CPI Worries, Greenspan Doesn't ... Mixed-up market Econoday Simply Economics 7/21/00 By Evelina M. Tainer, Chief Economist

Which way is up?
A week ago Friday, stocks ended the week on an upbeat note despite stronger than expected producer price and retail sales reports for June. Positive earnings took center stage. Yet by Tuesday the 18^th, a CPI spurt spooked market players and stock prices tumbled across the board. The NASDAQ composite index, which finally regained its year-end level the previous week, managed to tread water. The Russell 2000 remains the strongest of the four major market indices this year.

Alan Greenspan managed to save the day on Thursday with his semi-annual report to Congress, probably not intentionally. He spent a bit of time discussing the slowdown in consumer spending, citing four main contributing factors. He said higher interest rates were taking a toll on consumer durable goods spending as increased borrowing costs dampened demand. Higher energy costs (while inflationary) took a bite out of consumers' disposable income and prevented spending on other goods and services. The rather flat stock market diminished the wealth effect. Finally, he noted that the strong run-up in durable spending was simply going to run out of steam as consumers would simply run out of things to buy (after all, how many new cars and much new furniture do you need?)

This was somewhat of a shift in sentiment for Mr. Greenspan. Six months ago, he didn't see any moderation in consumer spending at all. And even if he wasn't sure whether this slowdown was going to last, at least he saw seeds of a soft landing, or so market players reasoned.

But Greenspan was balanced in his remarks. He wasn't entirely convinced that a 4 percent unemployment rate could keep inflationary pressures at bay. He did think that productivity gains would continue, but perhaps not at the same rapid clip of the past few years. While the spurt in energy prices did curtail consumer spending in other areas, the price hikes did contribute to inflationary pressures.

On the whole, most economists agreed that Greenspan's remarks were not altogether unfriendly but still left the door open for further rate hikes this year should conditions warrant. Indeed, the chances of a rate hike at the August 22 FOMC meeting are still 50/50. Several economic indicators will be reported in the next few weeks that could shift Fed sentiment into extreme vigilant mode. These include the employment cost index (July 27); second quarter real GDP (July 28); the employment situation (August 4); PPI and retail sales (August 11).

Investors are likely to shift between economic fundamentals and earnings reports over the next few weeks in terms of determining the direction of the equity market. After all, profit-taking on Friday led to moderate declines in the major market indices that had posted healthy gains on Thursday. As a result, all four major indices posted declines for the week.

Treasury securities in tight range this summer
For the past several weeks, Treasury yields have fluctuated in a relatively narrow range. The yields on the 10-year note and 30-year bond tend to vary between 10 and 15 basis points from week to week, while yields on the 2-year and 5-year notes fluctuate a bit more dramatically. Nonetheless, weekly changes have followed a seesaw pattern as market players try to determine whether the Fed has - or has not - completed its tightening phase. Yields rose earlier this week around the CPI figure that turned out slightly higher than expected (mostly due to energy prices). The downward trend in housing starts coupled with Greenspan's testimony (okay, mostly Greenspan's testimony) sparked a healthy rally in the Treasury market on Thursday as bond investors read the chairman's remarks with a decidedly optimistic bent.

The rather bullish market sentiment could set the stage for a sharp rise in bond yields next week if the employment cost index and GDP deflators are higher than expected. While most economists are predicting a substantial moderation in real GDP growth, there is always the chance that GDP comes in higher than expected as well.

Housing starts trend lower
Housing starts fell 2.6 percent in June to a 1.554 million unit rate, after decreasing 3.4 percent in the previous month. Note the sharp downward trend in total housing starts since February's peak. Indeed, the drop is mirrored by declines in single family construction as well. Starts of single family homes fell 3.2 percent in June to a 1.214 million unit rate after a 4.3 percent drop in May. Both total single family starts are now below year ago levels. It does appear that rising mortgage rates have finally taken a toll on the housing market. In an interesting shift, mortgage rates appear to have peaked a couple of months ago. Rates are now down about 35 basis points from May's high.

Economists and Federal Reserve policymakers focus their attention on the single family housing market because it is more sensitive to economic fundamentals such as interest rate movements and income growth. One also has to believe that the wealth effect works on the housing market as much as it does on other consumer expenditures. If stock prices are not appreciating at the heady pace of the past few years, new homeowners may not feel as "wealthy" and may not be inclined to trade up on their homes.

The bottom-line on the housing market? The housing market is feeling the pinch of higher interest rates coupled with less robust growth in equity prices which have helped consumers feel wealthier in recent years. The housing slowdown is already affecting durable goods spending on furniture and appliances. Since there tends to be a roughly six-month lag between new housing construction and furniture purchases, we are yet to feel the full brunt of the decreased demand for housing on retail sales. But make no mistake - current housing activity remains rather healthy by historical standards.

Consumer price spurt
The consumer price index rose 0.6 percent in June, quite a difference from the previous two months when it was unchanged in April and up 0.1 percent in May. But just like declines in energy prices dampened the CPI then, a 5.6 percent jump in energy prices accounted for three-quarters of the gain in June. Despite the rapid run-up in June prices, the second quarter gain in the total CPI amounted to 2.6 percent - less than half of the 5.8 percent spurt in the first three months of the year. Excluding food and energy prices, the CPI rose 0.2 percent in June, the same pace as the past several months. The core CPI appears to be drifting higher on a year over year basis, but note that it has remained below 2.5 percent since 1997.

We like to compare changes in prices of services versus commodities. The commodity price index has jumped in the past several months because this component includes energy prices. Even the service component includes a small share of energy prices. Prices of services are slightly edging higher, but the commodity price index has jumped sharply in the past two years. If energy prices start moderating even slightly, we could see some improvement in this component in coming months. Remember, though, that services are a larger portion of the CPI than goods, and the service component is up nearly 3.5 percent on a year-over-year basis. This has to be worrisome to Fed officials.

The bottom-line on inflation? The inflation news was neutral in June as the core CPI posted the same modest gain of the past several months. Energy prices remained a problem. The concern is that higher energy costs will start being felt in other sectors of the economy. For instance, airline fares have risen from strong demand - and higher fuel costs. A variety of shipping companies have also added surcharges for higher fuel costs. (Additional anecdotal evidence, my water cooler delivery service just added a surcharge for higher gasoline prices too!) This means that Fed officials will remain vigilant on the inflation front even if they see some moderation in demand for goods and services. The jury is still out whether the Fed will raise rates or not at the August FOMC meeting.

International trade deficit widens - big drag on second quarter growth
The international trade deficit on goods and services widened in May to $31 billion from April's $30.5 billion trade gap. Both imports and exports fell, but as usual, exports fell more than imports. Surprisingly, exports declined despite an increase in civilian aircraft shipments. Auto exports edged higher as well. However, these gains were offset by declines in nonauto consumer goods and industrial supplies. On the import front, industrial supplies and capital goods rose, but were offset by a sharp drop in auto products.

The chart shows both exports and imports trending lower on a year-over-year basis. The moderation in imports appears a bit more exaggerated. It is possible that this will taper off somewhat more rapidly in coming months and prevent the trade deficit from widening.

THE BOTTOM LINE
On the whole, one would have to summarize the week's economic data as friendly for the financial markets. Economic indicators such as housing starts and the Philadelphia Fed's business outlook survey (an indicator of manufacturing activity) both headed lower. These are favorable from the Fed's perspective because they show moderation in the pace of economic activity, but not out and out weakness. The international trade deficit widened and points to a greater drag on second quarter GDP growth.

On the inflation front, the consumer price index looked ugly - at least the headline number that includes energy prices. Excluding food and energy prices, the CPI rose on par with past months. While the CPI figures weren't bad enough to force the Fed into tightening, they weren't good enough to set the Fed's mind at rest.

Market participants were quite excited about Alan Greenspan's testimony before the Senate Banking Committee. Economists were generally more reticent. He didn't say that the tightening phase was complete. The jury is still out on another Fed rate hike at the August meeting.

Looking Ahead: Week of July 24 to July 28
Market News International compiles this market consensus which surveys about 20 economists each week.

Tuesday
The Conference Board's consumer confidence index is expected to increase to 139.5 in July from June's level of 138.8. Despite the anticipated rise, this wouldn't surpass May's level of 144.7. Nevertheless, it represents a strong dose of consumer optimism. (Forecast range: 138.5 to 141.0)

The consensus shows that June existing home sales are expected to drop 2 percent to a 5.0 million unit rate. Despite the anticipated decline, the overall level of housing activity remains relatively healthy. (Forecast range: 4.8 million to 5.1 million)

Federal Reserve chairman Alan Greenspan is scheduled to testify before the Housing Banking Committee. The prepared remarks will be exactly the same as those delivered this past week to the Senate. However, the question and answer period may reveal some new information.

Thursday
Market participants are expecting new jobless claims to drop 11,000 in the week ended July 22 from last week's 311,000 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. (Forecast range: +1,000 to -21,000)

Market players are looking for durable goods orders to edge down 0.2 percent in June following May's 6.1 percent spurt. Given the sharp jump in May, the June figure represents pretty strong activity for durable goods orders. (Forecast range: +1.0 percent to -2.7 percent)

The employment cost index is expected to post a 1.0 percent hike in the April to June period. This would be an improvement from the first quarter's rise of 1.4 percent. It puts the year-over-year gain at 4.3 percent, about on par with the first quarter. This indicator will be widely followed since an unexpected spurt here could cause Fed officials to be extra vigilant on inflation issues. Also, the Labor Department had announced that they would start including data on stock options as a compensation benefit, which was not previously included. (Forecast range: 0.7 percent to 1.2 percent)

Friday
Economists are predicting real GDP will grow at a 3.5 percent rate in the second quarter. This is a sharp moderation from the first quarter pace when real GDP advanced at a 5.5 percent rate. All sectors are expected to share in the slowdown, including consumer spending. Real final sales are expected to increase at a 2.7 percent rate - a sharp moderation from the first quarter pace of 7.1 percent! The GDP price deflator is expected to rise at a 2.4 percent rate in the second quarter, down from the first quarter pace of 3 percent. In both quarters, surging energy costs are contributing factors. (Forecast range for GDP: 3.0 percent to 4.2 percent; GDP deflator: 1.9 percent to 2.9 percent)

Looking ahead to the week of July 31
Early estimates show a consensus forecast of 75,000 for July's nonfarm payroll employment. This incorporates a drop in temporary Census workers. Excluding Census workers, the market consensus predicts a 230,000 gain in payrolls. Hourly earnings are expected to rise 0.3 percent and the unemployment rate is expected to remain unchanged at 4 percent in July.