Dear Mr. Secretary:
Since the Committee last met in early February the economy has continued to grow at a moderate pace, expanding at a 2.2% rate in the first quarter, a deceleration from the 3.0% pace registered in the final quarter of last year. Recent economic indicators have turned somewhat softer, reflecting in part some pay-back from weather-distorted readings earlier in the year as well as a turn in the inventory cycle. Even so, the economy appears to be on a firmer footing now than at this point in the last two years, when early enthusiasm gave way to significant growth concerns. Although the labor market stumbled in March, the economy has added over 200,000 jobs , on average, in the first three months of the year, and the unemployment rate continued to decline and has fallen over a half-percentage point over the past six months. Concerns regarding the European sovereign debt situation continue to weigh on sentiment regarding the global economy, though on the whole financial conditions in the US remain favorable for continued recovery.
Consumer spending accelerated at a 2.9% annual rate last quarter, the fastest pace in over a year. Rapid growth in auto sales supported a noticable acceleration in household outlays for durable goods. Spending on services continued to languish. Although some of this was due to unseasonably mild weather reducing outlays for utilities, service purchases have also been growing quite slowly. Almost all of the growth in consumer spending last quarter was accounted for by a decline in the saving rate: real disposable personal income expanded at only a 0.4% rate in the first quarter. Some of the disappointment in real income growth was due to inflation, as the rise in energy prices caused the PCE price index to accelerate to a 2.4% pace of growth. More recently oil and gasoline prices have eased, which should provide some relief to consumer spending growth in coming months.
Business fixed investment spending contracted at a 2.4% annual rate in the first quarter, the first decline in over two years. Over those two years, the pace of growth in capital outlays was robust as businesses resumed spending plans deferred during the downturn. With levels of capital spending having largely recovered, much of that catch-up spending growth may be behind us. Within capital spending, real outlays for equipment and software increased at only a 1.7% rate; the year-end expiration of favorable tax treatment for certain categories of capital equipment may have pulled forward spending in this category into late last year at the expense of outcomes early this year. Business spending on structures declined at a 12.0% rate in the first quarter, led lower by construction of oil and gas drilling structures. Industry reports indicate that the very low price of natural gas is curtailing investment in new gas drilling operations.
Businesses invested in inventories at a $70 billion annual rate in the first quarter, by almost all measures an unsustainably strong pace. Some inventory re-balancing seems due and the 9.0% annualized pace of manufacturing industrial production growth seen last quarter is likely to ease in the current quarter. Consistent with this, early manufacturing surveys for April indicate positive but slowing growth in industrial activity.
Residential investment increased at a solid 19.7% annual rate last quarter, led higher by spending on additions, re-modellings, and other improvements. Sales activity began the year on a very firm note, though the most recent data indicate more mixed conditions for housing demand. House prices have recently shown some signs of stabilization. Should this trend continue in coming months, it would represent a positive development for both household and financial sector balance sheets.
Real government spending rose at a 3.0% rate in the first quarter. Defense spending has contracted sharply in the last two quarters, and spending by state and local governments continues to decline.
In spite of concerns regarding global growth, exports grew at a 5.3% rate last quarter, about in line with the long-run trend. The monthly import data has been choppy recently, perhaps due to Chinese New Year distortions, but for the first quarter as a whole imports expanded at a 4.3% pace. Overall, foreign trade was a neutral influence on US GDP growth last quarter.
The labor market data in the first quarter was, on balance, quite favorable, though the recent indicators have raised some concern that the pace of improvement may be slowing. Nonfarm employment increased an average of 258,000 per month in January and February, though the pace of job growth slowed to 120,000 in March. Hopes for a quick rebound from the March disappointment have been tempered by the recent increase in initial jobless claims. Other labor market indicators remain more sanguine: the unemployment rate is down 0.3%-point since the beginning of the year and survey measures of business hiring intentions point to continued growth in employment. Measures of wage inflation remain subdued, and growth in average hourly earnings continues to come in near 2%.
Consumer price inflation accelerated last quarter, pushed higher by rising energy price. The headline PCE price index rose at a 2.4% rate in the first quarter, and the ex-food and energy core measure increased at a 2.1% pace. Core inflation remains contained, though it has come in firmer than many had expected. The resiliency of core inflation, in spite of the large amount of labor market slack, has become an increasingly-prominent puzzle. Possible explanation for this apparent anomoly include the stability of inflation expectations anchoring realized inflation outcomes , and the well-known resistance of workers to nominal wage cuts, thereby putting a floor under unit labor costs.
Since the Committee last met, Congress extended for the full year expiring unemployment compensation and payroll tax provisions, an outcome widely expected. Interest in fiscal issues is increasingly focused on the year-end fiscal tightening implied by current law. Nonetheless, few expect that these “fiscal cliff” issues will be resolved before the November elections.
Since early February monetary policy has remained on hold. Both the March and April FOMC meetings produced no change in the policy directive and little change in the economic outlook. Expectations for another round of large-scale asset purchases have diminshed some in recent weeks. Committee forecasts for the path of interest rates presented at the April meeting suggested participants foresaw a somewhat earlier initiation of rate normalization, though the Committee statement and the Committee Chairman continued to forecast exceptionally low interest rates at least through late 2014.
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.
The details of the Treasury Department’s request for comment around the proposed floating rate note (FRN) program were reviewed and an active discussion ensued. The Committee reiterated that its main goals in unanimously supporting FRNs were continued diversification of the investor base and average maturity extension through issuing floaters in lieu of shorter dated issuance. Furthermore, FRNs should lead to a reduction of term premium expense over time. While initial issuance should have final maturities of one to two years, eventually the Committee anticipates FRNs of longer final maturities.
TBAC was still undecided on the appropriate reference index with members uniformly divided amongst referencing T-bills, general collateral and Fed funds effective. Further work needs to be done on this topic.
The second charge was to study the evolution of fixed income markets, particularly with regard to the changing roles of financial institutions, technological advances, and regulation. The presentation (attached) highlights the current trends in fixed income markets. Specifically, the paper documents an environment characterized by increased secondary market liquidity in U.S. Treasuries, reduced liquidity in credit products, higher realized correlations, extraordinary government policy (ZIRP and balance sheet expansion), lower private sector risk tolerance, and regulatory uncertainty. While no recommendations were made, the scope of anticipated regulation and its impact on fixed income markets was raised as a concern.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the April 2012 to June 2012 quarter and the July 2012 to September 2012 quarter. The committee’s recommendations are attached.
Matthew E. Zames
Vice ChairmanTBAC Recommended Financing Table Q2 2012 TBAC Recommended Financing Table Q3 2012