By R. Mark Rogers, Senior Economist, Econoday

April 13, 2007

Last week the Federal Reserve released minutes for the March 20-21 FOMC meeting. The language was far more hawkish on inflation than most had expected. Last week’s indicators confirmed the policy risks the Fed saw earlier at the latest FOMC meeting. But by the end of the week, the damage to bonds was modest and equities had shaken the news off.

Recap of US Markets

OIL PRICES

Oil prices dipped early during last week but rose during the remainder. The low for the week was Monday’s close at $61.51, reflecting a sharp drop of $2.77 for the day. The decline was due to heavy fund selling and a drop in tension in the Persian Gulf. Prices were nudged back up partially on Tuesday over concerns over Iran’s nuclear program. By midweek, news of a sharp drop in distillate inventories in the U.S. boosted prices – even though crude inventories rose marginally. Net for the week, spot prices for West Texas Intermediate were little changed from close of the prior week.  The price per barrel had edged down $0.65 per barrel to close at $63.63 per barrel.

STOCKS

Equities posted moderate gains last week despite hawkish FOMC minutes at midweek. The week started out Monday mixed with the blue chips up slightly but the techs and small caps down somewhat. Stocks did not trade on the prior Friday due to a Good Friday holiday and stocks were still getting their bearings from the strong jobs report. Also, investors were somewhat on the sidelines, waiting for earnings reports to begin trickling out starting the next day. The drop in oil prices boosted transports for the day and Dow Chemical boosted the Dow index on talk that the company was the target of a leveraged buyout. On Tuesday, major indexes were up moderately except for a flat Dow. The energy sector was up somewhat on a rebound in oil prices and technology got a number of upgrades, although Seagate gave a downside warning on revenues, pulling down both Seagate and HP, for whom Seagate is a supplier. On Wednesday, stocks tanked broadly on the release of hawkish FOMC minutes. The hardest hit sector was financials but with some of its weakness caused by concerns that announced layoffs by Citigroup would not be enough. Thursday was positive despite a spike in jobless claims, downward revisions to forecasts for retail sales, and a firming in import prices. Basically, investors saw Wednesday’s sell off as overdone. Also, many decided that underlying fundamentals had not really changed much with Wednesday’s release of FOMC minutes. For the day, transports stood out as Warren Buffet’s interest in rails was a positive for the sector. Also, health care and energy were also strong. Stocks ended the week on a positive note. Investors liked the flat core PPI number and company earnings reports were mostly favorable.

Last week, the Dow was up 0.4 percent; the S&P 500, up 0.6 percent; the Nasdaq, up 0.8 percent; and the Russell 2000, up, 0.7 percent.

Year-to-date, the Dow is up 1.2 percent; the S&P500, up 2.4 percent; the Nasdaq, up 3.2 percent; and the Russell 2000 is up 4.0 percent.

BONDS

Interest rates continue to edge upward except on the short end which has been gradually easing. Last week saw rates little changed on Monday but dipped on Tuesday. The small decline in bond rates was largely due to unwinding of earlier positions. Rates nudged back up on Wednesday on news of FOMC minutes that were unexpectedly hawkish on inflation. Despite a somewhat unfavorable import price report, rates where essentially unchanged on Thursday as markets stood on the sidelines waiting for Friday’s producer prices report. Except for the short end, rates nudged up on Friday. The PPI report on Friday was initially positive for bond prices with the core rate flat. However, expectations of higher rates overseas, concern over relatively high oil prices, and a bump up in the inflation expectations number in the University of Michigan consumer sentiment report nudged rates up.

Net for the week the Treasury yield curve is up except for the 3-month T-bill. Yields were up as follows: 2-year, up 4 basis points; 3-year, up 4 basis points; 5-year, up 4 basis points; the 10-year bond, up 2 basis points; and the 30-year bond, up 1 basis point. The 3-month T-bill was down 3 basis points.

Bond rates are now at 1-1/2 month highs.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

The big news last week was the Fed’s hawkish minutes released on Wednesday for the March 20-21 FOMC meeting. Inflation news was mixed but markets chose to focus on a good number for the core PPI.

Fed FOMC minutes were more hawkish than expected

Last Wednesday’s release of the latest FOMC minutes was the focal point of the week and economic news on Thursday and Friday bore out the Fed’s concerns for risks to the economy. The minutes of the FOMC meeting held on March 20-21, 2007 indicate that the FOMC saw increased risks to both weaker growth and also to inflation remaining unacceptably high. But what stood out was the Fed’s emphasis on inflation - all FOMC members agreed that the predominant risk was too high inflation. Immediately after the release of the FOMC statement on March 21, many had seen the Fed as moving closer toward easing but the minutes crushed that view last Wednesday.

The Fed has a tough balancing act. The minutes indicate that the Fed has moved closer to seeing the economy in very mild stagflation but has not quite reached that conclusion. The Fed Board’s staff lowered its forecast for real growth but raised its inflation forecast slightly. The minutes do not give exact numbers for these forecasts but indicated that the Fed sees downward revisions to real growth in the first quarter of 2007 but improvement later in 2007. Importantly from the Fed’s view, real growth remains slightly below potential and is the basis for the Fed to continue to project a very gradual easing in core inflation.

Still, the Fed sees potential problems in getting inflation down. Its forecast for core inflation was revised up, largely due to a partial rebound in oil price and due to continued tight labor markets and high compensation costs. Nonetheless the Fed sees core inflation slowly coming down during 2007 and into 2008.

“At the same time, the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee's predominant concern."

The Fed still expects inflation to gradually ease under the current level of interest rates but it seems the Fed is clearly becoming less certain about its favorable inflation forecast. The FOMC was quite emphatic that the key risk to the economic is too high inflation. "All members agreed the statement should indicate that the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

From the Fed’s perspective, inflation is not coming down as fast as hoped and the Fed sees a number of economic factors standing in the way. But the Fed is looking for help in getting inflation down – and many on the FOMC see inflation targeting as helping ease inflation without having to raise interest rates further.  The Fed sees inflation expectations as one of the two broad factors determining inflation – with the other being the gap between capacity and actual utilization rates of resources.

Various markets see the FOMC minutes differently. Equity markets seem to have shrugged off any notable concerns about the Fed’s more hawkish minutes. Bond rates have edged higher. Curiously, fed fund futures rose only by an almost imperceptible amount. Investors in fed funds have been less optimistic about cuts in interest rates than other markets. Fed funds futures still see no cut in fed funds until at least November of this year.

Last week’s economic news confirmed the Fed’s view that there remain both upside and downside risks to the soft landing continuing.

Consumer sentiment points to problems in the real economy and in inflation

Just as a snippet of the issues facing the economy, the Reuters/University of Michigan consumer sentiment index slipped to 85.3 at mid-month from 88.4 in March. Consumers are increasingly concerned about a weak economy. At the same time, the survey showed an increase in inflation expectations. This certainly caught the attention of the Fed officials who have recently been preaching about the importance of inflation expectations and that they needed to be brought down.

Oil boosts overall PPI but core flattens

The key economic indicator last week was for producer prices and that report added to some of the concerns of the FOMC. For the headline number, the overall PPI jumped 1.0 percent in March, following a 1.3 percent spike in February. Most of the boost was due to higher energy costs. The Fed noted in the FOMC minutes its concern that higher oil prices might be feeding into core prices and into inflation expectations. However, the core rate slowed to no change in March, following a 0.4 percent increase in February.

For the overall PPI, strength was food and energy components. Energy increased a monthly 3.6 percent in March, following a 3.5 percent gain in February.  March’s boost was led by gasoline and residential gas. Consumer food prices rose 1.4 percent, following a 1.9 percent gain in February. The largest gain was for fresh & dry vegetables. Keeping the core rate flat were a dip in capital equipment and a modest rise in consumer goods excluding food and energy.

The year-on-year rate for the overall PPI rose to up 3.1 percent in March from up 2.6 percent in February.  The year-on-year core rate was slipped to up 1.6 percent in March from up 1.8 percent the prior month.

Import prices firm

Last Thursday, the import price report put the markets on edge prior to the PPI report on Friday as import prices jumped 1.7 percent in March, reflecting a 9.0 percent spike in petroleum prices. But non-petroleum import prices rose up 0.3 percent with consumer goods imports prices posting a 0.2 percent boost for the month. Continued strength in import prices is another reason the Fed has become more uncertain about its forecast for easing core consumer inflation.

Import price inflation hit a low in mid to late 2006 and has been trending up since for both petroleum and non-petroleum imports.

Import prices for capital goods have been soft, helping the business sector but prices for consumer goods have been on a notable up trend.

While import prices do not seem to have as large an impact on overall consumer prices as in the past, rising import prices clearly have helped nudge core inflation back up.

International trade looks deceptively good but confirms Fed’s two-way concerns

The markets liked the face value improvement in the trade deficit in the latest report but those numbers belie the underlying issues of potentially weaker real growth and high inflation – the dual concerns of the Fed in the latest FOMC minutes. The nation's trade deficit narrowed 0.7 percent in February to a better-than-expected $58.4 billion vs. $58.9 billion in January.  Imports fell 1.7 percent reflecting a drop in the price of oil along with a sharp drop in volume. Exports also fell, down an unusually sharp 2.2 percent reflecting a month-to-month downturn in exports of capital goods as well as a dip in exports of consumer goods.

However, the trade numbers are in nominal dollars and once the data are put into constant dollars (real terms), the February improvement will largely disappear – meaning that first quarter GDP is likely going to be softer than some realize. Additionally, oil prices have gone back up and even the nominal improvement will reverse in March most likely. Finally, most in the markets overlooked the fact that exports fell.  The manufacturing sector in the U.S. has depended in part on export growth to keep production on an up trend. So, what has been a big positive for manufacturing now does not look so certain even though a one month dip in exports does not make a trend.

The bottom line

It has become clearer that the Fed is more concerned about upwardly sticky inflation than too weak economic growth. This means low odds for lower interest rates any time soon. However, the markets seem to have adjusted to the idea that underlying fundamentals really have not changed and that we are in for moderate economic growth and very gradually easing inflation. But as the FOMC minutes have noted, both upside and downside risks have increased.  

Looking Ahead: Week of April 16 through April 20

Looking ahead, this week is heavy with economic reports. Monday will provide more information on the health of the consumer sector with the retail sales report. We will get the all important CPI report on Tuesday along with the latest updates on housing starts and industrial production. The week also sees regional manufacturing reports from New York and Philly Feds.

Monday

Retail Sales rose only 0.1 percent in February, following no change in January.  The consumer sector had been a key source of strength for the economy but now is in question. Even excluding motor vehicles, retail sales slipped 0.1 percent in February, following a 0.2 percent gain in January. But severe winter weather may have been a factor and the consumer sector may actually be stronger than the last two months’ data. An early Easter is expected to have boosted March sales.

Retail sales Consensus Forecast for March 07: +0.6 percent
Range: +0.2 to +1.3 percent

Retail sales excluding motor vehicles Consensus Forecast for March: +0.9 percent
Range: +0.5 to +1.2 percent

The Empire State manufacturing index fell sharply to 1.9 in March from 24.4 in February, indicating a flat manufacturing sector in the New York Fed’s region.  New orders also were flat while backlogs dipped into negative territory.

Empire State Manufacturing Survey Consensus Forecast for April 07: 10.0
Range: -4.0 to +18.0

Business inventories moderated in January with a 0.2 percent increase in January but sales fell 0.7 percent, pushing the inventory-to-sales ratio up 2 tenths to 1.30. Soft retail sales in February suggest continued weakness in business sales and a possible blip in inventories for the month.

Business inventories Consensus Forecast for February 07: +0.3 percent
Range: +0.1 to +0.3 percent

Tuesday

The consumer price index in February firmed to a 0.4 percent increase, following a 0.2 percent increase in January.  Meanwhile, the core CPI slowed to a 0.2 percent increase in February, following a 0.3 percent rise in January. Last week saw a favorable core PPI number for March and markets will be watching to see if this carries over to the CPI. Of course, the CPI has services not found in the PPI – notably for housing and medical care and these may keep the core CPI still on the high side. Additionally, higher food and energy prices are starting to cause concern that these will feed into core inflation.

CPI Consensus Forecast for March 07: +0.6 percent
Range: +0.4 to +0.7 percent

CPI ex food & energy Consensus Forecast for March 07: +0.2 percent
Range: +0.1 to +0.3 percent

Housing starts February housing starts jumped 9.0 percent in February to a 1.525 million annual rate. Weather has caused a good deal of volatility in the numbers as February’s gain followed a 14.3 percent drop the prior month. But based on inventories still being high and sales not yet on an uptrend, starts are likely to be soft.

Housing starts Consensus Forecast for March 07: 1.490 million-unit rate
Range: 1.436 million to 1.550 million-unit rate

Industrial production rebounded 1.0 in February, but primarily on a sharp spike in utilities output. The gain in manufacturing was more moderate with a 0.4 percent rise, following a 0.5 percent drop in January. March is likely to be slower, given the weak gains in retail sales, gains in inventory-to-sales ratios, and slowing export growth.  Also, from the March jobs report, aggregate hours in manufacturing rose 0.2 percent, suggesting a modest rise in the manufacturing component. Overall capacity utilization in February increased to 82.0 percent from 81.4 percent in January while for manufacturing, capacity utilization stood at 80.1 percent in February, compared to 79.9 percent in January.

Industrial production Consensus Forecast for March: 0.0 percent (flat)
Range: -0.3 to +0.3 percent

Capacity utilization Consensus Forecast for March 07: 81.9 percent
Range: 81.6 to 82.2 percent

Thursday

Initial jobless claims jumped 19,000 in the week ending April 7 week to 342,000, lifting the four-week average 7,000 to 323,250. The increase was generally attributed to seasonal adjustment problems related to an early Easter. Hence, little can be made of the spike and it will take at least another week of data to average out the Easter effects.

Jobless Claims Consensus Forecast for 4/14/07: 320,000
Range: 315,000 to 330,000

The Conference Board's index of leading indicators fell 0.5 percent in February following a 0.3 percent decline in January. The data reflect moderating economic conditions and, according to the report, point to moderate but choppy conditions ahead.

Leading indicators Consensus Forecast for March 07: +0.2 percent
Range: +0.1 to +0.4 percent

The general business conditions component of the Philadelphia Fed's business outlook survey index remained stagnant at 0.2 in March, compared to 0.6 in February. New orders also remained in a flat zone. However, price indexes remained high due largely to higher oil costs.

Philadelphia Fed survey Consensus Forecast for April 07: +1.0
Range: -4.3 to +7.1