US: Greenspan upbeat on the economy, dovish on inflation

Predicting the market reaction to a Greenspan speech is always difficult. He says a great deal and is so vague that there should be something for everyone. This time the markets chose to focus on two things: the apparent lack of concern about the weaker dollar, and a small downward revision to the inflation forecast.

The comments on the currency at least were nothing new. Greenspan said that the dollar decline so far had been 'gradual' and that it should help to narrow the US current account deficit. Both points are evidently true. He repeated his concern that the large federal budget deficit will pose 'serious longer-term fiscal difficulties' unless addressed soon, adding that 'given the already-substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on US residents.' This is also no more than what many people - including Greenspan himself - have been saying for a long time. The fact that the dollar took those statements so badly therefore reinforces our near-term pessimism about the currency. The 'twin deficits' may be an old story, but when told by Greenspan it is still a good one.

The downward revision to the inflation forecast was a surprise. The Fed expects consumer price inflation to be 1.0-1.25% in Q4 2004, compared to 1.0-1.5% in its previous report published last July. That is odd, because the Fed has also revised its growth forecast higher (from 3.75-4.75% to 4.5-5.0%), and its unemployment forecast lower (from 5.5-6.0% to 5.25-5.5%). Moreover, the Fed is forecasting headline inflation, not the core measure. Headline inflation was 1.6% in Q2 2003, 1.7% in Q3, and 1.4% in Q4-03. So the measure we are talking about here has been pretty stable. Nonetheless, the Fed expects it to fall in 2004 despite strong growth and lower unemployment (as well as higher commodity prices, a weaker dollar, and everything else that is going on). That story is clearly dovish. The question is whether it is credible. We have our doubts here, but until the data prove otherwise the Fed's view is obviously more important.

So where does this leave our interest rate view? It is clear that stronger growth alone is not enough for the Fed to raise rates. The latest forecasts assume that 5% GDP growth would be consistent with headline inflation falling as low as 1% and the unemployment rate remaining as high as 5.5% (it was 5.6% in January). But if inflation starts to rise rather than fall, and the unemployment rate continues its clear downward trend, those forecasts will be proven wrong. That should still happen in time for a June rate hike, though we do need to see stronger payrolls data soon.