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Fed can only fire blanks as economy teeters

The U.S. Federal Reserve building in Washington.


Think of Thursday's run of U.S. economic data like a pair of handcuffs for the Federal Reserve.

New reports show that manufacturing in the Philadelphia region contracted by the most in two years in August, sales of existing homes fell 3.5 per cent in July from the previous month, and first-time claims for jobless benefits increased by 9,000 last week, pushing total claims back above 400,000.

These data are secondary indicators. Still, the numbers are awful. All things equal, they would prompt a response from the central bank. But that's not likely to happen.

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A fourth report Thursday explains why. The consumer price index jumped 0.5 per cent in July on a higher gasoline costs. More troubling is more evidence of upward pressure on core prices, which exclude food and energy. The core rate rose 0.2 per cent on the month and was 1.8 per cent higher than a year ago.

That's a problem for the Fed.

Policy makers aim to keep inflation at an annual rate of about 2 per cent. The CPI isn't the Fed's preferred measure of inflation, yet it remains a strong guide. The core rate is signaling that higher energy and commodity costs are forcing businesses to charge higher prices, pushing underlying inflation close to the Fed's target.

The upshot is policy paralysis. New York-based investment bank Morgan Stanley said in a revised economic outlook Thursday that the U.S. is "dangerously close" to a recession. However, until inflation subsides, the Fed is limited in what it can do to stimulate demand. Capital Economics, a consultancy based in London, said the latest CPI data could keep the central bank from embarking on a third asset-purchase program until next year. (Should the Fed choose to do so, of course; Capital is betting it will.)

As always, there are flecks of data that contradict the overall tone. The latest report on U.S. leading indicators rose a 0.5 per cent, a solid increase that suggests the economy is pulling out of the swamp it ran into in the first half. The four-week moving average of initial jobless claims fell to 402,500 last week, the seventh consecutive weekly decline.

But those are faint glimmers of hope. Bank of America Merrill Lynch's Joshua Dennerlein pointed out in a note Thursday that almost half of the U.S.'s unemployed are collecting jobless benefits. At the end of the year, extended benefits are set to expire, putting at risk the unemployment insurance payments of more than 3.5 million people. "After the expiration, only a quarter of the nation's unemployed will be collecting UI cheques," Mr. Dennerlein said. "This will act as a hit to income, hurting consumption in the first half of the year."

The prospect of jobless benefits running out surely is a restraint on current spending too. That is contributing to the severe lack of confidence that risks dragging the economy back into recession. There's just little reason for consumers and businesses to feel good about spending money. The median expectation of Wall Street economists was that sales of existing homes would increase in July. Another decline suggests the U.S. housing market still is looking for a bottom. Until the market rebounds, consumers will remain cautious. Homes represent that the single biggest investment for some 60 per cent of U.S. households, and right now, that investment is losing value.

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Markets are panicking. The yield on U.S. 10-year notes dropped below 2 per cent for the first time ever Thursday, and mortgage rates fell to a 50-year low, as investors reshuffled their bets on fears of a return to recession.

So in some ways, the markets are doing the Fed's work. That's good, because until a weaker economy takes the steam out of inflation, the central bank is shackled.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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