Failure to Communicate, Part 2

The financial markets have begun to reassess Fed Chairman Bernanke’s monetary policy comments. Several Fed officials spoke last week, each echoing Bernanke’s key messages: 1) policy will remain data-dependent, 2) tapering is not tightening, and 3) a rise in the federal funds target rate is a long time off. With an emphasis on data-dependence, the economic figures should get more scrutiny from the markets. Still, there’s a sense that hope plays a major role the Fed’s economic outlook.

“I want to emphasize the importance of data over date. If the Committee's economic outlook is broadly realized, there will likely be a moderation in the pace of purchases later this year. If the performance of the economy is weaker, the Committee may delay before moderating purchases or even increase them. If the economy strengthens faster than the Committee anticipates, the pace of purchases may be moderated somewhat more quickly. The path of purchases is in no way predetermined; we will monitor economic data and adjust our purchases as appropriate.” – Fed Governor Powell

“Nothing we have said suggests a change in our reaction function for the path of the short-term policy rate, and my sense is that our sharpened guidance on the duration of the asset purchase program also leaves us close to where market expectations – as expressed, for example, in various surveys that we monitor – were beforehand.”;– Fed Governor Stein

Fed policymakers are optimistic that the economy will improve in the months ahead. Headwinds have faded. The housing sector is now a tailwind. Residential construction activity is a small part of overall GDP, but rising home prices have a big impact on household balance sheets. There are still a large fraction of homeowners underwater on their mortgages, but the increase in home prices helps to reduce these strains. The biggest drag this year is fiscal policy, which is expected to shave about 1.5 percentage points from GDP growth.

Oddly, while the Fed and most economists are optimistic about the second half of the year, the recent data point to softer growth in the first half of the year. Real GDP growth was revised down to a 1.8% annual rate in the 3rdestimate for 1Q13 and most of that was in the meat and potatoes (consumer spending and business fixed investment). Consumer spending (70% of GDP) now appears to have had much less momentum at the end of the first quarter and appears to be tracking at about a 1.6% annual rate in 2Q13. Shipments of nondefense capital goods ex-aircraft, a rough proxy for business fixed investment, fell at a 1.2% annual rate in the first two months of 2Q13 (vs. +5.8% in 1Q13). Note that annual benchmark revisions to the GDP data are due on July 31, so the trend in spending could change. In addition, this will be a comprehensive revision. The Bureau of Economic Analysis will make changes to the methodology (the biggest change will be the addition of intellectual property products to business fixed investment).

In recent speeches, Fed officials continued to note that fiscal policy is the major economic headwind this year. The expectation of second half improvement in growth is based on an expected fading of the fiscal policy drag. Most of the drag comes from the increase in the payroll tax. Households should be adjusting to that, but the impact on spending could still have a longer lag. In addition, sequester cuts to government spending occur over time. That should have a dampening effect on GDP growth in 3Q13, but it’s unclear how much and whether strength in other areas, such as housing, will offset that.

Except for St. Louis President Bullard, Fed officials have been complacent about the low trend in inflation, which is seen as being due to “transitory” factors. However, if economic growth fails to pick up in the second half, the low inflation trend could become much more problematic. Inflation-adjusted interest rates are what matters for the economy. Real rates have risen.

© Raymond James

© Raymond James

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