Fed Less Optimistic on Growth

MBA (8/11/2008 ) Velz, Orawin
Last week’s reports offered mixed news on inflation. While personal consumption expenditures rose strongly in June, boosted by the tax rebates, inflation also picked up sharply, eroding the impact of the stimulus.
Overall inflation, as measured by the price index tied to PCE, posted the biggest increase since September 2005 (or since 1981 excluding the impact of Hurricane Katrina). As a result of soaring prices, inflation-adjusted PCE declined 0.2 percent in June.

The index excluding food and energy (or the core PCE)—the Fed’s preferred measure of inflation—rose a strong 0.3 percent in June and 2.3 percent from a year ago, the largest increase since December 2007. The year-over-year increase in the core PCE has been outside the Fed’s comfort zone of 1.0 to 2.0 percent for 10 consecutive months.

There was one piece of good news on inflation from the productivity and cost report: unit labor costs—a gauge of inflationary pressures from compensation and essentially the difference between growth in productivity and hourly compensation—rose 1.3 percent (annualized rate) in the second quarter, slowing from 2.5 percent in the first quarter and 4.5 percent in the fourth quarter of 2007. Labor costs appeared to remain under control even as inflation increased, showing little indication of inflationary pressures coming from the labor market. From his testimony to Congress in July, Fed Chair Ben Bernanke expressed concerns that rising inflation and inflation expectations could potentially lead to wage increases.

The Federal Open Market Committee met on Tuesday and decided to hold the federal funds rate steady at 2.00 percent for the second consecutive meeting. In its statement, the Fed noted that inflation “has been high,” boosted by previous increases in energy and commodity prices. The committee observed that while downside risks to growth remained, “the upside risks to inflation are also of significant concern.” This replaced a stronger sentence in the previous statement noting that “the upside risks to inflation and inflation expectations have increased.” Notably absent from the current statement was the sentence in the previous statement stating that downside risk to growth had diminished. This suggested that the FOMC is more concerned about near-term growth than they were late June.

While the economy accelerated in the second quarter, thanks to the stimulus package and trade, the Fed is justified in being worried about the growth outlook. About another $30 billion in rebate checks were sent out in July, so the impact of the tax rebates on spending will continue in the near term. However, when the benefits of the rebate on consumer spending have been exhausted a few months from now, we’ll likely see a renewed deceleration in real consumer spending growth (or even an outright decline). Last week’s report of weakening chain store sales growth in July suggested that the lift from tax rebates has begun to fade.

Finally, one housing report last week offered some hope that existing home sales will rebound from their lowest level in over a decade. The National Association of Realtors Pending Home Sales Index—a leading indicator of existing home sales—rebounded in June, with every region posting increases, especially in the South and the West.

Stock and Treasury markets were volatile last week. Stocks rose sharply on Tuesday in response to better-than-expected results from the Institute for Supply Management’s nonmanufacturing survey. In addition, the FOMC statement suggesting that a rate hike is not imminent helped fuel stocks further. The increased appetite for risk eased demand for Treasuries, causing Treasury yields to go up.

On Thursday, stocks plummeted following concerns about the financial sector, weak same-store sales and a surge in weekly unemployment claims. Treasuries gained and yields dropped sharply. On Friday, stocks rebounded strongly as another decline in oil prices eased financial worries. Crude oil futures dropped by more than $30 a barrel since hitting a record high in mid-July. The yield on the 10-year Treasury note stayed around 3.95 percent by mid-Friday afternoon, slightly lower than the rate on the previous Friday. Fed funds futures expected less than a 20 percent chance that the Fed will raise interest rates by 25 basis points at its September meeting. The probability that the Fed will hike rates once by the end of the year dropped to about 35 percent from about 75 percent earlier in the week.

Housing and Mortgage Indicators:
The National Association of Realtors Pending Home Sales Index was up 5.3 percent to 89.0 from 84.5 in May, more than offsetting the 4.9 percent drop in May. The index was down 12.3 percent from last June.

Pending home sales increased in every region of the country: 9.3 percent in the South; 4.6 percent in the West; 3.4 percent in the Northeast; and 1.3 percent in the Midwest. However, compared with a year ago, every region posted declines. The West saw a modest year-over-year decline of 1.7 percent in June following two consecutive year-over-year increases in sales. The relatively stronger performance of existing home sales for the region partly reflects rising shares of foreclosed and distressed homes that were sold through the Multiple Listing Service. Attractive bargain prices have helped lure some buyers back into some local markets.

The index is based on signed contracts for existing single-family homes, condos and co-ops. It is a leading indicator of NAR’s existing home sales, which are based on closings, as the signed contract for the purchase of a home generally precedes its closing by one to two months. Following the 4.9 percent drop in the pending home sales index in May, reaching the second lowest reading in the index on record, total existing home sales fell 2.6 percent in June. The increase in June pending home sales suggests that existing home sales should rebound moderately in the near term. NAR will release the existing home sales figure for July on August 25.

Other leading indicators of home sales have not pointed toward a considerable improvement in the housing market in the coming months. The Mortgage Bankers Association’s weekly survey of mortgage applications showed that purchase applications dropped modestly in June and July as mortgage rates trended up. The segment of the purchase market that has been doing consistently well is the government (largely FHA) market, which continued to see steady increases in purchase mortgage applications.

The outlook for the new home markets, which have not been helped by distressed home sales, remains subdued: the National Association of Home Builders/Wells Fargo Housing Market Index, a measure of home builders’ confidence, fell to a record low in July. All three components of the index—current single-family home sales, six-month expectations of home sales, and prospective buyer traffic—declined during the month.

Economic Indicators:
Personal income edged up 0.1 percent after surging 1.8 percent in May. Income growth slowed considerably as the amount of tax rebates reduced. About $28 billion in rebates were distributed in June, compared with about $48 billion in May and $2 billion late April.

Consumer spending ended the second quarter strongly as consumers continued to spend their stimulus tax payments in June. Personal consumption expenditures increased 0.6 percent in June—slightly moderating from a 0.8 percent increase in May. Nondurable goods spending led the increase, while durable goods spending declined sharply as auto sales tumbled to the slowest pace since 1993.

Factory orders advanced 1.7 percent following a 0.6 percent increase in May. The factory orders report included unrevised durable goods orders data released earlier this month and contained new data on nondurable goods manufacturing shipments, inventories and unfilled orders.

Durable goods orders rose 0.8 percent, while nondurable goods orders (shipments) rose 2.5 percent. Most of the increase in nondurable goods shipment was led by petroleum and chemical shipments, which account for about half of the nominal value of total nondurable goods shipments. Excluding these categories, nondurable goods shipments increased 0.5 percent.

The Institute for Supply Management nonmanufacturing index rose to 49.5 in July from 48.2 in June. This is the second consecutive month that the index showed a reading below 50, indicating a contracting service sector. The pace of decline moderated, however, as the index recovered about one-third of the drop in June. The service sector includes the retail, transportation, health care, finance, real estate and construction industries, which make up almost 90 percent of the economy.

The new orders index fell from 48.6 to 47.9, the lowest reading since January. The export orders index fell from 52.0 to 47.5, similar to the drop seen in the ISM manufacturing survey released last week. The employment index rebounded to 47.1 from 43.8, which was the lowest reading since records began in July 1997. The reading in the employment index, which indicated contracting employment in the service industries, was consistent with the Bureau of Labor Statistics’ employment report released last Friday that service industry payrolls declined by 5,000 in July, the first drop since March.

The price-paid index eased to 80.8 from June’s 84.5, which was the highest reading on record. Crude oil futures have receded significantly over the past month, falling to around $115 a barrel Friday afternoon, compared with $145 a barrel in early July. However, costs of raw material faced by businesses are considerably above last year’s levels.

Nonfarm productivity, a measure of how much employees produce per hour, increased 2.2 percent (annualized rate) in the first quarter. Unit labor costs were up 1.3 percent, slowing from 2.5 percent in the first quarter and 4.5 percent in the fourth quarter of 2007.

Business inventories rose 1.1 percent in June and growth in May was revised upward. This report also showed that the increase in wholesale inventories was greater than what the Bureau of Economic Analysis has assumed in the advance estimate of second quarter gross domestic product report. This implied that economic growth could be revised higher, other things remain the same, from the 1.9 percent pace reported earlier.