Economy heads back to moderate growth
By R. Mark Rogers, Senior Economist, Econoday
June 1, 2007

Last week included the release of FOMC minutes, indicating the Fed remains concerned that economic growth is not staying below potential growth in order to help ease inflation. The Fed continues to see the risk that inflation will not ease sufficiently under current monetary policy. Last week’s economic data clearly showed that the first quarter’s sluggishness has faded. Equity markets seem to be focusing on positive economic news and are ignoring the implications for the interest rate outlook.

Recap of US Markets

OIL PRICES

Crude oil prices ended last week up slightly. As usual, the path to get there was not smooth. Traders continue to weigh a number of factors regarding crude and distillate energy prices. Distillates are under heavy supply constraints due to continuing maintenance problems in the United States. Markets continue to vacillate as to whether crude should be high due to long-term demand or lower due to backlogs at U.S. refineries. And markets are finally remembering that it is hurricane season (as of June 1) and we are not as likely to be as lucky this year as last in terms of low outages in refinery production due to hurricanes. Last week, key movements in crude oil prices were seen Tuesday and Friday. West Texas Intermediate fell $1.60 per barrel on Tuesday to $63.15 per barrel due to the easing of tensions in Nigeria as Nigerian unions suspended a strike that could have halted shipments from this key oil producer. On Friday, West Texas Intermediate jumped $1.07 per barrel to $65.08 over concerns over U.S. refinery capability and over a rebound in overall economic activity in the U.S. which boosts demand for oil.

The spot price per barrel for West Texas Intermediate was up somewhat for the week by $0.33 per barrel to close at $65.08 per barrel.

STOCKS

Equities posted notable gains last week – especially the small caps and techs. Nonetheless, the Dow and the S&P 500 both set new record closes during the week. The Nasdaq set a new six-year high.   Markets were closed on Monday for the Memorial Day holiday. On Tuesday, most of the action was in small caps and techs. Large caps tended to be muted in reaction to developments in China as the government there tripled its stamp tax on securities trading, pushing down Chinese equities. Wednesday saw significant gains in all major indexes as the Dow and S&P 500 set record highs. Stocks initially were down in early trading over concern that a drop in the Chinese stock market would pull U.S. stocks down. Stocks rallied before the afternoon release of FOMC minutes in hopes that there would be no damaging new commentary, and those making that bet were right —no new news from the Fed but the anti-inflation bias remained.  Mergers and acquisition activity also boosted stocks. On Thursday, the Dow eased off its record close but deal making kept other indexes positive. Equities were lifted Friday by generally positive economic data on employment, personal consumption, the ISM index, and consumer sentiment. The Dow and the S&P 500 ended the week at another record close for each.

Last week, all major indexes were up - the Dow, up 1.2 percent; the S&P 500, up 1.4 percent; the Nasdaq, up 2.2 percent; and the Russell 2000, up 2.8 percent.

Over the month of May, the Dow outpaced other major indexes although all posted healthy gains.

Year-to-date, the Dow is up 9.7 percent; the S&P 500, up 8.3 percent; the Nasdaq, up 8.2 percent; and the Russell 2000 is up 8.4 percent.

BONDS

The yield curve rose notably last week except on the near end. Markets were closed Monday for Memorial Day. On Tuesday, traders mostly were waiting on Wednesday’s release of the FOMC minutes for the May 9 FOMC meeting. Rates edged up slightly in anticipation of possibly stronger hawkish comments in the minutes. Also, a better-than-expected consumer confidence figure for May nudged rates up. The FOMC minutes on Wednesday were seen to have no new information for the markets and rates edged down. On Thursday, GDP was revised down but that was seen as old news. The NAPM-Chicago index posted a healthy gain and bumped rates up. Also, traders nudged bond rates up, positioning for Friday’s flurry of releases, including the employment report. Rates jumped the most on Friday due to a healthy gain in payroll employment, strong personal consumption numbers, a boost in the ISM, and a rise in the consumer sentiment index. Motor vehicle sales were a little soft but could not offset the earlier, strong data. While the inflation numbers on Friday looked good, it was clear that the economy had come back.

Net for the week the Treasury yield curve was up except for the 3-month T-bill. Yields were up as follows: 2-year T-note, up 11 basis points; 3-year, up 13 basis points; 5-year, up 13 basis points; the 10-year bond, up 9 basis points; and the 30-year bond, up 6 basis points. The 3-month T-bill was down 8 basis points.

Rates on notes and bonds have been on a gradual firming trend since the second week in May, reflecting the belief that the Fed will not be cutting interest rates soon. Based on trading in fed funds futures, the Fed now is not expected to cut rates until early 2008.

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 economy is rebounding nicely from a nearly flat first quarter. Manufacturing is showing signs of improvement and the consumer sector remains moderately strong. Only housing is notably weak. There are signs that inflation is improving but the Fed still worries that this is just temporary and that the economy may be too strong.

FOMC minutes still Fed concern over upside risks on inflation

Last week’s economic news can best be interpreted in light of the minutes of the most recent FOMC meeting. The minutes of the FOMC meeting held on May 9, 2007 indicate that the FOMC found that the risk of inflation remaining too high outweighs the risk of too weak economic growth. In fact, the FOMC had determined that downside risks “have diminished slightly.”  The risks of too high inflation remained the key concern.

“Nearly all participants viewed core inflation as remaining uncomfortably high and stressed the importance of further moderation. Although readings on core inflation in March had been more favorable, this followed several months of elevated inflation data and price pressures were not yet viewed as convincingly on a downward trend. Most participants expected core inflation to moderate gradually, fostered in part by stable inflation expectations and a likely deceleration in shelter costs.  . .  .  All participants agreed that the risks around the anticipated moderation in inflation were to the upside; and some noted that a failure of inflation to moderate could entail significant costs particularly if it led to an upward drift in inflation expectations.”

Essentially, the Fed sees the first quarter flattening in GDP growth as just temporary. Since the Fed has been counting on below potential growth to ease inflation, the key issue is whether economic growth is remaining moderate enough to stay a little below potential. Last week’s data may indicate that the Fed is not going to be getting the gap between potential and actual growth that it wants.

First quarter GDP is revised down but the economy has moved forward

Last week’s revisions to first quarter GDP really were not all that important.  But the data do provide a good starting point for the overview if for no other reason than to put the first quarter behind and focus on more current data. For the first revision, first quarter real GDP was revised down to an annualized 0.6 percent from the initial estimate of 1.3 percent. The first quarter pace followed a 2.5 percent annualized boost in the fourth quarter. It was the slowest growth since 0.2 percent annualized in the fourth quarter of 2002. The first quarter GDP price index was unrevised from the initial estimate of 4.0 percent. The core PCE price index also was unrevised and came in at 2.2 percent.

The downward revision to the initial estimate for first quarter GDP is based on newly available data that showed a sharp reduction in business inventories and a jump in imports in March.

Employment growth picks up

The highlight of last week was the jobs report. Nonfarm payroll employment posted a 157,000 gain in April, following a revised 80,000 increase in April and a 175,000 rise in March. May’s payroll gain was above the consensus forecast for a 135,000 boost in payroll jobs. April's payroll increase was revised down 8,000 from the initial 88,000 advance and March was revised down 2,000 from the previous estimate of a 177,000 increase. For April and March combined, the net revision was down 10,000.

Nonfarm payroll employment on a year-on-year basis was unchanged at up 1.4 percent in May.

Within the payroll survey, strength was in service-providing industries – manufacturing jobs fell while construction was flat. Overall service-providing industries rose 176,000 in May, following a 110,000 boost in April.

Wage inflation ticked up with average hourly earnings rising 0.3 percent in May, following a 0.2 percent gain in April. This remains an area of concern for the Fed. The longer-term trend is that wage inflation is still somewhat on the high side. Average hourly earnings edged up to up 3.8 percent on a year-on-year basis in May from up 3.7 percent in April.

Labor markets remain tight. The civilian unemployment rate was unchanged at 4.5 percent in May and just barely above the cycle low of 4.4 percent.

Personal income down on technical factor while core inflation is subdued

Last week’s personal income report required a little extra digging to sort out the real trend in income. Personal income fell 0.1 percent in April, following a 0.8 percent jump the prior month. Income was pulled down by a 0.4 percent drop in wages & salaries income. April’s wages and salaries component was coming off a first quarter surge in “unusually large bonus payments and the exercise of stock options,” according to the Bureau of Economic Analysis in the Commerce Department. This component surged 0.7 percent in March. So, on average, growth was moderately healthy over the last two months.

Consumers are still wanting to spend and support overall economic growth. Personal consumption expenditures increased a robust 0.5 percent in April, following a 0.4 percent rise in March. Consumer spending was led by a 0.8 percent jump in services and a 0.3 percent increase in nondurables spending. Durables dipped 0.2 percent for the month.

Inflation has been mixed. Overall PCE price index numbers remain on the high side due to high energy prices but the core numbers have been very good for two months. The overall PCE price index came in at 0.3 percent in April, following a 0.4 percent boost in March. The core PCE price index (excluding food and energy) remained subdued with a 0.1 percent increase, following no change in March. The unrounded percent change for the core PCE price index was 0.11531 percent, compared to 0.03786 percent in March.

Still, it is important to note that even core PCE inflation numbers have been volatile in recent months.  The Fed is certain to remember that core inflation was back up to a monthly gain of 0.3 percent as recently as February.  On both a year-on-year basis and on a 3-month-ago annualized basis, core PCE inflation is running at a 2 percent pace and is at the top of the Fed’s implicit target range.  On a year-on-year basis, the overall PCE deflator declined to up 2.2 percent in April from up 2.3 percent in March. On a year-on-year basis, the core PCE deflator slipped to up 2.0 percent from up 2.1 percent in March.

ISM and Chicago purchasers point toward stronger manufacturing

Both the ISM manufacturing index and the NAMP Chicago purchasing managers index picked up strength in May. The ISM index rose to 55.0 in May from a solid 54.7 reading in April. Chicago purchasers, representing a mix of both manufacturing and non-manufacturing industries, reported a big jump in business activity in May, to an index reading of 61.7 from 52.9 in April. Both reports showed a jump in new orders.

For both surveys, price pressures remain a concern. The ISM prices paid index slipped but remained high at 71.0 vs. 73.0 in April. Both months likely reflect high energy prices.  In the Chicago survey, prices paid jumped from 64.9 to 70.2 for the first 70-plus reading since August last year, also reflecting high energy costs.

Construction spending continues recent divergent trends

Construction spending edged up 0.1 percent in April, following a 0.6 percent boost in March. The April gain was led by nonresidential and public construction outlays. Once again, residential construction continued to decline. By sectors, private residential construction fell 1.0 percent in both April and March. Private nonresidential outlays rose a respectable 1.5 percent in April following an increase of 2.6 percent in March.

On a year-on-year basis, overall construction outlays slipped to down 2.0 percent in April from down 1.9 percent in March.  Private residential construction is down 14.4 percent on a year-on-year basis – the same as in March. Private nonresidential outlays are up 15.6 percent in April on a year-on-year basis, compared to up 16.4 percent in March.

The bottom line

The economy has recovered from the first quarter’s sluggish growth. The consumer sector is in good shape and we have had two good months of inflation news. The Fed remains concerned, however, that this improvement is temporary and that the inflation trend is still too high. Even should the Fed’s concerns prove correct, the economy still is not far from a soft landing and the Fed likely needs only minor adjustments in monetary policy.

Looking Ahead: Week of June 4 through June 8

This week has a light schedule of economic data. The key focus likely will be unit labor costs, unemployment claims, and company news.

Monday

Factory orders in March rose a very strong 3.1 percent, with strength primarily in durables. More recently, durable goods orders continued a recent upward trend, posting a 0.6 percent boost in April. This was despite weakness in aircraft orders. Excluding the volatile transportation component, new durables orders rose 1.5 percent in the advance report for April.

Factory orders Consensus Forecast for April 07: +0.7 percent
Range: +0.4 to +1.5 percent

Tuesday

The business activity index from the ISM non-manufacturing survey rose in April to 56.0 from a multi-year low of 52.4 in March. As are most non-housing indicators, the ISM non-manufacturing index is pointing toward a rebound in economic activity in the second quarter.

Business activity index Consensus Forecast for May 07: 56.0
Range: 54.0 to 58.0

Wednesday

Nonfarm productivity in the first quarter came in at an annualized 1.7 percent, down from the fourth quarter pace of 2.1 percent. Unit labor costs decelerated sharply to an annualized 0.6 percent increase, following a 6.2 percent spike in the fourth quarter. With the downward revision to first quarter GDP – from 1.3 percent annualized to 0.6 percent – we can expect a similar downward revision to productivity. Productivity is the ratio of output to hours worked.

Nonfarm Productivity Consensus Forecast for revised Q1 07: +1.0 percent
Range: +0.9 to +1.4 percent

Unit Labor Costs Consensus Forecast for revised Q1 07: +1.5 percent rate
Range: +1.0 to +1.7 percent rate

Thursday

Initial jobless claims were little changed in the May 26 week, down 4,000 to an as-expected level of 310,000. There were no special factors in the week. Continuing claims also continued to show improvement, down 52,000 to 2.472 million in data tracking the May 19 week. Jobless claims clearly show a still tight labor market.

Jobless Claims Consensus Forecast for 6/2/07: 310,000
Range: 310,000 to 315,000

Consumer credit jumped $13.5 billion in March, well above expectations and compared with an upward revised $5.5 billion in February. Revolving credit rose $4.6 billion to $6.8 billion, reflecting higher gas prices and strong retail sales, while non-revolving credit, reflecting solid vehicle sales, rose $3.3 billion to $6.7 billion. Growth in consumer credit is indicating both strong consumer spending and lots of liquidity in the economy. The Fed is certainly paying more attention to these types of liquidity indicators than most and if growth in consumer credit continues to be rapid, that may be one of the reasons the Fed could tighten late this year.

Consumer credit Consensus Forecast for April 07: +$5.0 billion
Range: $3.5 billion to +$10.0 billion

Friday

The U.S. international trade gap widened in March to $63.9 billion from a $57.9 billion shortfall in February. Imports rebounded 4.5 percent, largely reflecting an increase in the price of oil. Exports also rebounded, up 1.8 percent. We can expect oil prices to play a key role in swings in imports but markets will be watching to see if the uptrend in exports continues – a key support for U.S. manufacturing.

International trade balance Consensus Forecast for April 07: -$63.3 billion
Range: -$65.5 billion to -$62.0 billion