Fed tightening fears keep markets on edge, despite friendly inflation news

Hurricane Floyd impacts trading on Thursday
Economists and market players are used to hearing about the impact of weather conditions on economic indicators. The earthquake that shook San Francisco in 1989 or Hurricane Andrew in 1992 certainly affected the monthly economic indicators. In the same way, Hurricane Floyd is certain to have an adverse impact on such monthly figures as employment, housing starts and retail sales for September. Subsequent months could show corrections.

It is unusual that financial markets close because of severe weather. All the major stock exchanges remained open this week, but the cash bond market closed early on Thursday, as did the Chicago Board of Options Exchange. Mayor Giugliani of New York recommended that businesses close at noon. Indeed, several Wall Street firms did close early. So, even though the stock exchanges remained open, thin trading had to skew equity prices for the day.

The Chicago Tribune reported that estimated damages from Hurricane Floyd range anywhere between $2 billion and $8 billion. While the estimated damages are large, these would not be the worst suffered from weather or earthquake disasters. Hurricane Andrew (August 1992) was estimated to cost $15.5 billion dollars, while the Northridge, California earthquake of January 1994 was estimated to cost $12.5 billion in damages.

Incidentally, some have argued that the rebuilding from an earthquake or hurricane disaster boosts economic growth. Sure, it does in the near term. But remember that those resources had alternative uses. Rebuilding perfectly good homes or roads after a disaster doesn't add to the nation's wealth. Moreover, It is useful to remember that business associated with tourism is not replaceable.

Market players are skittish about Greenspan
Investors in the bond and equity markets aren't always in sync. Sometimes the bearish psychology in the bond market simply doesn't transfer over into the stock market, and vice versa. The markets were indeed in tune with one another this past week. As interest rates ticked higher on fears of further Fed rate hikes, stock markets tumbled. When interest rates dipped on good news, equity prices gained. There wasn't enough good news this week to push down interest rates or to boost stock prices from last Friday. Market players will remain insecure over the next few weeks as they try to read the economic tea leaves in the same manner they think that Fed Chairman Alan Greenspan sees them.

CPI reflects surge in energy prices, not elsewhere
The consumer price index rose 0.3 percent in August the same as last month. This was in line with expectations as energy prices jumped 2.7 percent for the month. This puts the year-over-year change at 7.2 percent on the energy front. Food prices rose 0.2 percent for the second straight month, but are only 2 percent higher than a year ago. All in all, this puts the total CPI 2.3 percent above August 1998 levels.

Excluding food and energy prices, the CPI inched up 0.1 percent in August, after a 0.2 percent hike in July. This puts the core CPI 1.9 percent above year ago levels. As evident in the chart above, the core components of the CPI are exhibiting a downward trend.

We like to look at the price changes in goods versus services. The uptick in goods inflation is due entirely to the surge in energy prices. Excluding food and energy from the good component leaves us with a year-over-year gain of 0.2 percent. While consumers clearly feel the impact of rising energy prices at the gas pump, prices of everyday goods don't seem to be rising. The downward trend in consumer prices for services is quite interesting as well. The bulk of consumer spending is on services.

The bottom-line on the CPI? The inflation news remains favorable. Short-term spikes in energy prices don't mean that prices of all goods and services have to rise. The Federal Reserve cannot point to this inflation index as a reason for further rate hikes at this time.

Consumer optimism helps boost retail spending
Retail sales jumped 1.2 percent in August after an upward revised gain of 1 percent in July. Robust sales of cars and light trucks boosted both months. Excluding autos, sales rose 0.7 percent in August nearly twice as fast as the previous month. But the bulk of the July gain was eaten up by higher gasoline prices. Even August sales were reduced after accounting for price increases at the gas pump. Yet, one can't deny that the non-auto portion of sales was healthy in August.

While retail sales were quite robust in August, a slowdown in June and July is holding down the third quarter average. With only September figures missing, total retail sales did accelerate in the third quarter, but non-auto retail sales are much softer for the period. This will help to hold down the consumption portion of GDP for the third quarter.

The bottom-line on retail sales? Retail sales turned up in August after a couple of less robust months. Consumer spending may be somewhat more moderate in the third quarter than the second, but confidence remains quite high. The University of Michigan's consumer sentiment index rose in September for the mid-month reading from August levels. The Fed is looking for slower economic growth so that inflationary pressures won't develop. They certainly couldn't have been reassured by the August retail sales report.

Housing finally trending lower?
The housing data continues to confound economists and market players. Housing starts edged up 0.4 percent in August to a 1.676 million-unit rate - more than predicted for the month. In addition, previous months' figures were revised higher. Single family construction is moderating. Single family starts averaged a 1.31 million-unit rate in the June through August period, 2.8 percent lower than the average for the March to May period. It is this portion (rather than the multi-family sector) that reacts more strongly to changes in interest rates. The chart below shows the sharp rise in mortgage rates over the past few months.

The bottom-line on housing? Housing starts were stronger than expected in August, but signs of slower growth are becoming evident. For instance, the NAHB housing index, which surveys home sale traffic, shows a downward trend over the past six months. Less housing construction also translates into lower spending for furniture and appliances. This will hamper retail sales in coming months. By the way, September housing starts will be hurt by the impact of Hurricane Floyd. Conversely, October and November starts might be boosted by reconstruction due to the hurricane.

Production softens in August
The index of industrial production increased 0.3 percent in August after a healthier gain of 0.7 percent in July. One-third of the August rise came from a surge in motor vehicle production. Other strong components were computer & office equipment and oil & gas drilling. The rest of the manufacturing sector was soggier. Indeed, the chart below shows that the year-over-year change in production moderated sharply in August relative to the previous two months. (It is worth remembering that last year's production was hampered by an auto strike in June and July, so year-over-year comparisons are tricky.)

The bottom-line on industrial production? Gains have been modest in the past few months. New orders figures have pointed to some improvement, but the increases are limited to few sectors (computers, motor vehicles). The capacity utilization rate has ticked higher in the past few months, but still remains well below "danger zone" levels (which would be around 84-85 percent). The Philadelphia Fed's business outlook survey (a leading indicator of production) did pick up in September, but gains in this survey were not uniform across categories. This should not cause Fed officials to worry about excess growth.

THE BOTTOM LINE
Economic indicators were abundant this past week, indicating that economic growth was continuing at a healthy pace, but inflation was held at bay. Most of the economic indicators turned out somewhat stronger than expected for August. Yet, the inflation news - outside of energy - was tame.

The Fed is concerned about the potential for inflationary pressures coming from a robust economy. Even though the CPI was sanguine, market players couldn't decide on what side of the fence the Fed would be leaning as they approach the October 5 FOMC meeting. Our view is always that Fed officials don't make their decisions until they are at the meeting. They analyze all possible information at their disposable.

Economic news will be sparse next week. It could create more skittishness than usual.

Looking Ahead: Week of September 20 to 24
We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Economists are predicting the international trade deficit on goods and services will narrow slightly to $23.8 billion in July from a $24.6 billion shortfall in June. Most economists expect a slight correction in imports which had jumped 3.9 percent in the previous month.

Wednesday
Financial market players are looking for the federal budget to show a $5 billion deficit in August, less than the average deficits posted for this month in previous years. This puts us on track for a surplus of roughly $100 billion for fiscal year 1999.

The Fed's Beige Book will be reported. Economists and financial market players will be looking for anecdotal evidence on moderation in the economy.

Thursday
Market participants are expecting new jobless claims to edge up 2,000 in the week ended September 18 from last week's 288,000. The number of economists predicting this indicator has diminished rapidly these past couple of months as its volatility has increased.