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stubbornly high as have spreads between retail and
wholesale prices so that the relief is only moderate.
Chart 6: Inflation Expectations High Part I
In addition, firms have been more successful than
anticipated in passing along higher costs to
consumers. In the short run, this has resulted in a
larger loss of purchasing power and weaker-thanexpected
consumer spending, as well as robust
corporate profits. The extent to which firms can
cannibalize their customer base seems limited, and
the stock market declines of late may reflect that
realization to some degree.
A variety of political uncertainties both inside and
outside the US have certainly intensified in recent
months and are probably a significant driver of rising
anxiety and caution that have slowed spending and
hiring. This suggests downside risks have also been
rising as a loss of business and consumer
confidence could tip into becoming a negative selfreinforcing
dynamic.
The loss of wealth as stock and home prices fall only
serve to emphasize that consumers will not be eager
to releverage and are likely to remain cautious and
price sensitive. Likewise, the loss of momentum in
hiring and capital spending as well as the dormant
mountains of corporate cash highlight continued risk
aversion amongst firms. Indeed, we would currently
put the chances of a recession at one in three.
On the other hand we are seeing a solid pick up in
July auto sales suggesting the resolution of supply
chain issues will be a boost to GDP growth in Q3.
Headline inflation is set to provide some relief to
consumer purchasing power; we expect it to rise
2.5% saar in H2 2011, down from the 3.8% pace in
H1 2011. Finally, the earnings season for Q2 has
been reasonably healthy and corporations are
tapping credit markets without hesitation suggesting
that, while firms are cautious, they are not in
retrenchment mode.
The FOMC is faced with some very tough choices
in the months ahead. We think they will take a
step toward easing at next week’s meeting by
extending the duration of their securities
holdings. QE3 is a close call at this point.
By a number of measures, the economic backdrop is
far worse than last year around this time GDP is
weaker, the manufacturing sector is weaker, fiscal
headwinds are greater, and home prices have been
falling for a year. Hiring by the private and state and
local sectors is just as weak (federal is excluded
owing to the census hiring swings last year), and
while the unemployment rate is lower, it is only
because labor force participation has dropped
sharply. The intensifying downside risks suggest the
Fed should be considering policy easing.
Source: Reuters EcoWin Pro
Chart 7: Inflation Expectations High Part II
Source: Reuters EcoWin Pro
However, one key factor is different. Both headline
and core inflation have picked up sharply over the
last year. While headline inflation is already falling
back, core inflation has been on a strong upward
trajectory. Stagnant wages and fading pass through
of past commodity price increases suggest some
easing in core inflation may be around the corner;
however, it has yet to materialize fully.
Trimmed mean measures of underlying inflation did
moderate notably in June and core PCE was also
much softer than expected; however, it is quite early
to declare this a trend. Thus, the Fed has made
progress on its policy mandate to maintain stable
prices, and deflationary risks are certainly not a
pressing worry at this point (see Chart 4).
Another complicating factor is that the measures of
inflationary expectations favored by the FOMC
remain fairly elevated despite the recent global
economic slowdown and distress in many areas of
the capital markets (see Charts 6 and 7). It can
certainly be argued that a 40bp decline in the yield
on the 30-year Treasury bond and a flattening in the
yield curve driven by a rally, rather than a selloff, are
in part indications of a decline in longer-term inflation
expectations. However, the Fed still likely views the
Julia Coronado 4 August 2011
Market Mover
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