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FOMC is likely to lower the fed funds rate for the first time since June 2003

Mon, Sep 17 2007, 13:11 GMT
by BHF-Bank Economics Department

BHF-Bank

• Manufacturing indices will probably indicate weakness in September 

• Inflation figures could turn out to have been quite moderate in August

• FOMC is likely to lower the fed funds rate for the first time since June 2003

• Housing data might continue to deteriorate

• Leading indicators could have fallen sharply in August

The New York Empire manufacturing index only declined slightly to 25.1 in August, whereas the Philadelphia Fed index lost 9.2 points, showing no growth at all last month. As the graph indicates, the gap between the two indices tends to narrow over time, and given the turmoil in the financial markets, we expect the New York Empire manufacturing index to go down to about 15.0 in September – ten points below the August level. However, after having fallen sharply for two consecutive months, the Philadelphia Fed index could remain unchanged at 0.0 in September.

At $120.9bn, June’s net foreign purchases of US longterm securities remained almost on the same elevated level as in May. However, the structure changed significantly, with a shift from corporate bonds to Treasuries.

Given the financial market turmoil and growing risk aversion, the inclination to buy safe-haven Treasuries is likely to continue. Total net foreign security purchases could have slowed to about $80bn in July, the same level as in April.

Producer prices (PPI) went up by 0.6% mom in July, mainly due to higher natural gas and gasoline prices. The latter were unexpected since gasoline prices at the retail level had corrected downwards. As they continued to decline, we expect producer prices to have fallen by 0.3% mom in August, just like import prices. The annual rate might decrease from 4.0% to 3.1%. The rise in core PPI moderated to a mere 0.1% mom in July, but the rise in August could turn out to have been about 0.2% mom. Consumer prices (CPI) rose by 0.1% mom only in July, as energy prices went down by 1.0% mom. As gasoline prices decreased by about 6% mom, we expect CPI to have remained stable in August and to have been only 2.2% higher than in August 2006, down from 2.4% yoy in July. The more recent CPI data illustrate that the upward pressure from owners’ equivalent rent has ceased. With apparel and medical care prices possibly having risen less markedly, core CPI might only have gone up modestly by 0.1% mom in August, lowering the annual rate to 2.0%.

After the last FOMC meeting on 7 August, the committee stated that inflation was still its primary concern. However, the ongoing deterioration in financial market conditions caused them to issue an additional statement on 17 August, which indicated that the FOMC was prepared to act as needed since the risks to growth had increased appreciably. Partly in order to promote financial stability, which is one of the primary goals of the Fed, the FOMC is going to cut the fed funds rate on September 18 for the first time since June 2003. This is generally expected by market participants, but opinions are divided on the extent of the rate reduction, probably within the FOMC too. Despite several Fed representatives emphasizing that it is not the Fed’s intention to bail out investors after losses from wrong decisions, we consider it justified to lower the fed funds rate by 50 basis points to 4.75%: Although not yet fully reflected in the data, economic growth prospects have deteriorated markedly. The financial market turmoil seems likely to intensify the downturn in housing, and the tightening of lending standards will have negative consequences on aggregate demand as well, particularly since the August labour market report revealed that the pace of job creation has been slowing noticeably. As the graph illustrates, the current real fed funds rate thus appears relatively high. Regarding inflation, the FOMC could state that a lower fed funds rate is no obstacle to preserving price stability, as underlying inflation pressures have already improved and might continue to do so in the light of a further moderation in economic growth.

Given the problems in the mortgage sector, the NAHB index will probably continue to weaken and fall from 22 to 20 in September, the lowest level since January 1991. Given the downward trend of the NAHB index and the fact that the level of homes for sale is at a historical high, we forecast that housing starts will have declined again in August, from 1381k to about 1350k. This would be 18% lower than in August 2006. Building permits could have declined from 1373k to about 1340k (–22% yoy).

Initial jobless claims rose slightly by 4k to 319k in the week ending 8 September – still a quite low level given the deterioration in employment figures, but the 4-week moving average has nevertheless been on a gradual upward trend since the end of July. We expect jobless claims to have increased again to about 330k in the week ending 15 September. One major reason for increases in the near future could be the lay-offs in the mortgage industry.

Leading indicators rebounded temporarily in July, but are likely to have suffered a major setback in August: Consumer expectations, jobless claims, the stock market and faster deliveries will have been the major negative contributors, probably causing leading indicators to fall by 0.6% mom. Real M2 could have made the only significant positive contribution. Leading indicators’ annual rate and the 6-month annualised rate could thus decline to a mere 0.2%. As the graph shows, this indicates a further slowdown in economic growth.

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Published on  Mon, Sep 17 2007, 13:20 GMT