Dear Mr. Secretary:
When the Committee last met in early May, the pace of economic growth had downshifted noticeably. Since then, growth has continued to disappoint, as second quarter real GDP advanced at only a 1.3% annual rate following a downward-revised pace in the first quarter of 0.4%. Growth was held back in the first half of the year, in part, by some temporary headwinds, including the drag from higher energy prices and the supply disruptions following the Tohoku earthquake. The fading of these drags may allow for somewhat better growth in the second half of the year. Nonetheless, the recent step-down in consumer sentiment and the slowdown in the pace of employment growth have tempered expectations regarding the vigor of the anticipated rebound.
The disappointment in second quarter growth was a result of domestic demand only advancing at a modest 0.5% annual rate; net exports and inventory building both made positive contributions to growth last quarter. Real consumer spending barely increased last quarter, edging forward at a 0.1% annual rate, which was the slowest pace in the two year-old current expansion. Nominal consumer spending advanced at a 3.2% rate, but the large coincident rise in consumer prices meant that the increase in dollar outlays was matched by a very small increase in volumes purchased. In addition to the drag from higher food and energy prices, survey measures of consumer attitudes indicate increased caution on the part of households, particularly regarding the health of the labor market.
Home buying has remained fairly stable at depressed levels. Construction activity appears to have increased somewhat in the multifamily sector, but homebuilding in the larger single-family sector is mired at historically very low levels. House prices have declined modestly over the last three months, though the pace of decline has become less severe and there is some evidence that prices for non-distressed properties may be modestly increasing.
The growth of outlays by businesses has held up somewhat better, and total real capital spending rose at a 6.3% annual rate in the first quarter. Real outlays for equipment and software advanced at a 5.7% pace, a solid outcome though slower than prior quarters, and the latest report on orders for capital goods indicates that the momentum in investment spending may have slowed down toward the end of the last quarter. Spending on transportation equipment appears to have been held back by supply chain disruptions and should normalize in coming months. Business spending on structures bounced back from a weather-depressed first quarter and rose at an 8.2% rate in the second quarter. Looking forward, strong profit growth and low borrowing costs should support further gains in capital spending, at least for large firms. Downside risks relate to uncertainty regarding the fiscal situation – which may have increased the option value of waiting to invest – and to financial constraints for small business borrowers.
Net exports contributed 0.6%-point to GDP growth last quarter, in part because supply chain disruptions temporarily slowed the pace of import growth. Gross export growth has held up reasonably well, advancing at a 6.0% annual rate in the second quarter, supported by continued demand from emerging market economies. While exports remain a bright spot for manufacturing, output growth in the industrial sector has stumbled in recent months. Moreover, the decline in the latest ISM manufacturing survey to 50.9 indicates that growth in industrial production is likely to remain subdued in coming months.
Progress in normalizing the labor market witnessed a frustrating setback in recent months, as the unemployment rate has increased 0.4%-point over the past three months to 9.2% in June. In addition, the pace of nonfarm job creation came skidding down to 22,000 per month, on average, in the May-June period, after averaging 179,000 per month in the first four months of the year. Other labor market indicators such as the average workweek, jobless claims, and average hourly earnings have also been quite soft in recent months. Survey measures regarding hiring intentions have been mixed, and uncertainty regarding the future state of the labor market is unusually heightened.
Headline inflation has eased in recent months, largely due to moderating increases or outright declines in the prices for food and energy. In the three months ending in June, the Personal Consumption Expenditure (PCE) price index increased at a 1.3% annual rate, noticeably slower than the 4.8% pace that prevailed in the first three months of the year. In contrast, the ex-food and energy core PCE price index has continued to exhibit relatively strong increases recently, rising at a 2.2% annual pace over the last three months. The pass-through of higher prices for globally-traded commodities into core prices has likely contributed to the recent increase, as has the rapid advance in vehicle prices following the reduction in inventories due to Japanese supply chain disruptions. The fading of these temporary influences will likely cause core inflation to ease back down in coming months. More importantly, wage inflation remains quite tepid and inflation expectations appear well-anchored, both of which should serve to restrain the pace of increase in core consumer prices.
Market participants generally expect monetary policy to remain on hold for the foreseeable future. The disappointment in growth and the easing in inflation have pushed back expectations regarding the timing of the Federal Reserve’s exit from its current accommodative stance. Chairman Bernanke has recently mentioned the possibility for further monetary policy stimulus, should economic developments warrant such action. Nonetheless, given the FOMC’s forecast for a rebound in economic activity in the second half of the year, most market participants view the policy stance of the Fed as neutral – neither pointing toward an imminent tightening nor easing.
Uncertainty regarding fiscal policy has been more elevated than at any other time in modern memory. A compromise measure on the debt ceiling has been reached, but the uncertainty engendered by this debate may have lingering adverse consequences for business and consumer sentiment. The compromise reduces deficits over the next ten years by $2.1 trillion to $2.4 trillion, and entails some further tightening of fiscal policy in 2012, in addition to the drag from expiring temporary stimulus measures. Meanwhile, at the state and local levels of government fiscal tightening is ongoing, and the onset of a new fiscal year brings with it the prospect of more tax increases and further cutbacks in state and local employment.
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. The Committee did not feel that any changes to Treasury coupon issuance were necessary at this time.
There was a broad discussion of the Budget Control Act and its implications. Given the path and timing of future debt limit increases, expansion of the SFP (Supplementary Financing Program) back to $200 billion this quarter is not possible. The Committee was aware, but not overly concerned, with the impact of this on the T-bill market.
Further discussion ensued regarding both the stock of the T-bill market and its relative size as a percentage of marketable debt. Members concluded that while T-bill yields are close to zero, the market does not appear to be distorted. The Committee continues to believe that Treasury should maintain its commitment to extending the average maturity profile of the debt.
Along these lines, the second charge was to examine the costs and benefits of extending the average maturity of marketable debt outstanding (presentation attached). The presenters considered the total interest expense over time, the volatility of interest expense through time, as well as roll-over and liquidity risks. The presentation highlights that longer dated term premiums appear elevated relative to the past. That said, today there are uncertainties surrounding the long-term fiscal outlook, inflation expectations, and future borrowing needs. A healthy discussion ensued amongst members as to whether or not the current long end premium was warranted. While no definitive answer was reached, members felt that the current term structure of yields should not deter normal long-end issuance. However, the Committee agreed that further analysis would be undertaken.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the July 2011 to September 2011 quarter and the October 2011 to December 2011 quarter. The committee’s recommendations are attached.
Matthew E. Zames