Is The Fed Done in the US? Don’t Bet on It

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

Stocks and bonds rallied last week, as investors breathed a long sigh of relief. A wealth of data releases had investors on edge, but by the Wednesday they were betting that the two-year cycle of steady interest rate hikes has come to an end. The Economist Intelligence Unit believes that any celebrations are premature.

Not just one, not two, but eight indicators that investors use to gauge inflationary pressures in the economy were published during the middle of last week, along with another handful that offer further insights into the direction of the economy. Investors digested them all and decided that inflation is well-contained and growth is slowing. This would lend credence to the idea that the Federal Reserve (central bank) is finally finished raising interest rates. The Fed took a pause in August following 17 consecutive rate hikes. 

Prices Right

The first positive sign for investors was the release on Tuesday of wholesale price data, which dominated financial news that day. The prices that businesses pay for consumer goods and capital equipment, along with the raw inputs to production, rose by just 0.1% in July. This compared with market expectations of 0.3% and was the slowest rate of growth since a sharp drop in February. More importantly, "core" wholesale price inflation, which excludes food and energy, actually fell by 0.3% in July, while investors had been expecting a rise of 0.2%.

Taken together the data were seen as the best vindication yet of the Fed's decision to pause in August, itself based on Fed forecasts of slowing inflation. Investors reacted favourably, boosting bond prices and sending yields on ten-year Treasury bills falling below 5%. Major stock indices gained more than 1%. The dollar weakened.

But market sentiment remained muted as investors awaited the release of the all-important consumer price inflation data on Wednesday. These also did not disappoint, with consumer prices rising by 0.4% in July, in line with consensus forecasts. Core inflation came in at 0.2%, while investors had expected a fifth consecutive rise of 0.3%.

When combined with data releases showing output growth in industry slowing by more than expected and the housing market continuing to cool off, investors plunged further into bonds and equities, with the yield on the ten-year T-bill falling to a four-month low of 4.87%, barely higher than where it stood when the Fed's rate-hike cycle began back in June 2004. Stock markets also rallied for another day.

Data released on Thursday were not as encouraging. The Philly Fed index, which measures the business outlook for firms in the mid-Atlantic region, came in stronger than expected, while initial jobless claims fell significantly—both an indication of some strength in the economy.

By Friday, however, the most important measure of consumer sentiment, from the University of Michigan, showed a steep decline. This had investors betting once again that the Fed is done, sending bond yields even lower. The market for Fed funds future contracts now only gives a 25% chance to a Fed rate hike in September.

A Pause for the Cause

The Economist Intelligence Unit does not argue with that short-term sentiment. We acknowledge—indeed, we forecast—that output data are going to look ever worse going forward. The Fed will have one more month of price data before its next rate decision on September 20th, and inflation in August could surprise again on the downside.

But nor do we see in last week's data a turning point that would make us believe that the Fed is definitely done raising rates. Lost in the noise surrounding the data releases were some fairly ominous indicators that inflationary pressure in the economy still remains strong. Wholesale prices surprised on the downside largely because of a one-off 3.1% decline in prices of light trucks, with intermediate inputs and raw materials rising by 0.5% and 3.2% respectively.

Consumer prices also came in favourably, largely owing to pessimistic consensus forecasts. Prices compared with a year earlier remained above 4% for the third consecutive month, while 12-month core inflation actually ticked up a notch, to 2.7%, well above the Fed's 1-2% comfort zone. On an annualised basis, core prices over the three months ending in July reached 3.2%.

Even the industrial production data reveal developments that will keep some Fed governors awake at night. Yes, industry is not using as much of its capacity as had been predicted by investors, further underpinning buoyant markets. But such forecasts were extremely pessimistic in the first place. Even so, capacity utilisation, a measure of how close the economy is to its natural speed limit, actually was higher than it has been in over six years, at 82.4%, and well above its long-term average of 81%. Consumer confidence fell on Friday primarily because of rising inflationary expectations.

Indeed, the president of the Dallas Fed, Richard Fisher, noted last week that while growth is slowing the "inflation pressure gauge needle is moving in the opposite direction". Mr Fisher does not have a vote in the Fed's interest-rate decisions, but comments from regional Fed presidents are usually taken seriously as representative of some voters' sentiments. But not this time, as markets completely ignored his warnings that the Fed will not hesitate to raise rates if the numbers warrant. Mr Fisher cited rising wage pressures and signs that firms are regaining the power to pass on price rises to consumers.

A Rise in the Fall

We at the Economist Intelligence Unit believe that there is still a significant chance that the Fed will have to turn around and raise rates in October in response to still-considerable inflationary pressure in the economy. The very act of the central bank restarting a tightening cycle that most investors thought had ended might itself be a trigger for a sharper bond-market correction. In turn this would lift long-term interest rates sharply and precipitate an adjustment in inflated property prices. Equity prices would also take a hit. (The Fed's target for short-term rates, at 5.25%, is now higher than the yield on Treasuries of any maturity.)

For this reason, many market participants are discounting the possibility of another rate rise. While it is certainly true that the Fed takes into account the likely reaction of financial markets to its rate decisions—and thus is very much aware what a rate hike would do four months after the last one—the Fed's new chairman, Ben Bernanke, will also be keen to reassert his inflation-fighting credentials, if inflation fails to fall from its current heights.

Even if the Fed is done, the slowdown in the economy should eventually take its toll, certainly on equity markets. The Economist Intelligence Unit sees annualised growth heading to around 2% over the next four quarters, and now forecasts growth for all of 2007 to average just 2.2%. Although not our baseline forecast, we do not rule out one or even two quarters of contraction, driven by a retrenchment of private sector demand in response to higher borrowing costs and fuel prices and a sharp cooling of the housing market.

With only a few important data releases between now and the Fed's next policy-setting meeting, the markets look likely to take a rest. Investors should enjoy their remaining summer holidays while they can--they could come in for a bumpy ride come autumn.