From the Wall St. Journal:
A price index for personal consumption expenditures -- or PCE -- that excludes food and energy increased by 0.2% in June, the third straight month it has risen that much. Compared with a year earlier, the core PCE price index grew 2.4% in June, the fastest growth since September 2002. The June rate was up from the 2.2% pace in May and April of this year.
Barclays Capital bond market strategist Michael Pond said the year-to-year increase is consistent with the Fed's forecast for the end of this year, but the "upward trajectory" seen already will concern policy makers.
And also...
Last month the Fed raised its forecast for core PCE inflation this year to 2.25%-2.5% from a previous projection of about 2%, while expecting 2%-2.25% inflation next year. The forecast suggested the Fed can tolerate inflation above its preferred 1%-2% zone for some time because it expects slowing economic growth and stabilizing energy prices to ease price pressures eventually.
Bank of America Treasury strategist George Goncalves said Tuesday's inflation data suggest the Fed will have to raise its short-term interest rate target again at its Aug. 8 meeting.
That's not the only news today. Manufacturing remains strong, and pressure on raw materials prices show signs of easing. (NY Times article).
The National Association of Purchasing Management-Chicago said yesterday that its regional index rose to 57.9 this month, from 56.5 in June. A reading greater than 50 signals growth. A separate index of prices paid for raw materials fell from its highest level in 18 years.
On days like this, I always look forward to Barry Ritholtz's take. I was not disappointed.
Once again, the portfolio wrecking crew know as "Team One & Done" have suckered investors for the umpteenth time (we have lost count) into believing that there is little inflation, the economy is slowing, and therefore the Fed is done.
Astonishing.
Indeed. If you have been following my blog for very long, you are aware that I try to avoid going back and forth on whether or not there will be a pause. My opinion has not changed much from what I wrote after the last Fed meeting.
If economic conditions remain status quo, the default option is to continue rather than pause. There is some evidence that higher energy prices are being passed through to the rest of the economy. Interest rates may have to go a little higher to make sure that this pass through is minimized.... Figuring out what the appropriate level is--in real time--is not a trivial matter.... Fortunately, ... we are not starting out quite so far behind the curve, but if we are behind the curve at all, it means that it will take more effort from the Fed to get real rates where they need to be. That is a risk that cannot be ignored.
As long as we're digging in the archives, let's go back almost a year. Last summer, recognizing that a pause was neither imminent nor necessarily advisable, I argued for a pause as early as December. By November, as inflation data came in and economic growth continued unabated, I could see that the rate hikes could continue for a while and that it wouldn't necessarily be a bad thing. In an Econoblog with Tim Duy, I wrote,
If incoming data forces us to redefine "neutral" as something higher, then (all other things being equal) I am slightly less worried than I was this summer about policy error. What concerns me more is, as you suggest, the need to communicate the transition to a new policy, especially if the economy begins to slow and the Fed is forced into some tough choices. If GDP growth slows at the same time that the recent increases in energy prices finally feed through and increase core inflation, the Fed must decide which objective is the most critical. If you advocate inflation targeting ..., your choice is clear. I sense that some of the more vocal opposition to Mr. Bernanke is coming from ardent proponents of price-level targeting who fear that he may not be tough enough.
It's been about 9 months since that Econoblog, and a year since the summer of my concern over policy error. "Neutral" has been defined upward, and the effort to communicate the Fed's new policy stance is, shall we say, "in progress." Concerns over Bernanke's inflation fighting credentials are still evident. As a result, I think there is a sentement developing that if the Fed did pause now in the face of today's inflation data it would paint Bernanke as extremely dove-ish.
I think it is a little more nuanced than that. The real issue is how you see the balance of risks to the economy shaping up in the 6 to 18 month time frame. James Hamilton does a nice job of laying out situation (prior to today's inflation numbers). It's the classic slow growth vs. inflation risk trade-off that any beginning student learns. More specifically to our current dilemma,
A. Energy prices may stay elevated, but they are not going to increase as they have in the last couple of years. Further, most of the pass through has already occurred. Thus inflationary pressures will start to ease gradually over the next year. As that happens, the real interest rate will rise, even if nominal rates are constant. This could threaten business investment in 2007. Coupled with a housing slowdown, this makes a recession likely.
B. Energy prices could go higher, and it is possible that some of the pass through has yet to occur. Rising inflation is keeping real interest rates too low to have the desired effect. Some might even say that this is the price we are paying for the "measured pace". Stopping too soon could turn what should have been a transitory inflation episode into something more serious. Inflation will remain at this elevated level until the next recession (a mini-repeat of the late '70s, though much less severe).
So which camp are you in? Today's data tells me I can't quite dismiss possibility "B" yet. If I'm advocating for a policy, I still say one more hike, then pause, then re-evaluate in December. Predicting what the Fed will do is another question. Do they lean towards "A" or "B"? Reuters tries to figure it out, but they don't see a clear answer either.
[SF Fed President Janet] Yellen said she believes the Fed needs to be "modestly restrictive" given the tightness of labor and product markets, but she concluded rates were in the "vicinity that is roughly appropriate" to keep inflation contained.
...
Some officials, however, may want to err on the side of higher rates out of concern that doing too little now may make their job that much harder should inflation risks morph into inflation.
"A slowdown is coming, but there are other factors sustaining hearty growth for now, and inflation risks are still rising," Richard Berner, chief U.S. economist at Morgan Stanley, said in a note to clients. "Consequently, it's premature to think that the Fed is finished tightening, much less that officials will soon ease."
But for every hawk on Wall Street, there seems to be at least one dove and markets see a better-than-even chance of the U.S. central bank holding its fire on August 8, although that could shift when key employment data is issued on Friday.
"Recession odds right now, according to our model, are around 40 percent, which is exactly where they were when the Fed went on hold in the summer of 2000," David Rosenberg, chief North American economist at Merrill Lynch, said in a note.
Yellen's entire speech can be read here. It is worth your time, especially the part on inflation, of which I reprint one paragraph.
Next, there is the issue of the role of energy prices in the recent disappointing data on core inflation. As I said, core inflation excludes energy prices. But there may have been some passthrough of higher energy prices into the prices of core goods that use energy as an input to production—airfares are a good example. If this is the case, and if energy prices level out as expected by futures markets, this pressure is likely to dissipate at some point. However, the whole question of passthrough is actually the subject of some debate. For example, recent evidence suggests that there has been much less passthrough in the past twenty-five years than there was back in the 1970s, when inflation got out of control in the face of soaring energy prices. If it's true that there's only a very small passthrough of higher energy prices to inflation currently, then that raises the concern that something more fundamental is pushing up inflation. Unfortunately, at this point, it's too soon to untangle these alternative interpretations.
Viewed in light of my description of scenarios "A" and "B" above, it's easy to see that this issue is far from settled and that intelligent people can differ. For my part, I think that Yellen gets it about right in describing the issue. I think there is probably more concensus about the risk of a slowdown than there is about the passthrough of energy prices and the risk that this temporary inflation episode is not so temporary. So while I lean towards advocating (and expecting--though it is a close call) one more hike, I would not cringe mightily at a pause. A pause simply means that the FOMC is tilting towards scenario "A" and that they see passthrough as becoming less of a problem as time goes on. Sooner or later, they will pause. The only question is what another quarter point would do to the expected, and ultimately the actual, path of the real interest rate over the next 6 to 18 months. That is perhaps the most critical, and most difficult question on the table.
UPDATE: Tim Duy weighs in. He wants to believe that a pause is coming next week--quite frankly, so do I--but he can't quite bring himself to believe. Nor can I. The financial markets also want to believe, and are having an easier time convincing themselves. Duy concludes,
Perhaps tomorrow’s employment report will help lift the cloud…
Well, the consensus forecast according to the WSJ is for 150,000 new jobs. I'll tell you right now that if the actual comes in close to that, it won't lift the cloud that much. Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.
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