Fed Leaves Target Rate Unchanged; Service Activity Shrinks

MBA (8/6/2008 ) Velz, Orawin
As widely expected, the Federal Open Market Committee held the federal funds rate steady at 2.0 percent. This is the second consecutive meeting that the FOMC left the target rate unchanged.
In its post-meeting statement, the FOMC noted that the economy expanded in the second quarter but realized that labor markets continued to weaken and financial markets remained stressful. It listed tight credit conditions, the housing downturn and high energy prices as factors that will likely constrain growth.

Regarding inflation, the FOMC said that it “has been high,” boosted by previous increases in energy and commodity prices. However, it continued to say that inflation is expected to moderate going forward and that there is still a great deal of uncertainty surrounding the inflation outlook.

Regarding the balance of risks, unlike the previous statement following the June 24-25 meeting, where the committee said that downside risks to growth have diminished while upside risks to inflation have increased, the committee is more neutral this time. The committee argued that while downside risks to growth remained, “the upside risks to inflation are also of significant concern.”

The drop of the reference to diminished downside risk to growth suggested that FOMC is more concerned about near-term growth than they were late June. Finally, the FOMC kept the statement that it will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

The FOMC also kept the discount rate at 2.25 percent. The fed funds rate decision was not unanimous. Dallas Fed President Richard Fisher voted for a rate increase, his fifth consecutive dissent this year.

Yesterday’s economic report continued to show sluggish service activity at the start of the third quarter, according to the Institute for Supply Management nonmanufacturing survey. The nonmanufacturing index rose to 49.5 in July from 48.2 in June. This is the second consecutive month that the index showed a reading below 50, indicating a contracting service sector. The pace of decline moderated, however, as the index recovered about one-third of the drop in June. The service sector includes the retail, transportation, health care, finance, real estate and construction industries, which make up almost 90 percent of the economy.

The new orders index fell from 48.6 to 47.9, the lowest reading since January. The export orders index fell from 52.0 to 47.5, similar to the drop seen in the ISM manufacturing survey released last week. The employment index rebounded to 47.1 from 43.8, which was the lowest reading since records began in July 1997. The reading in the employment index, which indicated contracting employment in the service industries, was consistent with the Bureau of Labor Statistics’ employment report released last Friday that service industry payrolls declined by 5,000 in July, the first drop since March.

The price-paid index eased to 80.8 from June’s 84.5, which was the highest reading on record. Crude oil futures have receded significantly over the past month, staying around $120 a barrel yesterday afternoon, compared with $145 a barrel in early July. However, costs of raw material faced by businesses are considerably above last year’s levels.

Overall, the ISM report pointed to elevated costs and sluggish growth in the service industries. The ISM nonmanufacturing index slipped below 50 in five of the past seven months this year.

The fed funds futures market shows about a 25 percent chance that the Fed will raise the fed funds rate to 2.25 percent, at its next meeting on September 16. The odds were slightly lower than those before the Fed meeting. Stock markets rose in response to better-than-expected ISM report. The Treasury market declined and long-term Treasury yields rose modestly. The yield on the 10-year Treasury note increased five basis points and stayed around 4.00 percent by mid-Tuesday afternoon.