Fed Eases, Signals Pause; Economic Growth Anemic Again in First Quarter

MBA (5/1/2008 ) Velz, Orawin
The Federal Open Market Committee cut the federal funds rate 25 basis points to 2.00 percent, following a 75 basis point cut on March 18. This is the seventh rate cut since it started lowering the target rate in September of last year for a total of 325 basis points.

In the post-meeting statement, the committee noted that economic activities “remain weak”—a slight change from the previous statement that economic activity “has weakened further.” It cited soft household and business spending and weakening labor markets. The committee did not mention business spending in the previous statement. The addition of a reference to business investment likely reflected the negative development in the first quarter (see below.)

The Fed maintained that while core inflation readings have improved, rising energy and commodity prices have risen. The committee noted that it will continue to monitor inflation closely as the inflation outlook is uncertain.

Perhaps a hint that an extended pause is likely was the removal of the sentence that said “downside risks to growth remain” from the March statement. The committee concluded that it will continue to monitor economic and financial developments and will “act as needed” to promote growth and price stability. In the March statement on future actions, the Fed said it “will act in a timely manner as needed.” Removing the words “in a timely manner” suggested that the Fed may choose to wait to give the fiscal stimulus a chance to impact the economy.

The fed funds rate cut decision was not unanimous. Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher voted for keeping the rate unchanged.

The gross domestic report (GDP) released earlier in the day supported the Fed’s view on the economy. The economy barely expanded in the first quarter of 2008, supported by an inventory buildup. Real (inflation-adjusted) GDP grew 0.6 percent, according to advance estimate of the Bureau of Economic Analysis. (Unless otherwise noted, data in the GDP report mentioned here are seasonally-adjusted annualized rates.)

Economic growth matched the pace seen in the fourth quarter of 2007. Inventory investment was a positive for growth in the first quarter, reversing the decline in the fourth quarter of 2007. Inventory investment contributed 0.8 percentage points to growth. Real final sales of domestic product, which is real GDP minus the change in inventories, fell 0.2 percent, compared with a 2.4 percent growth in the fourth quarter. This was the first decline since the fourth quarter of 2005.

Slowing demand likely caused an unintended increase in inventories, which bodes ill for the economic growth in the current quarter as businesses will likely pare down production to reduce unwanted stockpiles. About half of the increase came from motor vehicle inventories. Some automakers are already planning to cut back. This week, General Motors Corp., the world's largest automaker, reported that it is cutting production of large pickup trucks and sport-utility vehicles by 138,000 this year.

Offsetting the inventory buildup were weaker real personal consumption spending (PCE), higher imports and a decline in nonresidential investment. Government spending grew at the same pace as the fourth quarter last year.

Consumers pulled back significantly in the first quarter. Real PCE rose only 1.0 percent, moderating from 2.3 percent in the fourth quarter. This was the weakest growth since the second quarter of 2001. Real PCE added 0.7 percentage points to growth in the first quarter, less than half of its contribution in the fourth quarter last year. Real spending declined for both durable and nondurable goods. The drop in real spending on nondurable goods was the largest since the fourth quarter of 1991.

The housing market remained the biggest drag, with real residential investment declining 26.6 percent in the first quarter—the biggest quarterly drop since the fourth quarter of 1981. Real residential investment subtracted 1.2 percentage points from growth, the same as during the fourth quarter last year. Housing has been a drag on growth for nine straight quarters, the longest downturn since the mid-1950s.

Nonresidential investment fell 2.5 percent as a result of declines in both nonresidential construction and equipment and software investment. This was the first decline since the fourth quarter of 2006.

The trade sector, which has been a positive influence on economic growth over the past year, barely added to growth in the first quarter as imports rose strongly. Net exports of goods and services added only 0.2 percentage points to growth in the first quarter, after adding one percentage point in the previous quarter. This was the smallest contribution from trade in a year. Final domestic sales—real GDP minus net exports and minus the change in inventories—dropped 0.4 percent. This was the first decline since the fourth quarter of 1991.

One positive in the report was that inflation based on PCE eased in the first quarter. The PCE deflator rose 3.5 percent, moderating from 3.9 percent in the fourth quarter last year. The Fed’s favored measure of inflation, the core PCE (excluding food and energy items), was up 2.2 percent, slowing from a 2.5 gain in the previous quarter.

A separate report also bodes well for inflation, showing that, in the first quarter of 2008, labor costs grew at their slowest pace in two years as the labor markets loosened. The employment cost index (ECI) rose 0.7 percent, as wages and salaries grew 0.8 percent while benefit costs were up 0.6 percent.

Treasury yields declined following the FOMC meeting. The yield on the 10-year Treasury note fell seven basis points stayed around 3.74 percent by mid-Tuesday afternoon. Fed funds futures showed a 75 percent chance that the Fed will keep the target rate at 2 percent at the June 25 meeting.