Fed Decision More Tactical Than Strategic

Despite the Fed's taper delay, the end of the bond-buying program is a question of when, not if.

Robert Johnson, CFA 04.10.2013
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Looking at returns this week, it seems the stock and bond markets really didn't care much about anything other than the Fed's decision not to taper bond purchases. Although no one was expecting a big taper, it was still surprising that it did absolutely nothing after three months of talking up a potential reduction. The initial reaction to the no-taper decision sparked large rallies in both stocks and bonds after the announcement Wednesday. Reality settled in a little bit later in the week--markets seemed to have second thoughts as it occurred to participants that maybe they too should be concerned about slowing growth forecasts and potential fiscal disarray in the weeks ahead. Additionally, rates didn't back off all that much as tapering still seems to be an issue of when, not if, and rates were not going back to their old lows.

Inflation data released this week was tame, which effectively gave the Fed more room to operate its loose money policies. The year-over-year averaged inflation rate still remains a remarkably low 1.7%, and the single-month rate of Consumer Price Index inflation was just 0.1%. Housing data was mixed with existing-home sales and builder sentiment exceeding/matching recovery highs, as housing starts remained lethargic as homebuyers snapped up available supply immediately while avoiding new homes that couldn't be closed on right away. Unfortunately, even a modest slowing in new housing growth is bad news for the economy. Also, manufacturing appeared to make more headway in August after a generally rough 2013 that saw continually slow growth rates.

Fed's Decision to Delay Tapering More Tactical Than Strategic
The Fed decided to delay any decisions to either slow or end the purchase of mortgage and government bonds. The Fed had said in June that the economy was picking up nicely. In that context, extreme measures, such as the bond-buying program, could begin to be phased out starting in 2013, ending all purchases in 2014.

Although the U.S. economy has picked up some since the June announcement, it is definitely not on a moon-shot trajectory. Unemployment rates are down, but that's due to lower participation rates, at least recently. Also, inflation has remained below the Fed's 2% target. Slower GDP growth forecasts and that low inflation rate were the main reasons for the Fed's reluctance to start a taper program now.

There is a huge tactical issue, too. Congressional budget action is needed by the end of the September, just a few short days away. A budget showdown/standoff could cause a government shutdown in early October. Having an additional fiscal policy squeeze coinciding with a potential slowing in bond purchases just didn't seem like the most prudent thing in the world.

The unfortunate thing is the Fed didn't give any hint of how much more things would have to improve before it would move to slow purchases. The 7% unemployment marker for completing bond purchases was removed. Any calendar date information was also missing, including when the Fed next might be able to make a policy change. However, it seemed to be fairly clear that it would pull the plug on bond-buying programs at some point. Bond buying is considered an extreme measure, making the end of the bond-buying program a question of not if, but when. Bond yields might dip back a little in the months ahead, especially on slowing economic data, but the long-term trend in rates should be up. Interest rates have always had some relation to inflation, and the Fed can't keep rates unnaturally low forever. There are other bond market participants--not just the Fed.

Inflation Remains Key Tool for Economic Forecasters
Although inflation has stayed under good control recently, it remains one of the single most important variables in determining the direction of the economy. Both wage and income growth have been relatively stable and quite low. Therefore, a changing rate of inflation is one of the best indicators to determine if consumers are better off. Furthermore, the prices of high-profile commodities are key drivers of consumer confidence and willingness to spend in the stores. Finally, the rate of inflation is one of only a handful of indicators that the Fed watches in helping to determine monetary policy and establish the pace of bond-buying programs.

Inflation Lower Than Anticipated in August
The CPI grew just 0.1% in August (1.2% annualized) and the single month, year-over-year inflation rate was just 1.5%. Markets had been anticipating at least a 0.2% increase for August. This is well below the 3.1% median rate of inflation over the last 65 years. The month-to-month data can be quite volatile and subject to large seasonal factors. Therefore, I prefer to look at the aggregate data on a year-over-year basis averaged over three months, as shown below:


The current rate of 1.7% is one of the lowest since 2010. Ind eed, the current rate of inflation is in the bottom quartile of all reported inflation rates over the last 65 years. The December 2012-December 2013 rate now looks to be in the 1.5%-1.8% range versus my previous estimate of 2%. The GDP output gap of more than 5% suggests that inflation will remain under tight control for some time.

However, it is always worth keeping an eye on the sector data to make sure there aren't any early warning signs of increased inflation. The data for August was relatively balanced with both price increases and decreases. Also, some of the heretofore weaker categories are accelerating a bit (rent, medical) while some categories that had seen some extreme increases (used cars, airline tickets) are backing off. This ebb and flow of strong and weak groups is a positive; it indicates that we don't have pernicious inflation where everything goes up every month, and at an accelerating rate, to boot.

That said, medical costs are accelerating again after being extremely depressed for more than a year. A number of high-profile drugs (think Lipitor) moved off patent and generic competition sent prices through the floor. Overall, drug price increases were zero over the last 12 months. However, as the Lipitor effect began to diminish, drug prices overall are beginning to move higher, as shown in the medical commodities category above. However, there are still a few more blockbuster drugs to go off patent over the next several years, which could keep at least a small lid on prices.

Although it doesn't show up in the broad category data above, rents and owner equivalent rents are beginning to heat up, which could be a problem because they represent such a big part of consumer expenditures. Rents increased 0.4% in August, one of the biggest increases in some time, as increased demand and relatively limited supply affected prices. Prices in this category often turn up in later months for the owner equivalent rent category, which is almost 24% of the price index. Anecdotal evidence suggests that some of the rapid rent increases may be slowing, but the long-term trend toward renting will keep the pressure on rents in the months and years ahead.

Industrial Production Jumps After Poor Spring
Industrial production finally made its long-awaited bounce that has been anticipated for many months by rising Purchasing Manager Indexes. Overall, industrial production jumped 0.4% in August after showing no growth at all in July.

Most of the crummy performance in July can be attributed to a 4.5% decrease in July followed by a 5.2% increase in August. Again, that probably isn't economic reality, as auto demand and production were strong in both periods. Shifting seasonal patterns and the number of working calendar days are driving the volatility in the indexes.

Manufacturing-Only Data Looks Even Better
Industrial production indexes include manufacturing, utilities, and mining. Both mining and utilities can be affected by weather conditions and high volatility, which doesn't drive employment or other economic data. Therefore, I like to look at the manufacturing-only data, which grew a rather surprising 0.7% in August, far better than the 0.4% growth "all-in" industrial production figure. The year-over-year averaged data is shown below:

After slumping for a couple of years, the manufacturing data finally appears to be stabilized, although it is still running below long-term averages. The August data showed month-to-month growth for almost every category. Better August employment data for manufacturing corroborates an improving industrial sector, with autos leading the way. Strong year-over-year categories include wood products (housing improvement), motor vehicles, furniture, computers and apparel. Only perennial losers printing and textiles were down. Aerospace isn't looking nearly as strong as it did six months ago, as defense-related declines are offsetting  Boeing's (BA) strong commercial airline business.

Housing Markets Still Showing Rush to Close Deals to Get Best Rates
Buyers who are seeking homes they can close on immediately, in order to take advantage of low-rate locks, are distorting housing market data. Housing starts and permits remain disappointing as buyers are mainly interested in which home they can close on quickly.

Meanwhile, existing-home sales are going through the roof and are now back at the highest level since the recovery began. For now, builders seem convinced that this is a temporary phenomenon with sentiment still at its recovery high, despite poor new home sales and housing start reports. Because of the distortion, some of the data might not be as representative of the markets as one might hope. Nevertheless, there is no mistaking the fact that the overall housing market is not as robust as it was and higher mortgage rates take a toll.

Housing Starts and Permits Remain in Doldrums
Housing starts, while looking a little better in August, were still a disappointment. At 893,000, total starts (seasonally adjusted annual rate) are still well below the March high of 1 million units and the year-to-date average of 909,000 starts. And my 1-million-unit full-year estimate is looking a little suspect, too.

Single-Family Starts Did Improve, Though
However, there were a couple of bright spots. Unless starts completely fall out of bed in September, the full-quarter housing starts rate should be greater for the September quarter than the June quarter, helping the GDP growth rate. Also, while the overall starts rate wasn't great, the single-family portion of the index is looking noticeably better. August's 628,000 single-family performance level was the best of the recovery. There was even an uptick in the year-over-year rate, even as multifamily units slowed. Recall that multifamily construction has recovered a healthy portion of its recession losses (two thirds of peak levels); the single-family market isn't even close (at about one third of peak levels).

Permits Data Not Particularly Optimistic
Permit data (permits are required before a housing start can begin in most, but not all, localities) is generally a precursor of housing starts. The news here was not great. Permits have dropped from more than 1 million units in April to 918,000 in August. Permits are just barely above starts, and now permits are growing more slowly than starts.

I don't think housing is going over the cliff, but there certainly doesn't seem to be any acceleration, either. Maybe the modestly lower interest rates that followed the Fed's decision not to taper bond purchases will jump-start the market.

World Manufacturing Data, Personal Income and Consumption Data, and Pending Home Sales on Docket
Currently everyone seems to be the most worried about the Fed, but until recently the Markit World Purchasing Manager Surveys were among the most watched and influential economic reports of the month. There is some thought that outside the U.S., China is the world's most important growth driver. The Chinese PMI data was viewed as an earlier warning tool about that economy. Both the Chinese and European data showed improvement (and growth) in August, and everyone is waiting to see if those improvements continue, or if the August improvements were a statistical accident. Durable-goods order statistics are also due next week, which should shed a little more light on the manufacturing economy. Unfortunately, volatile airline orders will likely keep the headline number below the zero mark for the second month in a row. Ex-airliners, the prognosis is for an improved data set for August, especially in light of the positive regional purchasing manager reports that we have seen so far.

Watch Pending Home Sales Closely
Pending home sales did poorly in July, ostensibly because of higher interest rates slowing activity. Meanwhile, Realtors rushed to close pending deals quickly to lock in low interest rates agreed upon before interest rate increases accelerated. Therefore, existing-home sales have been on a tear, even as the pending home sales pipeline is emptied. The question is, have homebuyers had enough time to react to the new higher rates, and will pending home sales be moving into the black again in the August report?

Consumption/Income Report Could Be Difficult to Interpret
The most recent employment report was lackluster, but looked great compared with July data that was revised sharply downward. It's highly likely that the weaker July employment data will mean sharp reductions in the personal income and consumption data that is initially derived from employment data. Originally, both consumption and personal income data were reported as a relatively poor 0.1% for July. Those July numbers are likely to be revised downward, perhaps even to negative numbers. This in turn will most likely make the August numbers look explosive. Estimates are for income growth of 0.4% and consumption growth of 0.3% before inflation of about 0.1%. The income number may do even better than the consensus estimates, based on my analysis of employment, hours worked, and hours from the earlier Labor Department report.


Robert Johnson, CFA, is director of economic analysis with Morningstar.



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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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