In early May, Federal Reserve Bank Chairman Ben S. Bernanke and the Federal Open Market Committee unanimously voted to keep the Federal Funds rate unchanged at 5.25%, where it has sat since June 29, 2006. The Fed cited two primary concerns: slowing economic growth and “somewhat elevated” core inflation. First quarter gross domestic product was revised down to 0.6%, dragged down by the housing slump; and core inflation, the rate of price increases in consumer goods not including food and energy, remains higher than the Fed’s target rate of 2.1%.
The slow-down in the U.S. economy is real. And while the poor first quarter numbers may have been a temporary aberration, with a mixed bag of economic statistics and a markedly weaker U.S. dollar, the big picture is certainly more complicated than many people would hope. But it’s not all bad news on the U.S. economy.
Jon Silvia, chief economist for the Wachovia Corp., says that the decline in first quarter GDP was a “short-term blip,” caused by a substantial inventory adjustment and a higher than expected trade deficit, which came in at nearly $64 billion. “People were buying, they just weren’t buying enough,” Silvia says, adding that both retailers and wholesalers ended up with too much inventory.
The following inventory sell-off, combined with slightly easier prices then contributed to the downward pressure on the rates of inflation. “Looking forward, if you have good sales but your inventories have declined, that’s actually a positive for economic growth. So you will see a lot people who talk about 1% [first quarter] GDP also talking about 2% to 2.5% in the second quarter,” Silvia says. And so far, the Institute for Supply Management Index, which tracks manufacturing productivity, has been steadily above 50, indicating economic expansion, with the exception of January, when the ISM dipped to 49.3.
“What we have in April is a return to 54.7,” notes Joseph Trevisani, chief market analyst at FX Solutions LLC. “The last time the number was that high was last July. The new orders were even higher, at 58. Those numbers are great. You have a pattern bottoming out in the first quarter, but that is as preliminary as it gets,” he says, noting that the same pattern is evident in the non-manufacturing number, which came in at 56. “It’s better than it has been, and also a better number than expected.”
BRINGING DOWN THE HOUSE
The housing market is in the midst of a large and painful correction, and as per Bernanke’s Congressional testimony, the housing market is the number one significant risk to the Fed’s economic outlook for the second half of the year (see "Show me where it hurts," below).
“The pattern of building permits clearly shows that the dramatic downward correction in housing production still is underway,” said David Seiders, chief economist of the National Association of Home Builders.
“Home buyer demand has been sent into another down leg by the abrupt tightening of mortgage lending standards, and there is an increasingly heavy supply of vacant housing units on the market. Under these conditions, builders are cutting back on new construction and intensifying their efforts to bolster sales and limit cancellations.”
Kim Rupert, managing director of Action Economics, says, “The declines are hurtful and onerous, but to the overall economy it has been a speed bump.” But longer term, she anticipates more pain, noting that the NAHB/Wells Fargo Housing Market Index dropped to 30 from 33 in April, indicating the lowest level of builder confidence since September 2006. “We are not out of the woods yet, but the market doesn’t crumble,” she says, pointing out that non residential building growth is up 6% to 8%.
WHEN DOES IT END?
The implications of the housing market collapse could be large and have wide impact on the economy, as construction employs 5% of all American workers and could damage the lending industry, with sub-prime lenders especially at risk.
“Bernanke said that the spill-over from the sub prime to the housing sector seems to be very, very limited,” says Carl Tannenbaum, chief economist at LaSalle Bank/ABN AMRO N.A. and president of the National Association of Business Economists (NABE). And while Bernanke would not offer guidance on the duration of the correction, Tannenbaum takes away some positive news. “I would tell you that affordability is heading up. Prices going up are not good if you are long, they are attractive if you’re a buyer. And mortgage rates are, by and large, still very reasonable.”
Barry Ritholtz, principle of Ritholtz Research, is not as optimistic. He says throughout the 1990s, mortgage withdrawals accounted for just a few percentage points of discretionary income. “It was $10 or $20 billion a quarter. It was nothing.” But since 2000, he says mortgage withdrawals have grown to $200 billion per quarter, almost 10% of discretionary income. Historically, home equity funded retirement accounts. “You sold your house and moved to some place warmer and cheaper and you lived off it in your golden years,” he says. “Now people have been tapping the home equity for things that were typically paid for out of income, like vacations and cars and plasma screens.”
Silvia says the eventual correction will happen on a regional basis. “If you are in certain areas where you have job growth plus in-migration,” such as Charlotte or Raleigh, NC or Orlando, Fla., the correction should be very short. “Where there is out-migration and very little if any job growth — Michigan and parts of Ohio, Mississippi and Louisiana — those areas are looking at a workout of another two, three or five years.”
Another factor is the yield curve, which compares long-term interest rates with short-term interest rates and has been declining or flat for the last year or so. When short-term interest rates are consistently above long-term interest rates, the net-interest margin for many lending institutions and suppliers of credit is shrinking, explains Silvia. “The cost of them getting money, which depends on short-term interest rates, is higher than the cost of what they can lend.” As a result, they are less willing to lend.
Ashraf Laidi, chief currency analyst at CMC Markets US, expects the housing slowdown to be reflected in jobs. “That’s the key thing. The other thing is personal expenditures and how the U.S. consumer responds,” adding that how consumers respond will determine whether the U.S. economy has a hard or soft landing.
THE U.S. CONSUMER
In his testimony before Congress, Bernanke said, “Consumer spending continues to be the mainstay of the current economic expansion.” So, watching ground-level economic activity, including jobs, retail sales, inflationary expectations and confidence numbers, can provide insight as to how the economy is taking shape; and so far, numbers are just a little bit soft (see “I have confidence,” below).
The U.S. unemployment rate has been hovering between 4.4% and 4.6% since April 2006. And according to the U.S. Department of Labor, the seasonally-adjusted four-week-moving average of jobless claims was 304,500, and in May, the number of people filing unemployment insurance claims dipped below the 300,000 level twice, says Kim Rupert, managing director at Action Economics. “That suggests employment is healthy,” and strength should accompany income growth (see “Take this job and…,” below).
One of the caveats is that a strong labor market can contribute to inflation. “We have driven the unemployment rate down to a low level, we are seeing wages start to move ahead and the question is: is that going to become an issue for general inflation?” asks Tannenbaum, adding that productivity growth seems to be slowing down. “And if it slows and we are operating at a high level of capacity usage in the labor market, that becomes a risk of inflation.”
With jobs holding up substantially, the American consumer has been spending consistently. According to Bernanke’s testimony, Personal Consumption Expenditures (PCE), the goods and services purchased by individuals and accounting for more than two-thirds of aggregate demand, has been increasing by roughly 3.5% per quarter for the last three years.
But not everyone is so optimistic. “I don’t know if they accurately [portray] how much the consumer has slowed,” says Ritholtz, adding while government data indicates consumer spending is increasing, that is simply a reflection of higher prices.
“Go back and look at the laundry list of nonsense excuses we’ve heard for the past five months. ‘Christmas was weak, but don’t worry about Christmas because we have the gift cards.’ Then the gift cards didn’t show up in January so we heard that January’s too warm… February was too cold… In March it was too rainy. So that’s retail, and by the way, the excuses just go to validate the overall weakness of the economy,” Ritholtz says.
Inflation is clearly moderating, but it remains above the Fed’s target of 2.1%. “The inflation picture seems to be in reasonably good [shape], as far as the Fed is concerned,” Tannenbaum says. He expects the core PC Deflator will be just above 2% this year, which will not be high enough to induce a Fed Funds rate hike. But he also is not expecting the Fed funds rate to come down.
To some people, these numbers feel artificially low. Tannenbaum says the NABE survey shows a large divergence between headline and core inflation, which removes food and energy cost from the equation. “We are expecting the CPI to be up by 2.9% this year, whereas the PCE deflator will be up by 2.1%. Obviously, the difference is fairly large, one you could drive a truck through,” he says. “You know the Fed’s rationale for taking this stuff out: food and energy prices are historically quite volatile. And you don’t want to be whipsawing monetary policy on the basis of price component that could be very high one month and moderate the next. I understand that logic, but to take them out entirely doesn’t pass the smell test.”
Silvia also attributes the discrepancy to the shift from being a primarily manufacturing economy to being a largely services based economy and including credit quality in the adjusted numbers. Credit quality, which accounts for improvements made to goods, such as adding standard anti-lock brakes to a car. Such improvements increase the cost but are removed from the Bureau of Labor Statistics’ assessment because the buyer is getting greater value from the purchase. Another factor keeping inflation low is cheap imported goods, which inevitably leads to a substitution for more expensive, domestically produced goods.
The worldwide global product market also is driving down inflationary expectations, Trevisani explains. “The earnings that they are generating and recycling through the bond market are because of the world-market’s ability to keep inflation down because expectations are down.” The products cost less and consequently, there is less pressure for wage increases. “They are two sides of the same coin. That money flowing into the bond market is generated by pricing that keeps pricing down. So they both end up doing the same thing. That also means that long-term mortgage rates are down, so people can spend more on housing.”
The combination of moderating growth and slightly higher inflation has seemingly has everyone, including the Fed Chief Bernanke asking, ‘what next?’
“The Fed has historically paid attention to growth, although its rhetoric has been anti-inflationary for some time,” Trevisani says. “Central banks are coming around to believing that if you want to foster growth, the first thing you need to do is destroy inflationary expectations. The Fed has done a very good job of taking inflationary expectations out of the economy,” he says, and with an acceptable inflationary outlook, decisions on monetary policy will focus on the actual economy. “And this is where it gets interesting,” Trevisani says, “because right now, we are in the gray area,” he says, adding that the weakness in the U.S. economy is likely to continue, and the logical projection is that the Fed cuts rates later in this year.
A more consistent monetary policy has resulted in two of the longest, if slightly flatter, economic expansions in decades, observes Rupert. “Fed policy has been able to manage growth and inflation much more ably than in prior years, but it has gotten a lot of help from global stabilization and a global understanding that managing inflation helps mitigate against a lot of these big cycles,” Rupert says, adding that globalization has fostered improved economic conditions around the world and moderated inflationary pressures. “Two years ago was the first time that no country was in an economic recession. The entire world was on an upside economic path. It was quite remarkable,” Rupert says. She forecasts that the United States will return to trendline growth, between 2.5% and 3%, by the year-end and that the market is pricing out the expectation of a rate cut. “The Fed will have to tap the brakes to maintain credibility. The have been concerned for months if not years, that inflation is still not moderating enough.”
The NABE assigned a 25% probability to a recession developing the next 12 months, Tannenbaum says, “Certainly not a likelihood, but when we have asked questions like this in the past, we usually don’t get numbers that are that high.
Silvia says that if he has a bias, it is that the Fed will lower rates. “I think growth will pick up and that inflation will stay in the comfort zone for the Fed,” he says, adding that inflation data will be the key.
“At this point in the economic cycle, Fed cuts are really like waking up in the night after a big party and doing a couple of shots to make the hangover go away,” Ritholtz says. “You know you’re dealing with inflation, you’re dealing with a devalued currency. You cut rates and it’s like having another drink. But I don’t think that’s really the answer at this point.”
Laidi is expecting two cuts in the Fed funds rate, the first in August and another in September or October. “The more important developments will be in the housing markets: new home, existing home sales and payrolls.