Reports Support a Moderate Rate Cut

MBA (4/21/2008 ) Velz, Orawin
Last week’s economic data were mixed, with several reports performing better than expected. Industrial production, which is one of the indicators tracked by the National Bureau of Economic Research (the arbiter that tracks and dates U.S. recessions and expansions), unexpectedly improved in March. February’s decline was revised to a sharper drop, however.
In addition, The Conference Board’s Index of Leading Indicators posted the first increase in six months. Finally, regional Federal Reserve Banks’ manufacturing surveys showed mixed results for April, with the New York Fed survey showing a marked improvement and the Philadelphia Fed survey showing the worst performance since 2001.

Residential construction continued to be in a free fall in March, with housing starts and permits dropping sharply. From the peak in January 2006, single-family starts has declined about 63 percent, surpassing the previous record peak-to-trough drop of 59 percent set in the 1980 recession. The elevated months’ supply of nearly 10 months for new homes helped explain the depressed level of homebuilders’ confidence in April, which continued to hover around a record low despite the start of traditional home buying season. Given the sluggish housing demand, it is necessary for builders to cut activity further to bring about a more balanced housing market.

Both wholesale and retail inflation picked up in March, boosted by surges in energy prices. The news came after the previous week’s report of a jump in import prices due to a declining dollar. While it is possible that core inflation will moderate going forward with a slowing economy, recent prices’ performance has raised inflation concerns.

The minutes of the March 18 Federal Open March Committee (FOMC) meeting released earlier this month showed that, while members were bearish about economic growth outlook, given a revised Fed forecast of “a contraction in real GDP in the first half of the year,” they were also concerned about the elevated inflation.

The next FOMC meeting at the end of the month will likely produce another 25 basis point rate cut, bringing down the fed funds rate to 2.00 percent. While a bigger cut cannot be ruled out, it is less likely. The economy is weakening but it appears that it is not collapsing. In addition, core inflation has remained elevated, with upside risks from a weak dollar and rising energy prices.

Interest Rates:
After stabilizing during the previous three weeks, long-term interest rates steadily rose last week as funds moved from the Treasury markets to the stock markets. Stocks rallied in response to better-than-expected earnings from several businesses, including Citigroup Inc., Google Inc. and Caterpillar Inc. The yield on the 10-year Treasury note rose to 3.84 percent on Friday but later reversed and hovered around 3.78 percent by mid-Friday afternoon, 29 basis points higher than the closing rate on the previous Friday.

Housing and Mortgage Indicators:
Total housing starts fell 11.9 percent in March to a seasonally adjusted annualized rate (SAAR) of 947,000. Single-family starts dropped 5.7 percent. This is the 12th consecutive decline in single-family homebuilding, which has now reached the lowest level since January 1991. Multifamily starts were down 24.6 percent, more than offsetting the 11.7 percent increase in the February. Both starts of 5-and-over units and 2-4 units decreased 23.1 percent and 24.7 percent, respectively.

Total housing starts dropped in every region: 21.4 percent in the Midwest; 12.6 percent in the South; 8.5 percent in the Northeast; and 5.7 percent in the West. Through the first quarter of this year, single-family starts were 39.0 percent lower than those in the first quarter of 2007. By contrast, multifamily starts for the first quarter of 2008 were 6.6 percent higher than those last year.

Even with the sizable pullback in single-family homebuilding activity over the past two years, the new home market continues to show considerable imbalance. While the number of new homes available for sale dropped steadily over the past year, the months’ supply or the inventory-sale ratio for new homes remained near 10 months in February.

Given the huge overhang of unsold inventory and sluggish housing demand, a continued decline in housing starts is necessary to reduce the market’s excess supply. Permits, a leading indicator of starts, suggest further declines in activity in the coming months. Total permits fell 5.8 percent in March to 927,000 units (SAAR). Single-family permits dropped 6.2 percent, marking the 12th consecutive monthly decline. Both total and single-family permits have declined to the lowest levels since January 1991.

The National Association of Home Builders/Wells Fargo Housing Market Index (HMI) remained at 20 in April for the third consecutive month, two points above the record low of 18 reached in December. (A value of less than 50 indicates that more builders view the market as unfavorable.)

The survey asks builders for their sentiments about current sales, traffic of potential buyers and projected sales over the next six months. The index gauging current sales conditions dropped two points to 18, an all-time low. The index gauging sales expectations for the next six months rose four points to 30. This was the biggest increase in this component in over a year. The index gauging traffic of prospective buyers was unchanged at 19 for the third consecutive month. All indices are seasonally adjusted.

While it is true that the HMI has not deteriorated over the past several months, the lack of any upward movement in the index is discouraging given that April is usually the start of the traditional home buying season. Builders reported some improvements in traffic through their model homes from the end of last year but noted that increased traffic has not translated to sales.

Economic Indicators:
The Producer Price Index (PPI) rose 1.1 percent, following a 0.3 percent increase in February, driven by jumps in energy and food prices. Excluding food and energy items, the core PPI was up 0.2 percent, decelerating from a 0.5 percent increase in February. Holding down the increase in core prices was the decline in the volatile prices for passenger cars and trucks, reversing the increase in the previous month.

Over the past year, the core PPI rose 2.8 percent, the largest gain since July 2005. While the PPI is not a focus for the Federal Reserve’s policy, its recent rising trend is consistent with other price measures. March import prices, released last week, showed the fastest pace monthly increase since November 2007 and the largest year-over-year gain on record.

The Consumer Price Index (CPI) rose 0.3 percent after a flat reading in February. Excluding the volatile food and energy items, the core CPI rose 0.2 percent, compared with unchanged core prices in February. From a year ago, the core CPI was up 2.4 percent, accelerating from 2.3 percent in February.

Industrial production, the nation’s output at factories, mines and utilities, was up 0.3 percent in March, following a 0.7 percent drop in February. All three categories that comprise industrial production increased during the month, with mining and utility outputs seeing sizable increases and manufacturing output edging up 0.1 percent.

For the quarter, industrial production was flat, the first time it has not shown a quarterly increase since the drop in the fourth quarter of 2006. The report showed that capacity utilization, which measures a portion of plants in use and thus a gauge for inflation pressures, edged up to 80.5 percent from 80.3 percent in February. Despite the monthly increase, capacity utilization is about one percentage point below its recent peak last summer.

The Conference Board Index of Leading Indicators, a gauge of future business activity three to six months ahead, rose 0.1 percent in March, the first increase in six months. Half of the 10 components of the leading economic indicators increased during the month. The largest positive contribution was money supply, while the largest negative contribution came from average weekly initial claims for unemployment insurance. Over the six months ending in March, the leading indicator index fell 1.6 percent. According to The Conference Board, the economy will face a tough environment of weak or no growth in the near term.