Sat, Jun 18, 2011
It is Friday night, which means that any bad and self-discrediting news from Goldman Sachs are due any minute. Sure enough, the squid does not disappoint: “Following another dose of disappointing economic data, we have cut
our Q2 growth estimate to 2% (annualized) from 3%. We also have issued a
preliminary forecast for the manufacturing ISM in June of 52.0. At this
point, we still expect a bounceback in Q3 and beyond, but will need to
see significant improvement in the data over the next few weeks to
maintain that view.” Zero Hedge’s own ISM outlook is for a 48 print. And as we will comment on later, as JPM’s Michael Feroli demonstrates, the fate of the economic pick up in Q3 is all up to car sales surging by about 58% on an annualized basis as predicted by IHS. Good luck with that. As we said yesterday, we expect Goldman to lower its H2 outlook to under 2% within a month, most likely following the next ISM miss and the disappointing NFP report due out in 2 weeks.
Full mea culpa, and we have at this point lost track how many in a row this is, from Goldman’s economic team which has now lost all credibility.
Sizing the Fed’s “Zone of Inaction”
Following another dose of disappointing economic data, we have cut our Q2 growth estimate to 2% (annualized) from 3%. We also have issued a preliminary forecast for the manufacturing ISM in June of 52.0. At this point, we still expect a bounceback in Q3 and beyond, but will need to see significant improvement in the data over the next few weeks to maintain that view.
The deterioration in economic activity, on its own, would call for fresh monetary easing. Meanwhile, however, inflation has continued to run above our (and the Fed’s) estimates. In the latest installment of bad news on this front, the CPI excluding food and energy rose 0.29% in May.
The Federal Open Market Committee is therefore stuck between a rock (slow growth) and a hard place (higher inflation). We expect Chairman Bernanke to indicate at next Wednesday’s FOMC press conference that there is little prospect of either monetary tightening or monetary easing anytime soon.
We formalize the idea that the “zone of inaction” is wide by returning to our estimated Taylor rule analysis. Given our current forecasts, the rule implies that the appropriate federal funds rate is -0.6%, which seems broadly consistent with the Fed’s stand-pat stance. If this is correct, we would need to see about a ¾-percentage-point decline in the unemployment rate forecast or a ½-point increase in the inflation forecast for the rule to project any monetary tightening (including an announcement of asset run-off).
However, Fed officials seem even further away from renewed easing. Our analysis implies that it would take a 1¼-point increase in the unemployment rate forecast or a 1-point drop in the inflation forecast for additional easing moves.
More Deterioration in the Growth-Inflation Mix
The past week brought another dose of discouraging data on economic activity, especially in the manufacturing surveys for early June. Our rolling monthly MAP surprise score—a measure of data surprises—continued to decline, while our Current Activity Indicator (CAI) failed to regain momentum (Exhibit 1). Despite some encouraging signs of stability in the “hard” data, we have therefore shaved our second-quarter GDP estimate further to just 2% (annualized), from 3% previously.
The main fresh negative was a sharp decline in the New York and Philadelphia Fed surveys of monthly manufacturing activity in June. The Philadelphia Fed index fell to -7.7 in June from +3.9 in May, mirroring the drop in the New York Empire State index reported the day before to -7.8 in June from +11.0 in May. The Philly Fed reading is the lowest since May 2009. The sub-indexes of the report offered no silver lining, as the indexes for new orders, shipments and employment all declined. As the Japanese supply chain distortion in the auto sector can likely only explain some of this weakness, the disappointing surveys point to some downside risk to our expectation that the economy will accelerate into Q3. Based on these surveys and other information, our preliminary forecast for the ISM manufacturing index in June is 52.0.
On a somewhat more encouraging note, the “hard” data looked a little more stable this week. Although headline retail sales declined in May due to a further decline in the motor vehicle sector, core retail sales (excluding autos, gas and building materials) rose by 0.2% on the month. Industrial production increased slightly less than expected in May, but non-auto manufacturing output grew 0.6%, following a decline of 0.1% in the previous month. Finally, housing starts and building permits both rose in May. Although the month-on-month improvement is encouraging, overall both starts and permits show activity essentially flat at depressed levels.
Meanwhile, both consumer and producer price inflation surprised on the upside. The biggest concern from the Fed’s perspective is likely to be the sharp increase in core CPI inflation to 0.29% on the month. This print—the highest month-to-month increase since May 2006—pushed up the year-on-year core consumer price inflation rate to 1.5%. However, it is important to note that about half of the price increase in May was due to sharp gains in relatively volatile components like apparel, vehicles, and lodging away from home.
Lower Growth+Higher Inflation=No Fed Action
What are the implications of these developments for the Fed outlook? Our preferred tool for thinking about this question is our forward-looking Taylor rule, which describes how Fed officials have historically set the funds rate using their four-quarter-ahead forecasts of core PCE inflation as well as the expected unemployment gap (actual less “structural” unemployment). Moreover, we have adjusted this rule to take into account the Fed’s unconventional policies—including its “extended period” language and its asset purchase programs (“QE1” and “QE2”). Given this unconventional easing, our four-quarter-ahead forecasts for year-to-year core PCE inflation and unemployment imply that the “warranted” funds rate is -0.6%.
In this framework the FOMC pays roughly equal attention to changes in core inflation and unemployment. The weakness in activity data in recent weeks might thus broadly offset the higher inflation news in terms of their implication for the Fed’s warranted funds rate.
Sizing the “Zone of Inaction”
This framework can then be used to get a sense for how much the data flow would need to surprise—in either direction—to move Fed officials out of their comfort zone. To do so, we need to make two further assumptions.
First, we use our setup to identify a threshold above which the Fed might start to tighten. Assuming the FOMC moves in lumpy increments of 25bp, the model-implied funds rate could rise by about 100bp from its current -0.6% level before a tightening became warranted. This tightening could occur either via a hike in the funds rate or, more plausibly, via changes to the reinvestment of maturing/prepaid securities and/or the “extended period” language in the FOMC statement.
Second, we use our setup to identify a threshold for the model-implied funds rate below which the Fed might start to ease. Identifying this threshold is difficult, because it requires a view on the perceived costs of returning to unconventional easing. Prior to QE2, we estimated that because of these costs the FOMC was willing to accept a gap between the warranted and actual policy stance worth 100bps in the funds rate. Given the backlash against QE2 since then, these perceived costs might well have risen. We therefore believe that the threshold for further quantitative easing has risen, perhaps to 150bp.
Fed Unlikely to Move in Either Direction Soon
Given these assumptions and our estimated Taylor rule we can trace out by how much forecasts for core inflation and unemployment would need to change for Fed officials to move out of their “zone of inaction” (see Exhibit 2). Our framework implies that this zone is sizable and that much larger surprises—in either direction—are needed for the Fed to move.
For example, we would need to see about a ¾-percentage-point decline in the unemployment rate forecast or a ½-point increase in the year-on-year core inflation forecast for Fed officials to consider any monetary tightening (including an announcement of asset run-off). Conversely, it would take a 1¼-point increase in the unemployment rate forecast or a 1-point drop in the core inflation forecast for additional easing moves.
Our analysis therefore suggests that larger surprises than those seen in recent weeks are needed for the FOMC to move out of its zone of inaction. We conclude that the unexpected weakness in growth and uncertainty about the effect of temporary factors will keep policy and, most likely, policy communication unchanged for the foreseeable future.
The implication of this analysis for next week’s FOMC press conference is that Chairman Bernanke is likely to stay far away from indicating any changes in the policy stance. Most likely, he will be “balanced” by emphasizing both the disappointment in the activity indicators and the higher inflation data. So the press conference is unlikely to be pleasant for either the chairman or his audience.
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