Tuesday, August 28, 2007

Fed Minutes

The Fed released the minutes of the August 7 meeting. Because the Fed's perception of the economy is so incredibly important right now, let's take a detailed look at what the Fed is seeing.

The information reviewed at the August meeting suggested that economic activity picked up in the second quarter from the slow pace in the first quarter. On average, the economy expanded at a moderate pace during the first half of the year despite the ongoing drag from the housing sector. While the growth of consumer spending slowed in the second quarter from its rapid pace in prior quarters, wages and salaries increased solidly and household sentiment appeared supportive of further gains in spending. Business fixed investment picked up in the second quarter after little net change in the preceding two quarters. Inventories generally appeared to be well aligned with sales at midyear. Overall inflation receded in June because of a decline in energy prices, while the core personal consumption expenditure (PCE) price index rose bit less than its average pace over the past year.

The basic overall picture is OK. Things aren't too hot or cold. Barry Ritholtz over at the Big Picture has called growth "lumpy" which I think is a really good phrase to describe the general trend. Some areas are doing well and others are clearly dragging.

Private nonfarm payroll employment continued to increase at a healthy pace; the rise in July was about equal to the average increase over the first half of the year.

Bulls have argued employment is one of the big areas of strength in the economy, usually citing the 4.6% unemployment rate. The Fed is confirming this view. A serious drop in employment would be a clear signal there was a problem. However, so long as the Fed thinks employment is on solid ground, they will feel far less pressured to lower the Fed funds rate.

Industrial production picked up in the second quarter after little net change over the preceding two quarters.

This observation ties in with this point:

Economic activity in advanced foreign economies expanded somewhat less rapidly in the second quarter than in the prior quarter, but nonetheless appeared to have grown faster than trend, reflecting upbeat business and consumer confidence as well as favorable labor market conditions.

Another general consensus emerging is growth in US trading partners will help to alleviate the housing slowdown in the US. Starting in the first quarter of this year many commentators (including myself) observed that foreign profits were a big reason for the the first quarter profit increases from the big multi-nationals. So long as other countries continue to grow, US exports should as well.

Outlays for nonresidential construction rose rapidly in the second quarter. Business spending on equipment and software, other than transportation equipment, posted a solid increase after being flat, on net, in the preceding two quarter

Non-residential construction increased at a 22% seasonally adjusted annual rate in the second quarter. This pace is not sustainable. My thought is we are seeing the last hurrah (as it were) from the non-residential construction sector.

In addition, we saw some decent increases in business technology investment.

The growth of real consumer spending slowed considerably in the second quarter after substantial increases earlier in the year. The deceleration primarily reflected sharply slower growth in outlays for goods as purchases of motor vehicles decreased noticeably.


Demand for housing in the second quarter was restrained by higher interest rates and by tightening credit conditions in the subprime mortgage market.

Short version: the consumer -- which is responsible for 70% of US economic growth -- is spending less. This is not a good development.

The statement announcing the policy decision noted that economic growth appeared to have been moderate during the first half of the year, despite the ongoing adjustment in the housing sector. The economy seemed likely to continue to expand at a moderate pace over coming quarters. Readings on core inflation had improved modestly in recent months. However, a sustained moderation in inflation pressures had yet to be convincingly demonstrated. Moreover, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The bold-faced sentence from above is the real money quote from the meeting. The Fed is still concerned about inflation, and fighting inflation is still their primary policy orientation. This statement is currently sending markets lower.

The bottom line is this isn't a horrible picture. It says what we already know. Housing is in a nosedive. This is probably having a negative impact on consumer spending. However, other areas of the economy are doing OK. Given this outlook, the Fed is completely justified in not lowering interest rates.