The Federal Reserve just released the minutes to its most recent meeting, held on January 25th and 26th. Below we present the Staff’s assessment of the current economic environment. My commentary/translation of their assessment is interspersed throughout. I have also included links to posts that have discussed the more recent data that has come out since the Fed meeting, below were they discuss the older data.
“The information reviewed at the January 25–26 meeting indicated that the economic recovery was firming, though the expansion had not yet been sufficient to bring about a significant improvement in labor market conditions. Consumer spending rose strongly late last year, and the ongoing expansion in business outlays for equipment and software appeared to have been sustained in recent months.
“However, construction activity in both the residential and nonresidential sectors remained weak. Industrial production increased solidly in November and December. Modest gains in employment continued, and the unemployment rate remained elevated. Despite further increases in commodity prices, measures of underlying inflation remained subdued and longer-run inflation expectations were stable.”
I agree with most of what they say here. There are some indications that the labor market has been firming, but it is still a mixed bag. I do not see inflation as being a major problem at this stage.
Relative prices for commodities are rising, but they generally represent a very small fraction of the overall value of most products. While they might cause some margin pressure for some firms, what we have seen over the last year is significant increases in net margins, not pressure on margins.
I would say that the rise in commodity prices is a good reason to overweight commodity producing firms, but are not a reason to be tightening monetary policy. The Energy and Basic Materials sectors look attractive to me. Consider firms such as Southern Copper (SCCO) and Teck Resources (TCK) to play this trend.
“The labor market situation continued to improve gradually. Private nonfarm payroll employment increased in December at a pace roughly the same as its average for 2010 as a whole, and the average workweek for all employees was unchanged. Services industries continued to add most of the new jobs in the private sector.
“Initial claims for unemployment insurance trended lower in December and early January, and some indicators of job openings and firms’ hiring plans improved. The unemployment rate decreased to 9.4 percent in December, but this decline in part reflected a further drop in the labor force participation rate. Long-duration unemployment remained elevated, and the employment-to-population ratio was still at a very low level at the end of the year.”
January payroll growth was anemic, and well below the December level. However, the unemployment rate dropped another 0.4%, for the biggest 2-month drop in over 50 years. Yes, part of that was due to a declining participation rate, but not all of it.
The employment-to-population ratio increased for two months in a row. It is still at very depressed levels. I go into lots of detail about the employment situation in the January report here: Employment Report in Depth, Part 1 and Employment Report In Depth, pt. 2
“Total industrial production posted solid increases in November and December, in part because colder weather boosted the output of utilities. Although motor vehicle assemblies dropped back in those months, production in the manufacturing sector outside of motor vehicles posted solid gains that were fairly widespread across industries; as a result, capacity utilization in manufacturing increased further, although it remained below its long-run average.
“Most indicators of near-term industrial activity, such as the new orders diffusion indexes in the national and regional manufacturing surveys, were at levels consistent with further increases in industrial production in the near term; in addition, motor vehicle production was scheduled to move up again in early 2011.”
The weather effect on Industrial Production reversed itself in January. December was even stronger than the Fed thought. The rise in Industrial Production over the last year or so has been quite robust, but that is a snap back from a huge decline during the Great Recession. For more on the current state of Industrial Production and Capacity Utilization see: Utilities Drag Down Industrial Production
“Growth in consumer spending appeared to have picked up in the fourth quarter from the more modest pace seen earlier in the year. Nominal retail sales, excluding purchases of motor vehicles and parts, rose again in December, following substantial increases in the previous four months. In addition, sales of new light motor vehicles climbed further in December after stepping up to a higher level during the preceding two months. The available data suggested that consumer spending was supported by gains in personal income in the fourth quarter of 2010.
“Moreover, household net worth appeared to have risen in the fourth quarter, as the large increase in equity prices more than offset further declines in house values. Consumer credit started to increase again in October and November after having generally declined since the fall of 2008. However, consumer sentiment only edged up, on net, in December and early January, and it was still at a relatively subdued level.”
Retail sales were up in January, but less than expected. Weather may have played a role in the weaker than expected retail sales. If so, we should see a nice reacceleration in sales in February.
The increase in household net worth should help increase spending going forward, but more on high-end luxury goods than on more downscale products. Equity wealth is FAR more concentrated than is wealth from home equity.
“Activity in the housing market remained weak in an environment characterized by soft demand, a large inventory of foreclosed or distressed properties on the market, and tight credit conditions for construction loans and mortgages. Starts and permits for new single-family homes in November and December were still near the very low levels recorded since midyear.
“Sales of new homes rose in December but remained historically low. Sales of existing homes increased in November and December from the more depressed levels seen during the summer and early autumn, but these sales stayed relatively weak as well. Moreover, measures of house prices declined further in recent months, and survey responses indicated that households remained concerned that home values might continue to fall.”
Mixed recent news on the housing front. Housing starts were up more than expected, but building permits fell sharply. The strength in starts was all due to the very volatile multi-family sector.
Without a doubt, housing remains very depressed. It has been acting as an anchor on the economy for several years now. It was a slight positive for growth in the fourth quarter. I would expect that it will remain a slight positive in the first half of 2011, and then grow into a larger positive force for growth in the second half and into 2012.
It is the change in activity, not the level, that counts for economic growth. We are down so low that just about anything looks like up from here. Housing will help a great deal just by not being a drag on the rest of the economy, but it is NOT playing its traditional role and the locomotive that pulls us out of a recession. For more on housing starts and building permits see: Multi-family Housing Starts Soar
“Real business investment in equipment and software appeared to have increased further in the fourth quarter, although likely at a more moderate rate than in the first three quarters of 2010. After declining in October, nominal orders and shipments of nondefense capital goods excluding aircraft rose in November, and the level of new orders remained above the level of shipments, indicating that the backlog of unfilled orders was still rising.
“Available indicators suggested that business purchases of software stayed on a solid uptrend, and outlays for computing and communications equipment appeared to have risen briskly. However, business spending for transportation equipment, including aircraft and motor vehicles, likely declined in the fourth quarter of 2010 after expanding rapidly earlier in the year.
“Surveys of purchasing managers reported that firms planned to increase their capital spending this year. Reports on planned capital expenditures by small businesses showed some signs of improvement in recent months, although they remained relatively subdued.
“Business outlays for nonresidential structures stayed weak, reflecting high vacancy rates and low property values for office and commercial properties, as well as tight credit conditions for commercial real estate. In contrast, investment in drilling and mining structures increased, buoyed by rising energy prices.”
Business investment outside of real estate has been one of the high points of the economy over the last year, and is likely to continue to be so. Investment in equipment and software is a pretty small part of the overall economy, and it cannot be expected to carry the whole load, but it is doing its part, and then some. The Industrial and Tech sectors are the beneficiaries of this relative strength, and they also look attractive to me.
The construction sector appears to be very risky to me and I would avoid it. Consider firms like Rockwell Automation (ROK), Parker Hannifin (PH) and Qualcomm (QCOM) to play this trend.
“Real nonfarm inventory investment appeared to have slowed substantially in the fourth quarter after a sizable increase in the previous quarter. Much of the fourth-quarter downswing was likely associated with a drawdown of motor vehicle stocks after an accumulation in the third quarter.
“Book-value data for October and November suggested that the pace of inventory accumulation also was slowing outside of the motor vehicle sector. Inventory-to-sales ratios toward the end of 2010 were close to their pre-recession norms, and most purchasing managers surveyed in December reported that their customers’ inventories were not too high.”
Classic Fed understatement here. The swing in GDP growth due to inventories was MASSIVE from the third quarter to the fourth quarter, going to adding 1.6 points or 62% of the total growth in the third quarter, to subtracting 3.70 growth points in the fourth quarter.
In other words, absent the inventory effect, growth would have been 1.0% in the third quarter and 6.9% in the fourth quarter. I suspect that in the first quarter the inventory effect is going to be much smaller than in either the third or fourth quarters.
“Measures of underlying consumer price inflation remained low. In December, the core consumer price index (CPI) edged up, as goods prices were unchanged and prices of non-energy services rose slightly. The 12-month change in the core CPI remained near the very low readings of the previous two months.
“Other measures of underlying inflation, such as the trimmed-mean and median CPIs, also remained subdued. Despite the steep run-up in agricultural commodity prices over the second half of last year, increases in retail food prices remained modest.
“However, consumer energy prices moved up sharply in December, and prices of most types of crude oil increased during December and into January. The prices of nonfuel industrial commodities also continued to rise over the intermeeting period. In December and early January, survey measures of households’ long-term inflation expectations stayed in the range that has prevailed for some time.”
Yes, the PPI did come in a bit hot this morning, and the core was much higher than expected, but the increase in prices was narrow, with most of the unexpected rise in core prices due to a jump in Drug prices. For more on that see: PPI Stokes Inflation Fears
Tomorrow we will get the CPI numbers where the consensus is looking for a 0.3% rise overall (down from a 0.5% increase in December) and a 0.1% rise excluding food and energy prices. High inflation is simply not a problem here in the U.S. and I do not expect it to be one for some time to come.
The Fed tends to look more closely at the core prices in setting monetary policy than at the headline numbers. It is right to do so, since food and energy price can be very volatile, and using them to set monetary policy would be destabilizing and could induce the Fed to do the wrong thing.
If it were watching headline prices, it would have been tightening the screws hard on monetary policy in the summer of 2008, when the economy was already in a recession and that recession was on the verge of turning into a depression.
“Available measures of labor compensation showed that labor cost pressures were still restrained, as wage increases slowed along with inflation and productivity gains appeared to remain substantial. The 12-month change in average hourly earnings for all employees continued to be low in December.”
All of the gains from higher productivity are going to capital in the form of higher prices, and none are going to labor in the form of either higher wages or increased employment (although if employment increased, that alone would tend to negate the rise in productivity).
“The U.S. international trade deficit narrowed slightly in November, as both nominal exports and imports moved up by almost the same amount. The increase in exports was driven by agricultural goods, in part reflecting higher prices, as well as by consumer goods. In contrast, exports of machinery and automotive products fell, reversing their October gains.
“The rise in imports reflected an increase in the value of imported petroleum products, mostly explained by higher prices, and of capital goods, which was supported importantly by a jump in computers. At the same time, noticeable decreases were registered for imports of automotive products, services, and consumer goods, which were primarily due to pharmaceuticals. These developments, combined with the substantial narrowing in the trade deficit in October, implied that the trade deficit likely shrank considerably in the fourth quarter of 2010.”
The Trade deficit increased again in December, entirely because of higher oil prices. Export growth continues to be robust, and non oil imports have stopped rising. A weaker dollar helps on the non-oil side, but does nothing on the oil side as oil prices tend to go up when the dollar goes down. For more on the Trade deficit see: Trade Deficit Up As Expected
“Recent indicators of foreign economic activity suggested that the global recovery was strengthening. Much of this strength was centered in the emerging market economies (EMEs), where widespread increases in exports and in manufacturing purchasing managers indexes (PMIs) pointed to a resurgence in economic growth following a slowdown in the third quarter of 2010.
“For China and Singapore, real gross domestic product (GDP) data for the fourth quarter confirmed a rebound in economic growth. In contrast, the rise in economic activity in the advanced foreign economies (AFEs) remained at a subdued pace.
“In the euro area, the incoming economic data were mixed: Industrial production, manufacturing PMIs, and industrial confidence firmed, but retail sales and consumer confidence softened. The data also pointed to an uneven expansion across the euro area, suggesting that economic growth in Germany continued to outpace that in the euro-area periphery.
“In Japan, exports and household spending were soft, although industrial production firmed. Foreign inflation picked up noticeably in the fourth quarter of 2010, mostly because of an acceleration of energy and food prices. Measures of core inflation remained much more subdued, although they also moved up in some countries.
“In the EMEs, concerns about inflation prompted a number of central banks to tighten policy. Some EMEs reportedly took steps to limit the appreciation of their currencies by intervening in foreign exchange markets, and some acted to discourage capital inflows.”
Emerging economies are doing very well, and many are on the verge of overheating. Inflation is a problem for thee, not for me. It really is their own doing, not the Fed’s doing. Those steps they are taking to limit their currencies from appreciating are what is fueling inflation in those countries.
If their currencies appreciated, the cost of imported goods would fall, helping to dampen inflation, particularly with regard to things like oil. After all, if the price of oil in dollars goes up by 10%, but the value of say the rupee goes up 10% against the dollar, then the rupee price of oil is unchanged.
Growth in most of the rest of the developed world is anemic, even more anemic than it is here. Europe and the U.K. have gone down the austerity path and the result has been slower growth, or in the case of the UK an actual incipient double dip recession.
The periphery of Europe has been forced to go down the austerity route, and are very weak as a result. Not much likelihood of a rebound in southern Europe anytime soon. The European monetary policy is probably too loose for Germany (and the Netherlands among a few others) but to tight for places like Greece and Portugal. That is one of the big problems with the Euro itself.
Overall, the staff of the Federal Reserve appears to have things about right in their assessment (or to put it another way, I agree with their overall assessment). Growth slow but picking up, and inflation not a major problem here. That means that the Fed funds rate should stay where it is now, in a range between 0 and 0.25% for at least the rest of 2011. The $600 billion QE2 program will get completed, although I would not be hugely surprised it they slow down the pace a bit and it is completed in say September rather than in June, as is now called for.
PARKER HANNIFIN (PH): Free Stock Analysis Report
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