We have seen a steady flow of data the past week, but I can’t say that in sum it moves me much from my baseline as described in my last post. Starting with today’s CPI release, Reuters has this to say:
Consumer prices were flat in July for a second straight month and the year-over-year increase was the smallest in more than 1-1/2 years, giving the Federal Reserve room for further monetary easing to tackle stubbornly high unemployment.
I would be a little nervous about reading too much into the drop in headline inflation. True enough, core edged up just 0.1%, but looking at the year-over-year trends is important at this juncture:
I think the Fed will see the flattening out of core inflation as a sign that the hawk’s obsessive fear of exploding inflation was once again proved incorrect. That said, the opposite is true – even the doves will have a hard time fearing falling inflation unless the shift in headline is confirmed by additional declines in the core. Yes, you can make the argument that in sum this confirms the Fed’s forecast that inflation will remain at or below the 2% target, which in turn justifies additional easing. If I was on the FOMC, I would make that argument. But that argument has consistently fallen on the deaf ears of Federal Reserve Chairman Ben Bernanke, who has seen the costs of further easing as outweighing the benefits. Also note that gasoline prices are headed back up, which will reverse some of the recent decline in headline inflation:
While normally I would say the rise in oil/gas costs is a signal of improving demand, in this case I worry that we are seeing a potential supply shock from fears of war in the Middle East. That said, this is a perpetual fear.
As for the path of inflation overall, I tend to think the cost/risks that Bernanke worries about are overstated, a story that continues to be told in the productivity data:
I just can’t get bent out of shape over inflation with unit labor costs growing at anything below 4% a year, and we are well below 4%. Speaking of the productivity report, remember the 1990’s? Good, hold those memories tight, because it continues to look like they will remain a think of the past:
With the cycle-induced productivity gyrations in the rear-view mirror, it looks like productivity growth is settling into a disappointing rate. The days of thinking that long-term growth in the US might be 4% in higher are long gone; now we are looking at 2-2.5%.
Despite the generally soft tone of manufacturing surveys – see this morning’s Empire Business Report – industrial productive continues to climb:
The surveys tend to be diffusion measures – they don’t capture the magnitude of any individual firm declines. Even if those reporting slower orders exceed those reporting accelerating orders, the latter might still outweigh the former in magnitude. Thus, overall activity could still climb. In short, the survey data provides a warning – a warning the Fed has traditionally acted upon – but do not guarantee a broader manufacturing slowdown.
Jobless claims are showing the same pattern as last summer, with an increase beginning in April largely peaking and reversing by August:
This would be evidence in favor of Bernanke’s stated concerns that the weakness we saw over the summer was at least in part a consequence of seasonal/temporary issues. In favor of the opposite story is a rise in the inventory to sales ratio:
Looks like firms were caught with a little extra inventory this summer. To be sure, I would not raise too many red flags just yet. Notice the similar rise in 2006 that was largely reversed ahead of the recession. But it is certainly something worth watching.
Finally, retail sales rebounded in July:
Bottom Line: The sum total of the data suggests that the Fed’s much hoped-for acceleration in growth remains just hope, but that the worst downside fears have yet to be realized. Inflation continues to remain contained at rates below the Fed’s mandate, but will not decline precariously (nor would I expect them to given downward nominal wage rigidities). There are some warning signs in the data flow, such as manufacturing surveys and inventories, but nothing conclusive. I want to argue that the failure of the economy to accelerate and below-target inflation, combined with more negative than positive warning signals, argue for additional Fed easing in September. That, however, has been the case for months, and during that period Bernanke has not moved the Fed to that easing (I tend to see the continuation of Operation Twist as holding the status quo, not additional easing). And I suspect signs that some of the weakness in the data was temporary will push Bernanke further away from additional easing, especially given his cost/benefit analysis. On net, I think the outcome of the September FOMC meeting remains a toss-up. The wild card here is that Bernanke comes up with a new tool. I think that if he had a mechanism to shift his cost/benefit analysis in favor of further easing, he would jump in that direction. I just don’t think he sees that mechanism yet, and has little faith that additional quantitative easing has more to offer.
This post was originally published at Tim Duy’s Fed Watch and is reproduced here with permission.