Fed is Digging its Heel: Employment and Inflation

US February PMI index (61.4) continues showing strong economic growth in the US in February. New order, employment, and price paid are all up in February. This is not a surprise. So far, every regional economic activity indicator has shown significant increase in February. The Chicago Purchasing Managers Index for February exceeded expectations and was the highest headline reading since 1987. New York Fed Empire State Manufacturing Survey for February rose to 15.43 from 11.92 in January. Philadelphia Fed Business Outlook Survey for February spiked to 35.9 from 19.3 in January. Richmond Fed Manufacturing Survey for February was up to 25 from pervious 18. Dallas Fed Texas Manufacturing Outlook Survey increased by 9.5 points to 9.7 in February. The only negative shock recently is the spiking oil price due to conflicts in North Africa and Middle East. However, the shock in oil supply due to Libya's civil war looks to be temporary. When all major world powers reached an agreement to isolate Qaddafi, sanction him, and even oppose him militarily, it is just the matter of time that oil will flow again in Libya. And central bankers apparently think that the shock in inflation due to spiking oil prices will be short-lived as well. On February 28, William C. Dudley, President of New York Fed, said “…some of the recent commodity price pressures are likely to be temporary… commodities represent a relatively small share of the consumption basket… there has been very little evidence of commodity price pass-through into core inflation…” Bernanke also said the same thing on March 1, “…the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S.” When Federal Reserve Chairman and President of New York Fed have the same views, FOMC will follow. Their latest speeches just hammered home the message that Fed is determined to keep printing money as planned. Regarding QE2, Fed has bought $350 billion of Treasury bond since November 2010. If we count the divestment of MBS, the net increase of Treasury holding is $257 billion so far. Although it is clear that Fed is digging in its heel, investors may have a second thought on inflation and employment. Strong economic growth and loose Fed policy are not exactly news to investors and perhaps have already been factored in the price. Judged from the panic reactions after Presidents' Day in the market, investors clearly became more concerned about the gasoline price and its impact on headline inflation, which is dismissed by Fed. While oil supply could be recovered sooner, high oil prices may be more persistent than Fed thought. The simple principle in geopolitical events is that it only takes days to destroy a stable old system, but it will take years to rebuild a new one and make it run smoothly. Case in point: Iraq. Risk premium is simply much higher now than a month ago. And it is going to be higher in the foreseeable future. Regarding this Friday's employment number, employment outlook seemed to be bright for February. Survey results from the US ISM, Philadelphia, Dallas, and Richmond Fed districts also all showed improvements in number of workers employed in manufacturing industry. Only New York Fed Empire State Manufacturing Survey for February showed a slower pace of employment growth. There should be no doubt that the non-farm payroll number to be released this Friday is going to be much better than the 36k for January. The major excuse of disappointing employment figure in January is said to be the bad weather. If the unrealized employment gain in January is pushed to February, then this Friday's employment number should be “super good”, possibly much higher than 190k, the median forecast of 59 economists surveyed by Bloomberg News ahead of Labor Department data on March 4. The market expectation of monetary policy will shift if the employment gain is above estimation. The focus now is more and more on inflation. This Friday, good news on employment could be bad news for asset prices in short term. Medium to long term picture is more complicated. During the last recession, Fed cut the interest rate to 1% on June 25, 2003, the lowest level in that cycle. Monthly nonfarm employment growth bottomed out in September with a positive 103k and the unemployment rate at the time was 6.1%. From September 2003 to September 2006, monthly nonfarm employment change had been positive for 37 months in a row with an average monthly employment increase of 181k. Unemployment rate dropped 1.6% to 4.5% in September 2006. Fed began to exit from the extreme low rate on June 30, 2004 by raising 25 bps. From September 2003 to June 2004, the U.S. saw 10 months of employment growth with 162k per month. Today, half of the planned debt purchasing program has been implemented and unemployment rate is still at 9%. Given the severe unemployment situation now, if history is any guide, Fed is unlikely to achieve its goal after QE2 and will be forced to arrange new measures to keep its balance sheet from shrinking. As Dudley said in his speech, “Even if we were to generate growth of 300,000 jobs per month, we would still likely have considerable slack in the labor market at the end of 2012.”

By: Zhong Jin