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MONETARY POLICY ON HOLD FOR NOW
Prepared by
The Northern Trust Company
A strong likelihood of steady Fed policy at the close of the FOMC meeting on August 19 was one of the main inferences from the Humphrey-Hawkins testimony. Economic data that have become available since late-July have largely validated this expectation, particularly the economic reports released over the past two days. As the outcome of the August 19 meeting is nearly certain, the timing of the next monetary policy action is the question at hand.
The Fed's forecast of nearly 3.0% growth in the second-half of the year, following a 3.4% pace in the first six months of the year, clearly increases the legitimacy of inflationary considerations as the economy continues to push past its potential capacity. Recent evidence by way of July retail sales and early-August weekly retailing surveys support forecasts of renewed vigor in the economy after a second quarter slowing. Despite this milder pace of activity in the March-June period, following a robust first quarter, actual real GDP exceeded potential GDP by 1.5% (based on CBO's estimate of potential GDP). The puzzling aspect at this point in time is that in contrast to the typical postwar business cycle, measured price inflation is lower now than when the expansion began and has shown little tendency to rebound of late. In other words, inflationary evidence when the economy is approaching its seventh year of expansion is almost elusive. The Producer Price Index of Finished Goods has dropped for the seventh consecutive month–a record in the fifty-year history of this index. Pipeline price pressures at the producer price level, harbingers of future inflation, are absent. Consumer prices have risen at annual rate of 1.5% during the first seven months of the year versus 3.3% in 1996. Core consumer prices, excluding food and energy, have risen at a seasonally adjusted annualized rate of 2.4% in the January-July period, compared with a 2.6% increase in 1996. In a politically hostile environment, the Fed needs tangible inflationary evidence to justify further hikes in the federal funds rate.
However, this “exceptional” situation of economic growth for nearly seven years with low inflation appears to be evolving into a less favorable situation. In this wait and see game that each one of us is playing along with the Fed, there are emerging inflationary signals which bear watching. In the July Purchasing Managers' report, the supplier deliveries index (one of Greenspan's favorite inflation indicators) rose to 55.3, the highest level since May 1995. The current July reading exceeds the mark in January 1994 (54.3), when the Fed began to hit monetary brakes. The NAPM price index, another precursor of inflation, climbed to 53.6, the highest since July 1995 (with the exception of a 55.1 reading in February of this year).
The labor market continues to send messages of tight conditions, with the 4.8% jobless rate of July at a 24-year low. The unemployment rate has fallen below the NAIRU (let us not quarrel about the precise applicable NAIRU at the present time, but we are all willing to accept the economy is operating below this notional rate). History has show that inflation accelerates after a extended period of unemployment that is below the perceived rate of full employment. Voting members of the FOMC base their decisions on this empirical relationship (Governor Meyer's April 24 speech). The latest Beige Book cited six out of twelve Fed districts reporting a assortment of employee compensation increases. As a consequence of these labor market pressures, the cost of services (excluding energy) in the CPI has risen at an annualized rate of 3.4% during the six months ended July compared with a 2.8% gain in the prior six-month period. This is a indication of how labor market pressures could make their way into the CPI. The deceleration of core commodity prices to a 0.6% increase in the January-July period from a 1.1% advance in the prior six-month period has provided a partial offset. The durability of this type of offset is questionable.
Industrial commodity prices, leading indicators of inflation, have begun to inch forward. The JOC index now hovers in the neighborhood of 108.0, after holding in the 105-106 range during the April-July period. Weak recoveries in several industrial economies have restrained demand for industrial commodities. This bounty may well have seen its day as the much anticipated pickup in these economies gets underway. The surging value of the greenback has been a positive factor on the inflation front. This is a temporary event whose influence can be expected to diminish.
The message is that forerunners of inflation are gradually raising their ugly heads as demand also regains momentum. The market will have to bide its time until later this year to actually see Fed action. The November 12 date is a more viable option compared with the September 30 FOMC meeting for the simple fact that third quarter employment cost index and GDP estimates will be available, in addition to another month's employment figures and auto sales data. Moreover, recent Fed rhetoric, including the Chairman's comments, implies the central bank is in no rush.
August 15, 1997Paul L. Kasriel
The Northern Trust Company
50 South LaSalle Street, Chicago, Illinois
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