Chairman Bernankes speech on August 26 is much awaited for an in-depth explanation of the Feds August 9 policy statement. First and foremost the Chairman needs to explain why economic conditions warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Fed changed its opinion about the economy at the August 9 meeting indicating that more than temporary factors, such as higher energy prices and supply disruptions from the March earthquake in Japan, accounted for a weakening of economic activity.
The recent drop in energy prices is encouraging and allows the Fed to maintain the focus on economic growth. Oil prices are also back at levels when the Fed implemented QE2 in November 2010 (see Chart 1). In addition, the supply bottlenecks after the natural disaster in Japan are not an issue anymore. Inflation expectations do not present a threat and are close to readings seen in November 2010 (see Chart 2).
That said, the Fed is watching closely the recent increase of shelter costs in price measures. Shelter costs have moved up in 2011 as measured in the CPI and the personal consumption expenditure price index, after a significant deceleration in 2010 (see Chart 3). Shelter costs make up a large part of both core price measures (it has a smaller weight in the personal consumption expenditure price index, the Feds preferred price measure, compared with the CPI.) In July, the shelter price index of the CPI rose 1.4% from a year ago, while it moved up 1.12% in the personal consumption expenditure price index during June. The overall core price gauges have risen in recent months, with the July core CPI posting a 1.77% year-to-year increase (see Chart 3). The July personal consumption expenditure price index will be published on August 29; in June, the core personal consumption expenditure price index had risen 1.33% from a year ago. The Feds unofficial target for inflation is 2.0% or a tad lower. The upward trend of housing costs is noteworthy because the situation is different now compared with the November 2010 when QE2 was put in place.
At the same time, economic reports point to a noticeably weak economic conditions now vs. June 2011. The real GDP estimate of the first quarter (+0.4%) has been revised down and second quarter (+1.3%) growth is unimpressive. Labor market conditions have deteriorated and the housing sector remains in a slump. The national factory survey of July and regional surveys of August point to a loss of momentum in the factory sector (see Chart 5). Most of this information was available prior to the August 9 FOMC meeting and the policy statement noted that downside risks to the economic outlook have increased. Under these circumstances and the fact that the FOMC has already conveyed that it would hold the policy rate steady until mid-2013, Bernankes most likely option appears to be one of watchful waiting.
However, financial markets appear to be entertaining an announcement of additional easing of monetary policy. Of the options available, the Fed has already used a change in language as one of the tools of monetary policy easing, which appears to have been the least harmful choice. At the other extreme is QE3, but support for this route is absent and it generates further concerns about the size of the Feds balance sheet and the exit strategy of the Fed. There is a middle ground being discussed which is the Fed changing the maturity structure of its balance sheet and purchasing longer dated securities. This action is expected to result in investors purchasing more risky assets as safe assets will be bought by the Fed. The resultant reduction in the long term rates is seen to be favorable for economic growth. The Fed engaged in a similar program in 1962 called Operation Twist aimed to bring down long rates to promote housing expenditures and investment spending and hold short rates steady to maintain the value of the dollar. This program was 1.7% of GDP in size compared with QE2 which was 4.1% of GDP. The San Francisco Feds analysis indicates that Operation Twist succeeded in bring about a 15bps reduction of long rates. The road ahead involves the Fed weighing the costs and benefits of these choices. As mentioned earlier, Bernanke is most likely to explain the Feds August 9 policy statement, present the implications of the Feds other monetary policy alternatives, and indicate the Fed stands ready to take further action if economic conditions warrant a response.
Orders of Aircraft and Autos Lift Bookings of Durable Goods in July
Durable goods orders rose 4.0% in July after a 1.3% drop in the prior month. An 11.5% jump in orders of motor vehicles, a related 10.3% increase of the primary metal component, and a 43.4% increase in bookings of civilian aircraft account for the headline number. Excluding transportation, orders show a more moderate gain of 0.7% in July vs. a 0.6% increase in June. Nearly all other major components of durable goods posted decline in July. The July ISM factory survey results and August regional surveys point to a slowing of factory activity. The gains reflected in the auto component is largely a snapback in activity after supply disruptions in the second quarter following the earthquake in Japan. Therefore, the strength of orders implied in the July report should be discounted. August data of durable goods orders will be a better gauge of underlying conditions.