Fed Digging In Its Heels: Employment and Inflation

 |  Includes: QQQ, TLT
by: Zhong Jin
The U.S. February PMI index (61.4) continues showing strong economic growth in in February. New orders, employment, and prices paid are all up in February.
This is not a surprise. So far, every regional economic activity indicator has shown significant increases in February. The Chicago Purchasing Managers Index for February exceeded expectations with its highest headline reading since 1987. The New York Fed Empire State Manufacturing Survey for February rose to 15.43 from 11.92 in January. The Philadelphia Fed Business Outlook Survey for February spiked to 35.9 from 19.3 in January. The Richmond Fed Manufacturing Survey for February was up to 25 from a previous 18. The 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 the Middle East. However, the shock in oil supply due to Libya’s civil war looks to be temporary. When all major world powers reach an agreement to isolate Gaddafi, sanction him, and even oppose him militarily, it will be just a 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 the 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 …”
Ben Bernanke said the same thing on March 1, remarking that "the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in the U.S.”
When the Federal Reserve chairman and the president of the New York Fed have the same views, FOMC will follow. Their latest speeches just hammered home the message that the Fed is determined to keep printing money as planned. Regarding QE2, the Fed has bought $350 billion of Treasury bonds since November 2010. If we count the divestment of MBS, the net increase of Treasury holdings is $257 billion so far.
Although it is clear that the Fed is digging in its heels, investors may have second thoughts on inflation and employment. Strong economic growth and loose Fed policy are not exactly news to investors, and perhaps have already been factored into the price.
Judged by the panic reactions after Presidents’ Day in the market, investors clearly became more concerned about gasoline prices and their impact on headline inflation, which is being dismissed by the Fed. While the oil supply could recover sooner, high oil prices may be more persistent than the 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, the employment outlook seems to be bright for February. Survey results from the U.S. ISM and the Philadelphia, Dallas, and Richmond Fed districts also all showed improvements in number of workers employed in the manufacturing industry. Only the New York Fed's 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 are going to be much better than the 36k for January.
The major excuse for the 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 estimates. The focus now is more and more on inflation. This Friday, good news on employment could be bad news for asset prices in the short term.
The medium- to long-term picture is more complicated. During the last recession, the Fed cut the interest rate to 1% on June 25, 2003, the lowest level in that cycle. Monthly non-farm 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 non-farm employment changes had been positive for 37 months in a row, with an average monthly employment increase of 181k. The unemployment rate dropped 1.6% to 4.5% in September 2006. The Fed began to exit from the extremely 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 the unemployment rate is still at 9%. Given the severe unemployment situation now, if history is any guide, the 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.”
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.