Consumers Lose Steam, Raising Recession Odds

MBA (3/17/2008 ) Velz, Orawin
Betting against American consumers is usually the wrong wager. But rising gasoline prices, the continued housing slump, a weakening labor market, tighter lending standards and declining stock markets and falling home values appear to have taken their toll on consumers.
Last week’s report of a 0.6 percent drop in retail sales in February suggests a dim outlook for consumer spending for the current quarter. Retail sales account for about 40 percent of total consumer spending, with spending on services accounting for the rest. Consumer spending, after adjusting for inflation, was flat in both December and January.

Since consumer spending accounts for about 70 percent of gross domestic product, a marked deceleration in spending in the midst of a housing downturn and soft business investment will likely lead to negative economic growth in the current quarter. With many negative factors continuing to weigh on consumers, consumer confidence was little changed in March, lingering around the lowest level in 16 years, according to preliminary Survey of Consumer Sentiment from the University of Michigan.

Widening risk spreads raised new concerns about the credit crunch and the Fed responded with another initiative last week. On Tuesday it announced a new program called the Term Securities Lending Facility (TSLF) to inject liquidity into the financial system. The Fed will lend up to $200 billion in Treasury securities for 28 days to primary dealers via weekly auctions. Collateral includes agency residential mortgage-backed securities (RMBS) as well as AAA-rated private-label RMBS. In effect, the Fed will provide financing for an asset class of RMBS under stress, which cannot be financed through the Fed’s regular operations.

On Friday, the Fed needed to address the liquidity issue again in response to the deteriorating cash position of Bear Stearns. The Fed announced that it approved emergency funding to help Bear Stearns meet its obligations, as withdrawals by its clients intensified. The New York Fed will allow J.P. Morgan Chase & Co. to borrow funds from the Fed's discount window and reloan them to Bear Stearns for 28 days. (J.P. Morgan only serves as the operational conduit for the funds from the Fed simply because it had all the necessary arrangements in place to conduct business with the Fed). In its announcement, the Fed also said it would act "as needed to promote the orderly functioning of the financial system.”

Last week’s releases of flat consumer price index (CPI) as well as flat core CPI for the month of February left the door wide open for an outsized rate cut when the Federal Open Market Committee meets tomorrow. Fed fund futures have fully priced in a 75 basis point cut at the meeting. The calm inflation picture may be temporary, however, reflecting partly on declining energy prices during the month. Record-high oil and gasoline prices and rising commodity prices so far this month post upside risks for inflation pressures.

The on-going declining dollar also increases a pass-through risk from rising import prices to other goods and services. In addition, inflation expectations have been on the rise, according to both survey-based evidence (e.g., the University of Michigan’s Survey of Consumer Sentiment for early March) and market-based data (e.g., the widening yield spread between nominal Treasuries and Treasury Inflation Protected Securities or TIPs).

Long-term yields were volatile again last week. On Tuesday, the stock markets rallied following the Fed’s introduction of TSLF. As funds moved from the Treasury market to the stock markets, Treasuries’ prices declined and yields increased. The yield on the 10-year Treasury surged 16 basis points higher than the rate on Monday.

Recession concerns following weak retail sales report brought yields down on Thursday but yields later reversed as Standard & Poor's reported that writedowns by financial institutions on debt linked to subprime mortgages are near the end. The financial markets appear to have already disclosed much of the valuation writedowns, according to S&P. On Friday, the Bear Stearns bailout raised credit concerns, with S&P cutting its credit rating three levels to BBB. A flight to quality caused a rally in the Treasury market. The yield on 10-year Treasuries stayed around 3.44 percent by mid-Friday afternoon, 12 basis points lower than the rate on the previous Friday and the lowest rate since late June 2003.

Housing and Mortgage Indicators:
The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending March 7 showed that mortgage demand decreased as mortgage rates surged. This is the fourth drop in five weeks. The Market Index was down 1.9 percent to 671.7, as the 4.7 percent decline in the refi index outweighed the 1.6 percent increase in the purchaseindex.

The 30-year fixed mortgage rate surged 39 basis points to 6.37 percent, more than offsetting the 29 basis point drop in the previous week. The one-year adjustable rate surged 89 basis points to 6.72 percent.

The ARM share of mortgage applications of the number of loans dropped about two percentage points to 15.5 percent. The share of the dollar volume of new applications fell about one percentage point to 29.4 percent.

Economic Indicators:
The trade deficit in goods and services widened $0.3 billion to $58.2 billion in January, due almost entirely to the increase in the price of imported crude oil. Despite the increase for the month, the deficit is still about 14 percent lower than its peak in August of 2006.

For a number of years, the value of imports relative to exports was a drag on economic growth. Starting in the second quarter of 2007, the trade sector turned into a boost to growth. Trade has been a crucial source of economic growth at the time when the decline in home construction and other residential investment has subtracted substantially from growth. For example, during the fourth quarter, trade contributed 0.9 percentage points to gross domestic product (GDP), while residential investment subtracted one percentage point from it. Real GDP grew 0.6 percent (seasonally adjusted annualized rate) during the quarter and would have seen a 0.3 percent decline without the contribution from trade.

The declining dollar has helped improve the deficit because it makes U.S. exports less expensive to foreign consumers, boosting U.S. exports. In addition, strong global economic growth has so far spurred demand for U.S. exports. At the same time, the falling dollar makes U.S. imports more expensive to American consumers, discouraging U.S. imports. Slowing or declining economic growth in the U.S. should continue to restrain U.S. imports going forward; however, record-high crude oil prices will increase the value of imports, limiting improvements in the trade deficit. The danger of the declining dollar, however, is the inflationary impact of higher import prices and upward pressure on long-term interest rates as foreign investors shun dollar-denominated instruments.

Adjusted for inflation, the real trade deficit widened from $49 billion in December to $49.4 billion, smaller than the average for the fourth quarter of 2007. It is likely that trade will be a contributor to economic growth again in the current quarter.

Retail sales fell 0.6 percent in February following an increase of 0.4 percent in January. Over the past year, retail sales advanced 2.6 percent, the weakest gain since April 2007.

Consumers broadly cut back their spending, as sales dropped at auto dealers, restaurants, grocery stores, gasoline stations, building supply stores and electronics and appliance stores. Sales at furniture stores posted the seventh consecutive monthly decline, as the housing slump deepened. Sales at drug stores, warehouse clubs and sporting goods and hobby stores increased.

Retail sales excluding autos, gasoline and building materials—the components used to calculate consumer spending—remained unchanged in February following a 0.3 percent increase in January. The average of the first two months of the current quarter (1.2 percent annualized gain) was weaker than the annualized increase during the fourth quarter of 1.9 percent). The report suggests weaker consumption expenditures, which constitute about 70 percent of gross domestic product, in the first quarter than in the previous quarter. Economic growth may turn negative in the current quarter following a 0.6 percent growth in the fourth quarter.

Import prices increased a modest 0.2 percent in February, moderating from a 1.6 percent gain in January. However, over the past year, import prices were up 13.6 percent, the second largest year-over-year gain since the inception of the series in 1982. Imported crude oil prices rose only 0.7 percent for the month, moderating sharply from a 5.4 percent gain in January.

Despite the small increase in the overall import prices, import prices excluding fuel were up 0.5 percent in February. The year-over-year gain was 4.3 percent, the biggest increase since July 1995, when the dollar dropped significantly similar to now. Nonfuel import prices will likely be elevated all this year as a result of the dollar's decline, which makes import prices more expensive to American consumers, including commodity prices besides crude oil prices.

The Consumer Price Index (CPI) was unchanged in February from January. The last time inflation at the consumer level was zero was in August 2007. Energy prices fell 0.5 percent, the first decline in the energy CPI since August 2007. Food prices were up 0.4 percent, moderating from a 0.7 percent gain in January. Over the past year, the CPI was up 4.1 percent, decelerating from a year-over-year gain of 4.4 percent in January.

Excluding food and energy items, the core CPI was flat. This is the lowest core CPI inflation since November 2003. Owners’ equivalent rent rose only 0.1 percent, the smallest increase since May 2007. Apparel prices also declined 0.3, while medical care prices posted the weakest increase since August 2005. The year-over-year gain in the core CPI also moderated from 2.5 percent in January to 2.3 percent in February.

The University of Michigan’s Consumer Sentiment Index (preliminary estimate) edged down to 70.5 in March from 70.8 in February. The decline in the expectations components slightly outweighed the increase in current condition assessments. The slight decline put the index at the lowest level since February 1992.

One-year expected inflation increased to 4.5 percent from 3.6 percent in February. However, expected inflation over the next five years fell to 2.9 percent, the smallest gain since last November.

Next week:
• Monday—The National Association of Home Builders/Wells Fargo Housing Market Index for March and February industrial production;
• Tuesday—February Producer Price Index and February housing starts and the FOMC meeting; and
• Thursday—The Conference Board’s Index of Leading Indicators for February.