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Market Intelligence

Will the Fed Move? – Another Perspective

As 2007 gets under full steam, many of us in the banking and financial services industry are contemplating the fiscal landscape we face and how best to navigate it. In this month’s Market Intelligence, we offer the wisdom of guest columnist John Shin, economist of Lehman Brothers, to provide some perspective on the current economy and possible future Fed decisions that may affect us all.

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Object at rest

by John Shin, Lehman Brothers

With growth concerns at least temporarily allayed, and core inflation still elevated, Fed officials have been signaling that they may now be content to stay on the sidelines. The uptick in December inflation was a useful reminder that concern over rising inflation remains a crucial factor for Federal Reserve policymaking, replacing some of the recent market focus on growth and recessions risks. The downward surprises of the two previous CPI reports fed a general expectation that core inflation would come down on its own, allowing price pressures to take a back seat in terms of Federal Reserve priorities. However, core CPI is still growing at a 2.6% y-o-y rate even after those two soft months. This is outside the Fed’s comfort zone of 1.5-2.5% and we expect price pressures to stay elevated in 2007.

CPI: The bird’s-eye view

Macroeconomic fundamentals still point to inflation risks tilted to the upside. Previous near-term expectations for a cooler economy and lower inflation were two sides of the same coin: The economy had absorbed most of the excess capacity that developed after the 2001 recession and the combination of slower productivity and reduced labor force participation implied lower potential growth of around 3%. At the same time, near-term prospects for growth have brightened; we expect Q4 GDP growth of 3.3%. We also think the risks to our Q1 forecast of 2.5% are to the upside, especially with oil prices falling. Thus, our 2007 forecast implies that growth for the entire year will be only a couple of tenths below potential, which is unlikely to be enough to reduce inflation substantially.

Meanwhile, labor cost pressures have already been slowly, but consistently, building from the growth of previous years. With the unemployment rate at 4.5%, the labor market is probably slightly below the NAIRU inflation threshold. Some of the labor cost evidence has been mixed, but the average hourly earnings component has maintained steady growth and is now approaching levels not seen since the highs of the 1990s (Figure 1). With wages and labor costs potentially eating into profit margins and pushing their way into prices, this suggests that the labour market remains a source of inflationary pressure.

CPI: The worm’s-eye view

Delving into the micro-level details also reveals a dichotomy within the core CPI, suggesting that October and November’s downward moves are probably unsustainable. Even as core CPI has softened, the major shelter components did not fade by much. Owner’s equivalent rent, which makes up around a third of the core CPI, has come in with monthly readings of 0.3% or above. (Figure 2) Much of the downward pressure in the core CPI has come from goods. In particular, vehicles, apparel and medical commodities have driven the core inflation numbers south. Such relatively sharp declines would appear difficult to sustain over longer periods.

Let’s talk and talk and talk

Fed officials have been out in force at the start of the year, delivering a fairly consistent message: (1) The market has likely been too eager to price in rate cuts; (2) while inflation appears set to cool, the risks to inflation are to the upside; and (3) at the moment, the Fed is fairly happy to stand pat and see how things develop. Figure 3 shows the most recent wave of speakers and selected quotes from their commentary. Fed
officials did not interpret the October and November core CPI readings to mean inflation was no longer a top concern. There also was not as much immediate concern of housing weakness spreading to the rest of the economy. In particular, Vice Chairman Donald Kohn argued that “economic activity outside the housing and motor vehicle sectors is likely to post continuing healthy gains over coming quarters.”

On balance, we remain comfortable with our view of the Fed staying on hold through 2007. Markets already know that the Fed’s rate-setting behavior contains a significant amount of inertia: a Fed at rest tends to stay at rest. Without a significant and sustained change in the outlook, Fed officials have shown little inclination to move for the sake of moving, particularly in the current economic environment. And expectations have slowly converged to a more inertia-oriented view as well: previous market views that the Fed would cut 3-5 times in 2007 have diminished to an expectation of 1 or 2 cuts instead. In the longer term, the Fed will probably have to move rates down, as 5¼% seems too high to be a plausible neutral target. But, without a sharp downturn on the growth front, inflation is still too high to envision the Fed moving to cutting mode in the near term.

The views expressed in this report accurately reflect the personal views of John Shin, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein.

Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Valerie Monchi (vmonchi@lehman.com; 212-526-3173).

Lehman Brothers Inc. and any affiliate may have a position in the instruments or the Company discussed in this report. The Firm's interests may conflict with the interests of an investor in those instruments.

The research analysts responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work, firm revenues, including trading, competitive factors and client feedback.

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers") and has been approved by Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch (LBIS). Where this material is distributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. An investor should consult his Lehman Brothers representative regarding the suitability of the product and take into account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. © 2007 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.

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