The Capital Spectator

The bottom line for Gitlitz: "We don't believe the Fed will ease without a precipitous growth slump, and we see no indication that such a slowdown is in the works."

The Fed's FOMC meets again on October 24 and 25 to again consider the right and proper level of money's price. So far, the Gitlitz view of the world finds little support in the world of futures trading. As we write this morning, the November Fed funds contract is priced in anticipation of holding the Fed funds at the current 5.25%.

Then again, bulls and bears may both claim triumph if the pause remains intact at the next rate meeting. If the Fed truly thought a recession was coming, it would cut rates, right? On the other hand, some might reason that the Fed is worried that growth will stay stronger than expected and so prefers to keep rates unchanged for fear of cutting too early.

Perhaps, but for the moment the forces expecting economic moderation are in control, an influence that extends to the world of oil. A barrel of crude fell below $60 earlier today, a six-month low. When and if Mr. Market comes around to the Gitlitz view of the economy, oil prices are likely to be an early indicator. But today, at least, the slow-growth outlook prevails.

For the long-term strategic investor, the economic debate can be more than a little confusing. No matter, as we're still of a mind that better opportunities will emerge down the road, and so we're still overweighted in cash. At some point, valuations in one or more of the asset classes will present more compelling numbers. Meantime, we're happy to stay diversified across all the usual suspects, albeit without making aggressive bets anywhere. That will change, perhaps soon. But first, Gitlitz or Roubini must be proven wrong, a task that can only be delivered by the data.

Our suspicion is that the future will favor something closer to Roubini's outlook, if not quite so extreme. Nonetheless, the optimist in us still hopes for a scenario that tracks Gitlitz's. Call us crazy, but we prefer growth over recession. Nonetheless, we'll take what comes. More importantly, we aim to profit from it. Such is life in the cold, calculating and opportunistic trenches.

Posted by jp at 9:33 AM | Comments (1)

September 23, 2006

THE GREENSPAN FACTOR MAKES A TIMELY RETURN

The 10-year Treasury yield continued tumbling yesterday, falling below 4.6%, the lowest since late-February. The general catalyst: mounting worries about an economic slowdown. But yesterday's buying spree in bonds also found some unexpected support from the Greenspan effect.

Former Fed Chairman Alan Greenspan reportedly made comments Thursday evening about the prospects for a Fed rate cut, according to the Wall Street Journal. Rumors of the talk, delivered at a conference at Drake Management in New York, apparently inspired a fair amount of the buying yesterday that pushed yields lower (bond yields and prices move inversely). Nonetheless, there's some debate about what exactly Greenspan said on Thursday. The complete Journal story (available only to subscribers) notes that "two people who attended the event where Mr. Greenspan spoke said he didn't say anything about likely actions by the Fed, as some rumors suggested."

Nonetheless, rumors are a potent force these days as questions swirl about what comes next for the economy. Nature abhors a vacuum, and so do bond traders. Ours is a moment when buying Treasuries first and asking questions later is the preference du jour. The fad will continue until (and if) there's compelling evidence to rethink the trade. Meanwhile, momentum is alive and kicking (again).

Posted by jp at 8:24 AM | Comments (0)

September 22, 2006

ANATOMY OF A SLOWDOWN

The debate over whether the economy is slowing is dead. In fact, it's appears to have been deceased for some time. Some of us may not have realized this essential fact, but the discussion of relevance has necessarily turned to the magnitude of the decline.

The latest batch of numbers confirm what the bond market has been predicting for some time: economic momentum is slowing, and more than a little. The accumulated numbers below tell the story. Of particular interest is the Philadelphia Fed index, which tracks manufacturing activity in New Jersey, Pennsylvania and Delaware. The latest report shows that the index went negative for the first time in three years, and by a surprisingly wide margin from the previous number. Meanwhile, the Conference Board's leading index fell again by 0.2%, bringing the measure to its lowest since October 2005.

The accumulating evidence of economic downshifting inspired a fresh surge of buying yesterday in the 10-year Treasury Note. By the close of trading on Thursday, the 10-year's yield fell to 4.65%, a level last seen six months ago.

Of course, the 10-year's yield decline is nothing new, having been slipping for months. The big change yesterday is the stock market's confidence, which suddenly took a tumble. The S&P 500 slipped by around one-half of a percent yesterday. Although the upward trend in the stock market since July still appears intact, equities are vulnerable to a larger correction going forward. Much, of course, depends on the economic reports coming next week, which will inform Wall Street as to just how much the economy is slowing.

Indeed, next week is stuffed with scheduled releases of new numbers that could take a toll on equities. Among the highlights:

* Existing Home Sales (Sep 25, 10 a.m.)
* Consumer Confidence (Sep 26, 10 a.m.)
* Durable Goods Orders (Sep 27, 8:30 a.m.)
* 2Q GDP, final (Sep 28, 8:30 a.m.)
* Personal Income & Spending (Sep 29, 8:30 a.m.)

The slowing U.S. economy, in fact, seems to have company. BCA Research on Wednesday, citing a survey of analyst expectations on the global economy, reports that a continued slowdown is widely forecast.

The good news is that when cycles turn, volatility in prices in asset classes tends to rise as the markets struggle to digest the shift in trend. Traditionally, such periods produce attractive buying opportunities for strategic-minded investors.

Indeed, such opportunities have been notably lacking this year. Virtually all of the asset classes have been priced for perfection as it relates to their particular slice of the world. But something less than perfection is starting to arrive, and the repricing of risk in more than a subtle manner may have started. For those with the cash at the ready, the future may extend deals that are too good to pass up. If so, that alone would mark a considerable change from the recent past.

Of course, an enlightened investor must realize that if the economy slows, but by a degree that still manages to surprise on the upside, stocks could rally and bonds could suffer. Everything is relative when it comes to the link between prices and expectations. That's why the financial gods invented diversification. Nonetheless, redeploying capital across asset classes when expected returns rise, even on the margins, is the only game in town in the long run.

Posted by jp at 9:37 AM | Comments (1)

September 21, 2006

IN PERFECTION WE TRUST

There's a higher degree of respect today for the old saying: Don't fight the Fed.

In Fed Chairman Ben Bernanke's first six months on the job, such counsel was thought to be of fading relevance. But the chairman's verbal stumbles are gone while the Fed's credibility is higher, thanks to Bernanke and company's forecast that a slowing economy would complement lower inflation. So far, that prediction has proved to be accurate, and Wall Street couldn't be happier.

In fact, yesterday's decision by the central bank to hold Fed funds at 5.25% was widely expected. Fed funds futures have been predicting another pause for weeks.

But this new world order of respect for the institution that ultimately controls inflation's path is contingent, as always, on what happens next. From an investor's perspective, the future holds more than a few challenges, and perhaps some volatility in pricing because expectations in the present are fairly high and rising.

Investors seem inclined to believe that the so-called Goldilocks economy is assured--not too hot and not too cold. In this vision of future bliss, economic growth will slow enough to keep interest rates from rising, but growth will not tumble so much as to bring on a recession. Meanwhile, inflation will moderate to just the right level to stave off deflation while giving the Fed room to continue pausing and perhaps even begin cutting rates.

In a world where the yield curve is inverted, expecting perfection may be asking for more than the financial gods can deliver. A three-month T-bill currently yields 4.92%, about 20 basis points above the rate on a 10-year Treasury. Then again, perhaps this is the international signal that perfection is coming in economic and financial spheres. One has to keep an open mind in the new world order, even if we're keeping one hand on our wallets.

In any case, jubilation dominates trading in stocks and bonds. The S&P 500 yesterday on an intraday basis probed heights last witnessed in February 2001, while the 10-year yield yesterday briefly dipped to its lowest (~4.71%) since March.

Some of the buying is inspired by the correction in commodities, notably energy. With the froth coming out of prices for oil, gasoline and natural gas recently, the money is being redeployed in stocks and bonds.

But amid all the euphoria that's now sweeping Wall Street, it's worth remembering that the Fed still has work to do. The core rate of inflation still remains too high to ignore. Meanwhile, labor costs seem to be perking up, delivering what may turn out to be a headache for monetary policy in the near future.

"All the wage data show an acceleration to one degree or another yet the policy makers do not acknowledge that" in yesterday's FOMC statement, Mark Zandi, chief economist at Moody's Economy.com, told the New York Times today. "That is suggestive of a more dovish Federal Reserve. The small changes in this latest statement all suggest that the Fed will not be raising interest rates anytime soon. In fact, you can almost make the case that they are trying to drive expectations in the other direction."

To be fair, the Fed's statement did advise that "some inflation risks remain" and so "additional firming that may be needed...."

But for the moment, warnings fall on deaf ears on Wall Street.

Posted by jp at 9:52 AM | Comments (0)

September 20, 2006

LIQUIDITY RULES

It's too soon to declare that the Fed has once and forever stamped out the inflation embers, but it's clear that the central bank has won the current battle.

The concern that consumer and producer prices would spiral upward while the Fed kept interest rates flat has been demoted, if not yet completely quashed, as a topical worry. The FOMC meets today and will likely declare that the price of money can remain as is. In sum, the debate that the liquidity unleashed in the recent past is about to show up in official inflation numbers is dead for the moment. But the thornier issues of deciding where all the liquidity went, where it will go, and what it means for future price trends remains alive and kicking.

In an earlier era, the hefty injection of liquidity into the U.S. economy that prevailed in the years after 2001 would have delivered more of an inflationary kick, as tracked by consumer price gauges. That hasn't happened, but the reason has as much to do with deft central banking as it does with disinflationary and even deflationary winds blowing in the global economy.

The rise of emerging market economies in recent years, as The Economist points out this week, has been a major force for keeping broad measures of inflation relatively contained. As the survey asserts, emerging nations have delivered both a fresh and healthy dose of cheap labor and cheap capital to the world economy to a degree that's unprecedented. In turn, prices for a number of goods and services, along with wages, have stayed lower than they might otherwise be in the U.S. and elsewhere.

The Fed and other central banks, as a result, have found it easier to keep interest rates lower and permit liquidity to rise higher than prudence might have allowed a generation ago. But while the liquidity production hasn't come back to bite the economy, it's had an impact. Where has all that liquidity been going? It's not obvious, if one looks at the broad measures of inflation, as yesterday's producer price index and last week's consumer price report remind. But rest assured, the extra money the Fed has so generously printed has gone somewhere.

In the late-1990s, inflation arguably showed up in stock prices, which ran skyward. When the equity market collapsed in 2001 and 2002, cash found a new home in real estate. The bull market in housing in particular is said to be a boom of unprecedented proportions. Of course, that boom is now in the process of unwinding.

Liquidity has also migrated into emerging market economies, which hold 70% of the world's foreign exchange reserves, according to The Economist's latest world economy survey. That's extraordinary for a number of reasons, starting with the fact that while the lion's share of the planet's reserves are in emerging economies, those nations represent less than 20% of the world's stock market capitalization.

Imbalances are all the rage these days, and that extends to the extent that a large chunk of the liquidity held by the likes of China and India has migrated back to the United States in the form of funding of the country's current account deficit via purchases of Treasuries and other assets.

If the past is any guide, however, excess liquidity is a transient form of capital. Expecting it stay put may be expecting the impossible. If so, what does the future hold when the liquidity seeks out greener pastures? It's a timely question these days as some of the liquidity starts to come out of real estate and the global economy seems poised for a downshift in growth. Thus the question du jour: Where will liquidity go next? Perhaps it'll flow back into real estate, or gravitate back to stocks, or work its way into the economy so that the general price indices start moving up after all. Or, maybe the liquidity will surprise everyone and foment repercussions that no one can yet imagine.

Fed Chairman Ben Bernanke is on record as saying that the world has been awash with a global savings glut. That glut has been helpful to U.S. monetary policy so far. After Bernanke and company are done celebrating today, perhaps they might ponder if the global savings glut will continue to benefit the American economy, or if something might change.

Posted by jp at 9:24 AM | Comments (0)

September 19, 2006

ANOTHER GIFT FROM THE PRICING GODS

DUE TO A TECHNICAL GLITCH WITH OUR SERVER, WE WEREN'T ABLE TO PUBLISH UNTIL LATE THIS AFTERNOON. THE TECHNOLOGY GODS APPARENTLY ARE ANGRY WITH US. IN ANY CASE, HERE'S THE POST AS WRITTEN THIS MORNING...

Last week's report on consumer prices for August was encouraging. This morning's news on wholesale prices is even better.

Producer prices rose just 0.1% last month, the Labor Department announced. Subtracting food and energy from the mix revealed a core PPI that decline 0.4% in August. That's the second month running that core PPI fell. Falling car and light truck prices were the main factors weighing on producer prices.

Coming just a day ahead of tomorrow's FOMC meeting, today's news will likely deliver the extra muscle to insure that the Fed keeps interest rates unchanged. In fact, traders are starting to nibble at Fed funds futures this morning, providing what may be a preview of anticipating a rate cut in October.

Helping raise the prospect of a rate cut down the road is the Commerce Department's report this morning that housing starts dropped again to an annualized pace of 1.655 million--the slowest pace since April 2003. No one can doubt that real estate is now in the midst of something more than a temporary stumble.

Even so, the bond market apparently had the jitters yesterday, driving the yield on the 10-year Treasury up to nearly 4.85% at one point--the highest since late-August. But optimism has since returned, and in early trading this morning the 10-year's yield is again fallen below 4.80%. By the end of the week, even lower yields are expected.

For the moment, the optimists and doves are heroes. Meanwhile, Bernanke's star burns brighter this morning. Inflation is still a long-term enemy and the path of least resistance with a government and an economy that are hard wired to spend more than they take in. But such worries have been banished to the deepest recesses of Mr. Market's collective mind.

The trend is said to be your friend. For the moment, there's plenty of incentive to go with the flow.

Posted by jp at 5:30 PM | Comments (0)

September 18, 2006

THE PAST, PRESENT & FUTURE OF MONETARY POLICY

The accumulating signs of an economic slowdown in recent weeks have, in the eyes of many, confirmed the Federal Reserve's bias for pausing with interest-rate hikes. If economic growth is fated to become tepid, goes the reasoning, it will take the edge off inflation's momentum.

The conceit buried in this school of thought is that the supply of money carries marginal sway on inflation's course. That's a disturbing view for monetarists, who hold that inflation is a phenomenon driven by changes in the money stock relative to the economy.

Among the main lessons embedded in this belief is that inflation and rapid and/or dramatic price increases aren't necessarily one and the same. A shift in supply and demand moves prices. This has nothing to do with inflation, counsel the monetarists. Rather, an uninformed rise in the stock of money (i.e., a rise that's more than the general economic conditions require for maintaining an orderly functioning of the economy) is one that ultimately elevates prices, but for reasons that are detached from supply and demand trends.

A new paper that preaches the value of seeing inflation as a monetary phenomenon comes from Edward Nelson of the St. Louis Federal Reserve. The research (The Great Inflation and Early Disinflation in Japan and Germany) documents that Japan and Germany in the 1970s witnessed an inflation that peaked relatively early and generally stayed lower compared with other nations in the West, notably the United States. He concludes that the "German and Japanese experiences in the 1970s indicate that once inflation is accepted by policymakers as a monetary phenomenon, the main obstacle to price stability has been overcome."

The topic of debate before the house today is whether the "main obstacle" to price stability has been conquered in the collective mind of the Fed's leadership. The current head of America's central bank, to cite one example, has gone on record explaining that as the economy slows, so will inflation. Backing up that outlook with action, the Fed on August 8 put rate hikes on hold, an act that's widely expected to have a repeat performance on Wednesday, when the FOMC meets again to consider the proper state of money's price.

In fact, there are instances in history when an economic slowdown didn't deliver a commensurate drop in inflation, the 1970s being the egregious example. America, in particular, suffered from so-called stagflation during that decade. Nelson finds that Germany and Japan suffered less. The reason is mostly due to decisions about money supply in those countries, he counsels.

That brings us to the observation that the rate of money supply is again heading up in the United States. The M2 measure of the nation's money stock advanced by 4.9% over the past year through September 4--the highest since mid-July, according to Fed data. This is what one might expect when interest rates stop rising. Deciding if it's also the right policy at the right time, assuming it continues, is another matter.

Of course, confirmation or rejection of the Fed's current policy will come only after months and years, as opposed to the days and weeks that investors seem to think is the appropriate period for analysis. For that reason, we remain hopeful that the central bank will do the right thing in time, and that the recent trend in M2 isn't necessarily indicative of things to come in the long run. What's more, if inflation does in fact continue trending down, the risks of M2 growing lessen.

In the meantime, there is history to consider, including a variety of outcomes that central banks have dispensed over time by way of a variety of strategies. Some in the central banking system are studying that history. Only time will tell if those in the upper echelons are also availing themselves of the opportunity.

Posted by jp at 9:57 AM | Comments (3)

September 15, 2006

ALL CLEAR...FOR NOW

This morning's report on consumer prices for August is the gift that the markets have been looking for.

Inflationary pressures eased last month, the Bureau of Labor Statistics reported, with the CPI advancing at just 0.2% in August, down by half from July's 0.4%. The core rate of inflation, meanwhile, held steady: CPI less food and energy rose 0.2% last month, as it did in July.

The big contributors to the slowing of pricing pressures were energy and transportation. Energy prices gained by a mere 0.3% in August, a universe below July's 2.9% surge. The pace of transportation-related price hikes also took a healthy dive, registering a 0.2% rise, down sharply from the previous month's 1.6% climb.

August, in short, took a fair chunk of the momentum out of inflation's sails. The core rate of CPI is now running at an annual 2.8%. That's still a bit on the high side as far as the Fed's upper range of tolerance is concerned. Bringing core CPI down to the low 2% range is the immediate goal, and a prudent one if the central bank is still concerned (as it should be) with managing inflation as a long-term proposition. As such, the Fed will have to remain vigilant. But for the moment, there's no immediate sign that inflationary pressures are accelerating. Confirmation that the trend is more than a blip will only come in future months, but hope has suddenly taken a big step up in valuation.

Indeed, with oil prices down around 10% so far this month, a repeat performance of easing consumer prices looks on track for the September CPI report. Next Wednesday's FOMC meeting at the Fed, in short, will have fresh data to lean on for rationalizing keeping interest rates on pause.

Mr. Market has been anticipating no less. The S&P 500 has been climbing steadily if slowly since mid-July, and on Wednesday touched its highest level since May. The bulls have been in charge in the bond market too, pushing the yield on the 10-year Treasury Note down under 4.8% for much of this month--the lowest since March.

Year to date through last night's close, the total return is 6.9% for the S&P 500, and 2.2% for the widely watched Lehman Brothers Aggregate Bond Index. The upward momentum in equities is also evident elsewhere on the planet. MSCI EAFE, in dollar terms, is up more than 13% so far this year, and MSCI Emerging Markets (also in dollars) has climbed nearly 8.9% in 2006 through yesterday.

With so much having gone wrong in the recent past, the markets are inclined to celebrate now that a number of things seem to be going right. For the moment, the bulls can breathe a sigh of relief.

Having anticipated the current good news, where do the markets go from here? More of the same? The markets, after all, are about valuing the future, not the past.

But let's not spoil today's party with awkward questions. Let's save such inquiries for next week. Meanwhile, enjoy the show.

Posted by jp at 9:14 AM | Comments (0)

September 14, 2006

EMPHASIZE THE POSITIVE

Two data points are a drop in the economy. But the two that rolled off the wires this morning caught our attention just the same. Such is life in these data-dependent times, when every scrap of new information is inhaled in search of clues about tomorrow. In that state of mind, we found reason to do a double take at the sight of retail sales posting dramatically slower growth while import prices continue to reach upward. Was this something to worry about? Or should we simply chill and switch to decaf?

U.S. retail and food services sales for August grew by just 0.2%, the Census Bureau reported. After July's 1.4% surge over June, 0.2% looks a tad thin. Meanwhile, the Labor Department advised that import prices jumped 0.8% last month and the original estimate for July was revised up to 1.0% from a mere 0.1%. The combination of slowing consumer spending and rising prices by way of the nation's voracious appetite for imported goods is something less than ideal at this moment in the economic cycle. Gee, what will Bernanke think?

Of course, one could opt to emphasize the positive, such as it is. Let's give it a whirl, shall we? Let's start by noting that the 0.2% rise in retail sales is an improvement over the consensus outlook that called for a slight decline of -0.2%. In addition, retail sales look more robust by comparing August's tally to its year-earlier total. By that measure, retail sales jumped 6.7% on the year, or more than twice as high as the economy's pace of growth in the second quarter. Not too shabby for a consumer population that's thought to be laden with debt.

David Resler, chief economist at Nomura Securities in New York, finds reason to see the glass half full rather half empty on the retail front. The "underlying retail trend has picked up a bit after a sluggish second quarter and seems to be growing at a pace that is consistent with trend-like growth in overall consumer spending," he wrote in a note to clients this morning.

Over on the imports ledger, prices are advancing at a far slower pace once you remove energy from the calculation. While import prices overall rose 0.8% last month, the climb was a lesser 0.5% for non-petroleum imports. The year-over-year record is also slower once you take out energy: 2.7% vs. 6.6%. In addition, the 12-month rate of change for top-line import prices slowed again last month, as it has in the two previous months. The trend, at least, is encouraging. Meanwhile, the fact that oil prices have been dropping of late adds to the hope that the import prices will be revised down.

Mr. Market, in fact, continues to emphasize the positive. The initial reaction among traders in Fed funds futures to the news this morning on retail sales and import prices tells the story: the October contract is virtually unchanged, priced in anticipation for more inertia at next week's FOMC meeting, i.e., keeping Fed funds at 5.25%.

Steady as she goes, an optimist might say. One more hurdle before the weekend. Let's see how cheerful we are after reading tomorrow's report on August consumer prices. Meanwhile, optimism springs eternal...at least through the end of trading today.

Posted by jp at 9:59 AM | Comments (0)

September 13, 2006

DISSECTING BULL MARKETS (AGAIN)

A new research paper that analyzes the timing of stock market booms around the world in the 20th century in relation to macroeconomic conditions probably won't surprise enlightened observers of the money game. But what the paper lacks in shocking disclosures it makes up with a timely reminder that equity bull markets tend to thrive under a particular set of conditions. Conditions, some argue, that appear to be on the wane these days.

Indeed, a new working paper published on the St. Louis Fed's web site, When Do Stock Market Booms Occur? The Macroeconomic and Policy Environments of 20th Century Booms delivers fresh reason to wonder if the current run in stocks still has legs. "We find that booms generally occurred during periods of above-average economic growth and below-average inflation, and that booms typically ended when monetary policy tightened in response to rising inflation," write authors Michael Bordo (an economics professor at Rutgers) and David Wheelock (an economist at the St. Louis Fed). "Most booms were procyclical, arising during business cycle recoveries and expansions, and ending when rising inflation and tighter monetary policy were followed by declining economic activity."

How does that trend relate to the outlook for stocks in 2006? Or, perhaps we should ask, does it relate at all? Before we can even take a shot at an answer, there's the awkward problem of deciding if the economy is currently winding down, heading up or set for an extended period of treading water. Alas, the jury is out on this one--way, way out, to judge by the degree of uncertainty that permeates the economic news of late.

To be sure, a considerable downshift in economic growth has been recorded in the second quarter relative to the first. Meanwhile, there's any number of reasons to think that the slowdown is more than temporary, including the widely publicized slippage in the housing market. But the optimists aren't giving up just yet.

The latest catalyst for thinking that the old bull isn't dead yet comes by watching the decline in oil prices. A barrel of crude is priced under $64 in New York trading, the lowest since March, and down by more than $10 since early August. Hardly a bargain by the standards of the past decade, but the direction at least is expected to cheer the consuming masses.

Today's Wall Street Journal ran a story that explores the potential for a fresh burst of consumer spending fueled by the recent drop in energy prices. Although some dismiss the idea outright, others still find reason to think that a second wind is possible in the current cycle. Robert Mellman, senior economist at J.P. Morgan Chase, is one dismal scientist who thinks that Joe Sixpack may find inspiration anew for pulling out his credit card down at the local mall. Lower gasoline prices could raise the annual pace of consumer spending a full percentage point, he told the Journal. In turn, the annualized fourth-quarter economic growth would jump to 3.7% from an expected 3.0%.

Of course, oil and gasoline prices need to stay down for more than a few weeks to deliver tangible results. We'll see.

Meanwhile, Bordo and Wheelock's research raises some provocative questions at a time when inflation, while still relatively low, has ticked up. Stock market booms, the authors write, "typically arose when inflation was low and declining, and ended within a few months of an increase in the rate of inflation. Rising inflation tended to bring tighter monetary conditions, reflected in higher real interest rates, declining term spreads, and reduced money stock growth."

Among the many questions weighing on Mr. Market comes one more that's inspired from Bordo and Wheelock's research, namely: Does the paper's observation of the past inform investors about what comes next?

Posted by jp at 9:43 AM | Comments (0)

September 12, 2006

WAGERING ON WAGES

There are many things to fear when looking at the economy and its capacity for surprising, and wages taking wing may be one of them. Of course, if you're a long-suffering worker, the trend is worthy of celebration. But expecting the pace of labor income to keep running higher is something to lose sleep over if you're a central banker (or an investor betting that rates will stay flat or fall).

Indeed, the subject or wages promises to be the new new thing as 2006 goes into its final stretch. To be precise, how much of the bubbly wage growth of late will be inflationary? Or, to summarize the optimists, will the upward trend in wage growth be offset by productivity gains and weakness elsewhere in the economy, notably in real estate? Such are the questions that keep investors wondering and economists working.

Analysts Charles Dumas and Gabriel Stein of Lombard Street Research in London believe that the folks at the Fed may lose a little shut-eye in the foreseeable future. Stein wrote yesterday in a note to clients that "labor income growth is accelerating" in the U.S. His colleague, meanwhile, observed last week that "huge" revisions on wage growth estimates point to more Fed tightening.

Not everyone agrees, of course, and we'll get to that shortly. But first, a closer look at Lombard's analysis, starting with Stein. The U.S. economy is entering what he calls an anti-Goldilocks phase, which he defined as "both too hot and too cold at the same time…." Too hot, he continued, "in the sense that household incomes clearly remain strong and are likely to keep powering the economy for some quarters further. In fact,

with non-farm labor income rising by 6%, household spending by itself should be enough to propel the economy to close to trend rate growth--always assuming, of course, that the savings rate does not suddenly begin to rise."