(Archived Content)May 3, 2011
Dear Mr. Secretary:
When the Committee last met in early February, the momentum of economic growth had continued to firm after the 2010 midyear slowdown. Since that time, the pace of recovery has disappointed earlier projections, and considerable near-term headwinds persist, including rising energy prices and disruptions to domestic supply chains stemming from the set of tragedies in Japan. Nonetheless, labor market conditions have improved and business sentiment generally remains upbeat. For this reason, the expansion continues to appear firmly entrenched and most forecasters anticipate an eventual return to above-trend growth.
Real GDP expanded at a 1.8% annual rate in the first quarter, slower than the 3.1% pace registered the prior quarter and below most expectations when the quarter began. The reduction in payroll withholding taxes that took hold at the beginning of the year was anticipated to support some acceleration in consumer spending. Indeed, nominal consumer outlays did grow at a robust 6.6% annual rate last quarter. However, rising prices for food and energy absorbed much of the increase in dollar outlays, and real consumer spending grew at a more trend-like 2.7% pace. The ongoing rise in food and energy prices remains a drag on consumer spending early in the second quarter, though continued growth in labor income should serve as a key support for households. Moreover, the rise in equity prices has more than offset the decline in residential real estate values, leading to some improvement in the health of consumer balance sheets.
Real business outlays for capital equipment expanded at a solid 11.6% pace last quarter, though spending on structures declined at a 21.7% rate. The weakness in business construction activity may have been exacerbated by poor weather conditions early in the year, which probably also contributed to a 4.1% pace of decline in residential construction spending. More generally, home sales and housing starts remain fairly stable at very depressed levels. House prices continue to fall, and household expectations for further declines are contributing to caution on the part of potential homebuyers.
The government sector contracted again last quarter, with real outlays dropping at a rapid 5.2% annual pace of decline, the largest such decline in over 25 years. Spending in the volatile defense outlays category fell at a steep 11.7% pace. More persistent weakness is likely to occur in state and local outlays, an area that also saw an appreciable decline last quarter.
Export growth continued in the first quarter and remains a support for the manufacturing sector. Industrial activity has been quite solid so far this year, as factory production increased at a 9.1% annual pace last quarter. Looking forward, manufacturing output growth looks set to slow in coming months due to two factors. First, output growth outstripped anemic final demand early this year, leading to a decent increase in inventories—a development that should weigh on future output growth. Second, automaker production schedules are pointing to a significant contraction in vehicle assemblies this quarter, partly due to supply chain disruption caused by the disasters that hit Japan.
Although growth in the first quarter came in on the soft side, that disappointment was tempered by the recent improvement in labor market performance. Private sector employment has increased by more than 200,000 in each of the last two months, and employment gains have been broad-based across industries. The unemployment rate has declined by 1% over the last four months to 8.8% in March. Part of that decline is due to a decline in the participation rate, as some workers have become discouraged over the prospects of finding a job. More positively, part of the decline is due to favorable factors, in particular, layoffs and other employment terminations have slowed in recent months. Recently, however, new filings for unemployment benefits have increased, which may reflect the anticipated slowdown in manufacturing activity. Nonetheless, job openings have increased and business surveys point to continued solid hiring intentions.
Inflation news in the period since the last meeting has been dominated by developments in the prices of globally traded commodities. The Personal Consumption Expenditure (PCE) deflator increased a rapid 0.4% in both February and March, mostly reflecting the impact of higher food and gasoline prices. However, the exfood and energy core PCE deflator has also picked up lately, partly reflecting some passthrough of higher commodity prices, and has increased at a 1.5% annualized pace in the first
quarter— modest by historical standards, but high relative to the numbers that printed last year. Some further commodity price passthrough may continue to pressure core prices higher in the near term. Looking out to the intermediate term, low levels of resource utilization are likely to continue to put downward pressure on inflation. Consistent with this, average hourly earnings have increased a mere 1.7% over the past 12 months, and growth in unit labor costs has been even weaker. Measures of short-term inflation expectations have been elevated, reflecting increased prices for highly visible and frequently purchased goods like food and gasoline. Measures of medium-term inflation expectations have been relatively stable and remain within the ranges seen over the past few years.
At its most recent meeting, the FOMC signaled that the asset purchase program announced last November would end as originally scheduled in June—a decision well-anticipated by the market. Moreover, Chairman Bernanke suggested that an expansion of asset purchases at this juncture is highly unlikely. In his first-ever monetary policy press conference, the Chairman further indicated that halting the reinvestment of principal payments would be the first step in tightening policy. Although the Fed will no longer be providing stimulus beyond midyear, Fed rhetoric has not indicated any urgency to tighten policy: employment remains well below its mandate, and while inflation has increased in the context of stable medium-term inflation expectations, underlying inflation is also below the Fed’s mandate.
Against this economic backdrop, the Committee’s first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. At this time, the Committee did not feel that any changes to Treasury coupon auctions were necessary.
Given the near and medium term outlook for marketable borrowing needs, there was meaningful discussion around potentially reducing coupon issuance. However, the Committee felt that reductions in marketable borrowing should occur in T-bills. The Committee continued to focus on increasing the average maturity of the debt. Although the average maturity now stands at 61 months, (above its 30-year historical average of 58.1 months), the Committee felt that further extension was warranted. Along these lines, members were cognizant of, and comfortable with, the fact that T-bills as a percentage of marketable debt continue to decline.
Lastly, Committee members considered the potential implications for Treasury debt issuance should the Federal Reserve at some point cease to roll over its SOMA Treasury holdings at auction. This topic was raised in response to the discussion of the Federal Reserve's reinvestment strategy at Chairman Bernanke's recent press conference and the earlier discussion of this issue reported in the minutes from several FOMC meetings last year. Such an outcome would require Treasury to issue more debt to the public than would otherwise be the case.
The second charge was to comment on the state of public and private pension funds, in the U.S., contrasting their differing approaches to asset-liability management. The presentation (attached) discusses how these approaches affect the plans’ investment decisions in fixed-income markets and, in particular, drive demand for long duration assets. A noteworthy takeaway was the magnitude of the state and local governments’ unfunded shortfall and the sensitivity of that shortfall to various calculation inputs. The presenters described alternative models for pension regulation referring to both the UK and the Netherlands. Actionable items for U.S. public pension reform were also discussed.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the April 2011 to June 2011 quarter and the July 2011 to September 2011 quarter. The committee’s recommendations are attached.
Matthew E. Zames