Fed Stays Pat Econoday Simply Economics 6/30/00 By Evelina M. Tainer, Chief Economist

Major stock indices lower since year end - except for small cap
At first glance, investors might think that the first half of this year hasn't been particularly good. All major stock indices - with the exception of the Russell 2000 - are down from December 31, 1999 levels. And even the Russell is only up a meager 2.5 percent over this six-month period. Yet, when one takes a longer term perspective, only the Dow Jones Industrials seem to be taking a beating.

The Wilshire 5000 index, which measures the entire domestic equity market and is a Greenspan favorite, is down 1.4 percent over the past six months. But this market index gained a healthy 22 percent in 1999. The modest drop isn't enough to cause panic among investors or consumers. Yet the decline, which points to a negative "wealth effect", might be sufficient to prevent consumers from going on another wild shopping spree. Fed officials would be relieved to see some stagnation in the market, which would help prevent consumer spending from rising faster than disposable income.

The Dow Jones Industrial Average is the weakest stock market index, posting a 9.1 percent drop from year-end levels and offsetting about 40 percent of the 1999 appreciation in this index. The NASDAQ composite is posting the second largest loss among these indices with a 2.5 percent drop. This seems a drop in the bucket after realizing that the NASDAQ composite surged 85.6 percent in 1999. However, this is small consolation to those investors who bought into the NASDAQ near or at its high of 5049 in mid-March. The index now stands 22.3 percent below that peak.

The S&P 500 stands 1.0 percent below year end levels. This offsets only a small portion of the 19.5 percent gain recorded in 1999.

The Russell 2000 is up 2.5 percent from year-end levels, which follows a 19.6 percent gain in 1999. Incidentally, this index is reconfigured every year on the first of July. Since the Russell measures small cap stocks, any company that grows too rapidly and surpasses the small-cap definition must be removed from this index in the annual overhaul. To some extent, the Russell has benefited from the surging high tech market. Indeed, some of the high tech issues in the Russell have performed better than those in the NASDAQ composite. As this index is reconfigured next week, it remains to be seen if it will continue to outperform the other major market indices in the coming month.

Fed doesn't disappoint
Economic data was generally friendly this week, although Treasury prices backed up a bit on Friday when the Chicago purchasing managers' report came in above expectations. However, this week's main event, the FOMC meeting, didn't surprise bond investors. The general tone over the week was favorable as bond yields generally fell across the curve. Yields fell even further after the Fed announced at the end of their FOMC meeting that they left rates unchanged. Despite keeping the bias towards "heightened inflation risk" and despite expectations of a rate hike at the August meeting, sentiment was bullish.

The Consumer: Slowdown in Sight?
The Federal Open Market Committee decided to leave rates unchanged this week after raising rates six times and 175 basis points over the past twelve months. According to the announcement released immediately after the meeting, signs of slowing in aggregate demand and the rapid advancement in productivity allowed them to stay pat this week. However, officials remained concerned about the diminishing pool of available labor and thought the slower pace of growth was still tentative. As a result, they noted that the balance of risks point to heightened inflation pressures.

About half of the week's indicators were reported before the end of the Fed's meeting with the rest released at the end of the week. Even knowing the week's data ahead of time would not have swayed the Fed in either direction since the results were mixed.

Existing home sales jumped 4.3 percent in May reversing three-quarters of the previous month's drop. The figures were a surprise to market players, who had anticipated a modest drop in home sales for the month to parallel the drop in housing starts. This put economists and market players on edge for the new home sales figures. Yet, sales of new single family homes actually dipped 0.2 percent in May after an 8.6 percent drop in April. It appears that new home sales peaked several months ago. The chart below depicts the sum of new and existing single family home sales relative to the 30-year fixed mortgage rate. Since existing home sales account for the lion's share of the market, they tend to skew monthly movements. Nevertheless, a downward, albeit jagged pattern is taking shape.

A few weeks ago, the retail sales figures showed some moderation in consumer spending. Personal consumption expenditures, which also include spending on services, confirmed the downward trend. Indeed, after accounting for inflation, personal consumption expenditures increased a mere 0.2 percent per month from March through May. The chart below depicts the downward trend in yearly gains in personal consumption expenditures. At the same time personal income has shown some improvement in the past couple of months on a yearly basis, though the monthly trend is decidedly down. Personal income rose 0.4 percent in May - spurred by special gains in transfer payments. Wages and salaries, the lion's share of income, were unchanged for the month.

The personal saving rate has increased modestly in each of the past three months from the February low. Undoubtedly, monthly savings are meager. Should this upward trend continue, however, it would suggest that consumers may becoming more concerned about over spending. Fed officials would certainly be relieved to see an upward trend develop in the personal savings rate, as it would go hand in hand with slower consumption expenditures.

Government policymakers and market players both may be heartened by the downward drift in consumer confidence in June. Both the Conference Board and the University of Michigan reported modest declines in their respective measures of consumer sentiment. Granted, consumer optimism remains healthy by historical standards, but the downward trend, if sustained, might point to a slower pace of growth over the next several months.

The bottom-line on the consumer? After charging full speed ahead for several years, the consumer sector is showing some tentative signs of moderation. One could question whether these signs are sustainable. But the signs are coming from a variety of indicators and confirm the Fed's attempt to moderate the economy by raising interest rates over the past year. If home sales continue to edge down and personal consumption expenditures continue to moderate their rate of growth, it is possible that the Fed will not need to raise rates at the August FOMC meeting. But for the moment, let's look for additional evidence.

Manufacturing
New orders for manufacturers' durable goods jumped 6 percent in May - frightening financial market participants. How silly! This only reverses the previous month's 5.7 percent drop. And the bulk of the gain was due to a single sector -- electronic and other electrical equipment which surged a whopping 26 percent in May after plunging 17.6 percent in April. While the monthly figures were dramatic, the two-month gain was actually more modest than the February-March gains that on the surface didn't scare anyone.

The chart below compares quarterly changes (at annual rates) in total durable goods orders to nondefense capital goods, a leading indicator of capital spending. In both cases, orders are way down from the previous quarter. Only two of the three months of the second quarter are currently available, but it would take an astronomical gain in June to boost new orders to the pace posted last quarter.

The APICS survey of manufacturing activity confirmed this slower rate of growth. The index dropped more than six points in June to reach a level of 44. This index is interpreted like the NAPM survey - any level below 50 percent points to a contracting manufacturing sector. It is worth noting that the APICS survey fluctuates more dramatically than the NAPM. Indeed, the PMAC Survey (the Chicago version of the NAPM) actually edged higher in June in contrast to expectations. The PMAC Survey is widely followed because the distribution of manufacturing industries in the Chicago region mirrors that in the nation. But the Chicago index often moves more sharply than the national index.

Corporate profits & growth
The Commerce Department's final estimate of first quarter real GDP revealed a 5.5 percent growth rate. At the same time, the implicit price deflator was revised slightly higher to a 3 percent rate, from the initial estimate of 2.7 percent. As a result, corporate profits were also revised higher for the period. After-tax profits rose 13.3 percent in the first quarter over the previous year's level, just a bit less than the 15 percent yearly rise posted in 1999's fourth quarter. Note how yearly profits tend to correlate with yearly changes in stock prices (measured by the Dow Jones Industrials). In the second quarter, the DJIA declined on a year-over-year basis for the first time since mid-1993. This could point to a drop in yearly profit growth as well.

THE BOTTOM LINE
As widely expected the Fed left the federal funds rate target unchanged at 6.50 percent in June. They indicated that the balance of risks still favor heightened inflationary pressures unless the moderation in aggregate demand that began in May is sustained.

The week's set of economic indicators were somewhat mixed, but taken as a whole, confirmed the Fed's actions (or lack of action, in this case). Consumer demand appears to be moderating. This shouldn't come as a great surprise given that the Fed has already raised the federal funds rate target a cumulative 175 basis points over a period of 12 months. Yet, Fed policymakers and perhaps market players as well were becoming frustrated that higher rates had not taken hold of the economy.

It is important to remember that Fed policy changes don't have instant impact on consumer or business spending. Each of the 25 or 50 basis point hike in the funds rate should take at least three months - if not longer - to work through the economy. This means we could see further dampening in consumer spending in the months ahead. And let's not forget that higher gasoline pump prices are also already hampering retail sales. Unless we see a drop at the pump in the coming months, that will contribute to the slowdown as well.

So what does this mean for future Fed policy? At this point, the market consensus is looking for a 25 basis point rate hike at the August FOMC meeting. But if inflation figures don't worsen and consumer spending moderates sufficiently, the Fed might be able to leave policy unchanged after that meeting as well.

Looking Ahead: Week of July 3 to July 7
Market News International compiles this market consensus which surveys about 20 economists each week.

Monday
The consensus shows the NAPM Survey is expected to edge up in June to 53.6, from a level of 53.2 in May. The forecasts range from a high at 55.0 to a low level of 52.0 for the month. Most economists don't predict the prices paid component. The few that do are looking for the index to increase to 67 in June, up from 65.8 in May. This reflects higher energy prices, at least in part.

Construction expenditures are predicted to decrease 0.1 percent in May, following a 0.6 percent drop in April. This generally is due to the lower level of housing starts that we have seen in the past several months. The forecasts range from a high of +0.8 percent to a low of -1.0 percent.

Wednesday
Economists are predicting that the Conference Board's index of leading indicators will decrease 0.2 percent in May after dipping 0.1 percent in April. The new configuration of the leading indicators no longer means that three consecutive monthly declines signal a recession. However, the two-month dip does suggest some moderation in economic activity ahead. The forecasts range from a high of -0.1 percent to a low of -0.4 percent.

The non-manufacturing NAPM survey is expected to post a rise in June. Remember that this index is not adjusted for seasonal variation and must be interpreted with more caution than other economic indicators. Also, the business activity index is the component most followed, but it isn't a comprehensive index like the NAPM manufacturing survey. Rather, it corresponds to the production index in the regular NAPM survey.

Motor vehicle sales are predicted to increase in June after edging down in May. Even with the projected gain for the month, total sales are still expected to be lower than April levels. The consensus forecast is looking for a level at a 6.9 million-unit rate for cars and a 7.5 million-unit rate for light trucks. (Car sales forecasts range from 6.6 to 7.0; Truck sales forecasts range from 7.0 to 7.6.)

Thursday
Market participants are expecting new jobless claims to decrease 1,000 in the week ended July 1 from last week's 306,000 level. Claims are likely to be rather volatile in the next several weeks since summer factory shutdown schedules are not exact from year to year. The forecasts range from a level of 300,000 to 321,000.

Factory orders should record a gain of 3.8 percent in May after dropping 4.3 percent in April. This incorporates the burst in durable goods orders (coming from electronic equipment). Remember that this series fluctuates wildly. The two-month gain is still fairly sluggish relative to the first quarter. The forecasts range from a low of +0.4 percent to a high of +4.5 percent.

Friday
Market participants are expecting nonfarm payrolls to rise 275,000 in June; not very different from the 231,000 gain posted last month. Excluding the temporary Census workers, payrolls are also predicted to rise 275,000. Last month, payrolls excluding these workers actually declined. An increase of this magnitude would actually be considered moderate by recent historical standards (after taking into account last month's sluggish figure). Forecasts range from a low of 175,000 to a high of 470,000.

Economists are predicting the civilian unemployment rate will edge back down to 4 percent after rising 0.2 percent points to 4.1 percent in May. (The forecasts range from 3.9 percent to 4.1 percent.) The market consensus is looking for a 0.4 percent hike in average hourly earnings. Last month, hourly earnings rose a modest 0.1 percent. If the June forecast were realized, it would translate into a yearly rise of 3.6 percent, up from last month's 3.5 percent gain, but less than the previous several months. The forecasts range from a low of +0.2 percent to +0.5 percent. The average workweek should edge up to 34.5 hours in June from 34.4 hours in May.