The Fed left interest rates unchanged this week and concluded that inflation is low enough so that they can keep policy accommodation for "a considerable period." Most analysts read this as promising no imminent rise in the Federal funds rate, and that might be true. But there is no doubt that there has been a significant change of heart within the US central bank. And that is embodied in the new description of inflation risks in the explanatory statement that followed the FOMC decision.
The Fed officials changed the language along the lines that we suggested in last week's Freitagspapier: They admitted that the "probability of an unwelcome fall in inflation has diminished in recent months" and now appears "almost equal to that of a rise in inflation." But they still speak of the balance of risks in terms of economic growth as equal, which is odd given the tremendous strength demonstrated since the spring.
Our judgment is that the Fed has introduced more honesty into their assessment. In practical terms, they have taken the first (albeit hesitant) step toward a period when they will be increasing the Fed funds rate. Of course, when they finally do raise the funds rate for the first time, they will describe the resulting level as "still accommodative". ANY Fed funds rate below 2.5% is accommodative at this time, given the huge stimulus -- monetary, fiscal, and foreign exchange -- already coursing through the US economic and financial system.
The trigger for an actual tightening move will probably come from the inflation data themselves. But it is possible that the Fed will start to look more carefully at a number of factors that have had a relatively reliable track record over time as leading indicators of inflationary pressures. They include the following:
- The unemployment rate
- The rate of increase in labor costs
- The movement in a broad index of commodity prices
- The change in energy prices specifically
- The rate of capacity utilization
- The value of the dollar in the foreign exchange markets.
How are these indicators behaving now and what is the outlook? Basically all are tilting toward greater inflationary pressures though only moderate upward pressures over the next one or two years.
Unemployment: The rate of unemployment is gradually declining. The rate peaked in June 2003 at 6.4% and since then has come down to 5.9%. This has been brought about by a very substantial increase in the number of people who report that they are employed. Over half a million so reported in the November Household survey, in contrast to the rather meager 57,000 increase in payrolls that was identified in the November Establishment survey. Because the first half of 2004 is likely to post strong growth, 4% per annum or higher, the unemployment rate may come down another half point by next June. The progressive tightening of the labor market will tend to lift inflation.
Labor costs: The rate of increase in labor costs is best measured not by the monthly earnings data but by the far more comprehensive quarterly compensation survey, which amalgamates both wage and benefit costs. Compensation was up 4% per annum in the third quarter, mainly because of steeply rising costs of benefits. Given the quite considerable increases in medical insurance costs, there is no reason to predict that this pattern will change any time soon.
Commodity prices: They have risen persistently. As measured by the CRB index, they are now up about 10% from a year ago and fully 30% from their recession lows of 2001. Some analysts attribute the rise to strong incremental demand from China, where industrial output is already up 17% this year. Others suggest it is a rebalancing of a period of secular weakness in many commodity prices, reflecting previous changes in the structure of world demand toward high tech products. This year, of course, US final demand has been concentrated in old-fashioned cyclical goods cars and housing. So a combination of both factors seems most likely.
Energy prices: Over time, they have tended to be important influences on the overall inflation rate, although they no longer predominate. Oil prices are stubbornly high, well above the $22-25 bbl band that many industry experts forecast at the end of major military activity in Iraq last spring. Part of the explanation why they are close to $32 bbl for the WTI benchmark is the continuing chaos in Iraq. Scattered violence has stunted the recovery of output and exports of Iraqi oil. But another reason is that the global economy is doing better, not just the US and China. Next year the global expansion will speed up further, at least through the summer. This will naturally put some additional upward pressure not only on oil, but also on natural gas and coal prices as well.
Capacity utilization: The rate of capacity utilization is up from the trough, though it is still low. The Fed called attention to this statistic in this weeks explanatory statement. But this is not the whole story. The hard fact is that the US households and businesses spend more than the US economy produces. And that has been true for many years, regardless of the recorded level of capacity utilization within the US itself. Indeed, much of the excess capacity that goes into the calculation will never be brought back into production. Either it is simply uneconomic, given relative wage costs in the US as compared to factories abroad. Or it is outlawed by environmental or other legal impediments. To be sure, there is a cyclical element, as well, and some rise in capacity utilization is to be expected in the coming year. That will be another adverse factor for inflation.
The dollar: Finally, and most importantly, the pronounced depreciation of the dollar is bound to have inflationary effects. These effects may be taking longer than usual to materialize but they will nonetheless last for a considerable period of time. Since February 2002, the trade weighted exchange index for the dollar against major currencies has fallen by 20%. And the dollar continues under downward pressure, notably against the euro. It is worth recalling that the period of low US inflation from the late-1990s onward coincides almost exactly, with a lag, with the substantial 40% rise in the average value of the dollar from the low point in April 1995 until early last year. That dramatic movement was responsible for putting persistent downward pressure on the prices of imports, which in turn limited the ability of US manufacturers to raise prices or maintain profit margins. That era of imported disinflation is ending fast, if indeed it hasnt already ended.
In sum, virtually every leading indicator of future inflation has turned significantly higher in recent months. And the all important influence of a strong dollar in keeping inflation low in the late 1990s and early 2000s has all but reversed. It is no wonder that the Fed has changed its language to take account of the new reality. Sooner or later, but possibly sooner than the consensus anticipates, action will follow words.