Inflation targeting (IT) has emerged as a pivotal consideration for the Federal Reserve’s monetary policy. During a recent symposium in New York, Alan Blinder, a Princeton economics professor and former vice chairman of the Fed’s Board of Governors, suggested that embracing IT is a natural progression for the central bank. This transition is particularly noteworthy with the appointment of IT advocate Ben Bernanke as the new Fed chairman. Blinder spoke on the future of monetary policy at an event organized by the New York Association for Business Economics. It was symbolic that the discussion took place in the Canadian Consulate’s Manhattan office, representing a country that adopted IT in the 1990s.
Blinder remarked that the era of the “Greenspan standard” is over, signifying a shift from the previous doctrine. He humorously referred to the Greenspan standard as a rigid approach dictated by Alan Greenspan’s preferences. “The Fed must move away from the Greenspan standard, and IT appears to be the next rational move,” he stated.
Another participant, Laurence Meyer, an economist with Macroeconomic Advisers and former Fed governor, echoed Blinder’s sentiment, hinting at a gradual internal shift within the Fed towards adopting IT in his talk titled, “Coming Soon: An Inflation Target for the FOMC.”
However, despite the apparent clarity that an inflation target may bring, the transition from the Greenspan standard is likely to encounter challenges. Notably, the phrase “inflation target” carries a dated connotation and could be politically sensitive. Advocates of IT are increasingly opting for more indirect references to their preferred monetary approach. For instance, during the FOMC meeting in February 2005, discussions around IT were framed as a “comprehensive dialogue on the advantages and disadvantages of establishing a numerical definition for the objective of price stability in monetary policy,” as highlighted in the Fed minutes.
Economic data continues to provide contrasting narratives. Recently, consumer price reports have presented a dual message of alarm and reassurance. The latest data released regarding January consumer prices highlights this uncertainty, suggesting both potential challenges and optimism, resembling previous discussions on producer prices.
The overall inflation rate increased by a seasonally adjusted 0.7% last month, according to the Labor Department—a notable uptick compared to December’s slight decline in CPI. This rise surpasses the consensus prediction of 0.5% for January, marking the highest monthly increase since the 1.2% spike following Hurricane Katrina in September.
For those feeling uneasy about the current climate, there is more encouraging information to consider. As with previous instances of CPI-driven inflation, the recent surge is primarily attributed to rising energy prices—a point made evident by the much more subdued core CPI, which rose only 0.2% in January.
In summary, while headline inflation signals caution, the core CPI seems to alleviate concerns in the bond market. The critical question remains whether energy-related inflation will evolve into a significant threat or simply be noted as a footnote in future discussions.
While recently observing economic trends, it becomes evident that the economy is unlikely to face a slowdown anytime soon. The Conference Board’s index of leading indicators recently surged, serving as a significant reminder of the current economic resilience.
According to the Conference Board, the U.S. leading index increased by 1.1% last month, surpassing economists’ expectations, which anticipated a rise of less than half this figure, as reported by TheStreet.com. This marks both a noteworthy monthly advance and the fifth increase in the last six months, indicating ongoing robust economic growth.
Among the factors driving this rise are the decreasing weekly claims for unemployment benefits, which suggest that the labor market is gaining momentum. Although this information has been available for some time now, it continues to deserve attention, as a strong employment sector significantly influences overall economic health—particularly concerning consumer spending habits.
There is no need for concern; the U.S. is not on the brink of bankruptcy, according to James Galbraith, a senior scholar at the University of Texas, in a recent essay published by the Levy Economics Institute. However, the financial standing of Joe Sixpack—the average consumer—may be different.
Indeed, the U.S. government is navigating a substantial and expanding current account deficit, which could pose challenges, particularly because it may lead to a decline in the dollar’s value, even if the government circumvents bankruptcy in a more conventional sense. Nonetheless, Galbraith argues that such outcomes might not spell disaster imminently. “First, key global players have no immediate interest in allowing the dollar to collapse,” he contends. “Second, there currently exists no viable alternative to the dollar; the euro remains a distant prospect.”
Expanding on this point, he highlights that if a country like China were to start selling dollar-denominated bonds to acquire euro-denominated assets, the limited supply of suitable European bonds would result in complications. Galbraith elaborates:
There are no suitable European bonds available on the market; there are only euro-denominated bonds from individual nations, such as Italy. An extensive effort to purchase these would elevate the euro’s value and detract from the dollar’s. This would ultimately harm the Europeans, likely leading them to acquire dollar assets that other nations, like China and Japan, would be attempting to offload. Therefore, we would see a reallocation of dollar assets, with some decline in the dollar’s value—but this scenario wouldn’t dismantle the dollar-based system.
The U.S. stock market continues to reward risk in 2006. A clear illustration of this is the performance disparity among different market capitalizations through February 17. Small-cap stocks are significantly outperforming mid-cap stocks, which in turn are comfortably ahead of large-cap stocks, as demonstrated in the following chart. This trend aligns with our long-term expectations, and currently, this hierarchy appears well-established for 2006. (All charts below feature data sourced from StandardandPoors.com)
Further analysis of market capitalizations by style reveals a strong preference this year for smaller stocks and those with a value orientation. Value stocks have notably outperformed growth stocks throughout the 21st century. While speculations arise suggesting that growth stocks are due for a resurgence, current figures indicate that such a revival may be premature, as illustrated in the chart below.
In a sector analysis of equities, the appetite for risk appears to remain robust. In the large-cap sector defined by the S&P 500, telecommunications stocks are not only leading the pack but also outperforming even the buoyant energy sector this year. The telecommunications sector has shed its previous image of stability, and now operates as a more volatile space, with varying prospects across companies. This trend suggests that investors are not fleeing from risk but possibly embracing it as a preferred strategy.
In the mid-cap category, risk seems to be in favor as well. Although telecom stocks are not the top performers in this slice, they rank comfortably in third place, performing well. Meanwhile, information technology stocks are leading the mid-cap sector, indicating that a preference for risk persists here, albeit with different strategies at play.
The landscape appears more nuanced within small-cap stocks, where the leading sector through February is materials. We leave it to analysts to determine whether materials indicate a safer investment compared to telecom and tech at this time. Meanwhile, it is clear that sector rotation among small caps follows distinct patterns compared to mid and large caps, warranting ongoing observation.
It has certainly been an eventful week. A series of economic reports has suggested that forecasts of a growth slowdown have been overstated—at least for now. Today, the producer price index report delivered some unexpected news as wholesale prices for January rose more than anticipated. Analysts had projected a 0.2% increase in PPI, but the actual figure climbed to 0.3%, exceeding expectations, as documented by TheStreet.com.
Is this a cause for concern? Perhaps not. Monthly figures can be volatile, but broader trends are more telling. It is crucial to observe that wholesale prices are on the rise, with a 12-month change in PPI reflecting an annual increase of 5.7%, contrasting sharply with declines seen in 2002.
For those distressed by these developments, we have a positive note: wholesale prices, excluding food and energy, offer reassurance. The core PPI has recently moved to lower levels, indicating a more favorable inflation scenario. As illustrated in the chart, core PPI increased by 1.5% in January year-over-year, down from the 2.8% pace recorded last May, and significantly lower than the top-line PPI’s 5.7%.
The market has shown resilience, providing yet another piece of evidence that economic growth remains strong. However, the bond market presents a different narrative, which will be explored shortly. Recently, Fed Chairman Ben Bernanke presented his inaugural testimony before Congress, reinforcing suspicions that growth will likely continue as the dominant trend, albeit with inherent risks associated with such a viewpoint.
According to the Federal Open Market Committee’s “central tendency” forecast, GDP growth is projected to be around 3.5% for 2006, down slightly for 2007, as outlined in the Monetary Policy Report Bernanke submitted to Congress. This is a rise compared to the 3.1% GDP growth recorded for 2005. The committee also anticipates a slight decrease in unemployment rates for 2006 from the previous year’s 5.0%. Given that January’s unemployment rate fell to 4.7%, this estimate appears optimistic.
In addition to Bernanke’s testimony, a wealth of statistical data supports the argument that economic conditions are favorable. Among this is the recent release of initial jobless claims, which have remained below 300,000 for five consecutive weeks. Continuing claims for jobless benefits also remain robust, marking five weeks below the 2.6 million threshold. Together, these trends are placing labor market pessimism on the defensive. As Nomura Securities’ chief economist David Resler states, “Despite the challenges, the outlook for job and income growth suggests a favorable economic landscape leading into 2006.”
The dynamics of consumer behavior are proving puzzling to experts, with everyday Americans having a significant presence in economic discussions. A recent retail sales report indicated an impressive 2.3% increase in January compared to the subdued figures from December. More striking was the 8.8% rise from the same month last year, far outpacing overall economic growth and inflation rates. The notion that Joe Sixpack’s spending power is waning appears overstated.
Despite these robust figures, consumer debt is rising, both in relative and absolute terms, sparking anxiety among some analysts. However, regardless of future consumer spending trajectories, the focus remains squarely on Joe Sixpack as observers scrutinize his spending habits closely.
Now seems a fitting moment to delve deeper into January’s retail sales report, providing a more intricate view of the data as we await forthcoming updates. Below is a chart categorizing the major segments in the government’s retail sales survey, ranked by one-month percentage changes and expanded with 12-month comparisons for added context.
It remains uncertain how much information will be disclosed, but expectations are high for some clarity during the upcoming testimonies. Abstract discussions on monetary policy and inflation targets will likely not suffice for lawmakers this time around. Nevertheless, such vagueness may be all that Fed Chairman Ben Bernanke can offer during his first congressional inquiry.
One topic we hope to see addressed is Bernanke’s perspective on the interplay between inflation and wages/employment, which heavily influences monetary policy decisions. This is particularly relevant considering that unemployment reached 4.7% in December—the lowest level since July 2001. In parallel, wages are rising at a pace nearly matching top-line inflation, based on average hourly earnings and consumer prices respectively. Adjusting for core CPI, which excludes food and energy, wages are increasing at a rate substantially exceeding inflation. All of these factors collide with expectations regarding the Fed’s impending monetary policy decisions, specifically whether the central bank will soon declare inflation under control and halt current interest rate hikes.
Merrill Lynch is reportedly in discussions to acquire a 50% stake in BlackRock, a prominent firm known for its bond funds, although it also manages equities. This attempt may come at the expense of Morgan Stanley, which also sought a piece of this lucrative enterprise.
To understand the allure of BlackRock, one need only look at its stock performance, which illuminates the excitement surrounding such acquisitions. The fixed-income landscape has seen remarkable success recently—evident in the performance of the Loomis Sayles Strategic Income mutual fund, which adeptly identifies attractive bonds. This fund has achieved a three-year annualized total return of over 16% through the end of last year, according to Morningstar, significantly outperforming the Lehman Brothers Global Aggregate bond index, which returned 5.5%, and the S&P 500’s 14.4% gain during the same period. The enthusiasm for winners is palpable, and some investors are eager to own high-performing assets.
BlackRock has also capitalized on the current bull market in bonds. Their business has flourished, particularly as bond yields have remained low for an extended period. Their net income has surged more than 290% from 1999 to 2005, reflecting the prosperity enjoyed by those in fixed-income management during a time of low yields.
However, while the timing may be advantageous for acquiring bond managers, the question of how this acquisition will play out in the future remains. If today’s purchase is deemed savvy with yields on the 10-year Treasury below 4.6%, how might this be assessed if yields were to rise significantly in the years ahead?
This assessment ultimately hinges on expectations regarding the future cost of capital—inflation expectations, deflation, or potential scenarios in between.
