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Sept 16-17 ‘04 FOMC Meeting

In a Nutshell: “… a range of labor market indicators suggests that there remains significant underutilization of labor resources.”

Rate Decision: Fed funds rate maintained at a range between 0% and 0.25%

Quantitative Easing Decision: Bond purchases reduced by $10 billion to $15 billion.  Quantitative easing is expected to end at the next meeting.

One again, the FOMC and Janet Yellen tried to provide some clarity about how the monetary authorities will proceed with rate hikes when they eventually come.  And again, we did not get much that was new.

On the economic front, the economy continues to improve but there remains a significant amount of slack in the labor market.  That was Chair Yellen’s reason why wages are showing little change.  It is all about a tight labor market and the Fed doesn’t see that situation occurring soon.  As it does four times a year, the FOMC released the members’ forecasts for growth, inflation and unemployment rates. The central tendency of the forecasts puts full employment in the 5.2% to 5.5% range, which is not expected to be reached until sometime in late 2015 or early 2016.  However, the members are a bit more optimistic about pace of decline in the unemployment rate.

As for when the Fed might tighten, those who thought that the FOMC might signal that rates could rise sooner rather than later were disappointed.  The Fed Chair made it clear that she was in no hurry to raise rates.  But she also noted that the decision is not “calendar driven” but is “data driven”.  The hawks are not making very much inroads into Fed policy.

Finally, the Committee went over procedures for normalizing policy.  One new thing was that the FOMC would be targeting rate ranges rather than a given rate.  That may be reflection of the concern that transitioning to a normal Fed policy and a normal Fed balance sheet will likely have some bumps in the process.  It would be amazing if the Fed pulls off the normalization process without any hiccups.

So what should we make of all this?  Janet Yellen is firmly in command at the Fed and we should stop doubting it.  She is a dove and until the data make her think differently, she will run monetary policy accordingly.

But I have some issues with the Fed’s forecast.  The unemployment rate has declined by about 0.7 percentage point for the past three years yet the members think the decline will slow sharply starting in 2015 and only edge down in 2016 and 2017.  Yet growth is expected to be a lot stronger over the next two years than it had been.  This doesn’t seem to be consistent.  But it is necessary for the members to argue that the funds rate will not be increased soon and will not be raised quickly, which they seem to be indicating.

August Industrial Production

KEY DATA: IP: -0.1%; Manufacturing: -0.4%; Vehicles: -7.6%

IN A NUTSHELL:   “If you believe that vehicle production is crashing, I have a bridge for sale and you can buy as much of it as you like.”

WHAT IT MEANS:  One of my more common warnings is that the headline number hides what is truly going on and the devil is in the details.  Well, welcome to the August industrial production report.  Output fell in August for the first time since January, and we know what the weather did to everything that month.  Worse, manufacturing production was down sharply.  So, has the industrial sector finally come to a grinding halt?  Yeah, right.  The biggest decline was in vehicles, where assembly rates dropped by nearly 12%.  Of course, the pace of new vehicle construction had surged by almost 13% in July, highlighting the problem with seasonal adjustments when trends change.  The important point is that vehicle sales in August hit their highest level in 8½ years, so output is likely to expand further.  It is clearly not shrinking.  Indeed, the 3-month assembly rate average was the highest since early 2006, when the housing bubble was funding everything that moved and didn’t move.  Meanwhile, the rest of the economy was doing just fine.  Production of high tech products, consumer products, business equipment and business and construction supplies were all up. 

Adding to the belief that the manufacturing sector is in great shape was the September Empire State Manufacturing Survey, a product of the New York Federal Reserve Bank.   The index hit its highest level in almost five years as new orders surged, hiring jumped and backlogs built.  Enough said.

MARKETS AND FED POLICY IMPLICATIONS:  It is sometimes good to get a headline that is so obviously misleading as today’s industrial production number.  It is not that the data are wrong; it is just that sometimes the marquee number is not reflective of what is actually going on.  The data are often volatile and the seasonal adjustments sometimes don’t work right if conditions change.  That was true with today’s industrial production decline and was likely the case with the weak August employment report.  Basically, the manufacturing sector is strong and should continue to lead the way.  The FOMC starts its 2-day meeting tomorrow and on Wednesday Janet Yellen will hold a press conference.  I expect the statement and the discussion to focus on changing the thinking from rates staying low an extended period to the strategy that the data will drive decisions.  If the numbers are stronger than projected, the Fed will be prepared to move sooner than expected.  This report changes nothing and investors will have to start getting used to the reality that the Fed is going to raise rates, most likely during the first half of next year.

August Retail Sales and Import Prices

WHAT IT MEANS:  The missing link in this economy is strong household consumption.  It’s hard to buy more when your pay is barely keeping up with inflation.  But wage gains are slowly improving and with so many more people working, income is growing.  The added funds are being spent on just about everything.  Retail sales jumped in August, led by a surge in vehicle sales.  With the vehicle sales pace of 17.4 million units being the highest in over eight years, that was hardly a surprise.  But even when you exclude vehicles, consumers were pretty frisky.  Demand for furniture, appliances and electronics, sporting goods, home building supplies, medical products and clothing were all up.  We even went out to eat again.  The only weak links were department stores and gasoline stations.  The decline in gasoline purchases was probably due to the sharp drop in prices, not a fall off in purchases, as these data is not inflation-adjusted.  All this came on top of an upward revision to July sales.

Household spending power is not likely to be eroded very much by inflation.  Import prices dropped sharply in August as fuel costs cratered.  Excluded energy, prices rose just a little, with only vehicles showing a gain, though that was minimal.  The only real trouble spot is manufactured food import costs, which continue to surge.  As for exports, U.S. firms are also getting less for their products with the farm sector once again suffering sharp drops in its goods.

MARKETS AND FED POLICY IMPLICATIONS: The second quarter is setting up to be pretty good.  Consumers are spending again and not just on vehicles.  Right now they are being helped by the drop in gasoline costs, which is leaving a lot more money in their wallets.  Indeed, low inflation is has kept consumption from largely disappearing and with import prices essentially going nowhere, minimal inflation pressures are likely to continue.  Once we get better wage gains, spending could really surge.  The Fed generally treats energy costs as an indicator of consumer spending, not inflation and it looks like the downward trend in prices and the upward trend in household spending should continue.  Since it is all about a tightening labor market and the potential for rising wages, this report should buoy the spirits of the inflation hawks who worry that the Fed is waiting too long to start raising rates.  The FOMC meets next week and the pressure is building for the statement to drop the words “extended period” when describing how long rates will be kept low.  That would provide the flexibility to start tightening sooner than expected.  I suspect that will happen, since the public discussion about doing that has largely taken away any shock that would occur if the statement actually drops that language.  As for investors, it is the usual: Does good economic news trump rising rates?  Who know what side of that coin comes up on any given day?