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Daily Global Commentary

We continue to look at other components of the Index of Leading Economic Indicators for insights about Fed policy

Thu, Nov 9 2006, 02:33 GMT
by Northern Trust Economic Research Department

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Features of the Economy When Fed Has Changed Direction of Monetary Policy - II

We continue to look at other components of the Index of Leading Economic Indicators for insights about Fed policy. Yesterday’s comments closed with the University of Michigan Consumer Expectations Index. Here are other reliable indicators.

(4) Initial Jobless Claims
There is substantial historical evidence to support the view that initial jobless claims have the ability to warn about the future course of the economy. This is also the reason it is one of the ten components of the Index of Leading Economic Indicators. The year-to-year change in seasonally unadjusted jobless claims was 2.1% for the last week of October. Looking back, the year-to-year change in seasonally unadjusted initial jobless claims during the last week of December 2000 was a hefty 29.3% increase. This reading was the thirteenth consecutive monthly reading that carried a positive sign. The FOMC took action only in January 2001. Based in this information, it is reasonable to point out this was not a preemptive move. Monetary policy easings in September 1998 and October 1987 were targeted toward preventing unfavorable outcomes from extraordinary events like the Long-Term Capital Management crisis and a stock market correction. In 2001, 1989, and 1995, the Fed lowered the federal funds rate for fundamental economic reasons. Prior to each of these events, the year-to-year change in seasonally unadjusted initial jobless claims had turned positive for several weeks. Implication: Watch for the year-to-year change in seasonally unadjusted initial jobless claims in coming weeks. There are abundant signs that the latest positive weekly reading of the year-to-year change in seasonally unadjusted jobless claims may not be the last.

(5) Standard & Poor’s 500 Composite Index (S&P 500)
The S&P 500 has also served as a valid indicator of future economic growth. The 1987 year-to-year drop in the index was not a signal of weak economic growth. However, the signals prior to the 1990 and the 2001 recessions were on target. There was no forewarning from the S&P 500 index in 1995 when the Fed was successful in engineering a soft landing. In October 2006, the S&P 500 index was up 14.4% from a year ago. Implication: This time around, the S&P 500 has failed to send a signal consistent with other leading economic indicators.

(6) Average manufacturing workweek
The average manufacturing work week was 41.2 hours in October 2006, down from 41.4 in July 2006. Prior to the 1990 recession, the longest manufacturing workweek was 41.2 hours in February 1989 which declined to a 40.3 hour factory workweek by December 1990. The Fed began to ease in June 1989. A similar signal was available in the next recession. The average manufacturing workweek peaked in July 1999 at 41.5 hours and held close to it for several months (see chart 6) before posting a sharp drop to 40.3 hours in December 2000. The Fed delayed taking action until January 2001.
Implication: The manufacturing workweek in on our checklist for an early signal.

Conclusion – The ISM survey results, year-to-year change in seasonally unadjusted initial jobless claims, the 10-year – federal funds rate spread, and the average manufacturing workweek are strong leading indicators of economic activity. Each of these indicators is pointing in the same direction, at the present time, warning of weakening economic conditions. There is sufficient evidence to justify a lower federal funds rate but the FOMC is unlikely to take action until inflation data show moderation.

Australia: Reserve Bank Hikes Rates in Response to Credit Growth

For the eighth time in just under five years, the Reserve Bank of Australia (RBA) raised the benchmark Overnight Call Rate (OCR) by 25 basis points, bringing it to 6.25%. The market had largely expected this latest hike, but the statement issued by RBA Governor Glenn Stevens has raised concerns about additional tightening. We admit that higher interest rates look inevitable over the near-term, but we feel that this latest rate hike may not have been necessary.

Stevens said in the statement following the monthly RBA meeting that attention right now was focused on rising producer prices, wage pressures, rapid credit growth and a strong global economy. Of all of these, we feel that the credit issue stands out as the most noteworthy concern, since bank credit growth has averaged 14% this year – a peak not reached since the boom-bust period in the late 1980s. In fact, on a year-over-year basis, the acceleration of bank credit extension has been a good indicator of how the RBA’s policymakers would move.

The argument for strong producer prices and excessive wage growth is a little less convincing. Final-stage producer price growth decelerated to about 4% in Q3, and growth in earnings has retreated from its 6.1% growth in Q3 2005 to 4.7% as of Q2 2006 (Q3 data are due out next week). The downward trajectory of these indicators is likely to continue over the next few quarters as the lagged effects of previous rate hikes are taken into consideration. This suggests that producer prices and wage pressures will not be as much a concern looking forward.

Governor Stevens stated that the threats to inflation were “significant”, and that interest rates were more likely than not to rise. This statement is highly indicative that the RBA will be ready to raise rates again after another quarter of inflation and wage figures are released, – with February 6th, 2007 being the earliest opportunity. We believe that the Q4 CPI, PPI, and wage figures will not be suggestive of a troubling inflation environment. Those indicators are more than likely to show the impact of the rate hikes earlier this year. Credit growth could still be a problem, however, and could force further monetary tightening regardless of what the inflation figures show.

Japan: December Rate Hike Still Penciled In, But Not Everyone Agrees

We have stated for some time that the Bank of Japan’s (BoJ’s) next rate hike in its slow, gradual attempt to normalize monetary policy would be after its December meeting (Dec. 18-19). We still hold that as our base case, but also note that a few more voices have risen up in favor of keeping the benchmark overnight rate at its current 0.25% rate. Some of the dissent is hardly surprising, but others have given the market something new to consider.

The ruling LDP has thrown its weight behind a far more cautious approach to handling higher interest rates. It was reluctant to voice support for the first rate hike in five years back in July, and has been quite skeptical of further hikes any time soon. Currently, government policymakers are voicing doubts about whether the prolonged deflationary cycle that dragged down asset prices over the past eight years had run its course. Indeed, the new core CPI series (CPI less food and energy) is still contracting on an annual basis, though the BoJ’s preferred alternative measure – CPI less fresh food – has been in positive territory for four months. The LDP dreads the thought of a renewed deflationary cycle bringing an abrupt end to the current economic expansion, but it is also concerned that higher interest rates will put a larger price tag on all future debt it issues.

With a budget deficit expected to be in excess of 6.0% of GDP this fiscal year (April-March), higher servicing costs are not what the government wants.

The more interesting statements were made today by BoJ policy board member Atsushi Mizuno. As one of the prime backers of normalizing monetary policy, it was surprising to hear him speak in tones that were occasionally dovish. Of particular note, he pointed out how the central bank did not wish to surprise the markets with the timing of next rate hike. Other, more typically-hawkish Mizuno statements were also tempered, with suggestions that weak economic indicators would be recognized if the softness was not viewed as a temporary effect. However, he did confirm the BoJ’s forward-looking approach – a signal that short-term fluctuations would not deter the Bank from its long-term monetary policy objectives.

The increased discussion of monetary policy this week could be targeted strictly toward preparing the market for next week’s policy board meeting on November 15-16 with the likely result of steady interest rates after that point. We expect the higher-interest rate talk to start up on November 17th, with a few well-timed hawkish statements from the board members and an uncomfortable silence from LDP members as they prepare for the inevitable. By early December, the markets should be prepared for the first rate hike in almost five months, and nobody should be surprised.

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Published on  Tue, Nov 14 2006, 09:00 GMT

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