The Federal Reserve's 
Open Market Committee met this week, and as expected, left the fed funds target rate unchanged. How can the average investor anticipate Fed policy? By reading the same economic reports the Fed reviews and learning the difference between an economy that is too hot, too cold or just right.
The Federal Reserve is charged with maintaining price stability and promoting economic growth. If the Fed overstimulates the economy, inflation will rise. If the Fed fights inflation too aggressively, growth will suffer. The Fed tries to maintain the middle course, which has been described as "driving a country road at night with one headlamp and a loose steering wheel while staring at the rearview mirror." The cycle of expansion and recession occurs as the Fed "swerves from one side of the road to the other."
The good news is that the Fed has gotten better at its job over the past 70 years. The current expansion, which dates from mid-1991, is the longest in history. The bad news is that the definition of high noninflationary growth is elusive as ever. For example, 3.5% growth in GDP
is generally considered the highest level of growth consistent with low inflation. Over the past six quarters, however, GDP growth has averaged 5%, yet inflation remains close to a 10-year low.
TheStreet.Com provides an excellent summary of economic indicators in the
Economic Databank. Current activity is summarized under the Calendar tab. Let's see how some of them can help you read the Fed tea leaves.
We'll start with a look at the
Economic Calendar: May 29 - June 2. In the Calendar section, follow down to the jobs report (or "nonfarm payrolls" as the bureaucrats call it) released June 2. Here we see that payrolls grew 231,000 jobs, sharply lower than the 386,000 jobs expected and sharply down from the previous month, which had been revised upward to 414,000 from 340,000. When we saw this report (and read further that payrolls actually contracted in May when census jobs weren't included) we knew instantly the Fed would not raise rates at the June meeting, and we immediately put our excess cash balances to work in stocks.
Well, wait a minute -- do we invest our clients' money on the basis of a single report? No, this report was the confirmation of other trends we were following among these indicators.
The
Indicator tab summarizes the long-term trends in graphic form and provides links to the raw data. I categorize the major reports as follows:
Fed Indicators Beige Book
Leading Economic Indicators
Industrial Production Business Inventories
Durable Goods Orders
Factory Orders
Gross Domestic Product
Industrial Production and Capacity Utilization
Housing Construction Spending
Existing Home Sales
Housing Market Index
Housing Starts
New Home Sales
Consumer Confidence & Employment Consumer Confidence Index
Employment Report
Initial Jobless Claims
Personal Income and Consumption
Real Earnings
Redbook Retail Averages
Retail Sales
Inflation Consumer Price Index
Employment Cost Index
Producer Price Index
Productivity and Unit Labor Costs
Purchasing Managers Index
You must consider these reports as tiles in a mosaic. For example, if consumer confidence is high and real earnings are increasing and employment is strong, we would expect to see retail sales strong as well -- and that would cause us to add retail stocks to our portfolio. In fact, in the current environment, strong consumer data are not being confirmed by strong retail data, so for the time being we are limiting our exposure to the retail sector.
There are three kinds of inflation the Fed worries about:
Goods and services, which is tracked by the CPI, PPI and purchasing managers reports. Employment costs, which is tracked by the Employment Cost Index and the Productivity and Unit Labor Costs report. Asset inflation (rising real estate prices and excessive stock market valuations), which isn't tracked by any of the reports listed above, but the trends are easy to follow if you read financial publications like this one.
In the current environment, inflation in goods and services appears to be contained, and high stock market valuations appear to be taking care of themselves. However, employment costs are still on the rise. If we saw GDP growth slowing from 5.4% in the most recent report to a likely 3.5% level in the next report and a downturn in employment costs, you could conclude the Fed's need to raise rates further this year is limited.
We don't know for sure right now whether the Fed will raise rates on Aug. 22, but continuously reviewing these indicators has given us a one-month lead on correctly predicting Fed actions in the past year.
David Edwards
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