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Fed Is Ready to Watch and Wait

Wed, Apr 30 2008, 23:38 GMT
by Asha Bangalore

Northern Trust

Fed Is Ready to Watch and Wait

The Federal Reserve lowered the federal funds rate 25 bps to 2.00% and reduced the discount rate 25 bps to 2.25%. The Fed is ready to watch and wait. There were broad hints than the June24-25 meeting is likely to close with no change in the federal funds rate. Fed Presidents Plosser and Fisher dissented again and would have preferred to leave the federal funds rate at 2.25%.

With respect to economic growth the FOMC policy statement now reads as “[r]ecent information indicates that economic activity remains weak.” This represents a Fed that is less pessimistic about growth because the March policy statement observed that “recent information indicates that the outlook for economic activity has weakened further.”

The FOMC’s evaluation of the housing sector and financial market conditions has not changed; the policy statement retained March description that “financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.”

There was a subtle change in the manner in which the FOMC views consumer spending. Today’s statement reads as “household and business spending has been subdued” whereas in March the statement focused only on consumer spending and noted that the growth of consumer spending has slowed.

Today’s statement notes that “labor market conditions have softened further,” compared with the March observation that “labor markets have softened.” This is consistent with the increase in the March unemployment rate to 5.1% from 4.9% in February.

The policy statement today is noticeably less hawkish about inflation compared with the March 18 statement. Inflation is expected to moderate due to lower resource utilization and a leveling off of energy and commodity prices. The key is in the change regarding the outlook for inflation. Today, the FOMC noted that “uncertainty about the inflation outlook remains high,” but in March the statement read as “uncertainty about the inflation outlook has increased.”

The last paragraph of the policy statement shows a noteworthy modification. The grim observation that “downside risks to growth remain” of the March policy statement is not featured in today’s policy statement. Instead, the closing part of the statement opens with the remark “substantial easing of monetary policy to date,” which translates to enough has been done. In other words, the FOMC would prefer to wait and see the impact of the 325 basis point cut in the federal funds rate and the other programs it has put in place.

U.S. Economy Has Stalled For the Second Quarter in a Row

The U.S. economy grew at an annual rate of 0.6% in the first quarter, matching the gain seen in fourth quarter of 2007 and the first quarter of 2007. Effectively, the economy has grown in only two quarters of the last five quarters. The important difference to note between the first and fourth quarters is that inventories added substantially to the growth of the economy ($1.8 billion vs. -$18.3 billion in the fourth quarter) in the first three months of 2008 while it subtracted from GDP in the last three months of 2007. The implication is that in an environment of significantly weak economic conditions, the big build up in inventories in the first quarter entails a likely cutback in production in the second quarter. Real final sales (GDP less inventories) declined 0.2% in the first quarter, indicative of a contraction in demand. A larger contraction of real final sales last occurred in the third quarter of 2001, excluding the Katrina-related 0.5% drop in real final sales in the fourth quarter of 2005.

Going down the list of major components of GDP, exports (+5.5%) made a large positive contribution to GDP in the first quarter and they are most likely to remain as the source of strength during the rest of the year. Excluding exports and inventories, government spending, largely defense outlays, rose 2.0% in the first quarter and consumer outlays increased at an annual rate of 1.0%, the smallest increase since the second quarter of 2001.

Within consumer spending, purchases of durables (-6.1%) and non-durables (-1.3%) fell but spending on services moved up at an annual rate of 3.4%. Electricity and gas component (+14.2%) of household operations helped to maintain expenditures of consumer services. According to the Bureau of Economic Analysis (BEA), the first quarter was colder-than-typical which explains the sharp increase in electricity and gas expenditures even after adjusting for inflation. For lovers of GDP minutiae, this is an estimate based on heating degree days in the first quarter which is subject to revision in the preliminary estimate when the BEA obtains actual kilowatt/hour consumption from the Energy Information Administration. Getting back to consumer expenditures, combined expenditures on durable and non-durable goods declined at an annual rate of 3.0% in the first quarter, the weakest performance since the fourth quarter of 1991 (see chart 3). On a year-to-year basis, expenditures on durables and non-durables rose only 0.4%, the smallest gain since the fourth quarter of 1991 when the economy was in a recession.

Residential investment expenditures plunged at an annual rate of 26.6% in the first quarter, the largest drop since the fourth quarter of 1981 (see chart 4). An immediate turnaround is possible only after there is a significant reduction in inventories of unsold homes.

In the business sector, expenditures of structures (-6.2%) and equipment and software spending fell (-0.7%) in the first quarter. The decline in the CEO Confidence Index to a cycle low of 38 in the first quarter bodes poorly for business spending given the current situation of weak demand.

Exports will remain an important segment of strength in the quarters ahead. It is noteworthy that the trade balance has improved to -$495.9 billion in the first quarter from a historical high of $642.6 billion in the fourth of 2005.

Inflation readings remained elevated in the first quarter, with the overall personal consumption expenditure price index advancing at an annual rate of 3.5% in the first quarter, following a 3.9% increase in the fourth quarter. The core personal consumption expenditure price index, which excludes food and energy, rose 2.2% in the first quarter compared with a 2.5% gain in the fourth quarter.

In other related economic news, the Employment Cost Index for the first quarter increased 0.7% vs. a 0.8% percent increase in the fourth quarter. Wages and salaries rose 0.8% (no change from fourth quarter), while the benefits component increased 0.6% in the fourth compared with a 0.8% gain in the fourth quarter. On a year-to-year basis, the change in the Employment Cost Index has held at 3.3% for four consecutive quarters. Essentially, this measure of labor compensation indicates that there is no threat of inflation from the labor market.

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Published on  Wed, Apr 30 2008, 23:48 GMT