Insight Line—April 16, 2007

It seems to me that, given the current environment, the rate of inflation should be higher—but it isn’t. Why? Well, let’s just blame it on Bernanke’s (Federal Reserve Board Chairman Ben S. Bernanke) conundrum.

If all of this sounds somewhat familiar, it is. With some liberties, it essentially echoes the “Greenspan conundrum,” which officially entered the lexicon when former Federal Reserve Board Chairman Alan Greenspan publicly described the unexpectedly low level of long-term interest rates, despite rising short-term rates, as a conundrum.¹

Although a conundrum has only a conjectural answer, Dr. Greenspan’s utterance set in motion a proverbial landslide of explanations—debated to this day—from academia and Wall Street on his conundrum’s most likely cause. Even Dr. Bernanke, then a member of the Federal Reserve Board of Governors (the Board), weighed in, citing a global savings glut as a possible logical rationale (though not the definitive answer).² Two years later, I suggest a case exists that Chairman Bernanke might be facing a conundrum of his own.

By all appearances inflation is not behaving the way it should. The current behavior of observed inflation is not necessarily bad, it’s just not what the Board members, the economic staffs of the Federal Reserve Bank (the Fed) and its branches, nor students of economic analysis would have expected under the current set of circumstances. That is, if history is to be any guide.

Currently, commodity prices around the world are pushing to record levels, employment gains strain the edges of capacity and employment costs are accelerating. All of which, at one point or another in history, has held sway as the mostly likely cause for rising inflationary pressures. Yet the Fed’s preferred measure of inflation, the Core Personal Consumption Expenditures (ex-food and energy), rests closer to the lower end of its historical range than the upper end (see chart).³

Additionally, the “stickiness” of inflationary events— that is, how likely short-term inflation pressures persist into the long-term, as measured by the inflation persistence coefficient (see chart)—rests within striking distance of its multi-year low.⁴ Simply put, inflationary events don’t seem to be having the impact they once did.

Inflation Persistence Coefficient*

At this point, those schooled in the monetarist doctrine that inflation is always and everywhere a monetary phenomenon may tend to discount my reasoning. However, in that the Federal Open Market Committee no longer targets money supply growth as integral to their policy directives, I am skeptical, though respectful, that well-behaved monetary aggregates and central bank policy deserve disproportionate credit.

Unlike his predecessor’s public admission as to the inexplicability of his conundrum, I believe Dr. Bernanke more than likely will not publicly acknowledge the existence of an inflation conundrum. After all, that would be very un-central bankerish.

Nevertheless, I suggest Dr. Bernanke’s recent speech on globalization’s effect on inflationary trends was more than the typical economic analysis common to such speeches. In essence, the remarks allowed investors to eavesdrop on Dr. Bernanke’s conversation with himself on the merits of globalization as a logical reason underlying the subdued inflationary trends in the U.S.⁵ He concluded in a very conundrum type of way, “However, effective monetary policy making now requires taking into account a diverse set of global influences, many of which are not yet fully understood.”⁶

Simply put, as I see it, globalization changes everything—maybe even the dynamics of inflation. Let me welcome you to Dr. Bernanke’s conundrum.

¹ Testimony of Chairman Alan Greenspan, Federal Reserve Board’s semiannual Monetary Policy Report to Congress, before the committee on Banking, Housing and Urban Affairs, U.S. Senate, February 16, 2005.

² ”The Global Savings Glut and the U.S. Current Account Deficit,” remarks by Governor Ben S. Bernanke, at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10, 2005.

³ Source: Ned Davis Research Inc., Chart E707B, Core PCE monthly data annualized rate of change 01/1960- 02/2007, ©2007.

⁴ “Is Inflation Changing its Ways?” by Charles Carlstrom and Bethany Tinlin, Economic Trends, Federal Reserve Bank of Cleveland, March 7, 2007, page 3.

⁵ “Globalization and Monetary Policy,” remarks by Chairman Ben S. Bernanke at the Fourth Economic Summit, Stanford Institute for Economic Policy Research, Stanford University, Stanford, California, March 2, 2007.

⁶ Bernanke, “Globalization and Monetary Policy,” page 9.
 

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 4/13/07)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

March employment data contained a few pleasant surprises. Rebounding from the weather-affected revised February data, both measures of employment moved, once again, to record levels. Total household employment registered an impressive gain of 335,000, pushing the total to 146.25 million workers and the employment rate up to 95.6 percent. Payroll employment added a larger than forecast 180,000 workers. Total payroll employment is now a record 137.6 million workers. The overall data, including hours worked and wages earned suggests the consumer continuing to be a driving force for economic growth in the first and second quarters of the year. As such, I suggest the appropriate action on the table is to circle UP.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

Personal Income growth in February 2007 registered a surprisingly strong 0.6 percent increase. Wage and salary levels moved up to a record $6.24 trillion. The personal income data continues to suggest wage and salary growth are sufficiently strong to offset any shortfall in corporate capital spending. Please circle Up on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The nation’s measure of retail sales activity in March 2007 will be somewhat misleading due to a massive data revision. February’s original total of $370.5 billion is now $367.5 billion. Additionally, the growth in year-over-year totals, a good measure of momentum, rests just above multi-year lows. As such, I suggest the appropriate action is to circle Down on the table.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

New orders for durable goods, heavily influenced by swings in net aircraft orders, registered a less than forecast bounce-back of only 1 percent from the depressed January data. The all-important shipments data did little to brighten the picture. Slipping 0.5 percent for a second consecutive monthly drop, all but assures that the first quarter’s measure of the gross domestic product (GDP) will struggle to exceed 2 percent. That being said, aircraft orders continue to support the unfilled order book at record levels.
In light of the above commentary the appropriate action on the table, I believe, is circle Down.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex-food and energy price changes, at 2.4 percent year-over-year is only slightly above that forecast by Federal Reserve Chairman Ben S. Bernanke for all of 2007 during his Monetary Policy Report to Congress on February 14, 2007. That being said, Federal Reserve Board members along with Federal Reserve District Bank presidents continue suggesting inflation as their primary concern. Therefore, to reflect this heightened awareness I suggest the appropriate circle to remain High.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The most recently released monthly statement from the U.S. Treasury reports some sobering numbers, if viewed in isolation. The federal government ran a budget deficit for February 2007 of $120 billion, a record for the month. Yet for the first five months of the fiscal year, which began October 1, 2006, the Treasury estimates the federal budget deficit running 25.5 percent below a comparable point last year. Simply put, if the trend, identified in the Factors update months ago remains, the federal budget deficit will more than likely fall when expressed in percentage terms to the overall economy from that recorded in fiscal 2006. I suggest circling $IN on the table.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The Federal Reserve Open Market Committee continues to set the overnight inter-bank lending rate at 5.25 percent. In that the Committee convenes its next meeting on May 9, 2007, incoming data will play an important role. That being said, the adoption of a neutral policy directive at the March 20-21 meeting confirms our March action of moving the circle from $Out to $In. However, neutral is not an ease and as such investor expectations on the next move from the Committee are truly data dependent. Stronger than forecast data moves sentiment away from any policy actions, while weaker than forecast economic data moves consensus toward policy actions at the May or June meeting. In that the Committee chose to remove the tightening bias, I suggest the appropriate action on the table is to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was -27 basis points on April 13, 2007. The inversion in the most popular measure of the yield curve, the discount yield on 90-day U.S. Treasury bills and 10-year U.S. Treasury notes, remains a point of observation but has yet to reach the point where odds of a recession in the coming year move beyond a 50 percent probability. As a cross check, my read of corporate credit spreads does not suggest new levels of financial stress, usually evident prior to recessionary periods. Please continue to circle Negative.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

Though I have no certainty of knowledge, I believe anecdotal evidence on inventory, consumption and net exports suggests that economic growth in the first quarter of 2007 is not expanding meaningfully from the 2.5 percent annualized rate recorded in the fourth quarter of 2006. Granted, weather is playing a disproportionate role in the observed data, but I sense it is not sufficient enough to argue for a dramatic rebound into the second quarter. In that trend real GDP growth over the last five decades has centered around 3.3 percent I continue positioning the appropriate circle as Below.

Summary

Factors Driving The Economy

Economic Acceleration

Economic Deceleration

Employment

Up

Personal Income

Up

Retail Sales

Down

Durable Goods

Down

Inflation

High

Government Spending

$In

Monetary Policy

$In

Yield Curve

Negative

Gross Domestic Product

Below