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Daily Economic Commentary US

Wednesday, October 6, 1999

Y2K And Fed Policy

Could the Y2K event prevent the Fed from tightening on November 16? It could, but let's be clear about why. There are two separate Y2K issues with regard to Fed policy. One of these is the issue of liquidity. It is generally assumed that there will be an increased demand for liquidity around year-end. Entities will be much more inclined to borrow than to lend. This could put significant upward pressure on interest rates, especially interest rates on non-U.S. government guaranteed instruments. If the fed funds rate could spike up to 10% or higher around year-end because of this increased demand for liquidity, does it really matter if the Fed's target for this rate is 5-1/4% or 5-1/2%? Obviously not. The Fed already has addressed this liquidity issue by establishing a special Y2K discount window lending facility and expanding the list of acceptable collateral for open market operations. So, the Y2K liquidity issue is not one that would inhibit the Fed from tightening on November 16.

The issue that could inhibit the Fed has to do with disentangling Y2K-related "noise" in the economic data from the underlying fundamental "signal." For example, many analysts expect that businesses will want to hold higher inventories as we go into the new year in case of temporary Y2K-related production/delivery disruptions. This increased demand for inventories would increase manufacturing activity. But even without Y2K, it could be expected that desired business inventories would be rising given that inventories-to-sales ratios are extremely low. So, if the Fed observes strengthening factory activity and accelerated inventory accumulation, how can it separate the fundamental increased demand for inventories from the Y2K effect? This added uncertainty could inhibit the Fed's November 16 tightening ardor.

If the core CPI is showing signs of rising faster, if unit labor cost growth is starting to pick up on a year-over-year basis and no signs of a significant slowing in service sector activity are visible, then I think the Fed will have enough information to justify in its own mind a November 16 tightening, regardless of Y2K-related data interpretation problems. There is no doubt, however, these data interpretation problems imply that the tightening case will have to be buttressed by more evidence than otherwise.

Factory Inventory-Shipments Ratio At Record Low

New orders of factory goods rose 1.3% in August, following a 2.5% increase during the prior month. Bookings of durables were up 1.2% in August, previously reported as a 0.9% increase. Orders of non-durable goods climbed 1.5%, after a 0.2% increase in July. (We need to look at shipments of non-durables to infer about details about orders because breakdowns about the different components are not published.) Shipments of non-durable goods indicate widespread strength, in addition to the 3.9% jump in shipments of petroleum related products. Also, unfilled orders of non-durable increased 3.7%, the largest monthly gain since March 1994. Shipments of factory goods advanced 1.4% in August, while inventories slipped 0.1% in August (inventories rose 0.5% in July). The August inventory-shipment ratio dropped to 1.28 - the lowest on record -- from 1.30 in July. This lean inventory situation has raised expectations of a buildup in the third and fourth quarters not only as a precautionary measure in preparation for Y2K but also to meet healthy consumer demand. An accumulation of inventories is part of our forecast for the second-half of 1999. The complete picture of inventories, down the entire distribution chain, will be published on October 15, which could alter our current prediction. However, other factory sector data -- production and NAPM data - suggest that factory output has been growing rapidly which has to appear either as inventories, exports, or purchases in third quarter GDP data. If the increase in production is not reflected in inventories, exports and purchases should capture the gains in production.

Asha Bangalore

-- Helium (Heliumavid@yahoo.com), October 07, 1999

Answers

I am an independent (self employed with no bosses! yea, right) Real Estate Appraiser. The work appraisers get is predicated on interest rates. The lower the better. I have told my wife that next year, not only because of Y2K, but mainly because of interest rates going through the roof, there will be slim pickings in our industry. I did survive the early to mid 1990's by doing foreclosure work (felt very bad most of the time but the kids had shoes). However, if there are no viable institutions available to insure loans who will foreclose on the homes?

Just curious...

-- Uncle Bob (UNCLB0B@Y2KOK.ORG), October 08, 1999.