Markets muddle with stagflation lite
By R. Mark Rogers, Senior Economist, Econoday
November 16, 2007
Simply Economics will be taking off next week to celebrate
Thanksgiving. Simply Economics will return on November 30, 2007.
Happy Thanksgiving from all of us at Econoday!
This past week the markets muddled along as stagflation lite took center stage. Economic indicators pointed to a slowing in the consumer and manufacturing sectors while higher energy costs were only beginning to rear up. Meanwhile, Fed Chairman Ben Bernanke highlighted the importance of focusing on headline inflation – which is an important issue since markets have been content with allegedly in-target core inflation while overall inflation has been headed up. And the week ended with a key Fed official bluntly stating that he is OK with the slower growth.
Last week, equities generally rallied at week end to end the week up moderately despite sharp swings in both directions earlier in the week. The Dow actually netted a 1.0 percent gain for the week. However, small caps still finished the week down. During most of the week, worries over further write-downs related to subprime losses weighed on the markets. Stocks were bumped down on Monday in part due to a precipitous drop in E*Trade Financial after the brokerage company warned of further write-downs and on an announcement of an investigation by the SEC into its portfolios. Tuesday saw a big rally with the Dow jumping almost 320 points for its second-best day of the year. The jump was instigated by strong earnings from Wal-Mart and by key financial firms denying any further significant losses expected related to subprime problems. Stocks dipped on Wednesday and Thursday over the resurgence of subprime fears as Bear Stearns announced a $1.2 billion write-down. A surge in oil prices and a soft retail sales report weighed on stocks also. Most stocks rallied late in the day on Friday despite a reported drop in industrial production and hawkish remarks by a Fed official. Gains were due to bargain hunting and with techs led by Cisco announcing an expansion of its buyback program. Overall, equities were generally up moderately despite soft economic data, renewed worries over subprime losses, and still high oil prices. However, part of market strength may be due to possibly misguided belief that the Fed will still ease on December 11 at its next FOMC meeting.
Last week, major indexes were mostly up: the Dow, up 1.0 percent; the S&P 500, up 0.3 percent; and the Nasdaq, up 0.4 percent. The Russell 2000 was down 0.4 percent.
Year-to-date, the Dow is up 5.7 percent; the S&P 500, up 2.9 percent; and the Nasdaq, up 9.2 percent. The Russell 2000 is down 2.3 percent since year end.
Rates on Treasuries edged down across the yield curve except for the near end. Bonds got a late start after the Veterans Day holiday. Most of the movement in rates was in reaction to the stock market – whether up or down. Treasury rates rose on Tuesday as funds moved into equities as stocks rose sharply for the day. But Tuesday’s bump in rates was reversed on Wednesday and Thursday on equities dropped and investors fled to the safety of Treasuries. Rates were little-changed on Friday except for the 3-month T-bill which jumped 11 basis points for the day. For the week overall, Treasury yields were weighed down by fears of write-downs by financial firms. Economic data generally were soft and also supported prices.
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 slipped last week but remained near the historical high for West Texas Intermediate spot. Prices came under downward pressure on Monday after comments from Saudi Arabia’s oil minister that OPEC would discuss whether production would need to be raised to ease oil prices. Prices fell sharply on Tuesday primarily due to the expiration of December crude options and after a report from the International Energy Agency, cutting it forecast for 2007 world oil demand. Prices spiked on Wednesday as OPEC announced there was no need to boost production, reversing speculation earlier in the week. Also supporting oil prices was a drop in the dollar against the euro. Prices were little changed on Thursday with divergent undercurrents. Oil stocks were reported higher than expected but there also was militant activity in Nigeria and Iran was reported to continue to refuse to comply with U.N. demands that Iran stop its nuclear weapons efforts. Prices jumped on the last day of the week with the primarily impetus being the close of December futures contracts. Prices continued to supported overall by a weak dollar and expectations of a colder than normal winter in much of the U.S.
The spot price for West Texas Intermediate slipped $1.22 per barrel for the week to close at $95.10 per barrel, just $1.60 below the record high of $96.70 per barrel set November 6th.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
This past week we saw a slowing in consumer spending, mixed news on manufacturing, and headline inflation a little on the high side. And early in the week, Fed Chairman Ben Bernanke announced further movement in the Fed’s policy of greater transparency in the making of monetary policy.
Federal Reserve Chairman Ben S. Bernanke announced this past week a significant change in the Fed’s trend toward greater transparency in conducting monetary policy. The Fed will now be releasing to the public its forecast for the economy four times a year instead of twice a year. These projections will be in a similar format to the projections previously released semi-annually to Congress. FOMC participants (the Fed Board governors and regional Fed banks) will be providing forecasts for real GDP, overall personal consumption, the unemployment rate, and core PCE inflation. While not noted in the Fed Board’s official announcement, Bernanke’s prepared remarks indicated that the forecasts would also include overall inflation, traditionally the overall GDP price index. Also, the forecast horizon will be three years instead of the current two years.
The only comments that came close to addressing current monetary policy were those in which Bernanke indicated that he sees headline inflation as the best measure for the long-term. This means the Fed is worried about higher oil prices feeding into overall inflation and this lowers the odds – not eliminates the possibility – of another Fed cut in interest rates this year.
“Ultimately, households and businesses care about the overall, or "headline," rate of inflation; therefore, the FOMC should refer to an overall inflation rate when evaluating whether the Committee has met its mandated objectives over the long run. . . . However, at longer horizons, where monetary policy has the greatest control over inflation, the overall inflation rate is the appropriate gauge of whether inflation is at a rate consistent with the dual mandate.”
And the latest consumer price report corroborates his concerns about headline inflation.
Headline consumer price inflation in October was a little on the high side due to energy costs while the core inflation rate was steady. The overall consumer price index in October rose 0.3 percent in October, equaling the gain in September. For October, the core CPI inflation rate increased 0.2 percent, after rising 0.2 percent in each of the prior four months.
Once again, higher energy prices boosted the overall CPI in October. In the non-expenditure category for energy, prices spiked 1.4 percent, following a 0.3 percent rise in September. For October, motor fuel was up 1.5 percent; fuel oil up was up 2.6 percent; and piped gas & electricity was up 1.3 percent. Food price inflation eased in October but was still contributing to somewhat high headline inflation with a 0.3 percent increase, following a 0.5 percent jump in September.
If we are to believe that the Fed is focusing on headline inflation for the long-term objective of low and stable inflation, then the latest inflation numbers are somewhat dated given the sharp run up in oil prices in recent weeks. We can expect higher oil price to directly impact gasoline and heating oil prices and indirectly affect other prices through higher production costs. The year-on-year numbers show a disconcerting upward path in headline inflation. Year-on-year, the overall CPI jumped to up 3.5 percent in October from 2.8 percent in September. The core rate was unchanged at 2.1 percent in October on a year-on-year basis. Taking into account methodological differences in the CPI and the PCE price index, the core CPI is within the Fed’s comfort zone of 1 to 2 percent inflation (the CPI tends to run about a quarter percentage point higher due to differences in methodology). However, the headline CPI is now way above the Fed’s comfort zone and could be headed higher due to oil prices.
The latest producer price report was notably softer than the consumer price report. However, there were some unusual component changes to keep the PPI soft. The overall PPI increased 0.1 percent, following a 1.1 percent boost in September. The core rate held steady with no change, following a 0.1 percent rise in September.
For the overall PPI, the latest gain was kept soft by declines in energy and light trucks. By special groupings, energy fell 0.8 percent, following a 4.1 percent gain in September. This runs counter to recent oil prices gains and likely reflects quirks in seasonal adjustment and the energy component should head up in coming months. Within energy, gasoline dropped 3.1 percent, residential gas fell 2.4 percent, and home heating oil declined 2.5 percent. Consumer food prices, however, continue their strong uptrend with a 1.0 percent increase, following a 1.5 percent jump in September. Within the core index, consumer goods rose 0.1 percent while capital equipment prices slipped 0.1 percent. Within the core and within capital equipment, weakness was led by a 2.7 percent fall in prices for light trucks. So, weakness in the overall PPI was due to a drop in truck prices and due to a temporary dip in energy costs.
Despite the modest one-month movement for October, the longer-term trend confirms the Fed’s worries about headline inflation getting out of control if monetary policy is eased further. The year-on-year rate for the overall PPI jumped to up 6.0 percent in October from up 4.4 percent in September. The year-on-year core rate came in at 2.5 percent in October, compared to up 2.0 percent in September.
Many commentators as well as Fed officials have been indicating that they expect a softening in the consumer sector due to fallout from the recession in housing and from tighter credit. The latest retail sales numbers indicate that this slowing is already under way. Retail sales came in on the soft side for October, up 0.2 percent overall and following a 0.7 percent gain the month before. Excluding motor vehicles, October sales advanced a modest 0.2 percent, following a 0.3 percent rise in September. Gasoline unfortunately once again posted a steep increase, up 0.8 percent following a 1.8 percent jump in September. Excluding both vehicles and gasoline, retail sales inched only 0.1 percent higher in October, following a 0.2 percent gain in September.
Sales of home furniture and home furnishings were especially weak in October with general merchandise and department stores also showing declines. Sales of motor vehicles rose 0.2 percent vs. a 1.8 percent rise in September. On the strong side were sales at restaurants and sales of building materials.
Overall retail sales on a year-on-year basis, rose to 5.2 percent from a 4.9 percent rate in September. Excluding motor vehicles, the year-on-year pace increased to 5.2 percent from 4.7 percent the prior month. However, much of the latest advance was due to higher gasoline prices. Excluding both motor vehicles and gasoline, the year-on-year rate slipped to 3.9 percent, down from a 4.1 percent rate in September.
Retail sales in October show the consumer sector continuing to muddle along-not particularly weak but not robust either. The numbers probably suit the Fed just fine with the consumer holding up well enough to not be dragging down the overall economy but soft enough to have some constraining effect on inflation - at least outside of the energy sector.
Industrial production in October came much weaker than expected, posting a sharp decline. Overall industrial production fell 0.5 percent in October, following a 0.2 percent up tick the month before. The manufacturing component dropped 0.4 percent in October, following a 0.2 percent gain the prior month. For October, utilities output fell 1.6 percent while mining output declined 0.6 percent.
Overall capacity utilization fell in line with the output drop, declining to 81.7 percent in October from 82.2 percent the month before. The capacity utilization rate for manufacturing stood at 80.1 percent in October, down from 80.5 percent in September.
By market groups, manufacturing weakness was primarily in consumer goods, construction supplies, and business supplies. Consumer goods were down 0.7 percent; construction supplies, down 0.4 percent; and business supplies, down 0.8 percent. Business equipment edged down 0.1 percent.
The auto sector was mixed. Auto assemblies actually rose to a 3.92 million unit annualized pace from 3.64 million in September. Light truck assemblies slipped to a 6.23 million unit annualized pace from 6.48 million units in September.
Within manufacturing, durables output slipped 0.2 percent in October, following a 0.1 percent dip in September. Nondurables dropped 0.4 percent after a 0.4 percent boost the month before.
The Empire State manufacturing survey was relatively strong in November while the Philly Fed survey showed manufacturing as barely above flat. The Empire State's headline index dipped only fractionally to 27.4 in November from _ the month before. The latest numbers reflect a steady and healthy rate of new orders and shipments that are near the headline level. But unfilled orders contracted slightly in the month as did inventories. Also delivery times improved, reflecting easing pressures on the supply chain consistent with slowing activity.
Manufacturing activity in the Mid-Atlantic region is showing only mild growth at the most according to the Philadelphia Federal Reserve's November report. The report's headline index inched 1.4 points higher to 8.2 with the key index for new orders rising slightly to a very mild 3.5. A key piece of bad news is that the overall 6-month outlook tumbled to 11.6 from 41.5 -- an unusually severe change that may be indicating a crack in business confidence.
Both surveys showed high levels for prices paid, reflecting higher oil and commodity costs. Although not as high as for prices paid, both surveys came in with somewhat elevated levels for prices received.
For the economy, we have seen softening in both the consumer sector and in manufacturing while upward price pressure continues from the energy sector. How do these numbers fit in with Fed thinking' First, Fed Chairman Bernanke has noted the long-term importance of headline inflation. That indicates that rising oil prices must be concern for the Fed. But one other Fed governor was a little more specific about how he sees economic growth, inflation, and monetary policy playing out in the short-term. Federal Reserve Governor Randall S. Kroszner strongly indicated that current monetary policy is appropriate even with an anticipated “rough patch” in economic growth in the near term.
Kroszner believes that the September and October interest rate cuts were needed to stabilize the economy but that upside and downside risks are balanced – even after taking into the latest economic data, apparently including the drop in industrial production in October. Looking further ahead, the current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate. Bluntly, he is saying that the interest rate cuts made so far are adequate for getting the economy through the current slow-down. He is worried about high oil prices feeding into overall and core inflation. Despite what the financial markets believe, the plain meaning of Kroszner’s remarks is that the Fed will not be easing on December 11 unless the economy deteriorates far more than anticipated or unexpected events intervene.
So, to sum up, the economy seems poised to grow for a while at a noticeably slower pace than it did during the summer, in part because of lower home sales, less residential construction, and generally smaller increases in consumer and business spending. And the Fed is content in letting this slower growth ease some of the inflationary pressures.
The bottom line is that there is slow growth ahead in the fourth quarter and possibly first quarter of next year with sluggishness in the consumer sector along with the assumed continuing downturn in housing. But Fed officials are counting on a rebound early next year. We will get to see more detail on the Fed’s views this coming Tuesday with the release of their three-year economic forecast.
Due to Simply Economics taking this coming week off for Thanksgiving, Looking Ahead for November 26 through November 30 follows Looking Ahead for this coming week. For this week, the schedule is rather light due to the Thanksgiving holiday. A key highlight or rather lowlight is with housing starts on Tuesday giving us another update on the housing recession. The highlight will be the FOMC minutes with the first release of the Fed’s newly instituted quarterly economic forecasts.
Housing starts fell a sharp 10.2 in September percent to an annual 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 as sales have slowed due to both a softer economy and tighter lending standards.
Housing starts Consensus Forecast for October 07: 1.160 million-unit rate
Range: 1.000 million to 1.230 million-unit rate
The FOMC minutes of the October 30-31 FOMC meeting will be released this afternoon. The Fed cut the fed funds target rate by 25 basis points on October 31 and the minutes will likely give insight into what will motivate the Fed to either sit tight at the upcoming December 11 FOMC meeting or cut rates again. Also, the Fed has announced that it will publicly release the collective forecast of the Fed governors and Fed regional bank presidents four times a year instead of just two as in the past. This new policy takes effect with the release of the FOMC minutes. The forecast should give hints as to whether the Fed sees inflation coming down soon or not and whether the economy is going to slow too much or not.
Initial jobless claims spiked higher in the week ending November 10, rising 20,000 to 339,000. Importantly, there were no special factors to explain the jump. The Labor Department reported no information on the impact of the strike by Hollywood writers. California wildfires of late last month have added only slightly to claims, less than 2,000 in the latest week for a total of less than 6,000.
Jobless Claims Consensus Forecast for 11/17/07: 330,000
Range: 325,000 to 340,000
The Conference Board's index of leading indicators rose 0.3 percent in September, following a 0.8 percent decline in August. The largest positives in September were a slowing in vendor deliveries, a fall in jobless claims, and a rise in the stock market. The only negatives were a decline in building permits and a widening in the spread between the federal funds rate and the 10-year Treasury note.
Leading indicators Consensus Forecast for October 07: -0.3 percent
Range: -0.4 to -0.1 percent
The Reuters/University of Michigan's consumer sentiment index fell to 75.0 in the preliminary November report, down from 80.9 in October for the worst reading since Hurricane Katrina in 2005. Even worse news is a 3 tenth jump in 1-year inflation expectations to 3.4 percent, the result of rising gas prices. The consumer sentiment numbers corroborate the Fed’s view that the consumer sector is slowing but also that headline inflation is under upward pressure in the near term.
Consumer sentiment index Consensus Forecast for final November 07: 75.0
Range: 72.0 to 75.1
Thanksgiving Day. All markets closed.
After Thanksgiving week, we play catch up with quite a few indicators covering manufacturing, housing, and the consumer sector. Other than the November employment report out the first week of December, these are last series of key indicators that the Fed will be reviewing before its December 11 policy meeting.
The market consensus forecasts for this week will be revised on November 23.
The Conference Board's consumer confidence index fell to 95.6 in October from 99.5 in September. Consumer confidence is down to its lowest level since Hurricane Katrina and before that to the beginning of the 2001 expansion. While confidence in the economy is slipping, fears of higher inflation are rising. Twelve-month inflation expectations rose a tenth to 5.1 percent. One of the key concerns of the Fed is that inflation expectations should not be allowed to rise, otherwise reducing inflation is more difficult.
Consumer confidence Consensus Forecast for November 07: 91.0p
Range: 88.8 to 92.5
Durable goods orders are pointing to a slow-down in manufacturing as they declined 1.7 percent in September after dropping 5.3 percent in August. Orders did jump 5.9 percent in July, but July was before the troubles of August. September's weakness was centered in defense orders. Excluding defense, orders rose 0.7 percent in the month, though the gain follows a steep 6.2 percent dip in August. More recently, manufacturing surveys have been mixed with the Empire State index for November coming at a moderately strong level while the Philly Fed index was barely in positive territory.
New orders for durable goods Consensus Forecast for October 07: +0.4p percent
Range: -2.2 percent to +2.1 percent
Existing home sales fell 8.0 percent in September to a 5.040 million annual rate which was down 19.1 percent on a year-on-year basis. Housing is still in recession as supply remains very bloated at 10.5 months in September, the highest level since 1999. And supply is weighing on prices, which fell 5.7 percent for the month. Both existing and new home sales along with their supply numbers are probably the best indicators for when housing is coming out of recession. There are some indicators further “upstream” – such as pending home sales – but they are more volatile and difficult to interpret.
Existing home sales Consensus Forecast for October 07: 4.995p million-unit rate
Range: 4.800 to 5.140 million-unit rate
The Beige Book being prepared for the December 11 FOMC meeting is being released this afternoon. Look for hints at whether the Fed is more concerned about slowing economic growth or inflation remaining too high.
Third quarter real GDP showed no slowing down despite subprime problems with an initial estimate of an annualized 3.9 percent increase, following a 3.8 percent boost in the second quarter. More recently, the international trade gap has come in narrower than expected while inventory growth has been a little on the high side. Both suggest an upward revision to GDP. 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.
Real GDP Consensus Forecast for preliminary Q3 07: +5.0p percent annual rate
Range: +4.4 to +5.4 percent annual rate
GDP price index Consensus Forecast for preliminary Q3 07: +0.8p percent annual rate
Range: +0.8 to +_ percent annual rate
Initial jobless claims are due out for the week ending November 24. Early in November, there were signs that claims may be nudging up due to softer economic growth.
Jobless Claims Consensus Forecast for 11/17/07: 330,000p
Range: 330,000 to 330,000
New home sales rebounded in September but partly due to a sharp downward revision to August sales. New home sales in September rebounded 4.8 percent to an annualized rate of 770,000 after falling 7.9 percent in August. The August sales pace was revised down to 735,000 from the initial estimate of 795,000. Supply on the market improved but remains a major problem for homebuilders. Months supply eased to 8.3 from 9.0 months in August but is still quite high.
New home sales Consensus Forecast for October 07: 0.753p million-unit rate
Range: 0.720 million to 0.766 million-unit rate
Personal income in September remained strong, posting a 0.4 percent gain in September, equaling the advance in August. But on the spending side, the consumer sector has grown cautious with personal consumption slowing in September with a 0.3 percent boost, following a 0.5 percent increase in August. Strength was primarily in nondurables, reflecting higher gasoline prices. More recently, from the October employment situation, employment, wages, and hours worked were moderate and point to healthy income growth. However, retail sales for October were very soft, suggesting sluggish personal consumption numbers for the month. On the inflation front, the core PCE price index increased 0.2 percent in September, firming after a 0.1 percent rise the month before. The overall PCE price index also picked up with a 0.2 percent jump, following no change August. Based on the October CPI increases, we should see a mild acceleration in the overall PCE price index and either a 0.1 percent or 0.2 percent rise in the core PCE price index.
Personal income Consensus Forecast for October 07: +0.3p percent
Range: +0.3 to +0.4 percent
Personal consumption expenditures Consensus Forecast for October 07: +0.3p percent
Range: +0.1 to +0.4 percent
Core PCE price index Consensus Forecast for October 07: +1.8p percent
Range: +1.8 to +1.8 percent
The NAPM-Chicago purchasing managers’ index suggested a mild contraction in Chicago area business activity as it fell 4.5 percentage points in October to 49.7 and below the break-even level of 50. Production was further below the break-even 50 level at 46.9 -- down more than 11 points from September. Backlogs orders were well into negative territory, but new orders were still mildly positive.
NAPM-Chicago Consensus Forecast for October 07: 49.9p
Range: 48.8 to 50.5
Construction spending rose 0.3 percent in September after posting a 0.2 percent dip in August and a 0.8 percent drop in July. September's increase in construction spending was led by healthy gains in public and private nonresidential construction. As expected, private residential outlays fell significantly. With housing starts still weak and with the supply of homes for sale still very high, another decline in residential outlays is likely for October. The question is whether nonresidential and public construction can continue their uptrend and continue to offset residential outlays’ decline.
Construction spending Consensus Forecast for October 07: -0.3p percent
Range: -0.5 to -0.1 percent
|
