U.S.: Fed on the Defensive


11/22/2010 | Last Updated
Consumption: Do Expiring Unemployment Benefits Cast a Shadow?

Retail sales showed a 1.2% m/m gain in October, driven by a gain in auto sales, while the core retail sales component slowed further, showing a 0.2% m/m gain after rising 0.4% in September and 1% in October. In this week’s personal income and outlays report, we expect an increase of 0.6% m/m in nominal personal consumption (the Bloomberg consensus is 0.5%).The key data in the report will be the growth in wages and asset income. The payroll report for October showed an improvement in wages and hours worked, pointing to a boost for disposable income. However, while the recent signs of improvement in the labor market suggest improvement in income from wages, the gains alone may not be enough to sustain growth in consumer spending above 2% annualized. Government transfers—namely unemployment insurance benefits—have been the key to boosting household income and holding up consumption growth in 2010. However, on November 18, a bill to extend emergency unemployment benefits was rejected in the House by the Republicans.

On November 30, 800,000 unemployed people will stop receiving weekly benefit checks of US$300—an annualized drop of US$12 billion in transfer income. The number of unemployed people dropping out of extended benefit programs will climb through December to reach two million, implying a larger drop in personal income. This decline in income could weigh on spending during the important holiday season. While it is likely that a compromise to extend the benefits will be eventually reached, we do not expect this to happen until the New Year. With approximately 5 million unemployed people collecting benefits under extended and emergency federal programs, a failure to extend the programs entirely will result in a substantial drag on disposable income in Q1 2011.

Last week, headline CPI rose by 0.2% m/m in October 2010, driven by higher energy prices, as expected. Meanwhile, core CPI (excluding energy and food components) remained flat m/m for the third consecutive month, while the y/y gain in core CPI eased to 0.6%, the lowest annual rate recorded in the history of the data. In early 2010, disinflation skeptics suggested that the shelter component of the CPI, which accounted for a large portion of the CPI basket (the owners’ equivalent rent component accounts for about 40% of the core CPI basket), was exerting downward pressure on the total core index.

The data in October clearly reveal the broad-based nature of the price declines. The shelter component rose by 0.1%, after being unchanged in the previous three months. Meanwhile, discretionary spending showed widespread weakness. The apparel index fell by 0.6% m/m, its third straight decline following a 0.3% drop in September. The indexes for new cars and light trucks both fell in October. The recreation index fell for the fifth month in a row, while the index for personal care fell for the second consecutive month.

Meanwhile, the Cleveland Fed’s estimates of median and trimmed mean CPI showed that over the 12 months ending in June, the 16% trimmed-mean CPI rose by 0.8%, while the median CPI showed only a 0.5% increase, pointing at continued disinflationary pressure. In this week’s report on personal income and outlays for October, we expect the PCE deflator to slow to 1.2% y/y (Bloomberg consensus 1.3% y/y) and the core PCE deflator should continue to point to slowing in inflation, in line with the record y/y low of 0.6% observed in the core CPI data.

Figure 1: CPI

Source: U.S. Bureau of Labor Statistics and Federal Reserve Bank of Cleveland

After a sharper-than-expected collapse in data on housing starts last week, this week we will see data on new and existing home sales. Pending home sales based on contracts signed in September fell back by 1.8% m/m, the decline reflecting the softness in the mortgage purchase application data and in line with the disruptions in the foreclosure process that surfaced in September. In the existing home sales market, distressed sales (recorded as closed contracts) accounted for a hefty 35% of all sales in September, driving the median sales price sharply lower on a m/m basis, by 3.3%, while the average sales price fell by 3.5%. The repercussions of the foreclosure mess will drive existing home sales lower in October.

Meanwhile, the new home sales market should continue to point at stabilization at a low level. The NAHB/Wells Fargo Housing Market Index (HMI), a measure of builder perceptions regarding current and future home sales, rose by three points in October, the first improvement in five months, with the current sales component increased by three points to 16. While the new home sales segment remains unaffected by disruptions in the distressed sales market, we expect a small gain in new home sales, up to 310,000 on a seasonally adjusted annualized rate basis (Bloomberg consensus 314,000). The numbers on new and existing home sales indicate that housing demand is stabilizing at very low levels. Inventories are still above their long-term levels, clearly weighing on the price data.

Figure 2: Home Sales

Source: U.S. Census Bureau and RGE Forecast

Last week, the Philadelphia Fed manufacturing index sent out a signal of strength in manufacturing activity in November, at odds with the indicators from the preceding week’s Empire State regional manufacturing survey. In November, the Philly Fed index jumped to its highest level since December 2009, to a reading of 22.5 in November from a reading of 1 in October. (Negative values indicate declining activity.) Moreover, the details of the index were just as strong. The forward-looking new orders index rose by 15 points to positive territory, after four consecutive months of contraction, and unfilled orders moved back into positive territory. The index for employment pointed at expansion for the third consecutive month at an improved pace, while the index for the average workweek jumped by 16.9 points, entering positive territory. Firms continued to expect growth in their manufacturing business over the next six months, and the degree of confidence improved notably from past months. In sharp contrast, the New York Fed’s Empire State Index sounded a note of caution for November, showing a sharp drop in manufacturing activity. The forward-looking new orders component of the Empire State survey dropped sharply into negative territory, while unfilled orders fell further into contraction, pointing to moderating production. This week, the Richmond Fed manufacturing index will shed more light on whether the slowdown in manufacturing activity has run its course.

The Fed: Speaking Out Against the Critics

The Fed was under immense scrutiny in the days prior to the November FOMC meeting but, even after a policy decision largely in line with expectations, it continues to face an unusual amount of attention and criticism. Policy makers abroad have spoken out against the weakness of the dollar stemming from QE2 and strong capital inflows as destabilizing forces for their countries, Domestically, the Fed has come under criticism from conservative-leaning economists, who went so far as to write an open letter to Bernanke, calling for a retraction of QE2, citing the risk of “currency debasement” and the risk of inflation. Meanwhile, some Republicans, including Sen. Bob Corker of Tennessee, a member of the Senate Banking Committee, have called for a narrowing of the Fed’s “overly broad dual mandate” by proposing to remove full employment from its mandate.

Faced with this unusual level of criticism, the Fed has come out in defense of the November policy decision. Boston Fed President Eric Rosengren (a current FOMC voting member) offered assurances in a November 17 speech that large-scale asset purchases (LSAPs) do not represent a fundamentally alien policy, either in intent or mechanics, and are much closer to traditional monetary policy than many commentators assume. “And, like traditional monetary policy actions, we’re not talking about ‘bailouts’ or stimulus spending or placing a debt burden on future generations.” In an interview with the Wall Street Journal, Rosengren responded to the call to drop the dual mandate, noting, “right now there is no conflict between the two elements of our mandate. The unemployment rate is high and inflation is low…It wouldn’t have much impact whether we had a single mandate or dual mandate.”

In a November 16 interview with the Wall Street Journal, Chicago Fed President Charles Evans (an FOMC voting member in 2011) spoke even more strongly in favor of additional policy accommodation noting that US$600 billion was a “good place to start” and that more such purchases might be needed in the months ahead if the economic outlook doesn’t turn: “I would continue to want to apply accommodative monetary policy until I had some confidence that that situation was changing.”

Fed Board governor Janet Yellen and New York Fed president William Dudley both emphasized that the Fed’s action was not aimed at weakening the value of the dollar, but the strongest response came from Fed chairman Ben Bernanke himself, in a speech to the ECB on November 19.

Responding to the international critics of QE2, Bernanke stated that the Fed was “fully aware of the important role that the dollar plays in the international monetary and financial system,” but clearly stated that it would continue to act as warranted by its dual mandate: “the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar, as well as to support the global recovery, is through policies that lead to a resumption of robust growth in a context of price stability in the United States.”

Speaking on capital flows to emerging markets (EMs), Bernanke put the blame squarely on exchange rate policies in these economies, noting that “even before the crisis, fast-growing emerging market economies were attractive destinations for cross-border investment…beyond these fundamental factors, an important driver of the rapid capital inflows to some emerging markets is incomplete adjustment of exchange rates in those economies.”

Bernanke further stressed that, “amid all the concerns about renewed private capital inflows to the emerging market economies, total capital, on net, is still flowing from relatively labor-abundant emerging market economies to capital-abundant advanced economies. In particular, the current account deficit of the United States implies that it experienced net capital inflows exceeding 3% of GDP in the first half of this year. A key driver of this ‘uphill’ flow of capital is official reserve accumulation in the emerging market economies that exceeds private capital inflows to these economies,” particularly referring to China’s significant share in total EM reserve accumulation.

Bernanke emphasized that persistent global imbalances together with the multispeed global recovery were unsustainable, noting that while EM economies remained dependent on advanced economies, the “pattern of two-speed growth might very well be resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short.“

The Fed chairman defended the November FOMC decision, stating, “Indeed, although I expect that growth will pick up and unemployment will decline somewhat next year, we cannot rule out the possibility that unemployment might rise further in the near term, creating added risks for the recovery. Inflation has declined noticeably since the business cycle peak, and further disinflation could hinder the recovery…In light of the significant risks to the economic recovery, to the health of the labor market, and to price stability, the FOMC decided that additional policy support was warranted…”

However, he also made an appeal to the fiscal authorities, observing: “On its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone…in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”

This appeal to a fiscal complement to monetary policy has been echoed in several Fed presidents’ speeches in the past few weeks. Interestingly, amid the unusually high level of criticism from external sources, Fed presidents have sought to downplay divergent opinions within the organization. Narayana Kocherlakota (an FOMC voting member in 2011), who had earlier indicated some skepticism toward additional policy accommodation, declared in a speech on November 18: “I did express support for the FOMC’s decision at the recent meeting. I believe that QE is a move in the right direction. However, as I have discussed on earlier occasions, I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest.” Cleveland Fed President Sandro Pianalto (a current FOMC voting member) said: “FOMC members thoroughly debate policy options and sometimes differ in our opinions, but our commitment to the dual mandate is shared.”

This week’s FOMC meeting minutes will provide further insight on the discussion within the Fed regarding QE2, as well as a summary of the updates to the Fed’s economic projections.

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