High Noon for the Fed
By R. Mark Rogers, Senior Economist, Econoday
September 14, 2007
The Federal Reserve’s monetary policy group, the Federal Open Market Committee, meets this coming Tuesday and the markets fully expect a cut in interest rates. But it is not that simple for the Fed. As in an old western, it is high noon for the Fed – time to look the bad guy square in the eye and shoot straight. But there may be more than one bad guy for the Fed and, if so, which is the greater threat' Is it inflation or is it too weak economic growth' This past week gave us some key economic indicators that came in weaker than expected. Both retail sales and industrial production were soft. At this point, the markets are essentially 100 percent “certain” that the Fed will ease on September 18 by at least 25 basis points and most actually believe there will be a 50 basis point cut. But from the Fed’s perspective, while the risks for slower economic growth have risen, inflation risks remain significant. If the Fed does ease, there are many reasons why the Fed should do so only very incrementally.
The first reason to give the Fed pause on cutting interest rates has been a run up in crude oil prices. Spot prices for crude oil settled at $80.09 per barrel this past Thursday – a new record high and the first time crude has settled over $80 per barrel. Prices rose steadily last week except for the slight dip on Friday. Oil headed up early in the week over speculation that OPEC would not expand its output quota sufficiently to bring oil prices down – even though it was rumored that Saudi Arabia was pushing for a million barrel per day boost in OPEC production. A new record high of $78.23 per barrel was set on Tuesday as OPEC’s compromise decision to raise production by 500,000 barrels per day fell below market hopes for a million barrels. Another record high was set Wednesday at a $79.91 per barrel close due to a government report on petroleum stocks indicating that crude inventories had fallen sharply and due to concerns over storms in the Gulf of Mexico. Intraday trading put spot prices over the $80 mark during the day. Spot prices edged higher to $80.09 per barrel on Thursday – another record high – as Tropical Storm Humberto turned into a hurricane and caused a shutdown (but not notable damage) in many refinery operations along the Texas coast. Prices fell back somewhat on Friday, closing a little over $79 per barrel on weak U.S. economic data.
But the bottom line from the Fed’s perspective is that even though gasoline supplies currently are not under as much pressure as when refinery capacity was lower earlier in the year, higher crude prices eventually will put upward pressure on overall inflation and indirectly on core inflation through higher costs.
The spot price for West Texas Intermediate jumped $2.40 per barrel for the week to close at $79.10 per barrel. Friday’s close was only $0.99 per barrel lower than the record high for spot prices of $80.09 per barrel set just the day before.
Equities were moderately strong this past week despite the surge in oil prices and some concerns over a sluggish economy. Basically, the market’s near certain belief in a Fed rate cut on Tuesday the 18th and some positive company reports boosted equities. The week started on a negative note for most indexes as Fed Speak was either on the hawkish side (Dallas Fed’s Richard Fisher and Philadelphia Fed’s Charles Plosser) or focused on a too soft economy (San Francisco Fed’s Janet Yellen and Atlanta Fed’s Dennis Lockhart). While these four Fed presidents currently do not have an FOMC vote (off their rotation turn), their comments resurrected some concern that the Fed might not cut rates on Tuesday or as much as hoped for. Stocks posted a healthy gain on Tuesday, largely led by positive psychology from McDonald’s same-stores sales for August coming in much higher than expected. GM added to the positive mood with an announcement of strong sales overseas. Fed Chairman Ben Bernanke spoke before the German central bank but disappointed the markets with no commentary on current policy, discussing only the long-term issue of global savings imbalances.
Wednesday was a down day for the markets as near $80 per barrel oil lowered expectations of a 50 basis point cut in the fed funds target rate at the September 18 FOMC meeting. A declining dollar also added to this renewed pessimism. Energy stocks, however, fared well. On Thursday, McDonald’s helped lift the blue chips as the markets soaked in the company’s post-close announcement on Wednesday of a 50 percent boost in its annual dividend. Countrywide Financial boosted confidence in the financial sector with that company’s announcement of a $12 billion line of credit. The announcement increased confidence that markets will get past the subprime problems without too much damage. Markets were up slightly on Friday despite soft retail sales and industrial production which somewhat offset improvement in consumer sentiment during early September. Stocks rallied late in the day on the increased belief the Fed will ease on Tuesday.
Last week, major indexes were up. Major indexes were up as follows: the Dow, up 2.5 percent; the S&P 500, up 2.1 percent; the Nasdaq, up 1.4 percent; and the Russell 2000, up 1.0 percent.
Year-to-date, the Dow is up 7.9 percent; the S&P 500, up 4.7 percent; the Nasdaq, up 7.7 percent; and the Russell 2000 is down 0.5 percent.
Interest rates generally rose moderately this past week except on the short end. Most of the boost in rates occurred Tuesday through Thursday. But rates initially edged down on Monday as Fed Speak was mixed but interpreted to mean at least a 25 basis point cut in rates would be coming at the September 18 FOMC meeting. Rates firmed on Tuesday after Fed Chairman Bernanke spoke before the German central bank on global savings issued but did not speak on current monetary policy. The bond market was disappointed that Bernanke gave no hint of a pending rate cut. Rates rose further on Wednesday on profit taking and increased belief that the Fed might not be cutting 50 basis points as many had been hoping. A weakening dollar also nudged rates up. Bond prices fell on Thursday as funds moved into equities, especially the blue chips. Weak economic reports on retail sales and industrial production tamped rates down slightly on Friday. Overall, rates rose moderately primarily due to fund flows into equities and on Friday’s increased belief that the Fed will be easing 50 basis points.
Treasury yields were up as follows in the week: 2-year T-note, up 14 basis points; 3-year, up 14 basis points; the 5-year, up 15 basis points; the 10-year bond, up 9 basis points; and the 30-year bond, up 4 basis points. The 3-month T-bill rate declined by 7 basis points.
The 3-month T-bill remains low, reflecting expectations of a Fed rate cut on September 18. Other rates, not directly competing against the fed funds rate, rose moderately as bond funds moved into equities. The movement also reflected belief that credit crunch problems are being resolved.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week was viewed in terms of whether a news release added to the probability of a Fed rate cut or not – especially after the prior week’s soft jobs report. The real sector data generally added to the case for a rate cut but were not compelling for drastic action by the Fed. While retail sales and industrial production were sluggish, other numbers were a little more positive, including exports and consumer sentiment as well as some high frequency numbers.
Two of this past week’s economic reports added to the Fed’s need to shift its “bias” from anti-inflation to at least balanced risks or even too slow economic growth being the greater risk. The first such report last week was the retail sales report. Retail sales were mixed in August and point to a slowing in consumer spending for the month. Overall retail sales posted a 0.3 percent gain in August, following a 0.5 percent boost in July. Weakness was led by gasoline sales, which were pulled down by lower prices, and by building materials, which continue to suffer from the decline in the housing sector. Excluding auto sales, retail sales fell 0.4 percent in August, following a 0.7 percent gain in July. Excluding service station sales, retail sales came in with a 0.6 percent boost in August, equaling July’s increase. Excluding both motor vehicles and gas stations, sales slipped 0.1 percent, following a 0.8 percent jump in July.
While the markets saw the report as negative, there are reasons that the Fed will discount some of that talk. First, gasoline was pulled down by lower prices and real sales are stronger than nominal. Also, July numbers were revised up – especially for non-autos. The retail sales numbers will come up at the Tuesday morning FOMC discussions as part of the staff’s GDP forecast for the third quarter. With the strong July figure for retail sales and with building materials taken out for the PCE estimate (building materials do not go into PCEs but helped pulled down retail sales), the third quarter average for PCE related retails sales components will actually be moderately strong. The FOMC will likely see a staff forecast for third quarter GDP of at least 3 percent and due in part to healthy consumer spending. The Fed will not be seeing economic growth below potential – despite the face value soft retail sales for August.
Year-on-year, overall retail sales in August rose to up 3.7 percent from up 3.6 percent the month before. Excluding motor vehicles, August’s year-on-year sales dropped to up 3.9 percent from up 4.9 percent in July. Excluding motor vehicles and gas station sales, year-on-year sales in August declined to up 4.9 percent from up 5.6 percent in July.
A favorable sign that the consumer sees credit crunch problems as improving is a rebound in consumer sentiment. Consumer confidence appears to be coming back somewhat according to the Reuters/University of Michigan consumer sentiment index which inched 4 tenths higher in its mid-month September reading to 83.8 compared to August's final reading of 83.4. The assessment of current conditions, an important sub-index for an indication on public reaction to the subprime mess, was little changed at 98.3 vs. 98.4 in August.
While overall industrial production rose modestly in August, the manufacturing component declined – an issue likely to be of concern for the Fed. Overall industrial production increased by 0.2 percent in August, following a 0.5 percent boost in July. Overall industrial production came in below the market projection for a 0.3 percent rise in August. But the manufacturing component fell 0.3 percent in August, following a 0.7 percent boost in July. For August, utilities output surged 5.3 percent from higher electricity production while mining output fell 0.6 percent.
Overall capacity utilization was unchanged at 82.2 percent in August while the capacity utilization rate for manufacturing fell to 80.7 percent in August from 81.0 percent in July.
But the big picture for manufacturing is that August’s weak numbers followed a strong gain the prior month. It is not uncommon for a soft number to follow a robust number just as a matter of staying on trend. Additionally, order backlogs are still high and there are no signs of inventory overhang. Additionally, export demand is quite strong. While the economy may be entering a period of slow growth, these factors indicate that currently the risk of recession is low.
Year-on-year, overall industrial production was up 1.7 percent in August while manufacturing also was up 1.7 percent.
The nation's trade gap narrowed slightly in July to $59.2 billion from a revised $59.4 billion in June, previously reported as a deficit of $58.1 billion. The improvement reflects relatively stronger growth in exports as imports also rose. Export strength was in capital goods and autos while import strength was in autos and industrial supplies (including oil). The continued gains in exports will support U.S. manufacturing. Export growth may even pick up strength due to a weaker dollar.
At face value, import prices were favorable in August but detail indicates otherwise. Import prices slipped 0.3 percent in August helped by a 1.3 percent decline in petroleum. Outside of petroleum and petroleum-related products, results were mixed. Foods, feeds & beverages, which are definitely on the increase, rose a steep 0.7 percent following a 1.3 percent jump in July. Prices of capital goods and consumer goods both rose 0.2 percent for a second straight month. The consumer goods component most closely ties in with the consumer price index or the PCE price index. While a 0.2 percent rise seems moderate, it is much higher than declines seen a few years ago when overall inflation was low. We are not getting a favorable impact on inflation from the foreign sector and with the continued decline in the dollar, that trend is likely to continue.
Year-on-year, overall import prices are up 1.9 percent and up 2.3 percent excluding petroleum.
Year-on-year, overall import prices are up 1.9 percent and up 2.3 percent excluding petroleum.
But year-on-year, import prices for consumer goods excluding autos, capital goods, and autos have been trending upward and are now at 1.4 percent, 0.4 percent, and 0.9 percent, respectively. This contrasts with negative numbers a few years ago.
The Fed is now under pressure from recently weak real economic numbers to cut interest rates. A month ago, the Fed had to worry “only” about declining housing and subprime credit problems. Now, we have seen a slight dip in payroll employment, a decline in manufacturing output, and mixed retail sales. But the Fed has indicated that it will give greater weight to more current high frequency data. Some of these have been positive – such as low initial unemployment claims, better-than-expected chain store sales, and a pick up in mortgage applications. Creating concern over inflation risks are a jump in oil prices, a declining dollar, rising interest rates overseas, a jump in gold prices, still high unit labor costs, and a low unemployment rate. On Tuesday, it will be high noon for the Fed and the Fed needs to shoot straight. The tricky part is for the Fed to figure out which target is the current bad guy – a too weak economy or too high inflation'
Based on fed funds futures at close of September 14, the markets expect a 50 basis point cut in the fed funds target while a large minority expects only a 25 basis point cut. The markets currently have priced in a 4-1/2 percent target by January 2008 and a 4-1/4 percent target by April 2008.
This coming week gives the Fed a final look before the FOMC meeting at manufacturing with the Empire State manufacturing index and on inflation with the producer price index. Later in the week, after Tuesday afternoon’s FOMC statement, for the key indicators, we get a reading on consumer price inflation and another update on the housing sector with the housing starts report.
The Empire State manufacturing index came in at a healthy 25.1 in August, the third straight reading between 25 and 27 (zero is the breakeven point). New orders were very strong at 22.2 as were shipments at 28.8. The Empire State report has proven stronger than other regional manufacturing reports and stronger than the national ISM report. This report will be the last information for the Fed to review on the manufacturing sector before its Tuesday FOMC meeting.
Empire State Manufacturing Survey Consensus Forecast for September 07: 20.0
Range: 7.0 to 23.0
The producer price index jumped in July due higher energy costs but the core eased. The overall PPI increased 0.6 percent in July, following a 0.2 percent dip in June. The core rate eased to 0.1 percent in July, following a 0.3 percent rise in June. Most of the softening in the core was due to slower growth in capital equipment components. The August PPI report will be the last set of inflation data for the Fed prior to the Tuesday vote by the FOMC on whether to cut interest rates or not – unless some FOMC members get an advance look over Wednesday CPI report.
PPI Consensus Forecast for August 07: -0.3 percent
Range: -0.8 to +0.1 percent
PPI ex food & energy Consensus Forecast for August 07: +0.1 percent
Range: 0.0 to +0.2 percent
The FOMC announcement for the September 18 FOMC policy meeting is expected to result in a 50 basis point cut in the fed funds target to 4-3/4 percent
FOMC Consensus Forecast for 12/12/06 policy vote on fed funds target: 4.75 percent
Range: 42 percent probability for a 25 basis point cut versus 58 percent for a 50 basis point cut from the current target of 5-1/4 percent, based on fed funds futures close on September 14.
Housing starts in July fell 6.1 percent, following a revised 2.1 percent rise in June. On a year-on-year basis, overall starts are down 20.9 percent in July, compared to down 19.2 percent in June. While we saw a recent positive for housing with a boost in mortgage applications, that improvement is far upstream and will have little impact on current housing construction. Starts continue to be weighed down by excessive supply in both new and existing homes on the market.
Housing starts Consensus Forecast for August 07: 1.36 million-unit rate
Range: 1.32 million to 1.40 million-unit rate
The consumer price index overall moderated in July with a 0.1 percent rise while the core CPI inflation rate was unchanged with a 0.2 percent increase in July. The overall CPI was helped by a 0.1 percent dip in energy prices. Even though crude oil prices rose in August, gasoline prices may have actually fallen during the month due to a jump in operating capacity at refineries. Although the CPI report comes out a day after the FOMC meeting, there is a good chance that some of the FOMC members may get an advance peak at the numbers before the FOMC vote on Tuesday. A critical figure will be the year-on-year core CPI figure which stood at 2.2 percent in July.
CPI Consensus Forecast for August 07: 0.0 percent (flat)
Range: -0.1 to +0.2 percent
CPI ex food & energy Consensus Forecast for August 07: +0.2 percent
Range: -0.1 to +0.2 percent
Initial jobless claims partially rebounded by 4,000 in the week ending September 8 week to a slightly lower-than-expected level of 319,000. The rise in the latest week followed an unexpected drop of 22,000 the prior week. Initial claims are still relatively low. However, even though continuing claims were down 6,000 in the latest week, the 2.585 million level is somewhat high. Essentially, firms are reluctant to lay off workers while at the same time are cautious about hiring. It now is just as important to follow continuing claims as initial claims.
Jobless Claims Consensus Forecast for 9/15/07: 320,000
Range: 315,000 to 340,000
The Conference Board's index of leading indicators rose 0.4 percent in July, following a decline of 0.3 percent in June. The latest month’s gain was led by a rise in consumer confidence and a slowing in vendor performance. Building permits were July's biggest negative.
Leading indicators Consensus Forecast for August 07: -0.3 percent
Range: -0.7 to +0.1 percent
The general business conditions component of the Philadelphia Fed's business outlook survey index came in dead even flat at 0.0 in August, indicating no change from July. The index is not a composite of components, a look at which shows mostly strength. New orders showed growth at 7.1, though down from 11.3 in July, while shipments posted a similar month-to-month comparison at 12.4 vs. 20.3. The six-month outlook actually rose to 36.2 from 30.4, an indication manufacturers in the region are confident that orders will continue.
Philadelphia Fed survey Consensus Forecast for September 07: 4.0
Range: 0.0 to 12.0
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