50 still matters for the Fed

November 2, 2015

NBA: Cleveland Cavaliers at Memphis GrizzliesThe Institute for Supply Management’s manufacturing index, long one of the most reliable leading momentum indicators in the U.S. economy, has been flashing warning signs of late, but especially in the last few months.

Economists are lining up one by one, picking through the components of the latest lackluster report to hold up examples of whatever strength they can find.

A bump up in new orders comfortably above the 50 mark in the diffusion index that divides contraction from growth is probably the best of the bunch as it’s forward-looking. Some even say that the economy can still do just fine with an ISM below 50.

The one many are ignoring is the outright contraction in hiring, which bodes poorly for the U.S. jobs report due on Friday.

Absent from any of the commentary is that apart from a blip in mid-1985, which was soon followed by rate cuts, you have to go back to the late 1970s to find a time when the Fed thought it prudent to raise rates with the ISM at or below 50. When it was raising rates, that level in the ISM tended to coincide with a point when the Fed decided to pause or even stop.

ISM vs Fed funds

Back in the late 1970s, Fed Chairman Paul Volcker was at the start of a campaign to slay runaway U.S. inflation with eye-wateringly high interest rates by today’s “zero for longer” standards — a feat he accomplished only by sending the economy into a punishing recession in the early 1980s. The economy recovered smartly from that, but inflation now is a shadow of what it once was, dwindling away today in many parts of the world to be almost-non existent.

Manufacturing matters much less to the U.S. economy now than it did back then. Its share of the economy has shrunk to a little over 10 percent, which some economists now say gives us good reason to look to services to carry the direction and the day no matter how much damage the strong U.S. dollar may have done to exports of U.S. manufactured goods over the past year or so.

The report also suggested that the inventory overhang from the first half of the year that has been holding back economic growth is being run down to a reasonable degree. That left some thinking that the worst perhaps has now passed.

Jim O’Sullivan at High Frequency Economics wrote:

In short, not much change in the headline index, but a slightly better demand-vs-inventories composition.  The inventory drag is probably near its peak.  Without the inventory drag, the Q3 real GDP growth rate would have been 3.0% rather than 1.5% in last week’s report.

Overall growth in the economy has been led by the non-manufacturing sector, as signaled by a much higher level for the non-manufacturing ISM than manufacturing ISM index.  We expect the non-manufacturing index to be up a little in this week’s report for October.

Others aren’t so confident. Jay Morelock at FTN Financial:

Having stabilized around 50, the manufacturing sector is hovering between contraction or recovery.  Whether or not we head up or down from here will be dependent on a combination of global growth prospects and Federal Reserve accommodation.  For now, stabilizing in positive territory (albeit slightly) is better than many alternatives imagined when energy prices reversed in July and August.

History suggests that a prudent Fed would want to see the ISM leap well above current levels before embarking on a rate-rising campaign for the first time in nearly a decade. A rate hike next month may be in play, but it is still very much up for debate.

— Andy Bruce contributed to this post

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