Elevated Core Inflation Won’t Deter Fed’s Rate Cut

MBA (3/3/2008 ) Velz, Orawin
Last week’s economic reports suggest slower economic activity in the current quarter. Durable goods orders fell in January, indicating that business investment will be soft. Recent regional Federal Reserve Banks’ surveys also point to reduced manufacturing activity in February.
Consumers are unlikely to help boost growth because they are hurt by rising prices, especially gasoline prices. Crude oil futures hit a record high $103 a barrel last week, giving no relief to prices at the pump in the near term. Real (inflation-adjusted) personal consumption expenditures (PCE) were flat in January for the second consecutive month. Given that consumer spending accounts for 70 percent of gross domestic product (GDP), real GDP could show a decline in the first quarter, following the anemic 0.6 percent growth in the fourth quarter.

Measures of consumers’ mood kept sliding further in February. The Conference Board’s Consumer Confidence Index dropped to the lowest reading since 2003 (at the time of the invasion of Iraq), while the University of Michigan’s Consumer Sentiment Index fell to the lowest level since February 1992 (when the economy was recovering from the 1990-91 recession).

The revision to the fourth quarter GDP showed that real residential investment was downwardly revised to a decline of 25.2 percent—the biggest drop since the fourth quarter of 1981—when the economy experienced a severe housing and economic recession. As a result, residential investment subtracted 1.25 percentage points from economic growth in the fourth quarter and will likely act as a huge drag to the first quarter economic growth again. Both new and existing home sales declined in January. The months’ supply (inventory-sales ratio) remains elevated at about 10 months for both new and existing homes, indicating that further decline in homebuilding activity is necessary.

The oversupply in the housing market continues to put downward pressure on home prices. All measures of home prices released this week showed significant deterioration. The median price for new single-family homes posted the largest year-over-year decline on the record in January, while that for existing single-family homes saw the 18th consecutive year-over-year decline for the month. In the fourth quarter of 2007, the Office of Federal Housing Enterprise Oversight House Price Index showed the slowest pace of year-over-year increase since the fourth quarter of 1990 (0.8 percent). During the same quarter, Standard and Poor’s Case-Shiller national house price composite index posted the largest year-over-year decline since the inception of the series in 1988 (8.9 percent).

The data above, which are consistent with an economy on the cusp of a recession, point to continued aggressive easing from the Federal Reserve. Unfortunately, inflation has not moderated with the slowing economy, making the Fed’s job more difficult given its dual mandate of economic growth and price stability. Measures of core inflation (excluding food and energy items) have remained elevated.

The Fed’s favored measure of inflation—the core PCE—has remained outside of the Fed’s comfort zone in January for the second consecutive month. Furthermore, inflation expectations have risen, as evident in survey data (e.g., the University of Michigan’s Survey of Consumer Sentiment) and other data (e.g., the widening gap between the yield on the 10-year Treasury note and the 10-year Treasury Inflation Protected Securities or TIPS).

Despite elevated core inflation and rising expected inflation, it’s clear that Fed easing will continue. Last week’s Fed Chairman Ben Bernanke’s testimony to the House and the Senate and Vice Chair Donald Kohn’s speech left the door wide open for a sizable rate cut at the Federal Open Market Committee (FOMC) meeting on March 18. Fed’s rhetoric indicated that it is more concerned about the downside risks to growth than the upside risks to inflation—at least for now.

Treasury yields declined significantly last week. The Treasury market rallied as weak economic data sparked recession concerns and investors fled the stock markets in a flight to quality to default-free Treasuries. Comments by Bernanke also rattled the stock markets. During a Q&A session in his testimony to the Senate on Thursday, Bernanke said he expected some small, regional banks to fail as a result of the financial crisis.

On Friday, stocks plunged and a flight to quality intensified when American International Group—the world’s largest insurer—reported the biggest loss in its 89-year history, including an $11 billion writedown of mortgage-backed securities. Stocks declined further on the report that business activity in the Midwest contracted.

The financial markets increased expectations for a more aggressive rate cut in the near term. The odds of a 75 basis-point Fed cut in the fed funds rate to 2.25 percent at the FOMC meeting on March 18 have risen to about 60 percent on Friday from 40 percent on Thursday and from just two percent a week ago, according to fed funds futures. The yield on 10-year Treasuries stayed around 3.51 percent by mid-Friday afternoon, 28 basis points lower than the closing rate on the previous Friday.

Housing and Mortgage Indicators:
Total existing home sales edged down 0.4 percent in January to a seasonally-adjusted annualized rate of 4.89 million, as the drop in condo sales outweighed the small increase in single-family home sales. This is the sixth consecutive monthly decline. Sales of single-family homes rose 0.4 percent—the first increase in 11 months—while condo sales dropped 6.5 percent.

January’s pace of total sales is the weakest in its nine-year history. From a year ago, sales of single-family homes were down 24.4 percent, compared with a decline of 30.2 percent for condo sales. Single-family sales have declined 31.5 percent since their peak in September 2005. Condo sales have been down 40.9 percent from their June 2005 peak. Sales dropped in three regions: 3.6 percent in the Northeast; 0.5 percent in the South and 2.1 percent in the West. Sales rose 3.5 percent in the Midwest.

Inventories continued to rise in January. The number of total homes available for sale increased 5.5 percent from December. (The data are not seasonally-adjusted.) From a year ago, inventory was up 18.4 percent. The drop in the sales pace and a considerable increase in inventory pushed up the months’ supply (or the inventory-sales ratio) to 10.3 months from 9.7 months in December. The months’ supply for single-family homes was 10.1 months, compared with 6.5 months a year ago. The months’ supply for condos was 11.8 months, rising from 7.4 months in January 2007.

Elevated months’ supply continued to put downward pressure on home prices. The median price for single-family existing homes fell 5.1 percent in January from a year ago. This is the 18th consecutive month of year-over-year drop in prices. The median price for condos fell 1.0 percent from last January, the third consecutive monthly drop.

New homes sales decreased 2.8 percent in January to a seasonally-adjusted annualized pace of 588,000, following a 3.9 percent drop in December and 13.1 percent plunge in November. The January pace is the slowest since February 1995. New home sales were 33.9 percent lower than sales a year ago and 57.7 percent below their recent peak in July 2005.

The Census Bureau/HUD revised up sales in December by 1,000 but revised down the previous three months by 3,000. Sales declined in three regions: the Northeast (10.3 percent); the Midwest (7.6 percent) and the South (2.4 percent). The West was the only region that saw an increase (2.2 percent).

The number of homes available for sale dropped 2.2 percent to 482,000. This is the 10th consecutive month of decline to the lowest level since August 2005. Despite the drop in inventory, the months’ supply (or the inventory-sales ratio) rose to 9.9 months from 9.5 months in December and from 7.2 months a year ago. This is the highest months’ supply since October 1981. The reason that the inventory-sales ratio has not improved despite the steady cutback in housing starts over the past two years was because housing demand has fallen just as much as builders cut new construction. Tighter lending standards for all types of mortgage loans including prime loans have reduced the number of qualified homebuyers. In addition, some qualified potential homebuyers are reluctant to buy in a declining home price environment.

Elevated month’s supply continues to put downward pressure on home prices. The median price for new homes fell 15.1 percent in January from a year ago, the biggest year-over-year decline since the series’ inception in 1963.

The Office of Federal Housing Enterprise Oversight House Price Index (HPI) showed that home price appreciation slowed to 0.8 percent in the fourth quarter from a year ago, following a year-over-year increase of 2.3 percent in the third quarter. The HPI includes prices based on refinance and purchase transactions. The index excluding refinance transactions (i.e., the purchase-only index), which has a shorter history than the overall index, showed a year-over-year decline of 0.3 percent, the first drop in the index’s 16 year history. Of the 291 metropolitan areas covered by OFHEO, 99 posted declines in the overall HPI, up from 83 in the third quarter. All but two of the 20 worst performing metro areas are in California or Florida, with Michigan and Nevada being the remaining two.

The Standard and Poor’s Case-Shiller national house price composite index covers only purchase loans. It showed that home price declines intensified in the fourth quarter. The index was down 8.9 percent in the fourth quarter of 2007 from a year ago, following a 4.6 percent year-over-year decline in the third quarter. The fourth quarter was the largest decline since the inception of the series in 1988.

While both measures showed worsening home price trend, the OFHEO HPI painted a relatively better picture of national home prices because it has not yet registered a year-over-year decline in this current housing downturn. The OFHEO HPI tends to overstate home price trends as it is based on data from Fannie Mae and Freddie Mac. Thus the index includes only conventional, conforming loans and effectively excludes jumbo loans.

In addition, the OFHEO data include relatively fewer subprime loans as well as adjustable rate mortgage loans and other nontraditional mortgage loans, which have performed relatively worse over the past year. The Case-Shiller index therefore captured the impact of the considerable stress in the jumbo market since the August financial turmoil and significant tighter lending standards that is not reflected by the OFHEO HPI. While the Case-Shiller index has an advantage over the OFHEO HPI because it covers all loan products and sizes, it has a smaller geographical coverage than the OFHEO HPI, especially in smaller states.

The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending Feb. 22 showed that mortgage demand declined for the third consecutive week as refinance applications dropped sharply. The Market Index fell 19.2 percent to 665.1. The Purchase Index edged up 0.2 percent, while the Refi Index plunged 30.4 percent.

The 30-year fixed mortgage rate rose 18 basis points to 6.27 percent, the fifth consecutive increase. The one-year adjustable rate was up 12 basis points to 5.84 percent. The ARM share of mortgage applications of the number of loans increased 2.2 percentage points to 15.0 percent. The share of the dollar volume of new applications was up 2.1 percentage points to 26.8 percent. These are the highest ARM shares since mid-November.

Economic Indicators:
The Producer Price Index (PPI) rose 1.0 percent, following a 0.3 percent decline in December, driven by jumps in energy and food prices. Excluding food and energy items, the core PPI was still up a strong 0.4 percent.

Over the past year, the PPI surged 7.7 percent, the biggest increase since October 1981. The core PPI rose 2.4 percent from a year ago—the largest gain since October 2007. While the PPI is not a focus for the Federal Reserve’s policy, its recent rising trend is consistent with other price measures.

The Conference Board’s Consumer Confidence Index has trended down significantly in recent months, weighed down by many factors including declining housing market and home prices, more stringent lending standards in consumer and mortgage loans, slower employment growth and rising gasoline prices. The Index fell to 75 in February from 87.3 in January.

Both the present conditions and expectations components fell during the month. The expectations component fell 11.4 points to 57.9, its lowest level since 1991. The present conditions component dropped to 100.6 from 114.3 in January.

Consumers’ assessment of the labor market also deteriorated sharply. The share of respondents saying jobs are hard to get rose to 23.8 percent from 20.6 percent in January. The share of respondents indicating jobs are plentiful fell 3.2 percentage points to 20.6 percent, the lowest since 2005.

Durable goods orders declined 5.3 percent in January following a 4.4 percent increase in December. The 30.5 percent drop in nondefense aircraft orders to the lowest level since August 2006 and a 32.6 percent drop in military aircraft orders led the decline.

Nondefense capital goods orders excluding aircraft—a proxy for future business investment—fell 1.7 percent in January, the biggest drop since October 2007 following a 5.2 percent jump in December. Shipments for nondefense capital goods excluding aircraft—a component used in the calculation of economic growth in the current quarter—rose by 0.1 percent, after increasing 1.7 percent in December. The report confirms Bernanke’s view in his testimony before the House Committee on Financial Services last week, when he said recent data indicate subdued investment in equipment and software during the first half of this year.

Gross Domestic Product (GDP), adjusted for inflation, grew 0.6 percent in the final quarter of last year, according to the Bureau of Economic Analysis’ preliminary estimate, the same rate reported earlier in the advance estimate. (Unless otherwise noted, data reported here are seasonally-adjusted annualized rates.)

Exports revised higher and imports revised lower. As a result, the trade sector’s contribution to economic growth was 0.9 percentage points in the fourth quarter, nearly doubling the initial estimate. A large upward revision to net exports roughly offset small downward revisions to other categories, however. For example, residential investment growth was revised to a decline of 25.2 percent from a decline of 23.9 percent. The drop was the biggest since the fourth quarter of 1981. Declining residential investment subtracted 1.25 percentage points from economic growth during the fourth quarter.

Consumer spending growth was revised down slightly. The BEA also revised downward nonresidential fixed investment growth to 6.9 percent from 7.5 percent as a result of downward revisions in both equipment and structures. In his testimony before Congress last week, Bernanke warned that nonresidential construction growth should decelerate sharply going forward as economic activity slows and funding becomes more difficult to obtain.

Personal income rose 0.3 percent in January, following a 0.5 percent gain in December. Wage and salary income rose 0.5 percent, lifted by an adjustment for large bonus payments and pay raises for government employees. Excluding both bonuses and government raises, personal income rose a modest 0.2 percent. After adjusting for inflation, real disposable income increased 0.1 percent for the second consecutive month.

Inflation is undermining consumers' income gains and limiting their spending power. Overall inflation, as measured by the PCE deflator, picked up 0.4 percent in January. Excluding food and energy items, the core PCE increased 0.3 percent, accelerating 0.2 percent in December. Over the past year, the core PCE increased 2.2 percent for the second consecutive month and exceeded the Fed’s comfort zone of 1.0 to 2.0 percent.

Personal consumption expenditures (PCE) were up 0.4 percent in January. Real PCE was unchanged for the second consecutive month and increased 1.8 percent from last January, the smallest gain in four years.

The final estimate of the University of Michigan’s Consumer Sentiment Index fell 7.6 points in February to 70.8, its lowest level since the 1990-1991 recession. The expectations component dropped to 62.4 from 68.1 in January, the lowest in 16 years. The current conditions component fell 10.6 points to 83.8. One-year inflation expectations increased to 3.6 percent in February after staying at 3.4 for three consecutive months. Five-year expectations were unchanged at 3.0 percent.

The Kansas City Federal Reserve Bank manufacturing survey showed that the production index fell to a minus 5 in February from 7 in January. This is the first negative reading (indicating contracting in the Fed District’s manufacturing activity) in eight months and the lowest reading since 2001. The Kansas City Fed’s survey echoes the results from other regional Fed’s manufacturing surveys, (i.e., the New York Empire State, the Philadelphia Fed and the Richmond Fed surveys) indicating that manufacturing activity is contracting across the nation.

The National Association of Purchasing Management Chicago Business Barometer fell 7 points to 44.5, its lowest reading since 2001, suggesting that factory activity in the Midwest will remain weak well into the second quarter. Readings below 50 indicate a contraction in economic activity.

This Week:

• Monday: January construction spending and the Institute for Supply Management Manufacturing index for February;
• Wednesday: Fourth quarter productivity and costs; January factory orders; the Institute for Supply Management Non-manufacturing index for February; and the Beige Book;
• Thursday: January pending home sales; and
• Friday: February employment report.

(Orawin Velz is senior director of economics and research with the Mortgage Bankers Association. She can be reached at ovelz@mortgagebankers.org.)