Are Economic Gains Just (Temporary) Hot Air?

by: Barry Ritholtz
Inflation Has Best Showing in 3 Years, The Economy's Quickening Pace: So said the headlines. Even as hopes for a Fed rate cut faded, the Goldilocks crew were able to keep hope alive.

Modest growth uptick, inflationary pressures contained, why, this porridge is "just right." Only it's not.

The major data releases - the pre-revision, seasonally adjusted ones anyway - all manage to say one thing but mean another. Take the "upside surprise" of the December Retail data. Very few noted that both October and November numbers were revised downwards. I expect December will receive similar treatment next month also. After all, we heard from the retailers themselves, who were by and large disappointed with the holiday season. Other than sales gains caused by gasoline price increases, December was far from robust.

Next data point: Yesterday's CPI: Even though it was 0.1% worse than expected for January (+0.5% m/m, +2.5% y/y), we do not believe that number accurately reflects the prices we are paying. The Cleveland Fed offers their own view of inflation (Median CPI). It is a measure of core inflation, based upon data released in the Bureau of Labor Statistics’ [BLS]. It comports with our real world experience far better than CPI:

According to the Federal Reserve Bank of Cleveland, the median Consumer Price Index rose 0.3% (3.5% annualized rate) in December...

Earlier today, the BLS reported that the seasonally adjusted CPI for all urban consumers rose 0.5% (6.7% annualized rate) in December. The CPI less food and energy rose 0.2% (2.3% annualized rate) on a seasonally adjusted basis.

Over the last 12 months, the median CPI rose 3.7%, the CPI 2.5%, and the CPI less food and energy 2.6%.

That's correct, it is a +3.7% year over year increase.

But the most intriguing analysis we have seen asks the following question: Are economic fundamentals improving, or is this simply a function of the unseasonably and record breaking warm weather we've been having?

November was about 2 degrees warmer than usual, while December was 4 degrees warmer and the warmest in 50 years. Temperatures remained mild in the most of the East for the first half of January as well.

The calendar says it's winter, but tell that to the cherry trees blooming in Washington and to the construction workers busy starting houses in New England.

The economy has certainly benefited from the warm weather. Energy prices have tumbled on reduced demand, freeing up cash for other purposes. Ground-breaking on new homes increased in November and December. Fewer workers are losing their jobs.

The upshot of the heat wave has been that the Fed appears much less likely to cut interest rates anytime soon, according to Fed Futures, certainly not in 1H '07.

How significant has the weather been? Merrill Lynch's chief North American economist, David Rosenberg, notes that in October and November, more than 80% of the economic data came in below expectations . . . but since the first of December, more than 50% of the data have been stronger than expected.

These weather related gains reflect a host of non-recurring factors. As such, some of the gains in December and January may be borrowing from March and April. MarketWatch's Rex Nutting observes:

Some of the boost from the weather is real, but some of it is economic activity that's just been borrowed from the spring months. We probably won't know for several months how much it is real and how much of it is just people taking advantage of a few warm days to do now what they planned to do in March.

Meanwhile, economists are raising their estimates in the face of stronger, albeit temporary, data. NYU's Nouriel Roubini raised his Q4 GDP forecast from 0% to 2%; Merrill's Rosenberg boosted his Q4 and Q1 GDP to ~3%. And Gabriel Stein, an economist for Lombard Street Research, worries that economic rebound now raises the risks of a harder landing later, as the Fed overreacts to higher inflation by raising rates, ignoring the bomb shell that's still ready to explode as weakness in the housing market saps the willingness and capacity of U.S. households to borrow.

Golidlocks tales of the end of economic risk have been greatly exaggerated.

PS: It's January 19th, and old man Winter has finally arrived in the North East: Its snowing outside. The warm weather thesis will get tested sooner than you might think . . .

Economy stronger, but is it just the weather?
Rex Nutting
MarketWatch, 4:34 PM ET Jan 18, 2007

Median CPI Up 0.3% in December
News release: January 18, 2007