Fed to Pause in October
October 09, 2007
By Richard Berner and David Greenlaw (New York)|
The combination of healing in stressed financial markets and mixed economic news gives the Fed latitude to pause before easing monetary policy again. Since the Fed eased on September 18, the improvement in most markets has been dramatic, although incomplete. As the Fed intended, that improvement has partially offset the financial restraint from the summer liquidity squeeze. As for economic indicators, coincident or lagging indicators have shown resilience, but forward-looking data point to sluggish growth. Correspondingly, while economic activity in the third quarter seems likely to have run at a respectable 2½-3% pace, indicating that the economy can withstand tighter financial conditions, growth in coming quarters is still poised to slow to 1½ to 2%. Moreover, with slack in the economy increasing, we still believe that inflation will drift lower. Despite the October pause, therefore, the Fed has more work to do, reflecting downside risks to growth and a tame inflation backdrop. There’s no mistaking the healing underway in both money and credit markets, and thus the partial reversal of the summer’s liquidity squeeze. To be sure, term Libor and lower-rated commercial paper yields remain wide relative to policy or overnight index swap (OIS) rates. But commercial paper rates have declined steadily, even beyond the immediate impact of the Fed ease. Since September 19, yields on one-month asset-backed CP (ABCP) dipped by 22 bp to 5.16%, while 1-month yields on top-rated nonfinancial paper declined by 6 bp to 4.70%. Another indication of reduced stress: The spread between the 30-day AA ABCP yield and that on AA financial company paper declined to 36 bp on Thursday, October 4, from 66 bp on September 19, down from the September 12 peak of 113 bp. Activity also improved; many conduits have found funding and issuers have found investors receptive to term commercial paper issues as the fear of downgrades and money-market mutual fund redemptions faded.
| 2007E | 2008E | 2009E | Real GDP | 1.9% | 2.0% | 2.9% | Inflation (CPI) | 2.7 | 2.0 | 2.3 | Unit Labor Costs | 4.2 | 2.1 | 0.0 | After-Tax “Economic” Profits | 2.5 | 0.7 | 12.7 | After-Tax “Book” Profits | 3.0 | -2.2 | 9.9 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Risky assets have also fared well following the Fed ease. Although mortgage markets are still dislocated, credit spreads either maintained their post-FOMC improvement or tightened somewhat and global equity markets continue to surge. Measured by Series 8 CDX indexes, as of October 5, investment-grade spreads were stable at 57 bp and high-yield spreads tightened by 35 bp to 311 bp, and an index of leveraged loans (the series 8 LCDX index) has been roughly stable at 192 bp. Broad stock-market indices are up an additional 2-3% and the S&P 500 hovers close to a new record. Adding to the financial support for growth, the dollar on a broad trade-weighted basis has declined by 1.4% since September 18. In our view, however, the improvement in markets has only partly offset the financial restraint that accrued in the liquidity squeeze of the past three months. To be sure, the resulting repricing of risk from unsustainably lean spreads is a healthy development, but it is nonetheless restrictive. Moreover, beyond a rise in price, the availability of credit has also dwindled. That banks are reintermediating assets previously financed off the balance sheet and that mortgage lenders are still finding it difficult to issue paper in the nonagency market both add up to financial restraint (see “Reintermediation and Monetary Policy,” Global Economic Forum, September 17, 2007). Support from a strong global economy has so far offset the one-two punch of the housing downturn and tighter financial conditions, thwarting recession. Indeed, incoming data have followed a familiar pattern: All those related to housing — sales, starts, the balance between them, and home prices — continue to evince further weakness ahead, and our forecast for housing activity thus continues to be at the bottom of the Blue-Chip consensus. Elsewhere, however, coincident or lagging indicators have shown some resilience. Through August, shipments and output of capital goods suggest growth in the third quarter, nonresidential private and public construction appears buoyant, and through July, exports boomed. In addition, companies likely liquidated inventories in the third quarter, limiting the future downside risk. Finally, while employment growth is clearly slowing, the pace is still sufficient to maintain moderate gains in income — the critical ingredient for maintaining modest growth in consumer spending. The 110,000 September gain in nonfarm payrolls, paced by solid gains in services and government, also follows a familiar pattern. Weakness in construction, manufacturing, finance, and in temporary workers sliced 66,000 from the total. Upward revisions to past months, primarily in local education, aligned the data more closely with the reality of the school year and other labor-market indicators. Combined with hearty wage gains, running at a 4.1% pace from a year ago, those increases have supported consumer wherewithal. But employment gains are clearly slowing: Over the past four months, private payrolls rose by a monthly average of 90,000 — only 60% of the pace during the January-May period. And the rise in the unemployment rate to 4.7% from a low of 4.4% in March echoes that slow erosion. With financial conditions still tighter than three months ago, and with downside pressures on capital spending, we expect sluggish growth at best. As evidence, forward-looking data point to a further significant downshift in growth. Nondefense capital goods orders excluding aircraft and computers have declined at a 2.4% annual rate so far in 2007, pointing to softness in equipment capital spending (see also “Capex Recession Ahead?” Investment Perspectives, October 4, 2007). Office rents are starting to slip, suggesting reduced demands for space, and prudent local officials are reining in budgets. And while private job vacancies are still at a high level, they have recently leveled off. Correspondingly, we expect that real GDP growth in coming quarters will slow to 1½-2%. Moreover, with slack in the economy increasing and inflation expectations relatively low and stable, we still believe that inflation will drift lower. As noted, the jobless rate has moved up. Subpar growth has widened traditional measures of the so-called “output gap” — the difference between actual and potential GDP — by about a percentage point to 1.9% over the past year, and we expect that the gap will widen by another percentage point in the coming year. Both market- and survey-based indications of inflation expectations have edged lower recently; distant-forward (5-year, 5-year) inflation breakevens have settled at 2.5%, and the University of Michigan’s canvass of 5-10 year median inflation expectation edged down to 2.9% in late September. But some traditional inflation indicators — the steeper yield curve, the weaker dollar, rising food and other commodity prices, and precious metal quotes — seem to be hinting that the Fed’s recent easing will escalate inflation risks. In our view, that is misleading. The broader context of sluggish growth and dwindling pricing power to us suggests that those indicators evince the impact of reflationary policy aimed at countering economic weakness rather than a shift in inflation priorities by the Fed (see “Reflation, Inflation or Dollar Flight?” Global Economic Forum, September 21, 2007). For their part, Fed officials have made it clear that the sudden tightening of financial conditions warranted an aggressive move to mitigate emerging downside risks to growth, and that low inflation gave them the latitude to make it. For example, Fed Vice-Chairman Kohn last week noted that “I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little, or too slowly” (see “Economic Outlook,” October 5, 2007). He and Governor Warsh both observed that since September 18, markets have healed significantly, but they echoed the FOMC statement, which “emphasized the considerable uncertainty in the outlook.” That statement contained no assessment of the balance-of-risks, which underscores that sense of uncertainty, and which correspondingly gives officials maximum flexibility in upcoming policy deliberations. With markets healing and the urgency to act greatly reduced, officials can now pause for a couple of months and take stock of the outlook and what they have accomplished. As a result, while we think the Fed still has more work to do, officials likely will keep policy steady at their October 30-31 meeting. For market participants, this pause may interrupt the trends seen recently in financial markets, but are not likely to reverse them. The US yield curve likely will steepen further, reflecting elevated volatility, renewed expectations of Fed ease and a weaker dollar. But a more measured approach to monetary ease will slow the steepening pace, and bonds seem likely to trade in a range for now. Weaker growth and earnings disappointments may again challenge risky assets, especially where leverage is high and in the context of an uncertain monetary policy outlook. Against that backdrop, near-term downside risks to growth — and especially to earnings — still predominate. Rising food, energy and commodity prices could promote an inflation scare, giving fixed-income investors a buying opportunity in a near-term, range-bound bond environment. For their part, while equity analysts may be too sanguine about earnings, equity investors seem underinvested and thus are scrambling to rebalance portfolios in favor of risky assets.
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