The Economic News

I regularly attempt to explain the current state of the economy, the Federal Reserve’s policy stance, and other news items that could impact the markets. It is difficult to present the general state of the economy in just a few paragraphs, so I was thrilled when I discovered this scorecard designed by JPMorgan. I’ll try to regularly include it in my future newsletters. If the chart seems unclear just click on it to get a larger clearer view.

Many economists believe that we are close to full employment (5% or less unemployment is considered full employment by economists and the Fed). These gurus fear that full employment could lead to rising wages which could then cause inflation. The Federal Reserve is focused on the core rate of inflation (inflation less the volatile food and energy segments). Inflation is currently at the high end of the Fed’s defined range of acceptable. So the Fed’s board members want the core inflation rate to fall but don’t want to raise interest rates again to achieve it. The Fed wants the market to adjust itself.

When Bernanke became Federal Reserve Chairman he stated that he wanted to communicate the Fed’s intentions more clearly to investors. The unintentional result has been the inversion of the yield curve (short term interest rates are higher than long term rates). In order to get long term interest rates up, the Fed has begun to abandon its policy of clear communication and transparency. It is instead refusing to send a clear message. The Fed recently changed its stance to neutral (instead of signaling its intention by stating a bias towards raising or lowering rates) but it is all posturing. The most recent Fed minutes from its last meeting are meandering and unclear. Consider, for instance, this excerpt from the minutes:

…the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee’s predominant concern.

The Fed's mixed reactions regarding inflation are unsettling to many analysts and economists. It is all part of an elaborate game of chicken as the Fed desperately tries to balance the need to moderate inflation with keeping the economy growing. If the Fed has to raise short term rates to check inflation it might also destabilize the financial markets. If the Fed states a bias towards lowering short term rates, it could cause the markets to grow too quickly the old boom followed by bust pattern). The Fed hopes to avoid these scenarios by convincing the market to raise long term rates which should help moderate full employment and wages and hence cool the core inflation rate. It will be interesting to see who blinks first, the markets or the Fed.

The Financial Pragmatist

Libby Mihalka

Rise in Producer Price Index Shows Inflation Not in Check

Today, the Federal Reserve received mixed signals regarding inflation. Last week’s great news that inflation seemed under control, with no increase in November’s consumer price index, was obliterated by today’s report on November’s producer price index. This is the price that businesses charge each other for oil, produce, and metals.

The bad news, wholesale prices shot up 2% in November. The producer price index has not increased that much in a month for over 32 years. These latest figures will make it difficult for the Fed to change its stance from a defensive posture of raising interest rates to an expansive posture of lowering rates anytime soon.

It is unusual to see such a high rise in producer price index not reflected in the consumer price index. It means that companies absorbed the rising cost of production and did not pass it on to consumers in the form of higher prices. If the producer price index keeps climbing at such a high rate, these increases will inevitably have to be passed on to consumers. Inflation!

The economic fog is thickening and there are some strong cross currents. It is difficult to predict which way the economy will go in 2007. Fasten your seat belt and turn on the fog lights.

Federal Reserve Leaves Interest Rate Unchanged

The Federal Reserve held tight leaving its key overnight interest rate at 5.25%. The Fed gave no hint whether it would be changing interest rates anytime soon. Many economists expected the Fed to allude when it might start cutting rates. Instead, the Fed held open the possibility that it might increase rates if inflation does not moderate. It also expressed concern regarding the slowing housing market. The Fed described the housing slowdown as "substantial". This is stronger language than the Fed has used before.

The Fed is talking tough to keep a lid on inflation in hopes that it will not have to act tough and raise rates again. The stock market pulled back today (Tuesday December 12th), finishing slightly lower as investors grappled with the Fed's economic assessment and worries about accelerating inflation.

Friday’s release of November’s consumer price data will give us an indication of the Fed’s success at taming inflation. The Bloomberg poll predicts a 0.2 % increase, after food and energy items are removed. The increase for October was 0.1 %.

The Federal Reserve Meeting, Inflation and Interest Rate Changes

The big news this week is the Federal Reserve's scheduled meeting tomorrow (Tuesday). However, the Fed is not expected to make any big moves and should keep interest rates steady at 5.25%. Despite some of the recent gloomy news, the economy has been performing well. Why? The Service Sector of the U.S. economy is chugging along on all cylinders; it’s the manufacturing part of the economy that is causing some economists to worry. That’s the sector that manufactures things and builds homes, which appears to be on the brink of recession while the Service Sector continues to surge. The simple truth is that the Manufacturing Sector represents only one-fifth of the economy, and is not as important as it used to be. The Service Sector is the motor that now drives our economy. So what will the Fed focus on? It will look intently for any signs of inflation in the Service Sector. The members of the Federal Reserve will scrutinize all the employment and labor cost statistics. They will be worried about the low unemployment figures and the recent increase in wages. The Fed will remain cautious on inflation but they won’t take action. Do not expect a rate cut anytime in the near future.