ECON 101….A YEAR LATER

By Annaly Capital Management:

Today marks the one-year anniversary of the launch of Annaly Salvos, and we thought we would take advantage of this milestone to revisit the graph at the heart of our very first post. It is a snapshot of the factors we believe the Fed watches to determine the fundamental health of the economy: the Capacity Utilization rate (CapU) in white, core CPI in red, the unemployment rate in yellow and the Fed Funds rate in green. We observed that when there is a lot of slack in the economy—high unemployment and low factory usage—and inflation is quiescent, the Fed will typically start to lower rates. If the economy is performing well, generating tight resource utilization and more inflationary pressures, the Fed will typically start to tighten. A close look at the graph will also show that as the business cycle waxes and wanes, the Fed is asymmetrical in its response. It is much quicker to lower rates at the first sign of weakness than it is to tighten when the going is good.

Where are we now versus a year ago? From the Fed’s decision-making perspective, we think it is unchanged to worse. Capacity utilization at 74.1% has bounced off its recent lows, but it is still no better than the cyclical low of the 2000 recession. The unemployment rate is exactly where it was a year ago, though this is primarily due to a mass exodus from the labor force (the number of workers no longer in the labor force has increased by more than 3 million since last year). And the core inflation rate looks like it will soon be called the core deflation rate. So while the Federal Reserve may talk about economic growth being constrained due to “developments abroad” (as it did in the last FOMC statement), ultimately we think Bernanke & Co. may be more inclined to follow their Econ 101 graph of domestic activity and act accordingly. We’ll check in again next year. Have a happy 4^th of July!