Economic Data Warrant Further Easing

MBA (2/19/2008 ) Velz, Orawin
In testimony before the Senate Banking Committee, Federal Reserve Chairman Ben Bernanke indicated that more rate cuts are in the pipeline if the housing and labor markets as well as credit conditions deteriorate more than anticipated, putting an economic expansion at risk.
While a couple of economic reports released last week were stronger than expected, the landscape of growth remains the same. Economic growth sharply slowed in the fourth quarter and the outlook for the current quarter is likely to be about the same or worse.

Retail sales increased unexpectedly in January, pushed up by rising food and energy prices. The details of the report, with continued downtrend of sales in several major components, point to soft consumer spending in the first quarter. In addition, downward revisions in previous months indicated that consumption spending growth in the fourth quarter was weaker than initially reported.

Another surprise last week was the trade deficit, which narrowed more than the Bureau of Economic Analysis assumed in its advance estimate of gross domestic product (GDP) for the fourth quarter. As a result, the contribution from trade to economic growth was nearly twice the initial report of 0.4 percentage point. The improvement in the trade gap likely offset a downward revision in retail sales, however, leaving economic growth at around the advance estimate of 0.6 percent for the fourth quarter. In any case, the shrinking trade deficit—largely brought about by the declining dollar—provides some comfort that the trade sector will help support the economy in the face of declining domestic demand.

Measures of consumer confidence suggest a downbeat outlook for consumer spending growth in the near term. The University of Michigan’s preliminary estimate for early February showed a large drop in the Consumer Sentiment Index to the lowest level in 16 years. Business confidence also suffered a large pullback, with the National Federation of Independent Business (NFIB) optimism index dropping to the lowest reading since January 1991.

The $168 billion fiscal stimulus package signed by the President last week provides the economy with a silver lining. It won’t have a much-needed stimulative impact on consumption in the first half of this year, however, as the tax rebates to about 130 million households will not arrive until late May. The package includes proposals to increase the limit of loans eligible to be processed by Fannie Mae and Freddie Mac and insured by the FHA. They should provide some relief to the stressed jumbo segment of the housing market; however, the impact could be delayed for several months as there are a number of practical issues to be resolved.

Interest Rates:
Long-term rates were volatile last week. Given earlier reports of weak auto sales and chain-store sales, the financial markets had expected a decline in retail sales. The markets saw an increase in retail sales on Wednesday as a sign that consumers are resilient. This reduced recession worries and long-term rates rose as a result. On Thursday, rates jumped further to a five-week high. While Bernanke opened doors to more rate cuts in his testimony, some market participants perceived it as an increase in inflation risk in the longer-term.

Yields partially reversed on Friday on weak economic data, with the New York Fed’s Empire State Manufacturing Survey showing a sharp contraction in the area’s manufacturing activity and the University of Michigan’s Consumer Sentiment Index plunging nearly nine points. The yield on 10-year Treasuries stayed around 3.77 percent by mid-Friday afternoon—13 basis points higher than the closing rate on the previous Friday.

Housing and Mortgage Indicators:
The National Association of Realtors State and Metropolitan Median Prices for Single-family Homes showed that home prices deteriorated during the fourth quarter 2007. Of the 150 metro areas, 77 (51 percent) saw declining home prices from a year ago—the highest share since data are available in 1979. For the nation as a whole, the median price of single-family homes dropped 5.8 percent in the fourth quarter from a year ago—the largest drop since the inception of the series in 1968.

The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending Feb. 8 showed that mortgage demand declined modestly. This is the first drop in six weeks, with the Market Index falling 2.1 percent to 1063.5. The Purchase Index was down 0.4 percent, while the Refi Index dropped 3.0 percent.

The 30-year fixed mortgage rate rose 11 basis points to 5.72 percent. The one-year adjustable rate was up 10 basis points to 5.72 percent. The ARM share of mortgage applications of the number of loans increased one percentage point to 9.9 percent. The share of the dollar volume of new applications jumped to 20.3 percent from 17.9 percent in the previous week.

Economic Indicators:
Retail sales rose 0.3 percent in January following a decline of 0.4 percent in December. The increase was a surprise because it was inconsistent with other reports related to consumption spending. For example, despite an earlier report of a 6.3 percent decline in unit auto sales for the month, the retail sales report showed a 0.6 percent gain in sales at auto dealers. Furthermore, sales at apparel stores saw a large increase. The International Council of Shopping Centers reported earlier that chain-store sales had the weakest sales for the month of January since the inception of the series in 1970.

Details of the report did not indicate robust consumption spending growth. Contributing to the overall increase were gains in sales at food and beverage stores and gasoline stations, which reflected jumps in gasoline and food prices. Excluding autos and gasoline, sales were flat. Sales at building supply stores, sports and hobby stores, department stores and electronics and appliance stores had large declines. These components have seen a declining trend over the past several months. For example, furniture sales have dropped for six consecutive months, while electronics and appliance stores have seen two consecutive monthly drops.

Despite the stronger than expected headline, the report indicated soft consumption spending—which constitutes about 70 percent of gross domestic product—in the current quarter. The report also revised downward retail sales excluding auto, building materials and gasoline, which go into the calculation of gross domestic product, in the fourth quarter from 3.0 percent to 2.2 percent.

The trade deficit narrowed sharply to $58.76 billion in December from $63.12 billion in November as exports increased and imports decreased. The 1.5 percent increase in exports was the biggest jump since July. Imports fell 1.1 percent. With the exception of petroleum, most categories posted modest declines.

For the fourth quarter, the actual trade deficit was much smaller than the deficit of $71.5 billion the Bureau of Economic Analysis assumed in the advance estimate of gross domestic product. Trade likely added 0.7 percentage point to economic growth in the fourth quarter.

The import price index jumped 1.7 percent in January, following a decrease of 0.2 percent in December. A 5.5 percent increase in petroleum prices largely drove the overall increase in import prices. In December, petroleum prices fell of 1.9 percent. Excluding petroleum, the import price index rose 0.6 percent in January and 3.3 percent over the past year. The declining value of the dollar is largely responsible for the upward trend of the import price index excluding fuel.

Over the past year, the total import price index rose 13.7 percent—the largest increase since record-keeping began in 1892. Sustained increases in import prices post an inflation risk as American firms may try to pass through the higher costs of imports to consumers.

Industrial production—a measure of the nation’s output at factories, mines and utilities—edged up 0.1 percent in January for a second consecutive month. The 2.2 percent increase in mining output was responsible for the increase in industrial production. Manufacturing output was unchanged, while mining output declined for the third time over the past four months.

The report showed that capacity utilization, which measures a portion of plants in use and thus is a gauge for inflation pressures, remained at 81.5 percent for the third consecutive month—somewhat below its recent peak in the 2006 summer of 82.4 percent.

The preliminary estimate of the University of Michigan’s Survey of Consumer Sentiment showed that the Consumer Sentiment Index fell 8.8 points to 69.6 in early February. This is the first time the index has dropped below 70 since February 1992. Both the current condition and the expectations components of the index fell almost evenly by about nine points. The index has been down more than 20 points since last August.

Short-run inflation expectations picked up in February. One-year inflationary expectations increased to 3.7 percent after three months at 3.4 percent, while five-year expectations held steady at 3.0 percent.

The Federal Reserve Bank of New York’s Empire State Manufacturing Survey showed that manufacturing activity in the region contracted sharply in February. The business conditions index fell to minus 11.7 from 9.0 in January. The index fell below zero (a reading indicating a contraction) for the first time since May 2005.

This Week:
• Tuesday — The National Association of Home Builders/Wells Fargo Housing Market Index for February;
• Wednesday — January Consumer Price Index; January housing starts; and the Federal Open Market Committee minutes from its Jan. 29-30 meeting; and
• Thursday — The Conference Board’s Index of Leading Indicators.