February 5, 2013
Dear Mr. Secretary:
Since the Committee last met in late October economic activity stalled, as real GDP contracted at a 0.1% annual rate in the fourth quarter. The abrupt slowing after the third quarter’s 3.1% growth pace reflected a host of transitory factors. Even so, private final demand expanded last quarter, with real outlays of both businesses and consumers accelerating from their third quarter pace. A sharp contraction in defense spending last quarter – following a third quarter surge – subtracted 1.3%-point off GDP growth, the largest drag from defense spending in forty years. Additionally, a considerable slowdown in the pace of inventory accumulation subtracted another 1.3%-point off of last quarter’s growth outcome. While the step-down in the pace of stockbuilding was a drag on growth last quarter, it should leave businesses better positioned to weather what is expected to be a soft patch for consumer spending, as households digest the higher tax burden associated with the partial resolution of the fiscal cliff. Issues related to fiscal policy continue to pose headwinds to the growth outlook, but an ongoing easing in financial conditions as well as a developing recovery in the housing sector should support growth through these challenges.
One of the more welcome developments in the intermeeting period was the firming in business capital spending. After modestly contracting in the third quarter, real business capital outlays increased at an 8.4% pace in the fourth quarter, allaying concerns that companies were retrenching in the face of fiscal uncertainties. Spending on equipment and software rebounded to post a 12.3% rate of increase, led by a rebound in high-tech spending which had contracted the prior two quarters. Levels of capital spending are still somewhat depressed relative to pre-recession norms, and the cost of capital for businesses remains very low, both of which should support continued growth in capital expenditures.
Whereas business capital spending faltered in the third quarter of last year, business employment has increased in a steadier manner. Private employment increased 166,000 last month, and for 2012 as a whole, 2.2 million private jobs were created, the second consecutive year with greater than 2 million jobs created by the business sector. In spite of the steady increase in labor usage, business profit margins have remained wide, in part because labor costs remain soft. The Employment Cost Index (ECI) expanded only 1.9% over the last four quarters. Employer costs for health benefits increased only 2.8% over that period, well below the 6.2% average annual increase seen over the past decade.
Real consumer spending managed to increase at a 2.2% annual rate last quarter, somewhat better than the recent trend. Much of last quarter’s gain reflected a step-up in outlays for motor vehicles, in part as households replaced cars and trucks damaged or destroyed by Hurricane Sandy. Retail spending could be challenged early this year as the impact of the 2%-point increase in payroll taxes will depress after-tax income growth. Thus far there is little hard data to monitor the impact of higher taxes on consumer spending, though household sentiment measures have deteriorated some in recent weeks.
The housing rebound gained further momentum since the last meeting; real residential investment increased at a 15.3% rate in the fourth quarter, adding about 0.4%-point to overall economic growth. Recent data on housing permits point to continued robust homebuilding activity in the current quarter. House price indicators have also been firm as of late, with the Case-Shiller national index increasing 5.5% in the twelve months ending in November.
Exports declined in the fourth quarter for the first time in the current expansion, contracting at a 5.7% pace. On net, foreign trade subtracted 0.3%-point from overall GDP growth last quarter. Recent data from a few large US trading partners, particularly China, Japan and the Eurozone, suggest that the external environment could soon become somewhat more supportive for US exporters.
The recent growth in government spending has been dominated by gyrations in the volatile defense spending category. On a longer-run basis this sector of the economy, which accounts for 5.0% of overall output, has been trending down since 2010. Outside of defense, government spending was little changed last quarter. In the state and local sector, declines in employment have moderated some, consistent with an easing of financial strains at this level of government. The outlook for federal spending remains one of the greatest uncertainties for the outlook. Current law stipulates a sharp reduction in federal spending beginning on March 1st, which could restrain growth over the remainder of the year. In addition to the uncertain state of these automatic spending cuts, the ultimate decision on the Treasury’s borrowing limit has been deferred, but has not been fully resolved.
Inflation has been soft in recent months, held down by declines in energy prices. On a year-ago basis the price index for personal consumption expenditures (PCE) has increased only 1.3%. The ex-food and energy core PCE index has also been quite soft, rising only 1.4% over the past year. The deceleration in this category was even more pronounced in the fourth quarter, when core PCE prices increased at only a 0.9% annual rate. Inflation is likely to remain muted for the foreseeable future, as soft wage gains limit business labor costs.
The tame inflation readings have cleared the way for monetary policy to become even more active in fostering a growth-friendly environment. Since the Committee last met, the Fed has announced an open-ended program of Treasury purchases, to supplement the previously announced open-ended program of agency mortgage purchases. The Fed also altered their communciations to indicate that extremely low overnight interest rates will be maintained at least until the unemployment rate falls below 6.5%, provided the inflation outlook does not rise to above 2.5%. The reduction in macroeconomic tail risks, as well as the minutes to the December FOMC meeting, has led to some re-pricing of Fed policy, but market participants generally expect both asset purchase and interest rate policy to remain accommodative for a considerable period.
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 immediate changes to Treasury coupon issuance were necessary.
The Committee had a brief discussion on Treasury’s request-for-comment on proposed rules pertaining to the issuance of floating rate notes (FRNs). Based on comments received from market participants, the main unresolved item continues to be the choice of floating rate index, with more than half of respondents expressing a preference for repo rates, while the remainder preferred 13-week T-Bills. The Committee remains hopeful that the first auction of FRNs can occur at the November 2013 refunding, contingent on Treasury’s operational readiness.
In the second charge, the Committee examined primary and secondary market conditions in the financing market for housing credit. The presentation [Attached] highlights the impact of the Federal Reserve’s purchases on the secondary mortgage rate. It notes that the spread between the primary and secondary rate remains wide by historical measures, but may remain so due to a variety of constraints. Furthermore, the presentation outlines the various policy proposals that when either resolved, or implemented, will dictate the future market structure for housing finance.
In the third charge, the Committee discussed the prospect of even more rapidly extending the Weighted Average Maturity (WAM) of Treasury’s debt. The presentation [Attached] looked at three specific strategies, in all of which two-year and three-year issuance is reduced and replaced by increased issuance of securities 10 years and longer. In strategies two and three, the introduction of a 20-year and 50-year bond, respectively, is explored. While no consensus emerged, the Committee was comfortable that maintaining the current maturity structure of new issuance will already extend the WAM from 65 months to 80 months by 2022. A discussion ensued in which the Committee thought it appropriate to undertake further broad and detailed analysis on this issue.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the January 2013 to March 2013 quarter and the April 2013 to June 2013 quarter. The committee’s recommendations are attached.
Matthew E. Zames