Taking Away the Punchbowl

by Michael H. Strauss

Summary

• The 8.2 percent increase in real GDP in the third quarter is not just a sign of a short-term spike;underlying data portends a strong economic expansion for quarters to come
• It’s no longer just the consumer driving growth; business spending, industrial output, and employment continue to show positive signs
• The Fed should address its overly accommodative stance by mid 2004

The Thanksgiving celebration is over and our attention will quickly turn to the holiday shopping and parties that will consume the next four weeks. Lost in the hustle and bustle of the holiday shortened events last week was a deluge of strong economic data showing that we’re experiencing something that we haven’t seen in almost twenty years—a booming recovery. For the last several months the mantra of the Greenspan Fed has been that the Fed can keep an accommodative funds rate for a considerable period of time. Given the stream of strong data, the challenge for the Fed over the holiday season will be how to best prepare financial market participants for the likely change back to a neutral monetary policy stance.

In fact, the Greenspan Fed might be wise to take a lesson out of the Fed’s monetary policy history books by remembering the words of wisdom of former Fed Chairman William McChesney Martin, who ran our central bank for an unmatched 19 years from 1951 to 1970. Chairman Martin touted that a central banker’s duty is “to take away the punch bowl when the party gets going.”

Behind the Numbers
Real GDP growth in 2003:Q3 was revised upward from +7.2 percent to +8.2 percent, the fastest pace in two decades. Real consumption spending, which represents about 2/3rds of the economy, expanded 6.4 percent. Although the doom and gloom pundits focused on the temporary aspects of the auto-incentive induced 26.5 percent rise in durable good sales, general merchandise and clothing sales were strong as witnessed by the 7.6 percent gain in nondurable sales. The revised 18.4 percent gain in business equipment and software sales, up from a preliminary +15.4 percent reading, was especially impressive. Those touting the demise of the housing sector, following the back-up in mortgage rates at the start of the summer, missed the fact that residential investment outlays surged 22.8 percent in the July to September quarter. The gain in real GDP growth last quarter would have been even stronger if it were not for an unanticipated demand-induced depletion of inventories and a decline in defense spending. Moreover, a sharp upward revision to the durable goods report for September, which was released the day after the GDP statistics, suggests that the gain in real GDP growth could be revised to an even stronger increase when the final statistics are reported in late December.

Durable goods orders exploded 3.3 percent in October, after a revised 2.1 percent gain in September. This represented the largest gain since July 2002 and the fifth increase in the last six months, confirming that the demand for factory goods is back. Non-defense capital goods orders, often viewed by Fed officials as a proxy for business activity, rose 2.8 percent in October and are up almost eight percent since August. Similarly, the Chicago Purchasing Managers Index revealed a surge in factory activity in the Midwest as this index posted a 9.1 point increase to 64.1 in November, its largest increase since July 1983.

On the labor market front, initial unemployment claims dipped to just 351,000, reducing the four-week moving average to just 358,750, its lowest reading since February 2001. Similarly, the total people collecting unemployment benefits fell 105,000 to just 3.368 million, placing this reading more than 250,000 below its 2003:Q3 average. Although a grocery worker strike in California will constrain nonfarm payrolls in November, the reduction in unemployment claims implies that the unemployment rate is likely to fall below six percent over the next several months.

Personal income expanded 0.4 percent in October, representing a tie for its strongest monthly gain since June 2002. The solid growth in income, combined with the associated boost to the savings rate, improved consumer confidence and better labor market conditions, should provide the seeds for a strong Christmas sales season. In fact, Wal-Mart, the largest retailer in the U.S., reported a record $1.52 billion in sales on “black Friday”, a 6.3 percent increase over its year ago reading, showing the holiday sales season has gotten off to a solid start.

Is Inflation a Risk?
On balance, the reports showed that the U.S. economy appears on track for strong real GDP growth for the next several quarters. However, in contrast to the recent appeasing comments by a variety of Fed officials, moderate inflation pressures have now surfaced.

Caution flags are brewing that the best of the inflation news is behind us. Last week’s data confirmed that the GDP price deflator rose to a 1.7 percent pace in 2003:Q3, up from a 1.0 percent rate in 2003:Q2. Although this is still a low inflation reading, when combined with the surge in real GDP growth, it shows that the Fed funds rate of one percent is overly accommodative. The 2.3 percent increase in the personal consumption deflator is also troubling. Moreover, the spread between the year-over-year growth rate in nominal GDP and the Fed funds rate has now increased to 430 basis points, its widest, most stimulative reading in almost twenty-five years. On the factory front, the price component of the Chicago Purchasing Managers Index surged from 61.5 in October to 67.3 in November, its highest reading since July 2000 as well as an almost 18 point increase since June 2003. These higher input costs, combined with potential price pressures stemming from the continued drop in the value of the dollar are warning signs. Finally, the Fed’s Beige book survey of regional economic conditions suggests that the inflation story is changing as that report captured business input cost pressures, commodity price increases, and escalating health care costs.

The Market Response
These stronger economic readings appropriately placed upward pressure on Treasury interest rates, with the short end of the curve registering the greatest relative increase. As we have stated on several past occasions, we feel that this back-up in market interest rates is likely to continue as bond market participants adjust to the strength of the recovery and anticipate the eventual ending of the aggressively accommodative monetary policy associated with the current one percent Fed funds rate. The continued decline in the trade-weight value of the dollar, including new record lows for the greenback against the Euro, is likely to raise the price of many foreign goods. Several Fed members are likely to recognize that the risk for moderate inflation is at least equal, if not greater, than the risk for deflation as the inflation pendulum has swung.

As for the equity market, several pundits have voiced concern that U.S. equities are priced for perfection. The 8.2 percent rise in the latest real GDP reading and the associated more than 20 percent rise in corporate profits show that we’ve gotten A+ news. Moreover, the year-over-year earnings growth could accelerate to 25 percent in the final quarter of 2003. Nonetheless, the more than eight percent surge in real GDP growth is not sustainable. The growth rate in corporate earnings will decelerate in 2004. Net, despite the current euphoria we look for total domestic equity returns to register single-digit gains next year. However, if the Fed remains on the sidelines too long and price pressures mount at an accelerating pace, 2004 could be a challenging period for both stocks and bonds.

As we continue the celebration for the upcoming holidays, we should remember that moderation is important. Hopefully, our monetary policy leaders at the Fed, like those of us that will be hosts at upcoming parties, can remember to take away the punch bowl before it’s too late.