As anticipated, the Fed tightened monetary screws at the late-June meeting of the Open Market Committee (FOMC). By raising the Fed funds rate a quarter-point to 5 percent the Fed “took back” one of last year’s three quarter-point rate cuts. True to recent tradition, banks took the opportunity to raise the prime rate by a like amount, to 8 percent.
The FOMC also announced a retreat from May’s “tightening bias” back to a neutral stance. The key question arises: Does a resumed neutral stance mean the Fed’s tightening work is now completed and there is little likelihood for rate hikes in the future, as some optimists suggest? We doubt it and look for at least one more quarter-point hike in Fed funds by the October FOMC meeting.
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Why? Because the June tightening move was aimed at slowing the pace of economic growth that the Fed fears threatens inflation. Yet their increase in the Funds rate was followed by rejoicing in the stock market, accompanied by another ascent in consumer confidence and spending. Since the Fed identifies the exuberant stock market and spendthrift consumer with inflation-threatening economic growth, these reactions were hardly what Greenspan and his FOMC desired.
Besides, the FOMC’s press release after the meeting betrayed some lack of conviction about their resumed neutral bias:
“Owing to the uncertain resolution of the balance of conflicting forces in the economy going forward, the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action. [These days, this passes as cryptic Fed-ese for “neutral bias”]. The Committee, nevertheless, recognizes that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.”
The Fed seems worried that the inflation-daring pace of economic growth is mainly caused by overly exuberant consumption. Equally troubling is the spendthrift tendency that has consumers dipping into savings to finance a spending spree that exceeds current incomes. These spendthrift ways likely are related to the very strong labor and stock markets.
As for the labor market, it remained tight last month when the U.S. unemployment rate, at a mere 4.3 percent, stayed near generational lows. The bad news in the June employment release came with the big rise in hourly wages, up 0.4 percent over the past month, accelerating to a 3.7 percent rise over the past twelve. This indicator of wage inflation, closely watched by the Fed for signs of emergent wage-push inflation, is beginning to show worrisome signs. If and as wages accelerate further or productivity slows, the Fed will have a perfect excuse to tighten again.
Yet, current inflation gauges remain muted. Sharp downward reversals in oil product prices, contributed mightily to June’s flat consumer price inflation, cutting producer prices as well. Also, the “core CPI”, excluding energy and food price, showed minimal inflation in both May and June.
Of course, no one thinks that energy will deliver lower inflation this month and next. Quite the opposite: Crude oil prices are back toward $20/bbl. of late, engineered by production cuts of OPEC and friends. This means that the CPI and PPI will again be fighting against rising oil prices in the months ahead, which if accompanied by escalating labor costs, will easily push the CPI trend toward 2+ percent by year-end.
More pessimistic inflation news has been evident from the National Association of Purchasing Management. Its closely watched price index showed even more inflation last month, suggesting that pricing power is returning to the industrial sector.
As NAPM spokesman Norbert Ore put it, “I think we’re at the point where you have to start asking: ‘Are we running the risk of rising inflation?’ It is appropriate to ask this question about inflation, but at this point I don’t see it yet.”
But this may put the Fed on further alert, since they are in “preemptive mode”. As proven with last month’s tightening, the FOMC need not see actual current inflation before acting to raise rates in deference to its eventual emergence.
As for the stock market, it now faces our long-standing contention that profits would turn up this year after falling last year, the latter ignored by Wall Street. And recovering profits reflect the recovery in corporate “pricing power” that seems under way and may threaten the return of inflation.
But from the Fed’s perspective, increased corporate pricing power at once risks inflation and, through better profits, implies a better stock market. Both present the Fed with two strong temptations to raise rates further.
Most of all, the Fed must worry that the inflation-daring pace of economic growth is mainly caused by overly exuberant consumption. And exuberant consumption is enabled by the worsening habit of consumers to borrow with increasing abandon. In turn, liberalized willingness to borrow reflects great confidence in the economy, jobs, and especially the soaring values of their stock investments.
True, retail sales ground to a halt in June, providing some forecasters with “proof” that the slowdown is upon us and the Fed need not tighten further. But a closer look at recent consumption behavior shows, this will prove to be only a brief respite for the spendthrift consumer.
Accordingly, consumer spending was quite strong throughout last quarter, likely rising at a 5 percent real rate, and was “slow” only in comparison with the first quarter’s near-record 6.7 percent rise.
And it is not just the swift pace of consumption-lead growth that worries the Fed. Equally troubling is the spendthrift tendency that has consumers dipping into savings to finance their spending spree that exceeds current incomes.
The result has been a negative saving rate, a phenomenon not seen since the Great Depression, but now with obviously different implications. Some say not to worry about the negative saving rate, since consumers presumably have the wherewithal in income and real and financial assets to safely borrow and spend. But this phenomenon, which now continues into its third consecutive quarter, has reached quite remarkable proportions, descending a negative 1.2 percent of disposable income in May.
And the dollar value of dis-savings in May descended to a negative $77 billion, after spending the past twenty years in the positive range of $100 billion to $250 billion or higher! What is equally disturbing is the fact that the federal budget balance has only recently tilted into surplus during nearly the same period that consumer saving turned negative. Moreover, the latest rate of consumer dis-saving about equals the federal budget surplus, which has improved to nearly a $100 billion.
Is this really a case of “not to worry”? Consumers are now dis-saving at about the same rate the federal government is saving! The Fed seems concerned about this rampant borrow-and- behavior and has said so.
And where does this dis-saving show up? Well, it shows up as soaring credit demand. Consumers are borrowing like crazy, mentally pledging as “collateral” their soaring stock portfolios, appreciated home values, and consequent giddy levels of confidence. This has sent credit demand soaring. And all types of borrowings are engaged: first mortgages, home equity loans, stock margin accounts, and installment credit.
For instance, consider just installment credit, an important portion of consumer borrowing that includes loans for autos and other expenditures along with debit balances on credit cards and other general-purpose consumer loans: The pace of installment borrowing is again speeding up, after last year’s reprieve, to in excess of 7 percent growth. Moreover, this means that the level of installment credit is up by $90.3 billion over the twelve months ended May! And installment credit is just one of several means for consumers to borrow.
Besides, this pace far exceeds growth in personal income, which is running about 5 percent, or disposable income, which is running only 4+ percent. The fact that the 7 percent pace of installment borrowings far exceeds income gains means that the ratio of installment debt to income keeps rising.
And this ratio is a gauge of consumers’ ability to fund interest and installment paydowns to this debt: the higher it is, the worse off the borrower. Accordingly, the fact that this ratio keeps ascending to new record highs, to nearly 21+ percent is even more alarming.
And it should be no surprise that consequent credit quality, as gauged by payment delinquencies and bankruptcies, is deteriorating more than typically even in the aftermath of past recessions, although the economy continues very strong.
Accordingly, the Fed must be concerned that easily available credit is creating quite a ballooning of debt that could destabilize the economy. So, why do Wall Street pundits make light of the current spate of dis-saving and advise the Fed not to tighten credit any more? We leave you to answer that question.
Which brings us back to the stock market and our long-standing contention that profits would turn up this year after falling last year, the latter event having been ignored by Wall Street.
And the main factors spurring the profit turnaround are continued labor productivity and the gradual recovery in pricing power. Rising productivity has been blunting the rise in wages; a trend that continued last quarter when it rose 3+ percent, nearly offsetting a large 4.2 percent annualized increase in hourly labor compensation.
But there is no doubt that rising productivity is critical to the profit turnaround we expect, revised somewhat higher to show a 5.2 percent gain this year in after-tax profits and 6.1 percent in S&P-500 earnings per share.
But Fed officials, notably Chairman Greenspan, have also worried that those optimistic Wall Street earnings projections could only be met by a turnaround in corporate pricing power. And that would mean higher inflation.
Accordingly, we are of two minds about the return of pricing power that seems under way: To the good, it will contribute to stronger corporate profits this year; perhaps sufficiently to keep the stock market headed higher. To the bad, higher product prices mean higher inflation lies ahead and will likely mean at least another Fed tightening move in reaction.
Besides, insofar as the return of pricing power helps support stock prices, it ironically poses another challenge that the Fed wants to curtail. From the Fed’s perspective, increased pricing power at once risks inflation and, through better profits, implies a better stock market. Both present the Fed with two strong temptations to raise rates further.
Gary Ciminero is Economic Advisor, RI House Policy & Research Office. He writes regularly for this newspaper.
