Mild Inflation, Deteriorating Housing No Match For Fed Rate Cut

by: Tim Iacono

Temporarily mild inflation and a housing market that continues to deteriorate were overshadowed by a larger than expected half point rate cut by the Fed last Tuesday.

Stocks and bonds ended the week with the S&P 500 Index up 2.8 percent to 1,526, now up 9.0 percent for the year, and the yield of the 10-year U.S. Treasury note up 17 basis points to 4.63 percent.


New York and Philadelphia Manufacturing Surveys: Both the New York and Philadelphia area manufacturing surveys had shown strength in late-Spring after exhibiting weakness earlier in the year, but both now indicate that the mid-year resurgence will likely prove to be fleeting. The Empire State index fell to 14.7 in September following three months near 25 and, about 100 miles to the southwest in Philadelphia, a modest 10.9 reading followed last month's flat line at 0.0. These are volatile indexes and much less important than the broader ISM manufacturing index, but they both now show a weakening manufacturing sector.


Producer Prices: A pull-back in energy costs pushed wholesale prices lower in August, the overall inflation rate falling 0.1 percent for the month while the core rate, excluding food and energy, rose 0.2 percent . Energy prices fell 1.4 percent in August, however, since mid-August both crude oil and gasoline prices have more than gained back what was lost in the most recent energy sell-off, setting the stage for a much higher wholesale inflation number next month.


Housing Market Index: Home builder confidence sunk to an all-time low matching the January 1991 level of 20 on the National Association of Home Builder's housing market index. This should come as no surprise to anyone following the ongoing troubles in the nation's housing market as inventory continues at historically high levels, credit continues to tighten, and consumer confidence continues to erode. The most significant aspect of equaling the 16 year low on this index (at least as it concerns home building in California) is that real estate prices continued to go down for five years after this level was last reached back in 1991.


Treasury International Data Flows: The monthly report on net foreign purchases of U.S. securities has not been covered here previously, however, it is likely to gain in significance in the months and years ahead as weakness in the U.S. dollar continues. A dramatic drop in foreign purchases was seen in July as only $19.2 billion of U.S. securities were purchased after a whopping $97.3 billion in June. Note that, like the trade deficit, this report appears with an additional one-month delay relative to most other economic reports.


In the August reporting period, purchases are likely to have gone up as a result of the credit crunch, however, during the most recent month when lower interest rates in the U.S. were all but assured, look for this figure to fall back again as U.S. dollar denominated investments lose their appeal due to the combination of weaker dollar and a lower yield.


Consumer Prices: Both overall consumer prices and the core rate of inflation came in at modest levels in August, however, the big inflation news is set to begin as early as next month when recently surging energy prices will be combined with statistical quirks in the year-over-year comparison that receives much attention from the financial media.


For the month of August, overall consumer prices fell 0.1 percent after climbing by the same amount in July and, excluding food and energy, consumer prices rose 0.2 percent equaling last month's gain. On a year-over-year basis, overall prices are up 2.0 percent and core inflation is up 2.2 percent.

As indicated by the red arrow in the first chart above, the next three months will see consecutive monthly changes of -0.5 percent, -0.4 percent, and 0.0 percent roll out of the year-over-year calculation making for potentially higher annual inflation rates in September, October, and November if all other factors remained constant.


All other factors have not remained constant, however, as surging energy and food prices since mid-August are sure to make for big monthly increases at least in September and possibly November as well. Annual inflation rates in the four percent range, possibly higher, could once again be seen when higher energy prices this year are combined with last year's plunge in energy prices. The elevated levels of annual inflation, due in large part to statistical factors, are likely to be much discussed by the financial media in light of last week's half point cut in the Fed funds rate.


Housing Starts: Housing starts and permits for new construction plummeted in August as there continues to be no end in sight to the troubles in the housing market. Housing starts fell 2.6 percent and permits for new construction plunged 5.9 percent. Both of these important measures are at their lowest levels since 1995 and show no indications of improving in any meaningful way any time soon.


On a year-over-year basis, housing starts are down 19.1 percent and permits are down 24.5 percent. Note that year-over-year comparisons are now being made well past the early-2006 peak, yet double-digit declines are still being seen.

Conditions will not improve until existing inventory is reduced. Currently, the supply of existing homes for sale stands at 9.6 months and the supply of new homes rests at 7.5 months indicating a much greater willingness by builders to cut prices or provide incentives to an increasingly wary home buying public.


Regionally, the South saw some strength as starts rose 11 percent, but all other areas experienced declines led by the Northeast where starts plunged 38 percent and in the West where a decline of 18 percent was seen.


Overall, the news just keeps getting worse for housing as tightening credit conditions will put even more pressure on home prices as financing home purchases continues to be difficult for many would-be home buyers. Check the number of "Price Reduced" signs in your neighborhood or in the local real estate fliers - combined with an increasing number of foreclosure auctions (500+ homes to be sold at auction next week here in Northern California) and the steepest part of real estate price declines may be directly ahead.

Leading Economic Indicators: The index of leading economic indicators reported by the Conference Board fell 0.6 percent in August almost completely reversing the gain of 0.7 percent in July. As seen in other reports over the last month, consumer confidence has plunged recently as a result of credit market turmoil, a temporary stock market swoon, and weakness in the job market. This report, which maintains only marginal credibility amongst analysts, adds to the renewed discussion of a possible upcoming recession as early as the fourth quarter. In a bit of irony, given the Fed's inflation fighting bias until recently, all of the components of this index made a negative contribution to the overall reading except for the money supply, which rose in August.


Summary: Of course the big news last week was the rate cut from the Fed, but there were a host of economic reports released and all of them were either bad or will be bad next month (i.e., wholesale and consumer prices). More bad news on housing and further confirmation of a slowdown in manufacturing activity have combined with a quickly souring consumer outlook as seen in the index of leading economic indicators, all of which make the current outlook for the economy gloomier.


It's not hard to imagine how things could get worse from here. Until recently, job growth as reported by the Labor Department has been steady and, while initial jobless claims have pulled back from slightly elevated levels, last month's employment report showed a net job losses for the first time in four years. Don't be surprised if further weakness develops in labor markets given all the turmoil in the finance industry and sagging consumer confidence.


The Week Ahead: The week ahead will be highlighted by the third and final reading on second quarter GDP growth on Thursday. Also scheduled for release are existing home sales and consumer confidence on Tuesday, durable goods orders on Wednesday, new home sales on Thursday, and four reports on Friday - personal income/spending, consumer sentiment, construction spending, and the Chicago purchasing managers' index.