New Data puts Question to New Economy: Is Inflation a Threat?

Inflation fears slam stock prices
On Monday stock prices tumbled sharply, then drifted lower through the week, only to plunge further on Friday. Inflation fears haunted market players all week. Fed chairman Alan Greenspan was supposed to testify before the Senate Budget Committee on Tuesday morning, but Washington D.C. suffered a snow blowout. All government offices were closed on Tuesday and Wednesday. Greenspan did testify before the Senate Banking Committee on Wednesday afternoon, but everyone knew that would have to be a lovefest given its nature – a reconfirmation hearing. Greenspan wasn’t about to mention monetary policy then – and so close to the FOMC meeting anyway. Market players were thus disappointed, at least at midweek, about the lack of real news. Furthermore, the Labor Department had to postpone the all-important employment cost index by a day. When GDP figures showed a booming economy with accelerating inflation and the employment cost index showed an upward drift in compensation costs, bond and stock prices were bound to tumble.

The most interesting part of January’s market movement is that all major indices except the Russell 2000 are below year end levels. How ironic that only this small-cap sector, which lagged far into 1999, would be the least to suffer in the new year. But perhaps it reflects the fact that this is one sector that wasn’t overbought last year. All those value investors in the small-cap sector may now feel some relief.

Note of interest: The Dow Industrials are at their lowest level since November 11, 1999; the S&P 500 is at its lowest level since December 1, 1999; the Russell 2000 despite its relative strength is at its lowest level since January 10, 2000; and the Nasdaq composite stands at its lowest level since January 12, 2000.

Inverted yield curve
Generally one can talk about the direction of interest rates. Short term rates and long term rates don’t always move by the same magnitude, but short term rates are usually lower than long term rates and a normal yield curve has a positive slope. Life has changed these days. First of all, the yield on the 30-year bond fell below the yield on the 10-year note last week. Basically, the Treasury buyback program, which should begin within the next couple of months, has caused a run-up in prices of 30-year bonds – particularly off-the-run bonds (an off-the-run would be a 30-year bond with a remaining maturity of 25 to 28 years for instance). The increased demand for 30-year bonds comes from the fact that the upcoming supply of these bonds will be reduced. As a result, this raises the price and lowers the yield.

The inversion of the yield curve reached new depths on Friday. Not only did interest yields surge this morning on the bearish GDP and ECI reports, but technical players in the hedge fund market seemed to create a variety of strange occurrences in yield spreads -- between short and long term securities, between short and intermediate securities, and between intermediate and long term.

What’s the upshot of it all? Basically, the yield on the 2-year note is higher than the yield on the 30-year bond! Historically, an inverted yield curve like this would be a sign that the economy was poised for slowdown – or even recession. In this case, the 30-year bond yield is artificially depressed because of changes in Treasury borrowing policy. It is certainly too soon to tell, but the 10-year bond may become a more important benchmark going forward.

To top off the insanity in today’s markets, the tumble in the stock market caused some flight-to-quality buying in the bond market as investors sold stocks for Treasuries. In addition, the drop in the value of the euro (relative to the dollar) added more foreign investors as well. (For more discussion on the euro, see International Perspectives.)

Markets at a Glance

(BP = basis points; stock price indices are rounded)

Employment cost index disappoints
The employment cost index rose 1.1 percent in the fourth quarter of 1999 after posting a more moderate 0.8 percent gain in the three months ending September. Wages and salaries grew 0.9 percent in both quarters, but the benefit cost component jumped 1.3 percent in the year’s final quarter, much more rapidly than the previous three quarters of the year.

The quarterly pattern of changes in each of these components is quite jagged. The largest quarterly gain for wages and salaries was posted in the second quarter, while benefit costs grew most rapidly in the fourth quarter. Total compensation increased more in the second and fourth quarters relative to the first and third. This gives somewhat of a misleading picture of changing compensation costs. As a result, it is more worthwhile to look at the 12-month change in this series. In this case, the employment cost index rose 3.4 percent in December relative to a year earlier – its largest gain since the prior December. Total wages and salaries grew 3.5 percent in December relative to last year, but posted a larger gain in June. The 3.3 percent yearly rise in benefit costs was the largest in five years.

According to the Labor Department, benefit costs were boosted primarily by three factors: Health care costs accelerated; Sign-on bonuses picked up steam (perhaps in lieu of higher wages); and employees benefited from more paid-leave during the quarter.

The yearly distribution of the employment cost index shows somewhat of a different pattern than the quarterly changes. The employment cost index rose 3.4 percent in both 1998 and 1999. This is only marginally higher than the 3.3 percent increase for 1997. Gains were at 3 percent or less from 1994 to 1996. Wages and salaries peaked in 1997 with an annual gain of 3.8 percent, but moderated in both 1998 and 1999 despite tight labor markets. Workers may have opted to get better benefits packages. Indeed, benefit costs bottomed out in 1996 with a 2 percent hike, and increased steadily through 1999 when they rose 3.3 percent. While sign-on bonuses and more paid-leave are desirable outcomes for employees, one can’t say that the higher health care costs are due to tight labor markets.

The bottom-line on compensation costs? Even with the recent uptick in the employment cost index and its components, there is no question that the overall increases remained subdued despite a period of healthy labor demand and a robust economy. In the past several years, economists and policy-makers including the Federal Reserve Chairman have pondered the question of the relatively undemanding labor force. The tight labor markets – where the unemployment rate reached 4.1 percent by the end of 1999 – surely should have caused employees to demand higher wages. In the mid-1990s, Greenspan posited that workforce demands remained quiescent because the downsizing of the early 1990s traumatized workers and fears of layoffs kept workers in their place. Most economists who study the process of inflationary pressures noted that higher wages don’t necessarily create inflation. Perhaps workers didn’t demand wage gains because consumer prices were subdued and they didn’t feel worse off over time.

Though wage gains were marginally higher and benefit costs jumped, these are still a small portion of the employer’s compensation bill. Yet, policymakers at the Federal Reserve will be able to point to the ECI as a good reason why they need to raise rates at the February meeting next week. Some financial market participants may wonder whether the Fed will immediately raise the federal funds rate target by 50 basis points instead of the 25 basis point incremental increases used in the past several years. It is more likely that the Fed will institute more than one rate hike in rapid succession than 50 points all at once. The next FOMC meeting is on March 21.

Red hot economy
Real GDP expanded at a whopping 5.8 percent rate in the fourth quarter just about the same pace as the boiling third quarter. This just about matched the 5.9 percent rate recorded in 1998’s final quarter. As usual, the consumer sector made a major contribution to this robust pace. Personal consumption expenditures grew at a 5.3 percent rate, the fastest growth since the first quarter. To add insult to injury, spending on durable goods zoomed even after the Fed raised interest rates three times last year in order to stem spending on interest-sensitive sectors.

Buy some interest-sensitive sectors did stall. Residential investment expenditures fell 3.8 percent in the third quarter and a further 1.2 percent in the fourth. This reflects the slower pace of housing construction. Remember that "slower" is a relative term, because the housing market is still booming by historical standards.

Nonresidential investment spending also decreased for the fourth straight quarter. Clearly, this sector peaked even before the Fed began its round of credit tightening. Yet, capital spending on equipment and software continued to grow, albeit more slowly, in the fourth quarter.

Net exports deteriorated further in the fourth quarter as the 10.6 percent rise in imports surpassed the 6.9 percent gain in exports. Export demand picked up in 1999, though after anemic demand the previous year. The drag from the foreign sector was almost a blessing in disguise as import demand satisfied consumer and business demands.

Government purchases on consumption and investment surged at an 8.4 percent rate. Gains were across the board, although federal defense expenditures posted strong double-digit gains in both the third and fourth quarters. One has to believe that a good portion of the government expenditures came in response to the required compliance for Y2K.

While Federal Reserve policymakers have pretty much conceded that the economy can now grow faster than "the old days" without generating inflationary pressures, they are referring to a 3 percent pace – not twice that fast. Anxiety over the fourth quarter growth rate had to be heightened by the 2 percent rise in the GDP deflator. This matched the first quarter rate which was also boosted by higher energy prices. But looking at the chart above, it is evident that the quarterly growth in the deflator was higher in 1999 than in 1998.

The bottom-line on economic activity? The economy is sizzling, no doubt about it. Early last year economists were predicting that inventory building would boost growth in the second half of the year, but these inventories would be run down in early 2000 as Y2K worries disappeared. But according to anecdotal evidence, inventory building in the second half of 1999 was not due to worries about disruption coming from Y2K. Moreover, final sales, a measure of domestic demand, grew rapidly. The chart above shows growth in real GDP and real final sales over the past five years on a fourth-to-fourth quarter basis. Notice that final sales grew more rapidly than real GDP in both 1998 and 1999. This is scary! It could mean that it will take a bigger push on the part of the Fed to cool down this economy. (Read: higher interest rates)

Durable goods point to increased production in first half of 2000
New orders for manufacturers’ durable goods jumped 4.1 percent in December after a more moderate 1 percent hike in November. The volatile transportation (more specifically, aircraft) was largely behind the spurt. Excluding transportation, orders rose a modest 0.7 percent in December, less than the 2.5 percent gain recorded in the previous month.

It is useful to remove aircraft orders from one month to the next in order to see the pattern of the underlying durable goods data. However, aircraft orders are a major source of production and should not be discounted entirely. On a longer term basis, it is never a good idea to remove all the special factors. After all, what’s left?

Despite the December spurt in total new orders – and nondefense capital goods orders – the quarterly growth in this sector was meager as indicated by the chart below. But given the inherent volatility of durable goods, it is useful to take a longer term perspective of the pattern set in the chart below. Notice that the increases have outpaced the declines in the past eighteen months. Moreover, given the pattern set below, one would have expected a drop in orders in the fourth quarter. The fact that they rose even the slightest bit reflects more inherent strength in the series.

We like to look at unfilled orders as well as new orders. This series is much less volatile on a monthly basis – and also revised by smaller magnitudes. In essence, the series gives a much better reading of future production schedules. (By the way, Greenspan also prefers unfilled to new orders.) Note how unfilled orders bottomed out in late 1998 and have steadily increased in 1999. This upward trend certainly signals gains in production over the next few months.

The bottom-line on durable goods? Durable goods are highly volatile, but longer term trends show that the manufacturing sector is reflecting more strength, rather than less. The acceleration in unfilled orders coupled with the overall gains in new orders point to a pick up in industrial production in the next few months. This may be another nail in the coffin for a succession of rate hikes beginning next week.

The Bottom Line
Snowstorms on the east coast – and specifically Washington D.C. – set market participants on edge this week. They cancelled an appearance by Greenspan and caused government offices to close for two straight days. The employment cost index was delayed until Friday and reported with the GDP figures instead of a day earlier. Given that both figures were generally bearish with respect to the financial markets, it makes one wonder whether the news would have caused bond prices to drop more dramatically over a two-day period than the impact on Friday on alone.

In any case, the week’s data supports the view (already in the market for weeks) that the Fed is likely to tighten monetary policy by raising the federal funds rate target by 25 basis points. Most economists don’t believe that the data warrant a 50 basis point hike immediately. But many expect that the February rate hike could easily be followed by another 25 basis point increase at the FOMC meeting on March 21.

One prominent Wall Street economist suggested that the Fed might raise the discount rate by 25 basis points on February 2, in addition to the fed funds rate. The discount rate used to be considered another method in which the Fed could tighten policy. It offers little meaning these days. Some economists believe that the Fed changes the discount rate with the fed funds rate when they want to put an exclamation point on the deal. Whether they raise the discount rate or not next Wednesday won’t change the impact of a rate hike on consumers and businesses. Also, it won’t really reveal whether the Fed will be inclined to augment rates in rapid succession over the next few months.

Market participants will be very anxious to see how the Fed uses its new announcement policy. What statements will come forward with the announcement of the 25 basis point hike? Will it be less obscure than the old bias? Only time will tell.

Looking Ahead: Week of January 31 to February 4
Market News International compiles this market consensus which surveys about 25 economists every week.

Monday
Market players are looking for personal income to post an increase of 0.4 percent for December. This would match the November gain and would reflect the healthy showing in employment and earnings. At the same time, personal consumption expenditures are expected to jump 0.8 percent for the month. This would roughly double the November growth rate.

The Chicago Purchasing Managers’ index is expected decrease in January to 55 percent from December’s level of 56 percent. This still reflects healthy manufacturing activity in the Chicago region. Market players will also keep a close watch on the prices paid component, which stood at 67.7 in December.

Tuesday
The market consensus points to a drop in the NAPM Survey to 56.3 in January from a level of 56.8 in December. Once again, market players will also look closely at the prices paid component, which had edged up to 68.3 in December.

Construction expenditures are expected to remain unchanged in December, following a 2.6 percent spurt in November. Nonresidential construction expenditures are edging lower, but there is still life in the residential housing market.

FOMC Meeting – Day 1. No actions today.

Wednesday
The market consensus shows the index of leading indicators will record a gain of 0.4 percent in December, a bit higher than the November rise. This index reveals no pattern of uninterrupted growth in the economy.

FOMC Meeting – Day 2. 25 basis point rate hike expected.

New home sales are expected to rise 2.9 percent in December to a 890,000-unit rate. Sales had plunged 7.1 percent in November offsetting an October spurt. On the whole, housing activity moderated in the second half of 1999 relative to the first half of the year.

Thursday
Market participants are expecting new jobless claims to increase 4,000 in the week ended January 29 from last week's 266,000. Claims fluctuate more wildly during the holidays – and the holidays last through Presidents’ Day in February!

Factory orders should record a gain of 2.5 percent in December after rising 1.2 percent in November. This incorporates the 4.1 percent spurt in last week’s durable goods figures where a surge in aircraft helped propel the total.

Friday
Economists are predicting that nonfarm payrolls will rise 2505,000 in January, a solid pace but slower than the 315,000 gain posted in December. The civilian unemployment rate is expected to come in 4 percent, a downtick of 0.1 percentage points from last month. Average hourly earnings should rise 0.3 percent, less than last month’s 0.4 percent hike. If realized, it would mean a 3.1 percent year-over-year gain – down sharply from last month’s 3.7 percent yearly rise. Finally, the average workweek is expected to remain unchanged at 34.5 hours.