The Federal Reserve kept the Federal funds rate at 1% this week. Several Fed officials, including especially Chairman Greenspan, have depicted this rate as unsustainably low. The central banks explanatory statement did not specify when it would begin the process of raising interest rates. It only said it would likely remove monetary accommodation in a measured way. When it acts, it will move deliberately, not precipitously. So the direction of monetary policy— tightening— is clear. The timing and magnitude depend on two considerations: developments in the labor market and the course of US inflation.
Probably the greatest controversy surrounds inflation prospects. The Feds explanatory statement continued to portray the inflation situation in mild terms. Inflation is low and resource utilization is slack was the message. There was only a grudging acknowledgement that although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained.
That conclusion is questionable. The overall rate of consumer price inflation in the United States rose at a substantial 5.1% seasonally adjusted annual rate in the three months January-March 2004, while the core rate, excluding food and energy components, went up 2.9% per annum during that period. Moreover, there is no widely accepted method of measuring inflationary expectations. One proxy, based on the current yield on Treasury Inflation Protected securities (or TIPs), gives an estimate of about 2.5% for average market expectations for the CPI. That is up a little less than a percentage point over the past year. Other proxies, based on forecasts of economists, show slightly smaller increases in inflationary expectations. In the end, it will be Fed officials themselves who decide whether inflationary expectations have risen enough to justify a tightening of monetary policy.
In the past week or so, new information has become available from a variety of sources that point to broadening price pressures.
- The personal consumption expenditure deflator rose 0.4% in March, bringing the increase in the first quarter to 3.6% per annum. The annualized increase over the preceding three months was just 0.2%.
- The core personal consumption expenditure deflator rose a more moderate 2.0% per annum during January-March 2004, about the same as in the preceding three months. However, the 12-month change in this measure of inflation has accelerated from 0.8% in December 2003 to 1.4% in March 2004.
- The ISM manufacturing surveys prices paid component came in at an index level of 88.0 in April, a further rise from Marchs already high 86.0. The ISM says the last time this component registered a level this high was in November 1979.
- The ISM non-manufacturing surveys prices paid component rose to 68.6 in April, up from 65.7 in March.
- The ISM manufacturing surveys supplier deliveries component stayed at the high level of 67.1, just slightly below the March level. The component last reached comparable levels in 1983. It signifies strains and bottlenecks that are leading to a slowing in deliveries, usually a leading indicator of higher inflation.
- The ISM non-manufacturing supplier deliveries reading was up to 58.0 in April from 55.0 in March.
- The average price of existing homes nationwide increased to a level that is now 8.6% higher than a year ago.
- The CRB commodity futures index has eased slightly from the peaks reached in early April. But the net increase over the past twelve months is still 20%.
- Oil prices rebounded sharply in the first few days of May to just under $39 per barrel, measured by the West Texas Intermediate benchmark.
- Average hourly earnings picked up by 0.3% in the April employment report and weekly earnings are now about 2.5% higher than a year ago.
- The Employment Cost Index, the best measure of labor compensation because it includes the costs of benefits, not just wages, went up a strong 1.1% in the first quarter. Accordingly, despite a good rise in productivity in the first quarter, unit labor costs rose by 0.5%, for the first time since the 2001 recession ended.
Next week, release of several important price indicators for April is scheduled: import and export price indexes, the producer price index (which may be delayed because of persisting technical problems); and the consumer price index. Of these, the CPI carries the most weight in Fed decision-making, especially the so-called chained CPI. But the import-export price data are exceptionally valuable for tracking changing pricing behavior of both US and foreign companies. Here is a brief summary of what these data have been telling us in recent months:
Import prices: Last year, despite the sharp depreciation of the value of the dollar in the foreign exchange markets, non-petroleum import prices were essentially flat. In 2002, they had actually fallen. That behavior is changing. In the first quarter of 2004, these prices rose by 5.6% per annum. European exporters of manufactured products raised their prices the most— by over 10% per annum. Japanese exporters were far more cautious. They only raised prices by 1.6% per annum. Other Asian industrial suppliers, including China, aided by an unchanged currency value against the dollar, actually lowered prices by 5.6% per annum. Next weeks data will shed light on whether this pattern has continued, even as the dollar has steadied in the foreign currency markets, or whether China is starting to respond to political complaints against its growing trade surplus with the US.
Export prices: US companies demonstrated considerable pricing power in global markets during the January-March 2004 period. Non-agricultural export prices climbed 8% at an annual rate; last year they rose less than 2%. [Naturally, agricultural export prices benefited from taut commodity markets and shot up by over 20% per annum.] The list of products for which prices are rising relatively fast includes industrial chemicals, fertilizers, plastics, iron and steel, non-ferrous metals, computers, and electrical equipment.
Producer prices: The trend is up. For finished goods, the PPI fell 1.6% in 2001, when energy prices were collapsing, then rose 1.2% in 2002, 4.0% in 2003, when energy prices surged, and 5% per annum in the first quarter of 2004. For the core finished goods, excluding food and energy, the trend is milder: Core finished goods producer prices rose 0.9% in 2001, declined 0.5% in 2002, rose 1.0% in 2003, and accelerated to 2.1% per annum in the first quarter of this year. At the crude goods and intermediate level, the inflation rates are considerably higher. Crude materials prices are up by around 25% per annum this year. Intermediate goods prices are up almost 10%. How good a leading indicator of future inflation at the finished goods level is unclear, since not all of those increases can be passed along to consumers.
Consumer prices: Last year, the overall CPI was held down by a small number of products whose prices actually fell. Most striking was the huge 11% drop in used car prices. The data for the first quarter show that this phenomenon has ended, at least for a while. As for the chained consumer price index that Greenspan favors, it rose 0.6% in March 2004 and is 1.4% higher than a year ago. By comparison, the standard CPI rose 0.5% in March 2004 and is up 1.7% from March 2003.
In conclusion, the Fed has consistently downplayed the rise in price pressures in the US economy. It has focused mainly on price indexes that exclude rapidly rising energy and food prices, which have the most direct impact on inflationary expectations of most consumers. It has also disregarded substantial upward pressures on commodity prices and home prices, which both influence inflationary psychology.
However, a continuation of the kind of upward movement in the major inflation indexes that come out next week may be sufficient to change the Feds attitudes and set the stage for the first 25 basis point increase in the Federal funds rate as early as June. Indeed, if the employment report for May, which will be released on June 4, is any where as strong as todays solid report 288,000 new payroll jobs, on top of upward revisions for February and March that add another 75,000 then the odds that the Fed will begin the tightening process will become prohibitive.
What will this mean for the rest of the world? We have had a taste of this during the past two days. Stock markets throughout the emerging markets dropped sharply; Brazils for example plunged 4% just yesterday. Emerging bond markets also sold off, with prices on Brazilian, Turkish, and Russian debt falling especially fast. And the dollar will be boosted in the foreign currency markets.
In short, it is one thing for the Fed to ruminate about how the 1% Federal funds rate is unsustainably low. It is another when investors see it coming soon. And all the talk in the world about preparing the markets is meaningless if leveraged investors wait until the last minute before taking steps to hedge their exposures.