The Fed cuts rates, but now pausing'
By R. Mark Rogers, Senior Economist, Econoday
November 2, 2007
This past week the Fed cut the fed funds target rate by 25 basis points as expected. While the Fed’s interest rate decision usually is the highlight of the week by far, the Fed actually got a lot of competition from strong GDP, unexpectedly robust employment, new record highs for oil prices, a declining dollar, and more revelations of subprime related losses in the financial sector. Importantly, the wording in the FOMC statement and key economic releases forced the markets to rethink the path of interest rates in coming quarters. Despite recently strong headline numbers, there are still a number of problems in the economy.
Last week equities – other than the techs – took a dive despite the Fed cutting interest rates. The first negative blow during the week was a weak consumer confidence report out last Tuesday. The resignation of Merrill Lynch’s CEO over subprime problems also reminded markets that more announcements of subprime losses are likely ahead. And on the same day, P&G lowered its earnings forecast. On Wednesday, however, equities got a temporary boost from the Fed’s 25 basis point cut in the fed funds target rate. Markets perceived the Fed’s FOMC statement as indicating that the economy was in decent shape and not heading into recession. Stocks were pummeled on Thursday after a Citigroup downgrade and over Credit Suisse reporting a sharp drop in profits caused largely by subprime lending problems. Also, markets rethought the likelihood that the Fed will not be cutting rates as much as believed prior to the latest FOMC announcement. On Friday, equities were on a roller coaster ride all day, sorting through conflicting factors. The employment report was a positive but Merrill Lynch was downgraded and negative sentiment spread in the financials. But the broad markets ended up positive to end the day up slightly. Over the week, the only notable pluses were in the techs while the small caps were hardest hit – likely due to the shift in expectations that the Fed would not be easing again soon.
Last week, most major indexes were down: the Dow, down 1.5 percent; the S&P 500, down 1.7 percent; and the Russell 2000, down 2.9 percent. The Nasdaq managed a 0.2 percent gain for the week.
Despite the continued concern over financial turbulence, many stocks did quite well during October as a whole. Techs and small caps did particularly well with the Nasdaq and Russell 2000 up 5.8 percent and 2.8 percent, respectively for the month. Of course, the Fed’s rate cut on October 31 helped the monthly gains. In fact, without the Fed-induced increases on Halloween, the Dow would have been in negative territory for the month and the S&P 500 would have posted only a minimal advance. The S&P 500 and Dow rose 1.5 percent and 0.2 percent, respectively, for the month.
Year-to-date, the Dow is up 9.1 percent; the S&P 500, up 6.4 percent; the Nasdaq, up 16.4 percent; and the Russell 2000, up 1.3 percent.
Rates on Treasuries ended down net but there were sharp swings during the week. Rates were little changed on Monday and Tuesday heading into the Wednesday announcement of the FOMC statement. Markets still had lingering doubts about whether the Fed would ease and what direction the Fed would give on future rate cuts. Rates spiked up on Wednesday – except for the 3-month T-bill – despite the Fed’s 25 basis point cut in the fed funds target rate. Earlier in the day, a strong third quarter GDP number and higher oil prices had put rates under upward pressure. The bond market did not like language in the FOMC statement expressing concern about inflation still being a risk. A drop in the dollar also led rates higher. On Thursday and Friday rates continued to drop and it was all about flight to quality as stocks dropped – especially in the financial sector over concern about actual, pending, and even imagined losses over subprime problems. Flight to quality was particular strong on the near end with inflow of funds pushing down the 3-month T-bill rate by over 30 basis points.
Treasury yields that were down last week are as follows: 3-month T-bill, down 34 basis points; the 2-year note; down 10 basis points; the 3-year note; down 11; basis points; the 5-year note, down 10 basis points; the 10-year bond, down 8 basis points; and the 30-year bond, down 7 basis points.
Rates were down notably last week with flight to quality being a key factor as funds moved out of equities and into Treasuries.
Oil prices seem to have gone beyond the stratosphere this past week, closing at levels that were simply unimaginable six months ago. Spot prices for West Texas Intermediate never settled below $90 per barrel. Prices jumped on Monday on announcement by Mexico that it would be shutting down a sizeable share of production due to a storm but prices eased on Tuesday on Mexico’s announcement of restart for those facilities. Prices surged on Wednesday by a whopping $3.98 per barrel to set a record close at $94.36 as a result of the Fed’s interest rate cut pushing the dollar lower and on a drop in oil inventories. Prices dipped on Thursday simply on a reassessment of fundamentals and on a rise in the dollar against the euro. But the week ended with another surge in prices following the strong employment report for October which suggested a pick up in oil demand. Friday settled at $95.93 per barrel – another record high.
The spot price for West Texas Intermediate rose $4.41 per barrel for the week to close at $95.93 per barrel.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
For a change, economic data came in stronger than expected for the most part last week with GDP and employment being the highlights for the numbers. Meanwhile, the Fed cut interest rates but is hinting that it may be holding steady for a while.
The fact that the Fed cut interest rates by 25 basis points was not a surprise to the markets. The fed funds target rate is now 4-1/2 percent and the discount rate is now 5 percent. But what was a surprise was the extent to which the Fed went to indicate that inflation risk was still as much as the risk of too soft growth. There are signs that the Fed may not be easing again soon. While the Federal Open Market Committee cut the fed funds target rate by 25 basis points, the vote was not unanimous and this was perhaps the first sign that further rate cuts are questionable for now. The vote was 9-1 in favor to cut the fed funds rate but Kansas City Fed President Thomas Hoenig voted to keep the fed funds target rate unchanged.
There are a few key points from the FOMC statement. First, the Fed was being forward looking in its decision to cut interest rates. Second, the FOMC seems to be telling the markets to not count on another rate cut soon -- although another rate cut is not ruled out either. The Fed sees upside risks of too high inflation and downside risks for too weak growth as roughly balanced.
The Fed recognized that the latest GDP numbers for the third quarter indicated that the economy was growing at a substantial pace but that the impact of the housing correction will lead to a near-term slowing in growth. It was over concern about weak housing and "disruptions in financial markets" that was the basis for the cut. While the Fed acknowledges there has been improvement in core inflation this year, the Fed still sees upside risks from higher energy and commodity prices and other factors (likely still low unemployment).
"The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."
Essentially, the Fed carefully crafted the statement to manage expectations of the markets – in particular to disabuse the markets of expecting a continued series of rate cuts. Looking forward, the Fed and the markets should be evaluating incoming data in terms of whether the outlook for economic growth is remaining moderate and the outlook for inflation is to ease further. The Fed is not likely to be content with core PCE inflation stuck at or above 2 percent annualized.
It is tough to pick the lead off indicator to discuss this week but GDP wins out since it set the tone this past Wednesday morning just before the FOMC statement release. Part of the reason the Fed cut rates in August (discount rate only) and in September was because it was expected that the credit crunch would be damping economic growth – including somewhat in the third quarter. There certainly was some negative impact, but you could not tell it by looking at the broad numbers for GDP. Third quarter real GDP showed no slowing down despite subprime problems with an annualized 3.9 percent increase, following a 3.8 percent boost in the second quarter. The composition of GDP was largely as expected except perhaps some strong consumer spending. Strength in the third quarter growth was personal consumption, nonresidential structures investment, inventories, and exports. As expected, housing remained a sizeable negative. Overall, if one is looking for weakness in the economy, one is going to have to look at the more current monthly data which for the most part have been soft. So, we will look closely at the personal income report for that kind of detail.
While it appears we may be getting some dated information on economic growth from the GDP report, that also is likely the case on inflation. On the inflation front, the GDP price index slowed sharply to a 0.8 percent annualized rate, following a 2.6 percent increase in the second quarter. Oil prices were favorable in the third quarter on average and, of course, crude oil prices have shot up over the $90 per barrel mark. The core PCE price index firmed to an annualized 1.8 percent in the third quarter, after a 1.4 percent rise in the second quarter.
Year-on-year, real GDP growth jumped to 2.6 percent in the third quarter, compared to up 1.9 percent in the second quarter. Year-on-year, the GDP price index eased to 2.3 percent in the third quarter, down from up 2.7 percent in the previous quarter. The core PCE price index growth rate came in at up 1.9 percent in the third quarter, down marginally from up 2.0 percent in the second quarter.
While the Fed hinted that it might be pausing, what really got the markets to begin to agree with that view was the robust employment report for October. Nonfarm payroll employment in October jumped 166,000, following revised increases of 96,000 in September and 93,000 in August. For September and August combined, the net revision was down a moderate 10,000. Importantly, the jump in payrolls was more than double the expected gain of 80,000.
Within the payroll survey, strength was in the service-providing industries while goods-producing industries declined overall. Service-providing jobs advanced 190,000 in October, following a 127,000 increase in September. Service-providing gains were led by professional & business services, up 65,000; leisure & hospitality, up 56,000; education & health services, up 43,000; and government jobs, up 36,000.
There was one key positive in the industry detail for services and one key negative in terms of hinting at the direction of the economy. Temp hires rebounded 20,000 after a 19,000 decline the month before, suggesting that business may have to boost employment down the road. However, retail trade fell by 22,000 in what could be an indication that businesses expect slowing in the consumer sector. This is a key issue – that the consumer sector is softening notably.
While no one is surprised by softness in housing, manufacturing data are beginning to raise concern. Manufacturing employment fell 21,000 in October, following a 17,000 decline in September. Export strength may not be offsetting enough of the slowing in the consumer sector and the housing recession. Construction employment is still reeling from subprime lending problems as jobs slipped another 5,000 after a 14,000 drop in September. Natural resources & mining edged up 2,000 for the latest month.
The Fed did get some good news on the inflation front in the employment report despite the strong payroll gains. Average hourly earnings slowed to 0.2 percent in October, following a 0.3 percent rise in September.
On a final note on the employment report, the household survey still suggests that the labor market remains tight as the civilian unemployment rate was unchanged from 4.7 percent in September and is only slightly above the cyclical low of 4.4 percent.
Currently, the big question mark in the real sector is the consumer and it is around the consumer that the subprime and confidence issues revolve. And it is in the not-so-obvious concerns about the consumer that probably tipped the balance for the Fed’s latest interest rate cut. But the headline number for personal income in September was healthy as income posted a 0.4 percent gain, equaling the advance in August. Within personal income, the wages and salaries component rose an even stronger 0.6 percent, following a healthy gain of 0.4 percent the month before. Personal income on a year-on-year basis eased to up 6.8 percent from up 6.9 percent in August.
But it is on the spending side where the consumer is showing caution after the recent credit crunch. Personal consumption slowed in September, rising 0.3 percent, following a 0.5 percent increase in August. Strength was primarily in nondurables and this was largely due to higher gasoline prices. By components for personal consumption, durables rose 0.2 percent after a 2.5 percent spike in August. Reflecting swings in gasoline prices, nondurables rebounded 0.6 percent in September, following a 0.6 percent drop the month before. Services slowed sharply to a 0.2 percent increase, following a 0.7 percent jump in August. After taking into account inflation, real personal consumption in September rose a meager 0.1 percent, following a 0.6 percent jump the month before.
Although the consumer is slowing down a bit, you cannot see it in inflation numbers and this is why the Fed is keeping inflation as a risk at least equal to soft growth. The core PCE price index increased 0.2 percent, firming after August’s 0.1 percent rise. In contrast to the more dated quarterly number in the GDP report, the overall PCE price index firmed in September with a 0.2 percent jump, following no change August. Higher oil prices boosted the September number but were not yet high enough to boost the quarterly average much.
On a year-on-year basis, the inflation numbers look decent – but they may be deceiving. The core PCE price index on a year-on-year basis was up 1.8 percent in September, the same as in August. This is within the Fed’s implicit comfort zone of 1 to 2 percent annualized inflation. However, the overall PCE price index rose to up 2.4 percent in September from up 1.8 percent the month before. Higher oil prices will be boosting the overall PCE price index at least in the near term and could be seeping into core inflation, too.
Another sign of the consumer retrenching somewhat is some softening in motor vehicle sales. Lower interest rates were not enough to boost this sector as sales of domestic-made motor vehicles slipped in October to a 12.1 million unit annualized pace from 12.4 million units the month before. The fourth quarter is not getting off to a good start so far in terms of consumer spending.
Despite the low unemployment rate, employment cost inflation has held steady – good news for the Fed although the Fed probably would like to see some easing in cost gains. The employment cost index showed moderate but non-accelerating pressure in the third-quarter, up a non-annualized 0.8 percent, after a 0.9 percent rise the prior quarter. The year-on-year rate for the latest quarter came in at 3.3 percent and is down slightly from 3.4 percent in the second quarter.
The Fed cut interest rates but the Fed is hinting that further rate cuts may be a while away. Nonetheless, the Fed sees risks of sluggish economic growth and too high inflation as roughly balanced. For the real sector, the biggest new risk is for the consumer. So, the Fed will be closely watching all of the major and minor indicators on the consumer sector while at the same time evaluating inflation pressure. And currently, the key inflation worries revolve around soaring oil prices, a declining dollar, and a still tight labor market. In these circumstances, the Fed would be happy with a sluggish but still positive fourth quarter. And despite the strong third quarter and jump in October employment, the Fed is likely to get that soft fourth quarter with much of the deceleration coming from the consumer.
This coming week primarily focuses on the international sector and consumer sector. We will get a reading on whether exports are continuing to support U.S. manufacturing with the September international trade report and we will also get a reading on import prices. For the consumer sector, the markets may be giving the consumer credit report a little more attention than usual given the recent credit crunch problems. Also, the Reuter’s/University of Michigan consumer sentiment report will give us an update on how consumers are recovering or not from subprime problems, higher oil prices, and jittery financial markets.
The business activity index from the ISM non-manufacturing survey slowed slightly in September to 54.8 from 55.8 the month before. Still, September’s figure is moderately positive. But the outlook for future activity is uncertain given weakness in order readings. New orders moderated to 53.4 vs. 57.0 in August. And backlog orders fell from an even 50.0, down 3 points to 47.0. Prices paid showed increasing pressure to 66.1 vs. 58.6, no doubt related to high energy costs.
Business activity index Consensus Forecast for October 07: 54.0
Range: 51.7 to 56.1
Nonfarm productivity rose an annualized 2.6 percent in the second quarter, reflecting strong GDP growth. With the healthy 3.9 percent boost in third quarter GDP and with moderate hours worked, we should get another good number for third quarter productivity. If so, this would be good news for the Fed on the inflation front.
Nonfarm Productivity Consensus Forecast for initial Q3 07: +3.2 percent
Range: +2.4 to +4.2 percent
Unit Labor Costs Consensus Forecast for initial Q3 07: +1.0 percent rate
Range: +0.5 to +1.8 percent rate
Consumer credit rose $12.2 billion in August, extending a long string of increases. The gain was split between revolving credit and non-revolving credit, the latter reflecting the month's strong vehicle sales. Vehicle sales have since leveled off and could slow credit growth. However, anecdotal reports of some consumers increasing the use of credit for everyday purchases could boost credit growth for worrisome reasons. While everyone knows housing is in decline, whether or not the consumer sector is in serious problems or not depends on the overall financial status of the consumer and not just on job growth. With housing equity growth flat and little or no growth in home equity for consumers to tap, markets should be paying closer attention to these types of reports for more insight into the health of the consumer.
Consumer credit Consensus Forecast for September 07: +$9.0 billion
Range: +$6.0 billion to +$10.0 billion
Initial jobless claims fell 6,000 to 327,000 in the week ending October 27. The 327,000 level is higher than September's levels and is about where claims were in August, a time when subprime-related layoffs hit in force. Still, levels are consistent with a strong labor market.
Jobless Claims Consensus Forecast for 11/3/07: 330,000
Range: 320,000 to 330,000
The U.S. international trade gap narrowed noticeably in August to $57.6 billion from a revised $59.0 billion in July. The improvement was due to both a decline in imports and a rise in exports. Markets need to pick apart the details in this report and not just look at the headline number. Yes, we need to see continued export growth to support domestic manufacturing and with earlier declines in the dollar, we will likely get higher exports. But there will be interesting detail in imports. Much of the decline in imports in the last report was due to lower oil prices but also from dips in imports of consumer goods and motor vehicles. We will likely see a price induced rise in oil imports but it will be interesting to see whether businesses expect healthy consumer spending according to the strength or lack of strength in consumer related imports.
International trade balance Consensus Forecast for September 07: -$58.5 billion
Range: -$60.5 billion to -$57.0 billion
Import prices jumped 1.0 percent in September reflecting a 5.4 percent surge in petroleum prices. The year-on-year rate is very high at 5.2 percent. But excluding petroleum, import prices dipped 0.2 percent in September for a year-on-year increase of 2.0 percent. But the devil is in the detail. Most of this decline in nonpetroleum import prices was primarily due to a 1.4 percent drop in industrial supplies & materials excluding petroleum. Imported capital goods prices were flat in September. Autos and consumer goods excluding autos both rose 0.2 percent in both September and August. To get an idea of the impact of import prices on the consumer, markets need to look more at these details and not just on the alleged core figure for import prices.
Import prices Consensus Forecast for October 07: +1.0 percent
Range: +0.7 to +1.8 percent
The Reuters/University of Michigan's consumer sentiment index fell to 80.9 in October from 83.4 in September. The index fell its sharpest since the aftermath of Hurricane Katrina two years ago. But consumer confidence indexes can be volatile, often showing major drops and major gains in sudden bursts. Current losses are concentrated in the most important sub-component, the assessment of future conditions which fell to 70.1. The assessment of current conditions is steady at a much firmer 97.6. Inflation expectations do show some pressure, no doubt tied to oil prices. Twelve-month inflation expectations are at 3.1 percent, up 1 tenth from mid-month but unchanged from September.
Consumer sentiment index Consensus Forecast for preliminary November 07: 80.0
Range: 77.6 to 81.5
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