Fed Minutes Part 2 by Phil:
Staff Economic Outlook
In the forecast prepared for the December FOMC meeting, the staff raised its projection for average real GDP growth in the second half of 2009 somewhat, and it also modestly increased its forecast for economic growth in 2010 and 2011. Better-than-expected data on employment, consumer spending, home sales, and industrial production received during the intermeeting period pointed to a somewhat stronger increase in real GDP in the current quarter than had previously been projected. In addition, the positive signal from the incoming data, along with the sizable upward revisions to household income in earlier quarters and more supportive financial market conditions, led to small upward adjustments to projected growth in real GDP over the rest of the forecast period. The staff again anticipated that the recovery would strengthen in 2010 and 2011, supported by further improvement in financial conditions and household balance sheets, continued recovery in the housing sector, growing household and business confidence, and accommodative monetary policy, even as the impetus to real activity from fiscal policy diminished. However, the projected pace of real output growth in 2010 and 2011 was expected to exceed that of potential output by only enough to produce a very gradual reduction in economic slack.The staff forecast for inflation was nearly unchanged. The staff interpreted the increases in prices of energy and nonmarket services that recently boosted consumer price inflation as largely transitory. Although the projected degree of slack in resource utilization over the next two years was a little lower than shown in the previous staff forecast, it was still quite substantial. Thus, the staff continued to project that core inflation would slow somewhat from its current pace over the next two years. Moreover, the staff expected that headline consumer price inflation would decline to about the same rate as core inflation in 2010 and 2011.
Oil, nat gas and copper are up 20% since the staff determined consumer price inflation was "transitory."
Participants’ Views on Current Conditions and the Economic Outlook
In their discussion of the economic situation and outlook, meeting participants agreed that the incoming data and information received from business contacts suggested that economic growth was strengthening in the fourth quarter, that firms were reducing payrolls at a less rapid pace, and that downside risks to the outlook for economic growth had diminished a bit further. Although some of the recent data had been better than anticipated, most participants saw the incoming information as broadly in line with the projections for moderate growth and subdued inflation in 2010 that they had submitted just before the Committee’s November 3-4 meeting; accordingly, their views on the economic outlook had not changed appreciably. Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion would imply slow improvement in the labor market next year, with unemployment declining only gradually. Participants agreed that underlying inflation currently was subdued and was likely to remain so for some time. Some noted the risk that, over the next couple of years, inflation could edge further below the rates they judged most consistent with the Federal Reserve’s dual mandate for maximum employment and price stability; others saw inflation risks as tilted toward the upside in the medium term.A number of factors were expected to support near-term expansion in economic activity. Consumer spending appeared to be on a moderately rising trend, reflecting gains in after-tax income and wealth this year. Recent upward revisions to official estimates of the level of household income in recent quarters gave participants somewhat greater confidence that consumer spending would continue to expand. The housing sector showed continuing signs of improvement, though housing starts had leveled out after increasing earlier in the year and activity remained quite low. Businesses seemed to be reducing the pace of inventory reductions. The outlook for growth abroad had improved since earlier in the year, auguring well for U.S. exports. In addition, financial market conditions generally had become more supportive of economic growth. While these developments were positive, participants noted several factors that likely would continue to restrain the expansion in economic activity. Business contacts again emphasized they would be cautious in adding to payrolls and capital spending, even as demand for their products increases. Conditions in the commercial real estate (CRE) sector were still deteriorating. Bank credit had contracted further, and with many banks facing continuing loan losses, tight bank credit could continue to weigh on the spending of some households and businesses. Some participants remained concerned about the economy’s ability to generate a self-sustaining recovery without government support. In particular, they noted the risk that improvements in the housing sector might be undercut next year as the Federal Reserve’s purchases of MBS wind down, the homebuyer tax credits expire, and foreclosures and distress sales continue. Though the near-term outlook remains uncertain, participants generally thought the most likely outcome was that economic growth would gradually strengthen over the next two years as financial conditions improved further, leading to more-substantial increases in resource utilization.
Financial market conditions were generally regarded as having become more supportive of continued economic recovery during the intermeeting period: Equity prices rose further, private credit spreads narrowed somewhat, and financial markets generally continued to function significantly better than early in the year. Participants noted, however, that securitization markets were still substantially impaired. In general, U.S. asset values did not seem out of line with improving fundamentals. While investors evidently had become less cautious and more willing to bear risk, they appeared to be discriminating among risky assets. Banks were raising new capital and in some cases paying back funds received from the Troubled Asset Relief Program. Bank loans, however, continued to contract sharply in all categories, reflecting lack of demand, deterioration in potential borrowers’ credit quality, uncertainty about the economic outlook, and banks’ concerns about their own capital positions. With rising levels of nonperforming loans expected to be a continuing source of stress, and with many regional and small banks vulnerable to the deteriorating performance of CRE loans, bank lending terms and standards were seen as likely to remain tight. Participants again noted the contrast between large and small firms’ access to financing. Large firms that can issue debt in the markets appeared to have relatively little difficulty obtaining credit. In contrast, smaller firms, which tend to be more dependent on commercial banks for financing, reportedly faced substantial constraints in gaining access to credit. While survey evidence suggested that small businesses considered weak demand to be a larger problem than access to credit, participants saw limited credit availability as a potential constraint on future investment and hiring by small businesses, which normally are a significant source of employment growth in recoveries.
So this is GOOD news for the market because small firms are being wiped out as the rich (large firms) get richer. This is just another verision of the Tale of Two Economies playing out but this one is good for stocks and the top 10% who invest in them while the middle class and small, non-public businesses with limited access to capital join the bread line with their former employees.
The weakness in labor markets continued to be an important concern to meeting participants, who generally expected unemployment to remain elevated for quite some time. The unemployment rate was not the only indicator pointing to substantial slack in labor markets: The employment-to-population ratio had fallen to a 25-year low, and aggregate hours of production workers had dropped more than during the 1981-82 recession. Although the November employment report was considerably better than anticipated, several participants observed that more than one good report would be needed to provide convincing evidence of recovery in the labor market. Participants also noted that the slowing pace of employment declines mainly reflected a diminished pace of layoffs; few firms were hiring. Moreover, the unusually large fraction of those individuals with jobs who were working part time for economic reasons, as well as the uncommonly low level of the average workweek, pointed to only a gradual decline in unemployment as the economic recovery proceeded. Indeed, many business contacts again reported that they would be cautious in their hiring, saying they expected to meet any near-term increase in demand by raising their existing employees’ hours and boosting productivity, thus delaying the need to add employees. The necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, also could limit the pace of employment gains. Nonetheless, the reported rise in employment of temporary workers in recent months could presage a broader increase in job growth and thus was a welcome development.
The prognosis for labor markets remained an important factor in the outlook for consumer spending. Recent data on household expenditures were encouraging. Retail sales increased, spurred by price discounting. The Bureau of Economic Analysis revised up its estimates of the level of real disposable income–and thus of the personal saving rate–in the second and third quarters of this year. Those revisions, along with recent gains in equity prices, suggested a smaller probability that households would reduce spending to rebuild their savings more rapidly. However, uncertain job prospects, modest growth in real incomes, tight credit, and wealth levels that remained relatively low despite this year’s rise in equity prices and stabilization in house prices were seen as likely to weigh on consumer confidence and the growth of consumer spending for some time to come. Anecdotal evidence on consumer spending in this year’s holiday season was mixed.
Participants noted that firms had made substantial progress in reducing inventories toward desired levels and were cutting stocks at a slower pace than earlier in the year. This adjustment likely was making an important contribution to economic growth in the fourth quarter, and participants expected that it would do so into 2010 as well. The combination of rising consumer spending, slower destocking, and rising goods production was reflected in reports from major transportation companies that shipping volumes were up.
Investment in equipment and software appeared to have stabilized, and recent data on new orders continued to point to some pickup next year. Even so, many participants expressed the view that cautious business sentiment, together with low industrial utilization rates, was likely to keep new capital spending subdued until firms became more confident about the durability of increases in demand. Many also noted widespread reports from business contacts that uncertainties about health-care, tax, and environmental policies were adding to businesses’ reluctance to commit to higher capital spending. CRE activity continued to fall markedly in most parts of the country as a result of deteriorating fundamentals, including declining occupancy and rental rates, and very tight credit conditions. Prospects for nonresidential construction remained weak.
In the residential real estate sector, home sales and construction had risen relative to the very low levels reported in the spring; moreover, house prices appeared to be stabilizing and in some areas had reportedly moved higher. Generally, the outlook was for gains in housing activity to continue. However, some participants still viewed the improved outlook as quite tentative and again pointed to potential sources of softness, including the termination next year of the temporary tax credits for homebuyers and the downward pressure that further increases in foreclosures could put on house prices. Moreover, mortgage markets could come under pressure as the Federal Reserve’s agency MBS purchases wind down.
Stronger foreign economic activity, especially in the emerging market economies in Asia, as well as the partial reversal this year of the dollar’s appreciation during the latter part of 2008, was providing further support to U.S. exports, including agricultural exports. Further improvements in foreign economies would likely buoy U.S. exports going forward, but import growth would also strengthen as the recovery took hold in the United States. Participants noted that any tendency for dollar depreciation to put significant upward pressure on inflation would bear close watching.
Most participants anticipated that substantial slack in labor and product markets, along with well-anchored inflation expectations, would keep inflation subdued in the near term, although they had differing views as to the relative importance of those two factors. The decelerations in wages and unit labor costs this year, and the accompanying deceleration in marginal costs, were cited as factors putting downward pressure on inflation. Moreover, anecdotal evidence suggested that most firms had little ability to raise their prices in the current economic environment. Some participants noted, however, that rising prices of oil and other commodities, along with increases in import prices, could boost inflation pressures going forward. Overall, many participants viewed the risks to their inflation outlooks as being roughly balanced. Some saw inflation risks as tilted to the downside, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, a few participants noted that banks might seek, as the economy improves, to reduce their excess reserves quickly and substantially by purchasing securities or by easing credit standards and expanding their lending. A rapid shift, if not offset by Federal Reserve actions, could give excessive impetus to spending and potentially result in expected and actual inflation higher than would be consistent with price stability. To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.
There’s plenty of nice-sounding items for the bulls to point to but is this really the report of a market that’s going to retake the 2007 highs 25% from now? The Fed is blind towards rampant commodity inflation and not one thing I read here regarding CRE is positive.
Small companies are being squeezed out by big ones, people are losing their good jobs and taking crap ones and we’re counting on the rising Chinese middle class to create demand for the food our old American middle class can no longer afford – what can go wrong?
Another silly run-up while I was writing this up but once the big boys get back from theri meetings we should get an end of day sell-off. Just another day of churning into a flatline – just as we predicted we’d get on Monday…
– Phil
