It is becoming increasingly difficult for the Federal Reserve to justify reducing stimulus next week. A slowdown in consumer spending and sluggish job growth screams of a recovery that is losing momentum. Inflationary pressures are virtually nonexistent which means that if the central bank were to consider a policy action, arguments could be made easing and tightening. However the recovery is stable enough that the Fed is not worried about a sudden contraction in growth, which is why they want to reduce asset purchases. At this stage, there are only 2 motivations for changing monetary policy next week – timing and pricing. One of the greatest fears for the central bank is that 10 year U.S. bond yields will shoot through 3% when they taper and luckily the recent disappointments in U.S. data has eased the pressure on bonds so there may not be a better time than now to tweak monetary policy. December is also a tricky period to reduce stimulus because the meeting is so close to the holidays and the central bank risks sending stocks sharply lower, causing a retrenchment in spending that could make this holiday shopping season particularly difficult for retailers. With this in mind, the Fed cannot justify an aggressive move so if they decide to taper it may by only $5 billion to $10 billion per month.
The odds of delaying a reduction in monetary accommodation shot up after today’s retail sales report. Consumer spending is the backbone of the U.S. economy and unfortunately retail sales growth slowed to 0.2% from 0.4% in the month of August. Although the July figures were revised higher, the improvement does not diminish the grim reality of slower spending. Excluding autos and gas, the numbers were even more disturbing – sales growth slowed to 0.1% from 0.6% the prior month. High unemployment, slow income growth and greater payroll taxes restrained spending last month. For policymakers who may have been on the fence, today’s report could push them to vote against dialing back asset purchases in September. A number of U.S. economic reports are scheduled for release next week but this was the last piece of data that could have swayed the central bank’s decision. It is no secret that the Fed sees the housing market as the engine of growth for the economy and the decline in spending on building materials and garden supplies is another reason for them to be worried.
Producer prices on the other hand grew 0.3% in August but excluding food and energy costs, prices stagnated last month. On an annualized basis, year over year PPI growth slowed from 2.1% to 1.4%. The combination of softer inflationary pressures and weaker consumer spending means that tapering next week is not a done deal. In fact we expect the dollar to continue to weaken ahead of next Wednesday’s FOMC announcement, as the increased uncertainty and risk encourages a reduction in U.S. dollar positions. The University of Michigan consumer sentiment report is scheduled for release later this morning and we don’t expect the report to alter our outlook for a further near term correction in the dollar.