Soft core or not, inflation still a Fed concern
By R. Mark Rogers, Senior Economist, Econoday
June 29, 2007
Last week included weak housing numbers, mixed data on manufacturing, and low core inflation. And the Fed still retained its anti-inflation bias in its latest FOMC statement. Although not mentioned in the statement, continued high oil prices certainly played a role in the Fed’s continued concern over inflation.
Crude spot oil prices jumped sharply last week despite being back at elevated levels. Oil traded above $70 per barrel during each of the last three sessions of the week but closed above $70 per barrel only on Friday. However, the first moves during the week were down. Spot prices for West Texas Intermediate were down incrementally on Monday but fell by $1.13 per barrel on Tuesday to $67.80. Tuesday’s drop was in anticipation of Wednesday’s inventory report in which across-the-board increases were expected. However, gasoline and distillate stocks were down and boosted oil prices by $1.17 per barrel to $68.97 on Wednesday. Also, even though crude stocks were up nationwide, crude stocks were down in Cushing, Oklahoma – the delivery point for U.S. crude futures. Prices continued to rise Thursday and especially Friday primarily over concern about low stocks in Cushing. Spot prices jumped $1.11 per barrel on Friday.
The spot price per barrel for West Texas Intermediate was up for the week by $1.73 per barrel to close at $70.68 per barrel. Crude oil prices are back to the elevated levels seen during late summer of last year. While gasoline prices have not yet reacted to the higher crude prices, that is almost certain to happen over the summer driving season – another reason for the Fed to be worried about a rebound in inflation.
Equities were mixed last week with small caps down but other indexes generally posting modest gains. However, stocks generally were down on Monday and Tuesday. Continued worries over fallout of losses by Bear Stearns' hedge funds got the better of the markets despite gains early in each of the first two sessions last week. These concerns even offset the lift the markets got on Tuesday from lower oil prices. The negative reports on declines in both existing and new home sales as well as a dip on consumer confidence were shrugged off early in the sessions. Weakness crept up late each day over the hedge fund concerns. A key source of the concerns were comments by Pimco founder Bill Gross, manager of probably the largest bond fund in the world, who stated his belief that the sub-prime problems eventually would have a large, negative impact on the U.S. economy. Wednesday saw the biggest jump in equities for the week with techs and small caps leading the way. Oracle got a boost from stronger-than-expected quarterly profits and other techs benefited from the lift – including Intel. Financials also lifted indexes as bargain hunters saw this sector as oversold. Stocks were essentially flat on Thursday with the Fed’s FOMC statement being little changed in terms of its anti-inflation bias. Stocks declined on Friday despite being up early in the day on a favorable personal income report, including a weak core PCE price index. Equities were pushed lower by a jump in crude oil prices and a listless market. The finding of a car bomb in London earlier in the day did not appear to impact U.S. equities.
Last week, most major indexes were up: the Dow, up 0.4 percent; the S&P 500, up 0.1 percent; and the Nasdaq, up 0.6 percent; However, the Russell 2000 was down 1.6 percent.
Year-to-date, the Dow is up 7.6 percent; the S&P 500, up 6.0 percent; the Nasdaq, up 7.8 percent; and the Russell 2000 is up 5.8 percent.
The yield curve fell last week except on the near end. Throughout the week, prices were supported by flight to quality over concern of the potential spillover effects from the sub-prime sector. Yields were pushed down on Monday primarily by weak existing home sales and a jump in supply of existing homes. Rates rebounded incrementally on Tuesday despite a dip in new home sales and in oil prices. Supply of new homes on the market came in better than for existing home, indicating that housing might not be as weak as believed the day before on existing home numbers. Rates were mixed on Wednesday but with the largest movement being a 5 basis point dip in the 3-month T-bill. Rates generally were up slightly on Thursday as traders sold on the news of the FOMC statement – even though there were no surprises in the Fed’s announcement. Rates dropped on Friday except on the near end. The weak core PCE price index for May, rising only 0.1 percent, nudged rates down.
Net for the week the Treasury yield curve was down but less so on the near end. Yields were down as follows: 2-year T-note, down 4 basis points; 3-year, down 7 basis points; 5-year, down 9 basis points; the 10-year bond, down 11 basis points; and the 30-year bond, down 12 basis points. The 3-month T-bill rose 9 basis points.
Most interest rates slipped further last week but remain not far from cyclical highs. The 3-month T-bill has basically made a U-turn, rising sharply for the week.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week was headlined by the most recent FOMC statement which left the fed funds target unchanged. Home sales continued to decline. Manufacturing was mixed. But the week ended with a very favorable personal income report which included a soft core PCE price index. But with the current economy very moderate and with core inflation numbers soft for several months, why should the Fed retain its anti-inflation bias and not move toward a neutral stance'
Last week the Federal Open Market Committee kept the target for the federal funds rate unchanged at 5-1/4 percent and retained its anti-inflation bias. The vote was 10 to 0 in favor of no change. While not unexpected the big news was the lack of change in the wording on the Fed’s anti-inflation bias. But the statement did invite discussion of inflation issues by noting improvement in core inflation, changing the wording on that issue from “core inflation remains somewhat elevated” to “readings on core inflation have improved modestly in recent months.” Importantly, the Fed stated that the improvement in core inflation “has yet to be convincingly demonstrated.”
The Fed clearly is relying on its forecasts for the economy as a basis for retaining the anti-inflation bias. The Fed expects economic growth to rebound and this rebound starts from already high levels of resource utilization (implicitly the labor market). The Fed statement noted that economic growth has improved since the last FOMC meeting, changing from “economic growth has slowed in the first part of this year” to “economic growth appears to have been moderate during the first half of this year.” The bottom line is that the Fed remains on hold. Interest rates are not likely to come down this year. With current resource utilization high, a near-term cut in the fed funds target would likely boost core inflation back up.
For the final revision, first quarter real GDP was revised up incremental to an annualized 0.7 percent from the previous estimate of 0.6 percent. The modest upward revision to real GDP was primarily due to an increase in the estimate for exports. Given that the markets are already focusing on a pick up in growth in the second quarter and beyond, the anemic first quarter growth is no longer a concern.
Inflation numbers were revised up slightly. The first quarter inflation numbers overall were boosted by higher food and energy costs while the core numbers were beginning to ease. The first quarter GDP price index was revised up to 4.2 percent from the prior estimate of 4.0 percent. The core PCE price index also was revised up to 2.4 percent for the first quarter, compared to the prior estimate of 2.2 percent for the first quarter. While we have more current inflation numbers, the first quarter revisions are reminders of the two-track path inflation is on currently – core has been soft but non-core has been strong. The issue the Fed worries about here is that higher food and energy costs could feed into core inflation. And this is but one of the reasons the Fed has retained its anti-inflation bias in the FOMC statement.
Year-on-year, real GDP fell to up 1.9 percent in the first quarter from 3.1 percent in the fourth quarter. Year-on-year, the GDP price index rose to up 2.8 percent year from up 2.5 percent in the prior quarter. The core PCE deflator growth rate edged up to 2.3 percent year-on-year from up 2.2 percent in the fourth quarter.
The personal income report came in with moderate income and spending numbers and a low core PCE price index figure – all good news. The key negative was a surge in the overall price index from the non-core components. Personal income rebounded 0.4 percent in May, following a 0.2 percent dip in April. The key wages and salaries component also rebounded, rising 0.4 percent, following a 0.5 percent drop in April. April’s wages and salaries had been weak due to a return to normal levels after a surge in bonus payments earlier in the year.
Personal income on a year-on-year rose to up 6.1 percent from up 5.8 percent in April. For the wages & salaries component, year-on-year jumped to up 6.1 percent from up 5.1 percent the prior month.
Personal consumption continued to be healthy in May with a 0.5 percent boost – equaling the prior month’s gain.
The big news was on the inflation front. The core PCE price index remained soft, rising 0.1 percent – the same as for April and matching the consensus projection. On a year-on-year basis, the core PCE price index slipped to 1.9 percent from 2.0 percent in April – just within the top end of the Federal Reserve's implicit target. The overall PCE price index continues to portray inflation problems, surging 0.5 percent in May, following a 0.3 percent rise in April. The overall PCE price index rose to 2.3 percent on a year-on-year basis from 2.2 percent in April. While FOMC members may or may not have seen an early version of the personal income report before the Thursday FOMC vote, the Fed members certainly have been aware of continued strength in food and energy and they likely expected the core PCE price index to not have differed much from the already known core PCI number. Essentially, the inflation numbers in the actual personal income release had to either have been known by the FOMC members or closely expected during their deliberations and policy vote. One of the inflation concerns that Fed officials continue to harp on is that if inflation expectations do not stay firmly anchored, then higher food and energy costs could feed into core inflation.
The core CPI and core PCE price index tend to track each other closely.
The core PCE price index has edged down to within the Fed’s implicit inflation target range of 1 to 2 percent inflation even on a year-on-year basis. Over the last two months, if one looks at annualized 3-month ago changes, the core PCE index has fallen almost to the bottom of the Fed’s target range. However, the Fed remains skeptical that core inflation is truly at such a low trend and also worries that a pick up in economic growth will push core inflation back up. The below chart clearly shows that core inflation can be volatile.
Existing home sales fell 0.3 percent in May to a 5.99 million annual rate in May - the lowest pace since June 2003. Existing home sales have fallen for three consecutive months. The year-on-year sales pace is down 10.3 percent in the latest month. Supply on the market is at its highest since 1992, at 8.9 months and compared with 8.4 months in April.
New home sales slipped 1.6 percent in May, following a 12.5 percent boost the month before. The May annualized sales pace of 915,000 is down 15.8 percent year-on-year.
Supply on the market, closely watched by builders, rose 1 tenth to 7.1 months but was not as bad as for existing homes.
The Fed still sees housing as weak in coming quarters for its forecast for the economy. But the Fed also sees that housing is not the whole story for construction. This is reflected in construction outlays.
Construction spending jumped 0.9 percent in May, following a 0.2 percent increase in April. The May boost in construction was led by private nonresidential outlays with public construction outlays also quite strong. Residential construction continued to decline.
By sectors, private residential construction fell 0.8 percent in May, following a 0.4 percent decline the prior month. Private residential construction is down 17.6 percent on a year-on-year basis, compared to down 15.8 percent the prior month.
Private nonresidential outlays jumped 2.7 percent in May, following an increase of 0.9 percent in April. Private nonresidential outlays are up 18.9 percent in May on a year-on-year basis, compared to up 14.9 percent in April.
Clearly, construction overall is a positive for the U.S. economy. Strength in nonresidential and public sector construction is more than offsetting declines in housing. The Fed sees any slowing in the decline in housing as only adding to strength in construction overall.
Manufacturing has been showing signs of strengthening over the last few months. However, the latest durables report puts this strengthening into doubt somewhat. Durable goods orders fell 2.8 percent in May, following a 1.1 percent gain in April and a 5.1 percent jump in March. Excluding the volatile transportation component, new orders declined 1.0 percent in May, following a 2.5 percent gain the prior month. Weakness in durables orders in May was broad based. Industry categories declining in May were primary metals, down 3.6 percent; fabricated metal products, down 1.0 percent; machinery, down 1.6 percent; electrical equipment, down 3.9 percent; and transportation, down 6.8 percent. The computers & electronics component rose 1.8 percent. Within transportation, weakness was in nondefense aircraft.
However, unfilled orders are still providing momentum for manufacturing. On a year-on-year basis, unfilled durables orders were unchanged at up 20.0 percent year-on-year in May from the prior month. Additionally, one should bear in mind that the new orders series is very volatile and not much should be made of one month’s decline.
Calling into question the one month drop in new durables orders was a favorable report from Chicago purchasers, covering both the manufacturing and non-manufacturers sectors. The Chicago NAPM index has posted gains for fourth straight months with the June increase. The June and May gains were particularly strong. The index came in at 60.2 vs. 61.7 in May.
The input price index remained high at 68.1 in June vs. 70.2 in May, largely reflecting high energy costs and rising costs for metals. Basically, less volatile manufacturing data sources suggest continued momentum in manufacturing but also continued price pressure from the energy sector.
Last week portrayed the economy much as in recent trends. Housing remains on a decline. Manufacturing, however, was mixed but the big negative was durable orders which are well known to be volatile. Inflation remains on a two-track path – core inflation has been low the last few months but non-core components are quite strong. The Fed is likely focusing on its internal forecasts which are known to project a rebound in economic growth this year. The Fed likely sees a rebound in economic growth, continued tight labor markets, and higher food and energy prices as threatening to lift core inflation from its currently soft pace. While Fed officials have not openly discussed such scenarios, internally Fed officials certainly have explored the impact of lower interest rates in the near term on core inflation and those alternative forecasts likely project a jump in core inflation. The Fed certainly will not embrace a policy change that would boost core inflation back up. There is little reason to expect the Fed to lower rates this year.
Next week we start the month of July with the usual suspects – ISM reports on manufacturing and non-manufacturing. We end the week with the jobs report for June.
The Institute for Supply Management’s manufacturing index has strengthened over the last two months, coming in at a 55.0 reading in May. New orders have been especially strong, at 59.6 in May and at 58.5 in April. However, these numbers did not translate into similar strength for national data on industrial production and new factory orders for durables in May. Still, if the ISM numbers continue to hold up, then the official government statistics should follow. Most recently last week, the Chicago purchasers index remained strong in June with a 60.2 reading – only marginally below the 61.7 level for May.
ISM manufacturing index Consensus Forecast for June 07: 55.0
Range: 53.5 to 56.2
Factory orders were moderate in April, rising 0.3 percent. More recently, however, in the advance report, new factory orders for durables fell 2.8 percent in May with weakness broad based. We are likely to see strength in nondurables even though much of it is likely a price effect from higher oil prices.
Factory orders Consensus Forecast for May 07: -1.2 percent
Range: -1.5 to -0.6 percent
Motor vehicle sales dipped to a 12.2 million annual rate in May, down from 12.4 million in April. Higher gasoline prices appear to have cut into sales overall and have boosted auto sales at the expense of the light trucks category – which includes SUVs and minivans. Car sales rose to 5.5 million units from 5.0 million in April while light trucks dropped to 6.7 million units from 7.4 million in April. These rates are for U.S.-made vehicles only.
Motor vehicle sales Consensus Forecast for June 07: 12.4 million-unit rate
Range: 12.0 to 12.7 million-unit rate
Independence Day – all markets are closed in the U.S.
Initial jobless claims fell back in the June 23 week, reversing what had been a puzzling jump in the prior week. Claims fell 13,000 to 313,000 with the four-week average up 1,000 to 316,000. Once again, there were no special factors in the week.
Jobless Claims Consensus Forecast for 6/30/07: 315,000
Range: 313,000 to 325,000
The business activity index from the ISM non-manufacturing survey jumped to 59.7 in May, from 56.0 in April. However, other components showed a mixed picture for looking ahead. New orders, at 57.4, were the strongest since September but backlog orders slipped 2 points to 48.0 – somewhat contradictory movement relative to each other. Inventories were also puzzling, showing sharp accumulation at 61.0, up 9 points for the month. Businesses could be building inventories in anticipation of stronger demand.
Business activity index Consensus Forecast for June 07: 57.5
Range: 56.5 to 60.0
Nonfarm payroll employment has shown renewed strength on average in recent months. 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. Wage gains have been moderate over the last two months with average hourly earnings rising 0.3 percent in May, following a 0.2 percent gain in April. Notably, labor markets are still tight with the latest reading for the civilian unemployment rate coming in at 4.5 percent in May and just barely above the cycle low of 4.4 percent.
Nonfarm payrolls Consensus Forecast for June 07: 125,000
Range: 85,000 to 150,000
Unemployment rate Consensus Forecast for June 07: 4.5 percent
Range: 4.4 to 4.6 percent
Average workweek Consensus Forecast for June 07: 33.9 hours
Range: 33.8 to 33.9 hours
Average hourly earnings Consensus Forecast for June 07: +0.3 percent
Range: +0.2 to +0.3 percent
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