The Fed's dilemma
By R. Mark Rogers, Senior Economist, Econoday
October 19, 2007
This past week gave us quite a bit of excitement with a sharp drop in equities and in interest rates. We also got updates on inflation, housing, and manufacturing. The real sector numbers indicated that housing is worse than expected and that manufacturing may be turning sluggish. On the inflation front, record high oil prices have boosted headline inflation at the consumer level even though the core rate is holding steady thus far. Importantly, the core rate now appears to be just above the Fed’s implicit comfort zone of 1 to 2 percent annualized inflation. At the upcoming FOMC meeting at the end of the month, the Fed will have to weigh the increasingly apparent risk of a too slow economy versus inflation that is not coming down as quickly as hoped. The “correct” decision for the Fed is not entirely obvious although many think the Fed is now more concerned about growth than inflation.
Meanwhile, equities took it on the chin as stocks did a more sedated encore of Black Monday on the 20th anniversary of the October 19, 1987 melt-down.
Last week saw a sizeable correction in the stock market on disappointing earnings, lowered projections for Q4 and 2008, and on higher oil prices. Monday set the tone for the week as Citigroup’s weak profit report raised concerns in the market over how much more is still to come in terms of losses related to subprime lending problems. A spike in oil prices helped the energy sector but sent transports down. Earnings were lackluster on Tuesday and a drop in homebuilder confidence and soft industrial production also weighed stocks down. The one bright spot for the week was a temporary boost in techs on Wednesday with gains led by Yahoo! and Intel with the chipmaker reporting a jump in sales related to a robust PC market. But the rest of the market was pulled down by a sharp drop in housing starts and a spike in oil prices. On Thursday, financials led the markets down along with a record high for oil prices. Bank of America and Washington Mutual both announced weak earnings that missed expectations. Also, a jump in initial unemployment claims added to negative sentiment as did a slowing in the Philly Fed manufacturing index. Friday saw the stock plummet with the Dow down 367 points. Stocks were led down by Caterpillar announcing weak third-quarter profits. Negative sentiment from Thursday’s weak financial sector was made worse by Wachovia joining the parade of announcements revealing the negative impact from the subprime crisis.
For the week, the small caps were hit hardest, followed close behind by the blue chips. The tech sector also was down but more moderately.
Notably, last week’s stock market decline was nowhere comparable to that of “Black Monday” on October 19, 1987. In 1987, prices had run up more sharply. The 2007 one day dip in equity prices was “only” in the general range of 2-1/2 to 3 percent whereas the October 19, 1987 drop was in the 25 percent vicinity. More specifically, the Dow fell 2.6 percent this past Friday – a mere bump in the road compared to the 22.6 percent fall on October 19, 1987.
Last week, major indexes were down sharply. The following major indexes were down as follows: the Dow, down 4.1 percent; the S&P 500, down 3.9 percent; the Nasdaq, down 2.9 percent; and the Russell 2000, down 5.0 percent.
Year-to-date, the Dow is up 8.5 percent; the S&P 500, up 5.8 percent; the Nasdaq, up 12.8 percent; and the Russell 2000, up 1.4 percent.
Last week, interest rates plunged on flight to quality as money flowed out of stocks and on weak economic data. Weak earnings and warnings from the financial sector — such as Citicorp, Wachovia, and Bank of America — also fueled the flight to quality. While a positive Empire State manufacturing report briefly boosted rates Monday morning, economic data the rest of the week were seen as pointing toward economic slowing, boosting prices on Treasuries and pushing rates down. Notably, the drop in housing starts and housing-related concerns thumped rates on Wednesday. The spike in initial unemployment claims did the same on Thursday. Rates fell the most last week on Friday with the key factor being flight to quality as stocks plunged. For the week, the entire yield curve declined sharply but rates fell the most for Treasury notes, followed by the short end.
Treasury yields were down as follows in the week: 3-month T-bill, down 36 basis points; 2-year T-note, down 45 basis points; 3-year, down 44 basis points; the 5-year, down 40 basis points; the 10-year bond, down 30 basis points; and the 30-year bond, down 22 basis points.
Rates fell sharply across the yield curve last week on flight to quality and as weak economic data increased the odds for a Fed cut in interest rates on October 31.
Oil prices surged again last week, with intraday trading crossing the $90 per barrel mark for the first time. Spot prices for West Texas Intermediate hit new record highs on Monday, Tuesday, and Thursday. Key drivers behind the oil price hikes were the Turkish government announcing on Monday plans to send its troops into northern Iraq to quell Kurdish rebel activity, the Turkish Parliament’s approval of the plan at mid-week, and a continuing decline in the dollar. On Thursday, oil jumped $2.07 per barrel to set a new record high at $89.47 per barrel. Boosting prices that day were currency traders hedging against further declines in the dollar through oil futures. Oil is generally priced in U.S. dollars and a drop in the value of the dollar means producers receive less value for their oil unless producers raise the dollar price of oil.
The spot price for West Texas Intermediate jumped $4.91 per barrel for the week to close at $88.60 per barrel -- $0.87 per barrel below the record close of $89.47 per barrel set the day before on October 18.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
This past week painted a picture of an economy with a softening real sector but with inflation still under upward price pressure.
Consumer price inflation has been whipsawed in recent months at the headline level by swings in oil prices. And the latest data indicate that the core rate — instead of easing as believed earlier in the year — is now stuck at or just above the upper band of the Fed’s comfort zone. In September, consumer price inflation rebounded overall on energy and food price increases. The overall consumer price index in September rebounded 0.3 percent, following a 0.1 percent dip in August. The core CPI inflation rate rose 0.2 percent, after rising 0.2 percent in each of the prior three months and matched expectations.
The two big stories in the CPI report are that food and energy costs are trending upward and can no longer be ignored as “irrelevant” components outside of the core rate and also that the core rate seems to be stuck at an annualized pace around 2 to 2-1/2 percent.
Higher energy and food prices boosted the overall CPI in September. Energy prices rebounded 0.3 percent in September, following a 3.2 percent drop in August. Food price inflation jumped in September with a 0.5 percent boost, following a 0.4 percent gain in August.
The impact of food and energy can be seen in the year-on-year rates for the CPI. Year-on-year, the overall CPI jumped to up 2.8 percent in September from 1.9 percent in August. Higher energy costs are likely to still be feeding into the overall CPI as recent spikes in oil prices have not fully passed through the cost structure of the economy. The core rate came in at 2.1 percent in September, unchanged from August on a year-on-year basis.
The downward stickiness in the core rate is seen in both the year-on-year rate and also in a more current measure — a three-month-ago annualized rate. First, the four consecutive months of the core rate rising 0.2 percent sounds moderate and, indeed, some of those months were soft. The devil is in the detail — that is, was each month’s increase on the low side or the high side of 0.2 percent rounded' September and August were contrasts on that issue. On an unrounded basis, the core CPI in September increased 0.21964 percent, compared to a modest gain of 0.15028 percent in August. When those two months are annualized, September spiked 2.7 percent, following a 1.8 percent rise in August.
Smoothing these monthly annualized numbers somewhat, the 3-month-ago annualized increase for September was 2.5 percent where it was also the prior two months. Taking into account that the Fed’s preferred inflation measure is the core PCE price index and that core CPI inflation tends to be about 1/4 percentage point higher than for the PCE, core CPI inflation is just above the Fed’s implicit target range of 1 to 2 percent. The bottom line is that for the Fed to ease on October 31, the Fed is going to have to believe an internal forecast that the economy is slowing enough in coming months for both headline and core inflation to ease.
Housing starts fell sharply in September raising the risk that housing will continue to soften up the consumer sector as well as manufacturing in coming months. Starts dropped a sizeable 10.2 percent in September to an annualized rate of 1.191 million -- the lowest rate since 1993. Permits are also at their lowest since 1993, down 7.3 percent in the month to a 1.226 million rate. The data reflect the swollen supply of homes on the market and slow-down in home sales.
For the latest month, within starts, weakness was led by the multifamily component which dropped 34.3 percent, following a 10.9 percent rise in August. The single-family component slipped another 1.7 percent after a 7.4 percent fall in August.
On a year-on-year basis, overall starts were down 30.8 percent in September, compared to down 27.7 percent in August. On a year-on-year basis, overall permits were down 25.9 percent in September, compared to down 23.6 percent in August.
Last year and during the second and third quarters of this year, the rest of the economy has been strong enough to significantly offset the drag from housing. With the consumer sector slowing, that may not be the case in coming months. The decline in housing certainly will be spreading to consumer-related spending on furniture, carpet, and other direct spending on housing. We can expect a slowing if not a decline in subcomponents in durables PCEs that are related to housing in coming months. Also, the lack of significant growth in home equity will restrain overall growth in consumer spending. These are the indirect effects on the economy from the housing recession that will likely tip the Fed’s thinking on October 31 in favor of another interest rate cut.
With housing pulling overall economic growth down, the manufacturing sector has provided a welcome source of strength for most of this year. However, the last two months of data have raised questions about the magnitude of strength. Overall industrial production edged up 0.1 percent in September, following no change in August. The manufacturing component was even more sluggish win a 0.1 percent rise in September, following a 0.4 percent decline the prior month. September’s strength was in mining which was up 0.2 percent while utilities output slipped 0.1 percent.
Overall capacity utilization was unchanged at 82.1 percent in September while the capacity utilization rate for manufacturing eased to 80.4 percent in September from 80.5 percent the previous month.
The market group data show changes in output to reflect changes in demand from a slowing consumer sector and construction sector to a still healthy investment sector. Consumer goods were down 0.3 percent and construction supplies production declined 0.2 percent. On the positive side were business equipment, up 0.4 percent; business supplies, up 0.3 percent; and materials, up 0.2 percent.
Within manufacturing, durables output slipped 0.1 percent in September, following a 0.4 percent drop in August. Nondurables edged back up 0.1 percent after a 0.4 percent drop in August.
On an important technical note, while manufacturing has turned sluggish, it likely is not quite as soft as the manufacturing total due to recent strike activity in the automotive industry. Excluding motor vehicles, overall industrial production rose 0.2 percent in September after a 0.1 percent rise in August, while for manufacturing, output rebounded 0.3 percent in September after a 0.3 percent drop the month before.
More current data on manufacturing have been mixed as the October Empire State report shows firming conditions in the region's manufacturing sector while the Philly Fed survey indicated that manufacturing slowed during the month. The New York Fed’s October general business conditions index rose to 28.8 from 14.7 with new orders and shipments posting similar gains.
In contrast, the Philadelphia Fed's regional had its October business activity index ease to a still positive 6.8 from 10.9 in September. New orders were barely in positive territory while backlogs were somewhat negative and for the second month in a row. A reading above zero indicates positive growth in both surveys. The Philly Fed index has a larger survey sample than the Empire State index and is considered more reliable.
On the inflation front, both surveys showed some firming in price pressures with surprising strength in prices received. For prices paid, the New York survey showed only a modest rise with prices paid edging up to 36.1 from 35.1 in September. The Philly Fed survey showed a spike in prices paid with this index jumping to 40.3 from 23.1 the month before. Higher oil and other commodity prices appear to be the cause for the surge in prices paid.
Thus far this year, the Fed has been getting reports that manufacturers have not been able to pass along higher costs. The latest reports from New York and Philadelphia indicate that may be changing. For the Empire State report, prices received rose to 15.1 from 11.7 in September. For the Philly report, prices received climbed to 12.4 in October from 3.3 the month before. Clearly, current data on inflation are headed in the wrong direction for the Fed’s preferences. The Fed will have to count on a slowing economy to ease price pressures in its forecast – if indeed that is what the Fed is forecasting internally. With a weak dollar and with strong growth abroad, it is unrealistic to expect much softening ahead for prices.
The Beige Book just released this past week in preparation for the upcoming October 30-31 FOMC meeting reflects the difficulty the Fed faces over weakening economic growth but with inflation still high. According to the Fed's contacts for the Beige Book, consumer spending is expanding but at an uneven and slower pace than in August. Housing continues to decline while commercial real estate remains healthy. Importantly, most contacts see little spillover effect from the recent credit crunch but remain cautious. While job growth has eased, labor shortages remain in a number of occupations. At least wage growth is still reported to be moderate except for “workers in short supply.” Manufacturing is still expanding but has been hurt by the housing recession. Export strength has helped, however. On the inflation front, “upward pressure on input costs” was reported by most Districts due to higher energy and raw materials costs. Notably, the Beige Book points out that the weaker dollar “has made imported goods more expensive.” Food prices are reported higher while service sector inflation has not accelerated.
The latest Beige Book adds to the Fed’s conundrum of facing weakening economic growth combined with higher food and energy prices that are creating inflation pressures. With housing slumping more than most expected and consumers beginning to retrench, the Fed will be relying on its forecasts for inflation and real growth when making its interest rate decision more so than relying just on actual data. The balance is tipping more toward economic growth being a concern but inflation is being obstinately high.
This past week, Federal Reserve Chairman Ben S. Bernanke indicated that both potentially weak growth and too high inflation remain concerns. He confirmed that the FOMC cut rates on September 18 not just to stabilize the financial markets but also to preclude too soft economic growth. While not outright saying which direction he is leaning, a number of comments indicate that too weak economic growth is becoming the primary issue – but with inflation remaining stubbornly high. The Fed recognizes that inflation is a difficult policy issue currently and this was emphasized with comments by Bernanke that the FOMC intended to keep its option to reverse its recent rate cut. The only real news last week from the Fed chairman was that the FOMC cut the fed funds target rate by 50 basis points on September 18 with the understanding by the FOMC members that the FOMC would reverse that rate cut “if inflation pressures proved stronger than expected.”
His comments indicated a tilt in concern toward economic growth being too soft.
“As most of the meeting participants saw growth likely to run below trend for a while and with the incoming inflation data on the favorable side, the risks to inflation from this action seemed acceptable, especially as the Committee was prepared to reverse the policy easing if inflation pressures proved stronger than expected.”
“Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year.”
Being a true economist, Bernanke then brings out “the other hand” in regard to inflation still being a worry.
“On the inflation side, prices of crude oil and other commodities have increased somewhat in recent weeks, and the foreign exchange value of the dollar has weakened. However, overall, the limited data that we have received since the September FOMC meeting are consistent with continued moderate increases in consumer prices. As the Committee noted in its post-meeting statement, we will continue to monitor inflation developments carefully.”
While Chairman Bernanke and other Fed officials are being careful to emphasize that the Fed is still evaluating incoming data, it appears that sluggish economic growth is elbowing out (barely) inflation as the primary concern. And this past week, many investors agreed with this assessment as implied fed funds futures rates fell significantly. The fed funds futures market now has priced in a better than 75 percent probability for a 25 basis point cut in the fed funds target rate on October 31. This belief is seen in the November futures contract.
The Fed has a tough choice to make on October 31 and this past week’s data on inflation, housing, and manufacturing highlighted the quandary over which is a greater concern — too weak economic growth or too high inflation. For now, the data are suggesting that too weak growth is the primary concern although inflation could come back quite easily. That is, we may be facing the prospect of the Fed halting the easing cycle early on with the result being “stagflation lite” until the Fed likes the inflation trend and resumes easing.
This coming week is a little light on economic data. We do get key updates, however, on housing with existing and also new home sales. We will not get any sustained improvement in housing starts until we see home sales improve. September’s durable goods report will give the Fed a better idea of whether manufacturing is slowing too much or not.
Existing home sales fell 4.3 percent in August to a 5.50 million annual rate. The worst part of the report, however, was supply rising to a new record at 10.0 months. The glutted market is impacting prices as the median price slipped 1.8 percent for the month to $224,500.
Existing home sales Consensus Forecast for September 07: 5.30 million-unit rate
Range: 4.95 to 5.8 million-unit rate
Durable goods orders posted a sharp 4.9 percent drop in August, following a 5.9 percent surge in July. Aircraft orders have been even a little more volatile than usual, pulling down August orders. Nonetheless, excluding the volatile transportation component, new orders dipped 1.8 percent in August, following a 3.3 percent jump the month before. It is not unusual to have a partial reversal of a strong month with a decline the next month. That is the nature of the durable goods orders series. However, the Fed and the equity markets still would prefer to see moderate improvement in new orders to confirm that manufacturing is not softening too much.
New orders for durable goods Consensus Forecast for September 07: +1.8 percent
Range: -0.1 percent to +3.0 percent
Initial jobless claims took a sudden jump in the week ending October 13, up 28,000 to 337,000 and their highest level since the trouble-filled month of August. The Labor Department told Market News International there were no special factors in the week -- but it did say that seasonal adjustments, tied to an expected downturn in the second week of a quarter that apparently did not happen this time around, may have played a factor. The October 13 week also includes Columbus Day, a government and banking holiday. However, next week’s data will be important to clarify just before the Fed’s policy meeting whether the labor markets are softening as could be suggested by the October 13 week.
Jobless Claims Consensus Forecast for 10/20/07: 320,000
Range: 310,000 to 330,000
New home sales dropped a whopping 8.3 percent in August to an annual rate of 795,000. The recent credit crunch, tightened lending standards, and consumer nervousness clearly have weighed on new home sales. Year-on-year sales were down 21.2 percent in the month. As with existing home sales, supply on the market rose sharply to 8.2 months from 7.6 months in July. The supply glut is hurting new home prices more than existing home prices. The median sales price fell 8.3 percent in August to $225,700 from $246,200 in July. The median sales price is down 7.5 percent year-on-year.
New home sales Consensus Forecast for September 07: 0.770 million-unit rate
Range: 0.740 million to 0.814 million-unit rate
The Reuters/University of Michigan's consumer sentiment index slipped to 82.0 in mid-October from 83.4 for final September. The latest reading is the lowest since August last year. The worst of it was in expectations, which fell 2.5 points to 71.6, also the lowest reading since August 2006. Troubles in the credit market and sagging home values are taking their toll on confidence. Confidence is key for the consumer to keep spending at healthy levels. Any drop in confidence would spell trouble for economic growth. Also, the Fed will be watching the inflation expectations figure, given the recent surge in oil prices toward $90 per barrel. In the latest report, 12-month expectations fell one tenth to 3.0 percent and one tenth for 5-year expectations to 2.9 percent.
Consumer sentiment index Consensus Forecast for final October 07: 82.0
Range: 80.0 to 84.0
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