Rates Higher But Economy Afire Econoday Simply Economics 2/7/00 By Evelina M. Tainer, Chief Economist

Stocks indifferent to Fed rate hike
The Federal Open Market Committee (FOMC) met on February 1 and 2. As was widely expected, they announced a 25 basis point increase in the federal funds rate to 5.75 percent and a 25 basis points rate hike in the discount rate to 5.25 percent. The increases were ho-hum, but market participants were anxious to see the Fed’s new policy announcement. The official statement noted that the FOMC was worried about supply problems despite enhanced productivity growth. Furthermore, the statement said:

Last year, each time the Fed raised rates, it set its bias back to neutral. This statement that talks about "heightened inflation risks" is analogous to a "bias towards tightening". While the Fed can never be called "clear," this statement is the closest the Fed has come to revealing its inclination to raise rates at least once, if not more, this year.

It’s true that equity investors were expecting a Fed rate hike – and built that expectation into market prices. Nonetheless, the equity market barely blinked at the Fed. The Dow remained virtually at a standstill this week after the Monday run-up in advance of the FOMC meeting. The DJIA did end lower after Friday’s trading session. The Nasdaq composite showed its normal pattern of ignoring any fundamental news and increased sharply from last Friday. The S&P 500 is still down from the end of the year, but performing marginally better than the Dow. In contrast, the Russell 2000 has risen fairly steadily so far. In fact, the Russell 2000 and the Nasdaq composite are the only two indexes that are currently up from the December 31 close.

Humpback yield curve defies explanation
What the heck is going on in the Treasury securities market? The U.S Treasury announced its quarterly refunding package on Wednesday – the same day as the FOMC’s rate hike announcement. To some extent, the refunding was bullish for the bond market since it was smaller than expected. But the surprise didn’t end there. Indeed, the Treasury announced its plans to scale back the 52-week bill auction to four times a year (it currently auctions the year bill every four weeks) and to eliminate half of the 30-year bond auctions. Instead of two regular 30-year bond auctions and two 30-year TIP bond auctions, there will now be only one of each this year. The Treasury reiterated its plan to buy back long bonds over the next two months.

To say that the Treasury bond market rallied would be an understatement. Moreover, not all maturities across the spectrum moved by the same magnitude. On Wednesday, the yield on the long bond fell 13 basis points; on Thursday, it fell an additional 15 basis points. This brought the 30-year bond yield down to 6.14 percent by the market close. This two-day drop is not revealing the entire story. Ever since the Treasury announced the buyback program a couple of weeks ago, long bond yields have declined. On January 20, just three weeks ago, the long bond yield peaked at 6.74 percent! Bond traders and hedge fund managers have been scrambling to find 30-year paper. In fact, the drop in bond yields has so dramatic over the past couple of days that markets were abuzz over rumors of financial crises at hedge funds and large bond houses.

The change in supply conditions has created a sharply inverted yield curve. The yield on the 30-year bond is below yields for 2-year, the 5-year and 10-year notes. In fact, it is only barely above the yield on the one-year bill! The short end of the curve (from the 3-month bill to the 2-year note) reflects a rising interest rate environment – coming partly from the tighter monetary policy. In the past, market players could look to the longer end of the Treasury curve to indicate the prospects of inflationary expectations. The 30-year bond is clearly out as a benchmark security. In today’s environment, it wouldn’t be entirely useful to look at even the 10-year note as an indicator of economic fundamentals. Technical factors are simply outweighing everything else.

One would think that the general drop in interest rates in the Treasury yield curve helped bond markets everywhere. Unfortunately not. Corporate bonds and agency securities suffered in the past week as everyone scrambled to hedge positions and find Treasuries. It will take more than a week to figure out what the Treasury curve can tell us going forward.

Markets at a Glance

(BP = basis points; stock price indices are rounded)

Payroll surge weather-related – but still strong
Nonfarm payroll employment jumped 387,000 in January, on top of a 316,000 spurt in December. The Labor Department immediately cited mild weather conditions during the reference week as a source of the strong growth. Indeed, construction employment surged 116,000 in January after posting average monthly gains of 36,000 the previous four months. Warm weather allowed workers in this industry to stay on the job longer than usual.

The robust nature of the employment report can’t be dismissed so easily, though. Even if we only assume that construction would have grown at the average pace of the past several months, this still would have yielded a payroll gain in excess of 300,000 per month – and faster than predicted by economists. Gains were widespread among the various categories. Only finance, insurance and real estate even posted a decline for the month. The chart below shows that the three-month moving average is on a growing trend – not a moderating one – and stands at its highest level since December 1997!

The civilian unemployment rate edged down to 4.0 percent in January and now stands at its lowest level since January 1970 when the rate was 3.9 percent. Both employment and the labor force grew by roughly similar amounts during the month. The Labor Department also started to seasonally adjust the size of the labor pool this month. This indicator, a favorite of Alan Greenspan’s, was previously available only on an unadjusted basis. The Labor Department’s series showed a drop of 214,000 in January in the pool of available labor. Any movement in a downward direction can only be viewed negatively by the Fed chairman. Despite the drop in the unemployment rate, average hourly earnings didn’t accelerate on an annual basis. Earnings rose 0.4 percent in January, but were 3.5 percent higher than a year ago, the same as last month.

The bottom-line on the employment situation? Despite mild weather conditions, there is no getting around the fact that economic momentum is going gangbusters. The combination of private sector employment and the average workweek can serve as a proxy for GDP growth. The chart below looks at the growth in total hours worked in the economy (private payrolls times the average workweek) and shows its relationship to real GDP. The missing link between the two series is productivity, which caused real GDP to increase at a more rapid clip than total hours worked during this time horizon. Note that the total hours worked in January expanded more rapidly than the previous seven quarters! Even if February and March employment and hours moderate, the stage is already set for faster growth! How can the Fed ignore this? Another interest rate hike at the March 21 FOMC meeting is practically in the bag – and maybe so is a rate hike at the May 17 meeting as well!

Manufacturing boom
Factory orders jumped 3.3 percent in December, fueling the healthy growth that already began earlier in that quarter. Whether we are looking at total new orders, or just the roaring information technology sector, the yearly gains posted in the fourth quarter were at their fastest since the first quarter of 1995! The manufacturing sector took a hit in 1997 when Asian economies collapsed. It was easy then for consumers and businesses to import less expensive foreign goods – and our exports were too expensive to foreigners. As foreign economies have turned around, U.S. exporters of manufactured goods are seeing moderate improvement.

Although manufacturers’ new orders have generally been on a rising trend for the past couple of years, a similar pattern has not emerged in the payroll data. On a year-over-year basis, factory payrolls are still running well below year ago levels. However, a new upward trend in these payrolls may suggest that the bleeding of workers has stalled over the past few months. Yet to some extent, orders rising faster than payroll has to reflect the sharp productivity gains made in the manufacturing sector in the past few years.

The bottom-line on manufacturing? Until the second half of 1999, the manufacturing sector was pretty much the poor relation in the U.S. economy. The sector then took off as momentum built through the end of the year. The surge in new orders in the fourth quarter generally guarantees that industrial production growth will expand at a healthy pace in the first half of 2000. Unfilled orders, a more reliable but less well-known series than new orders, confirms that the turnaround in manufacturing is likely to be sustained for more than just a couple of months.

Like the battery bunny, the consumer keeps on going
Personal income edged up a modest 0.3 percent in December, but personal consumption expenditures jumped 0.8 percent for the month. The fact that consumption expenditures are growing faster than income is nothing new. This only exacerbates the decline in the personal saving rate. Consumers are not losing their sense of well-being (wealth) from stock market investments. It will be interesting to see if the greater market volatility will create enough unease among consumers to moderate their spending behavior over the next several months.

Some economists and market players were claiming that the three rate hikes engineered by the Federal Reserve in 1999 had absolutely no impact on the consumer. That’s not entirely true. Home sales have clearly, though modestly, moderated their pace. New and existing home sales did peak in the first half of 1999. The Fed initially raised its funds rate target at its June 1999 FOMC meeting. Mortgage rates also ticked higher in the second half of the year as the Fed pursued a tighter monetary policy. Market participants correctly anticipated that the Fed would raise rates at its February FOMC meeting. As a result, the 30-year fixed mortgage rate increased in January to about 8 ¼ percent. The decline in home sales should eventually lead to declines in spending on furniture, appliances and home furnishings.

While rising interest rates affected the housing market in the second half of the year, the same can’t be said about other interest-sensitive sectors. Motor vehicle sales jumped in January as domestic cars were sold at a 7.3 million-unit rate and light trucks at a 7.8 million-unit rate. As evident in the chart below, this surpasses the sales pace of the past several months. It seems that interest rates are just not high enough yet to hamper spending on cars and trucks.

The bottom-line on the consumer sector? U.S. consumers really are like the energizer bunny – they keep going and going. But eventually, a rising interest rate environment will stall this sector. The slower level of home sales is bound to constrain expenditures on durable goods. The Conference Board’s buying plans survey did show that consumer plans for auto purchases over the next six months have come down. It will take more than one month of stock market data to frighten investors, but the greater volatility in the market combined with (perhaps) slower stock gains might lead consumers to curtail their spending due to concern over their wealth.

The Bottom Line
The U.S. economy is soaring. It doesn’t matter that mild weather conditions boosted payrolls during the month because numbers were strong regardless. Manufacturing conditions are improving and consumers keep on spending. Motor vehicle sales and chain store sales reported red-hot sales in January. A longer term perspective does show that the housing market cooled down (marginally) in the second half of 1999 relative to the first half. Higher mortgage rates are hampering sales to some extent.

The Federal Reserve resumed its tightening stance in February after a brief pause. They figure that rates are going to have to go higher before consumers actually take notice. The latest spate of data supports more Fed rate hikes in the near term. Most economists are predicting a minimum of three rate hikes for the year – some are looking for four. Just about everyone recognizes the fact that it is an election year and rate changes will likely stop by mid-year (barring a serious acceleration of inflation). While the economic data support at least a couple more rate hikes in the near term, there is no reason for the Fed to pursue a more aggressive policy. The gradualist approach should work well for the first half of 2000. After all, while some of the survey figures are showing higher prices for raw materials, average hourly earnings are not accelerating.

Looking Ahead: Week of February 7 to February 11
Market News International compiles this market consensus which surveys about 20 economists every week.

Monday
Market players are looking for consumer installment credit to post an increase of $8.0 billion in December. This would be a marked slowdown from the hefty November pace of $15.6 billion.

Tuesday
The market consensus indicates that nonfarm productivity growth will increase at a 4.5 percent rate in the fourth quarter of 1999. In the third quarter, nonfarm productivity expanded at a 4.9 percent rate. At the same time, economists are predicting that unit labor costs were unchanged in the fourth quarter; these had inched down at a 0.2 percent rate in the third quarter.

Thursday
Market participants are expecting new jobless claims to remain virtually unchanged in the week ended February 5 from last week's 274,000.

Friday
Economists are predicting that retail saleswill record a 0.6 percent increase in January, roughly half of December’s 1.2 percent gain. Excluding autos, sales are expected to rise 0.5 percent – dramatically slower than the previous two months.

Week of February 15 to 18
Industrial production is expected to rise 0.5 percent in January, faster than the 0.4 percent increases of the previous two months. At the same time, the capacity utilization rate should rise to 81.5 percent, up 0.2 percentage points from December.

The preliminary consensus shows that the producer price index could increase 0.2 percent in January. Higher energy prices are still hurting this series. Excluding food and energy prices, the PPI is expected to rise only 0.1 percent for the month.

Economists are predicting that the consumer price index will rise 0.3 percent in January, hit by higher energy prices. Excluding food and energy, the CPI is expected to increase a more moderate 0.2 percent for the month