Declining Oil Prices Crucial as Trade, Fiscal Stimulus Impacts Wane

MBA (8/18/2008 ) Velz, Orawin
Second quarter economic growth likely picked up more strongly than initially reported. In the advance gross domestic product report released at the end of July, the Bureau of Economic Analysis assumed that trade contributed 2.4 percentage points to growth, already the largest contribution since 1980.
Last week’s report of a surprising decline in the June trade deficit indicated that trade now likely contributed more than three percentage points to growth, likely bumping up economic growth to about 2.5 to 3.0 percent from the advance estimate of 1.9 percent (annualized rate). The next GDP revision will be released on August 28.

The declining dollar over the past year helped improve the trade deficit because it made U.S. exports less expensive to foreign consumers and made U.S. imports more expensive to American consumers, and thus helping boost U.S. exports and reduce U.S. imports. Strong global growth also helped spur U.S. exports and improve the trade deficit. These factors are now reversing, however. First, the dollar has strengthened over the past month.

Second, the economies of America’s major trading partners, including the euro zone (15 countries that have adopted the euro as their official currency) and Japan, are weakening. On Thursday, the European Union's statistics agency reported that GDP in the euro zone contracted 0.8 percent (annualized rate) in the second quarter, the first decline since its data series for the euro zone started in 1995. Also reported last week, the Japanese economy shrank by 2.4 percent (annualized rate) in the second quarter, the biggest quarterly decline since the third quarter of 2001, when Japan was in recession.

For the U.S., domestic demand will likely slow in the second half of the year as the lift from the stimulus payments has dissipated. Retail sales, which account for about 40 percent of consumer spending, declined in July as auto sales plummeted. While ex-auto sales increased, the gain decelerated sharply from May and June, when the bulk of the tax rebates was distributed.

Another factor weighing down on consumers is tighter lending standards. The latest Federal Reserve’s Senior Loan Officer Survey for the three months ending in July showed that more banks tightened lending standards for almost all loan types than in the previous survey in April. Lending standards were also tightened for all categories of residential mortgages, including for borrowers with good FICO scores and credit history. About 74 percent of banks tightened standards on prime mortgage loans, while about 85 percent of banks reporting more stringent standards for nontraditional and subprime mortgage loans.

In the April 2007 survey—the first in which the Fed separated mortgages into prime, nontraditional and subprime categories—only about 15 percent of banks reported that they had tightened lending standards for prime loans.

One bright spot in the economy is sharp declines in commodity and energy prices over the past month. The import price index and the consumer price index rose sharply in July, but relief should be underway. While a firmer dollar bodes ill for the trade deficit, it will help moderate import price increases and reduce their pass-through risk to the overall inflation. Declining energy prices, if sustained, will help moderate inflation going forward and give the Fed more room to leave interest rates unchanged for the rest of the year, as currently expected by fed funds futures.

Long-term Treasury yields rose on Monday then declined steadily throughout the week as stocks declined. The yield on the 10-year Treasury note managed to stay below four percent every day last week,the first time that happened since the first week of July. The 10-year yield stayed around 3.84 percent by mid-Friday afternoon, about 10 basis points lower than the rate on the previous Friday.

While the benchmark 10-year yield has trended down in recent weeks, there was no relief on mortgage rates, which have remained elevated. The spread between the yields on 10-year Treasury notes and conforming fixed-rate mortgages widened from about 200 basis points in late May to about 260 basis points last week, the widest spread since mid-March, during the time of the Bear Stearns crisis. The yield on 30-year fixed rate mortgages stayed above 6.50 percent last week, according to both the Mortgage Bankers Association’s Weekly Mortgage Applications Survey and Freddie Mac’s Primary Mortgage Market Survey. Rates were up by more than 100 basis points from the low seen in the beginning of this year.

Housing and Mortgage Indicators:
The Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices for the three months ended in mid-July showed that banks continued to tighten lending standards this year. What began at the end of 2006 as more stringent lending standards for only subprime and nontraditional residential mortgage loans have spilled into the overall mortgage market. A net 74.0 percent of banks tightened standards on prime mortgage loans in the July survey, up from 62.4 percent in the April survey and 50.0 percent in the January survey.

Banks also continue to make lending standards more stringent for subprime mortgage loans, with about 86 percent of banks reporting an increase in standards, up from 78 percent in the July survey. For nontraditional mortgage loans, about 84 percent reported that they had tightened standards, increasing from 76 percent in the previous survey.

The survey contained special questions on securitizations and sales of conforming-jumbo mortgage loans. About 30 percent of banks indicated that they had securitized with, or sold to GSEs conforming-jumbo mortgage loans over the past three months, and about 45 percent of banks expected to do so over the next six months. As reasons for not securitizing or selling conforming-jumbo loans over the past three months or in the next six months, about 50 percent of respondents pointed to a lack of demand for conforming-jumbo loans; and about 45 percent cited the cost of the GSEs’ guarantee fees or other pricing terms. Roughly 40 percent of banks pointed to a limited number of mortgage applicants who meet the GSEs’ underwriting criteria.

Regarding commercial real estate lending, about 80 percent—a similar share to that in the April survey—reported having tightened their lending standards over the past three months. Regarding demand for these types of loans, about 30 percent of banks reported weaker demand for commercial real estate loans. The share was slightly smaller than that in the previous survey.

Economic Indicators:
The trade deficit in goods and services narrowed to $56.8 billion in June from $59.2 billion in May. Both exports and imports of goods and services increased but exports, which posted the biggest gain since February 2004, grew faster than imports. The trade deficit improved despite sharply rising import crude prices during the month. Petroleum imports increased to a record level as oil prices soared, registering the biggest monthly price gain on record. Adjusted for inflation, real exports increased while real imports dropped, narrowing the real trade deficit to $39.1 billion from $43.5 billion in May.

For a number of years, trade was a drag on economic growth. Starting in the second quarter of 2007, trade turned into a boost to growth. During the second quarter, net exports contributed 2.4 percentage points to economic growth, according to the advance estimate of gross domestic product released at the end of July. Real GDP was 1.9 percent (seasonally adjusted annualized rate) during the quarter and would have seen a 0.5 percent decline without the contribution from trade.

Retail sales decreased 0.1 percent in July following a 0.3 percent gain in June. This was the first decline since February. A 2.4 percent drop in auto sales was responsible for the decline in overall sales. In terms of units, sales of cars and light trucks for the month dropped 8.3 percent to 12.5 million units (annualized pace), the weakest pace since 1993. Tighter lending standards have contributed to slumping auto sales. Excluding autos, retail sales increased by 0.4 percent, slowing from a 0.9 percent increase in June.

Sales increases were broad-based, including housing-related sales, such as those at building supply, appliance and furniture stores. Outside of sales at auto dealers, only sales at restaurants and sporting goods and hobby stores posted declines among major sales categories. Retail sales weakened in July as the boost from the tax rebates began to dissipate. Nearly 90 percent of the stimulus tax payments were already distributed by the end of July, with a small amount from revised returns projected for next year, according to the Treasury Department.

Import prices rose 1.7 percent in July, the seventh consecutive increase, moderating from a 2.9 percent surge in June. On a year-over-year basis, import prices were up 21.7 percent, the largest increase on the record.

While energy prices led the increase, non-energy prices also posted a strong gain. Imported petroleum prices increased 4.0 percent, and imported natural gas prices rose 5.8 percent. Excluding fuels, import prices increased 0.7 percent for the second consecutive month and were up 6.9 percent on a year-ago basis, also a record high. Import prices will likely moderate in the coming months as crude oil prices have tumbled since mid-July and the dollar has recently strengthened.

The Consumer Price Index rose 0.8 percent in July after a 1.1 percent gain in June. Rising food and energy prices continued to boost the overall inflation. From a year ago, the CPI was up 5.6 percent, the biggest increase since January 1991.

Excluding the volatile food and energy items, the core CPI rose 0.3 percent in July for the second consecutive month. Core service inflation moderated to 0.3 percent from 0.4 percent, while core goods inflation jumped to 0.5 percent from 0.1 percent, led by apparel price and airfare increases. Over the past year, the core CPI was up 2.5 percent, accelerating from 2.4 percent in June to the upper end of the Fed’s comfort zone of 1.5 to 2.5 percent.

Other price measures also showed rising core inflation. The Federal Reserve’s favored measure of inflation—the core personal consumption expenditures—rose 2.3 percent in June from a year ago, the fastest pace of increase since December 2007.

The Fed has continued to express concerns about inflation risk. In the statement following the Federal Open Market Committee meeting on August 4, the committee noted that inflation “has been high,” and “the upside risks to inflation are also of significant concern.”However, it continued to say that inflation is expected to moderate going forward.

With plummeting crude oil prices since mid-July, slowing overall inflation in the coming months now seems likely.

Industrial production—the nation’s output from factories, mines and utilities—was up 0.2 percent in July, following a 0.4 percent increase in June. Utility output fell 1.9 percent in July, partially reversing the 2.3 percent gain in June. Mining output increased 0.9 percent for the second consecutive month.

The industrial production report showed that capacity utilization, which measures a portion of plants in use and is a gauge for inflationary pressures, edged up to 79.9 percent from 79.8 percent in June, the second consecutive increase.

Manufacturing output, which accounts for about four-fifths of industrial production, gained 0.4 percent, led by motor vehicles output. Outside of motor vehicles, manufacturing output rose 0.1 percent.

The University of Michigan’s Consumer Sentiment Index edged up to 61.7 in early August from 61.2 in July. Lower energy prices helped improve sentiment.

Consumers’ assessment of current conditions dropped 3.8 points to 69.3. The component measuring their expectations increased 3.3 points to 56.8. The survey showed that one-year inflation expectations fell to 4.8 percent from 5.1 percent in July. Consumers expect inflation in five years to be 3.2 percent, the same as July.