Bernanke Sees the Economy in Transition
By R. Mark Rogers, Senior Economist, Econoday
November 9, 2007
This past week saw equities take a dive over concern over subprime losses by financial institutions and over negative reports from major corporations such as General Motors. But the bigger story looking ahead came from congressional testimony from Fed Chairman Ben Bernanke who gave his views on near-term trends for economic growth and inflation. According to the Fed chairman, the economy clearly is in transition and markets may not be listening as closely as they should be.
Last week saw another sharp drop in equities with the primary concern being further losses from subprime assets. Warnings from Fed Chairman Ben Bernanke of an expected worsening in housing and a slowing in consumer spending further weighed on the markets along with a few key negative company reports. The week started off on the downside with Citigroup’s announcement of an additional $8 billion to $11 billion write-down due to subprime related losses. Stocks rebounded on Tuesday, led primarily by the energy sector on record oil prices and also with bargain hunting. Wednesday started the day with bleak earnings news from GM. Financials continued to pull the markets down sharply later on Wednesday as a number of firms warned on subprime losses. These included Washington Mutual and Morgan Stanley. The Dow fell 361 points for the day. Thursday was mostly down with the Nasdag leading the way. Fed Chairman Bernanke’s comments about further declines in housing and slowing in the consumer sector pulled most stocks down. The exception was the Russell 2000 which came back somewhat after being pummeled the day before. The week ended on a down note with techs down sharply. Equities were down due to continued worries over subprime losses, a rebound in oil prices reminding traders that consumers are being pinched by higher energy costs, and over a weak consumer sentiment number released by the University of Michigan.
Last week, major indexes were down: the Dow, down 4.1 percent; the S&P 500, down 3.7 percent; the Nasdaq, down 6.5 percent; and the Russell 2000, down 3.2 percent.
Year-to-date, the Dow is up 4.7 percent; the S&P 500, up 2.5 percent; and the Nasdaq, up 8.8 percent. The Russell 2000 is back into negative territory, down 1.9 percent since year end.
Rates on Treasuries fell this past week and especially so on the near end. But at the start of the week, rates edged up slightly as traders took profits after the prior week’s sharp gains and as some funds moved into equities during Tuesday’s stock rebound. But the stories behind the rate declines the rest of the week were not that complicated. Flight to quality was huge after further revelations by banks and financial institutions of more subprime losses and analysis of more to come. Fed Chairman Ben Bernanke’s comments during Congressional testimony on Thursday of further weakness in housing and a slowing in consumer spending added to the decline in rates. His expectation for a rise in housing foreclosure rates and potential impact on overhang of unsold homes stood out as a factor weighing on rates. The yield curve steepened as many in the markets believe the Fed will cut rates again at its December 11 FOMC meeting even though Fed officials have been going out of their way to suggest to the markets that the Fed sees inflation risks equal to those of economic weakness.
Treasury yields were down last week as follows: 3-month T-bill, down 34 basis points; the 2-year note; down 27 basis points; the 3-year note; down 30 basis points; the 5-year note, down 20 basis points; the 10-year bond, down 10 basis points; and the 30-year bond, down 2 basis points.
Rates were down notably last week on both flight to quality due to more revelations by financial institutions on subprime related losses and on concern over economic weakness with Fed Chairman Bernanke’s testimony being a key factor.
Oil prices ratcheted up again, setting another record high during the week for spot West Texas Intermediate. Prices started on the downside on Monday as Kurdish rebels released eight Turkish soldiers, easing some tensions in the Middle East. But spot prices for West Texas Intermediate jumped $2.72 for the day to set a new record high settle at $96.70 per barrel. Upward price pressure was due to fears of declining supplies, a strong demand forecast from the Energy Information Administration, a further decline in the dollar, and scattered tensions in the Middle East. Prices eased a little after the weekly petroleum status report indicated that U.S. stocks had declined somewhat less than expected. Several points come out from this past week’s oil prices. Higher energy prices are going to be more of a concern for the Fed. This will be in terms of both higher inflation and a negative for consumer spending. Also, the Fed cannot ignore the interaction between lower interest rates, a lower dollar, and higher oil prices as oil producers demand higher prices as the dollar falls.
The spot price for West Texas Intermediate rose $0.39 per barrel for the week to close at $96.32 per barrel, just 38 cents below the record high set Tuesday of the week.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Economic data did not carry much of the markets’ attention last week as announcements of subprime write-downs, record high oil prices, and Fed Speak had more impact. But there were some temporarily favorable reports on international trade and unit labor costs.
Speaking before a Congressional committee this past week, Federal Reserve Chairman Ben Bernanke warned of weaker economic growth and higher inflation in the near term. Both trends are contrary to the Fed’s goals of healthy, sustainable economic growth and low inflation. But the Fed’s options may be limited. The Fed may not be able to achieve either in the near term and may have to let monetary policy and the economy play out until sometime next year.
On the inflation front, the Bernanke sees core inflation as having "improved modestly" but that "recent increases in energy prices will likely lead overall inflation to rise for a time." "In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well."
In the real sector, he anticipates that mortgage delinquencies will be rising further in coming quarters and that a jump in foreclosures could worsen the recovery in housing as foreclosed houses are put on the market. Importantly, Bernanke sees improvement in financial markets since the September FOMC meeting but problems remain.
He notes, in particular, that while GDP was quite healthy in the third quarter that growth is likely to slow due to housing and softer household spending. "Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term.”
The Fed Chairman sees housing and consumer spending behind the slowdown. ”Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing." Bernanke sees consumer spending being supported, nonetheless, by a healthy labor market and believes that strong export growth will help keep overall economic growth positive.
The bottom line is that the Fed is still warning the markets to not build in further interest rate cuts. The Fed expects both sluggish economic growth and higher headline inflation in the near-term but is willing to rely on its forecasts for both healthier economic growth and lower inflation further down the road. Some in the markets argue that the Fed’s position that risks are balanced were before the latest spate of announcements of subprime related losses and now the Fed will respond by easing again. It is true that the markdowns came after the latest Fed meeting, but it also is true that oil prices have spiked further and the dollar has declined more since the last FOMC meeting, indicating higher inflation risks. Also, Bernanke reiterated that it is not the Fed’s job to protect investors from unsound investment decisions. The December 11 FOMC meeting may put that statement to a real test in terms of whether the Fed lets the subprime losses tip the balance in cutting interest rates or not.
The nation's trade gap narrowed slightly in September to $56.5 billion from a revised $56.8 billion in August. The improvement reflected exports rising notably faster than import gains, confirming that exports remain on a healthy uptrend. Also, consumer-related imports picked back up, reflecting a little more optimism about the consumer sector.
Export strength in September was in food, feeds & beverages, industrial supplies, consumer goods, and automotive. Capital goods exports declined but this was largely related to a monthly drop in aircraft shipments by Boeing which typically are volatile. Import strength in September was in capital goods, automotive, and consumer goods. Industrial supplies declined despite a surge in the crude oil subcomponent. Foods, feeds & beverages declined.
The latest improvement in the trade gap should add a little more growth to third quarter GDP especially since the number of imported barrels actually declined. As the trade deficit likely worsens in the fourth quarter due to higher oil prices, there should be divergent effects on nominal and real GDP. Higher oil prices will likely boost the total cost of imported oil but may reduce the quantity imported in real terms, thereby helping to narrow the deficit in real terms.
High energy and food prices are feeding inflation pressures as import prices jumped 1.8 percent in October, following a 0.8 percent increase the month before. The latest boost was led by petroleum prices and also foods, feeds & beverage which rose 6.9 percent and 1.0 percent, respectively for the month. Prices excluding petroleum rose 0.5 percent. Consumer goods price gains have been more moderate with a 0.1 percent increase in October.
On a year-on-year basis, overall import prices are up a steep 9.6 percent while prices excluding petroleum are up 3.2 percent, a still elevated rate that is certain to raise concern at the Federal Reserve. Looking ahead, the Fed will also be worrying over whether higher food and energy costs will be feeding into core inflation.
The Fed did get good news on the inflation front with the third quarter productivity report. Third quarter productivity surged an annualized 4.9 percent, following a 2.2 percent gain in the second quarter. The faster growth in productivity reflected strong growth in output while hours worked edged down. Not only was the latest productivity number striking, but unit labor costs not only moderated but fell 0.2 percent annualized in the third quarter, following a 2.2 percent increase in the second quarter. The decline in unit labor costs suggests modest inflation pressure from the labor sector overall.
Overall, the numbers reflect modest underlying inflation pressures as of the third quarter and support the Fed's view that the latest interest rate cut was justified to preclude economic weakness in light of then lower inflation risks. Of course, the question moving forward is whether sharply higher oil prices, a declining dollar, and continued economic growth limit further rate cuts. And in terms of labor costs, the Fed will be projecting forward the impact of slower output growth and perhaps downward sticky compensation growth which would be worrisome.
Year-on-year, productivity came in at up 2.4 percent in the third quarter, compared to up 0.7 percent the prior quarter. Year-on-year, unit labor costs in the third quarter stood at up 4.3 percent, down from up 5.1 percent in the prior quarter.
Subprime problems and higher oil prices continue to get the markets’ attention and both of these issues will be carefully evaluated by the Fed in coming months. Fed Chairman Ben Bernanke, however, gave investors good advice on how to view pending changes in the economy. Housing will not bottom out before mid-2008 and the consumer sector is likely to slow in the near term. Many see his “forecast” as hinting that the Fed will ease on December 11, but the Fed may well be comfortable with sluggish economic growth to let inflation pressures ease.
Believe it or not, this coming week gives us most of the key monthly indicators that will weigh on the Fed’s next interest rate decision. This week brings releases for the CPI, PPI, retail sales, and industrial production. The next FOMC meeting is December 11 and will occur before these indicators are released during December. So, we will get most of the important inflation news that we are going to get before the Fed’s next decision other than the wage component in the December release of the employment report and the PCE price indexes later this month which are mainly rehashes of the CPI data. So, this coming week is going to play a key role in whether the Fed cuts rates again before 2008.
Veterans Day. U.S. stocks and futures markets open. Banks closed.
The U.S. Treasury monthly budget report showed a surplus in September of $111.6 billion, making for a fiscal year-to-date deficit of $162.8 billion, 34 percent below this time last year. A big reason for the improvement is slowing growth in outlays, at 2.8 percent in fiscal 2007 for the slowest rate 10 years. On the income side, taxes receipts were very strong, especially the dominant category of individual income taxes which is up 11.5 percent year-to-date. With the economy slowing, we may not be getting such good numbers for the rest of the year. The month of October typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for the month of October has been $39.3 billion.
Treasury Statement Consensus Forecast for October 07: -$59.0 billion
Range: -$60.0 billion to -$50.0 billion.
Retail sales were unexpectedly strong in September with a 0.6 percent boost, following a 0.3 percent gain in August. September's increase was led by gasoline station sales, motor vehicles, and electronics. Excluding auto sales, retail sales rose 0.4 percent in September, following a 0.4 percent drop in August. Excluding both motor vehicles and gas stations, retail sales posted a more moderate 0.2 percent gain, following a 0.1 percent dip the month before. More recently, gasoline prices have risen significantly and may boost the headline number. However, weekly store sales numbers have been very soft, and core retail sales are likely to be sluggish.
Retail sales Consensus Forecast for October 07: +0.2 percent
Range: -0.1 to +0.5 percent
Retail sales excluding motor vehicles Consensus Forecast for October 07: +0.3 percent
Range: +0.1 to +0.4 percent
The producer price index in September rebounded 1.1 percent on higher oil prices, following a 1.4 percent drop in August. The core rate slowed to a 0.1 percent rise in September, following a 0.2 percent gain in August. Due to higher oil prices, we are likely to see a strong headline number for October. With import and export prices rising, U.S. producers may be starting to pass along higher prices and we may see that in the core PPI.
PPI Consensus Forecast for October 07: +0.4 percent
Range: +0.1 to +0.6 percent
PPI ex food & energy Consensus Forecast for October 07: +0.2 percent
Range: 0.0 to +0.3 percent
Business inventories slowed in August, rising only 0.1 percent, following a 0.5 percent boost in July. But the components varied widely. Manufacturer inventories edged down 0.1 percent, wholesaler inventories nudged up 0.1 percent, but retailer inventories, jumped 0.5 percent. But the gain in retail is centered in dealer inventories which rose 1.5 percent in August, a month when the industry was preparing for a strike at GM. Excluding autos, retailer inventories were flat in the month. The September numbers will be much more telling for how businesses see the economy moving forward after the credit crunch and turbulence in financial markets over the August and September period.
Business inventories Consensus Forecast for October 07: +0.4 percent
Range: +0.2 to +0.7 percent
The consumer price index jumped at the headline level in September with a 0.3 percent rebound, following a 0.1 percent dip in August. But the core CPI inflation rate rose 0.2 percent, after rising 0.2 percent in each of the prior three months. Of course, the recent spike in crude oil prices should continue to keep upward pressure on the overall CPI. The core rate has been stuck at the upper portion of the Fed’s comfort zone and the Fed clearly would like to see some lower core numbers. The question is whether higher oil prices are starting to feed into core inflation along with higher import prices or whether slower consumer spending is keeping core inflation contained.
CPI Consensus Forecast for October 07: +0.3 percent
Range: +0.2 to +0.4 percent
CPI ex food & energy Consensus Forecast for October 07: +0.2 percent
Range: +0.1 to +0.2 percent
The Empire State manufacturing index rose to 28.8 in October from 14.7 the month before. New orders came in at 25.0, up sharply from 13.6 in September. Unfilled orders were only marginally in positive territory. Price pressures remained elevated with prices paid coming in at 36.1 versus 35.1 in September and 34.4 in August. Prices received moved higher to 15.1 from 11.7 the prior month.
Empire State Manufacturing Survey Consensus Forecast for November 07: 20.0
Range: 15.0 to 22.0
Initial jobless claims fell 13,000 to 317,000 in the week ending November 3, a positive result for the labor market though the 4-week average remains high at 329,750. Wildfires in California added less than 3,000 to the week's results. Continuing claims for the Oct. 27 week fell 4,000 to 2.579 million. October's payroll data proved strong despite negative signals from claims data. Further improvement in claims data will point to even stronger payroll growth for November.
Jobless Claims Consensus Forecast for 11/10/07: 320,000
Range: 292,000 to 325,000
The general business conditions component of the Philadelphia Fed's business outlook survey index slipped to 6.8 in October from 10.9 in September, indicating only modest growth. New orders showed a weakening in forward momentum with a drop to a barely positive 2.7 from 15.1 the month before. Unfilled orders and shipments were actually in negative territory. Inflation readings were disconcerting with prices paid way up to 40.3 and with prices received rising to 12.4. The Fed will be watching to see if we get more indications of “stagflation lite” – sluggish output but with stronger inflation.
Philadelphia Fed survey Consensus Forecast for November 07: 6.0
Range: 0.0 to 10.0
Industrial production edged up 0.1 percent in September, following no change in August. The manufacturing component increased 0.1 percent in September, following a 0.4 percent decline the prior month. 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. More recently, various manufacturing surveys have been mixed but mostly sluggish. Meanwhile, production worker hours for October fell 0.4 percent, suggesting weak manufacturing output for the month.
Industrial production Consensus Forecast for October: +0.1 percent
Range: -0.5 to +0.3 percent
Capacity utilization Consensus Forecast for October 07: 82.0 percent
Range: 81.8 to 82.3 percent
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