in existing home sales, but this seems like an echo of the spike we saw the last time the housing tax credit was about to expire. It would be a mistake to read too much into a pick-up in existing home sales in the next few months, and besides, existing home sales don’t do much to stimulate the economy, it is new home sales that are really important.

"Real spending on equipment and software increased at a solid pace in the fourth quarter of 2009 and apparently rose further early in the first quarter of 2010. Business outlays for motor vehicles seemed to be holding up after a sharp increase in the fourth quarter, purchases of high-tech equipment appeared to be rising briskly, and incoming data pointed to some firming in outlays on other equipment.

"The recent gains in investment spending were consistent with improvements in many indicators of business demand. In contrast, conditions in the nonresidential construction sector generally remained poor. Real outlays on structures outside of the drilling and mining sector fell again in the fourth quarter, and nominal expenditures dropped further in January. The weakness was widespread across categories and likely reflected rising vacancy rates, falling property prices, and difficult financing conditions for new projects. However, real spending on drilling and mining structures increased strongly in response to the earlier rebound in oil and natural gas prices."

Business investment on equipment seems to be the most healthy part of the economy right now, and is the key locomotive pulling us forward. Spending on commercial real estate normally lags the overall economy, and with the very high vacancy rates around the country and across almost all major property types, it is likely to be a drag for a very long time.

"The pace of inventory liquidation slowed considerably in late 2009. As measured in the national income and product accounts, real nonfarm inventories excluding motor vehicles were drawn down at a much slower pace in the fourth quarter than in each of the preceding two quarters. Available data for January indicated a further small liquidation of real stocks early this year in the manufacturing and wholesale trade sectors.

"The ratio of book-value inventories to sales (excluding motor vehicles and parts) edged down again in January and stood well below the recent peak recorded near the end of 2008. Inventories remained elevated for equipment, materials, and, to a lesser degree, construction supplies, while inventories of consumer goods and business supplies appeared to be low relative to demand."

Inventories are the other bright spot in the economy, and accounted for about 2/3 of the 5.6% growth in the fourth quarter. The really good news was that big growth push came from a slowdown in the pace of liquidation, not a build up of inventories on store shelves. There has been a very long-term secular decline in the ratio of inventory to sales, one that was dramatically interrupted by the recession.

The inventory-to-sales ratio is now back down to around where it was at the start of the recession. We should have so more growth due to inventories in the first half of 2010, but it will not be as dramatic a driver as it was in the fourth quarter.

"Although rising energy prices continued to boost overall consumer price inflation, consumer prices excluding food and energy were soft, as a wide variety of goods and services exhibited persistently low inflation or outright price declines. On a 12-month change basis, core personal consumption expenditures (PCE) price inflation slowed in January 2010 compared with a year earlier, as a marked and fairly widespread deceleration in market-based core PCE prices was partly offset by an acceleration in nonmarket prices.

"Survey expectations for near-term inflation were unchanged over the intermeeting period; median longer-term inflation expectations edged down to near the lower end of the narrow range that prevailed over the previous few years. With regard to labor costs, the revised data on wages and salaries showed that last year's deceleration in hourly compensation was even sharper than was evident at the January meeting."

The Fed has little control over energy prices, and using monetary policy to fight rising oil prices is a decidedly unsubtle instrument, sort of like expecting a heart surgeon to do his job with a chain saw. The high price of oil is due to the increasing difficulty of producing high quality light oil, and the fact that it has to be drawn from more and more difficult locations (difficult both technically, like deep water, or politically, or both).

The big demand driver, at the margin, is not the U.S. but China, and to a lesser extent India. Raising short-term interest rates due to energy-led inflation when core inflation is very tame, and threatening deflation would be a very serious mistake.

A better way of addressing the high price of oil is to switch over to other fuels. Natural gas, which is domestically produced and abundant would be the best bridge fuel. Longer term, we really need to get serious about Wind and Solar. Making the switch over will take a very long time, so we need to get started now, and in a serious way.

"The U.S. international trade deficit widened in December but narrowed slightly in January, ending the period a little larger. Both exports and imports rose sharply in December before pulling back somewhat the following month. For the period as a whole, the rise in exports was broadly based, with notable gains in aircraft and industrial supplies. Oil and other industrial supplies accounted for much of the increase in imports over the two months, while purchases of consumer products declined."

Again, substituting for different energy sources would be like a serious dose of radiation to help cure the economic cancer of the trade deficit. Much better to have Chesapeake Energy (CHK) and EnCana (ECA) creating jobs by drilling for natural gas in the Barnett and Marcellus shale formations than to send all of our money to Saudi Arabia and Venezuela.

The recent move to open up new offshore drilling areas is a step in the right direction and seems to strike the right balance between the need for more domestic energy supplies and the need to protect the environment. However, it will be a long time before those supplies actually find their way to your gas tank.

Still, it is likely that we will be even more in need of domestic energy supplies a decade from now than we are today, so we will be glad we have those supplies when they finally do come on line. The deepwater Central/Eastern Gulf of Mexico is probably the most promising of the areas opened up. That should cause even more demand for deep water rigs that are already in rather short supply, much to the benefit of the owners of those fleets like Transocean (RIG) Diamond Offshore (DO) and Pride International (PDE).  

"Economic performance in the advanced foreign economies was mixed in the fourth quarter, with real gross domestic product (GDP) advancing sharply in Canada and Japan but rising only slightly in the euro area and the United Kingdom. That divergence appeared to have persisted in the first quarter, as indicators pointed to continued rapid economic growth in Canada and moderate expansion in Japan but somewhat anemic growth in Europe.

"In the emerging market economies, rebounding global trade, inventory restocking, and increased domestic demand supported generally robust fourth-quarter growth. Continued rapid expansion in China and several other Asian economies offset slowdowns elsewhere in the region. In Latin America, Mexican activity was buoyed by rising manufacturing and exports to the United States, while Brazil's economy again grew briskly.

"Headline consumer price inflation picked up around the world over the past two months, principally reflecting increases in food and energy prices. Excluding food and energy, consumer prices were generally more subdued."

The U.S. economy is sort of in the middle of the pack. We are doing better than Europe, but not as well as China and the Tiger economies. Resource-based economies like Canada, Australia and Brazil are all doing much better than we are. Their strength is helping us, and increased exports is a ray of hope for the economy.

Overall the tone of the minutes is hopeful, but there is little there that suggests that we have gotten to the point where the Fed can seriously consider tightening up monetary policy dramatically. There will be some efforts to first reverse some of the extraordinary steps to loosen policy that were taken in the crisis.

For example, the quantitative easing program of buying $1.25 trillion of mortgage-backed securities is now finished, but it is unlikely that the Fed will be selling them anytime soon. They will probably just let them mature and do a gradual roll-off of them.

The Fed funds rate is not likely to be raised before the end of this year. To do so would be to ignore half of the Fed’s legal mandate, which is to fight inflation AND foster conditions that keep the economy as close to full employment as possible.

Aside from energy, inflation is not a serious issue right now. While the bond market has recently sold off a bit, long-term rates remain very low by historical standards, and the recent back up in rates has been driven by an increase in real rates, not by an increase in inflation expectations (judged by the spreads between inflation protected TIPS and regular T-notes).

Whatever some hysterical commentator might tell you about Washington turning into Weimar Republic II, the market does not believe for a single minute that inflation is going to be a problem anytime soon.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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