Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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Swine flu aside – and it now appears that we may be able to set it well aside, at least for now – the economic news has acquired a decidedly more positive hue in recent weeks, moving from jet black to much lighter shades of gray, with hints of blue visible to some analysts.

Following a meeting with his economic advisors, President Barack Obama described “glimmers of hope across the economy.” Federal Reserve Chairman Ben Bernanke has spotted “tentative signs that the sharp decline in economic activity may be slowing,” leading him to predict that the most severe downturn since the Depression may end this year. In the same relatively optimistic vein, Lawrence Summers, the president’s top economic advisor, has seen “green shoots of spring” reflected in recent economic reports. While the economy remains “severely distressed,” Summers noted in a recent speech, “we no longer have that sense of a free-fall.”

No one is suggesting that the recession has ended or that a recovery has begun. The economic fundamentals are shaky, at best, and the statistics in most key areas of the economy remain deeply in negative territory. But there has been a decided change both in tone and emphasis in the news coverage and economic commentary.

Getting Worse More Slowly

Economic reports t that for months have heralded one “record low” after another, are now coming in “better than anticipated,” still declining, in most cases, but “at a slower pace.” A few recent examples:

  • Construction spending increased by 0.3 percent in March, beating the 1.3 percent decline analysts had predicted.
  • In another better-than-expected showing, durable goods orders slipped by 0.8 percent in March, beating projections of a 1.5 percent decline.
  • New home sales, similarly, declined by only 0.6 percent in March, surprising analysts who had expected another 1 percent to 2 percent reduction in volume.
  • Home prices, as measured by the closely-watches S&P/Case-Shiller Index, declined by 18.6 percent for a 20-city composite and by 18.8 percent for a 10-city composite. While this hardly reflects a healthy market, it is the first time in 16 months that the annual rate of decline has not set a new record.
  • The Institute for Supply Management’s service index also contracted more slowly in April, putting the service index at 43.7 – still below the 50 percent mark that indicates decline, but up from 40.8 in March. New orders increased from 38.8 to 47 – the highest level since September —while the employment index for the service sector rose from 32.3 to 37.
  • A survey by the National Association of Business Economics found increases in both the number of companies that increased capital spending in April (15 percent vs. 12 percent in January) and in the number planning to boost spending by more than 10 percent over the next 12 months – 6 percent in April vs. none in January. “Declines still outnumber gains, but fewer firms are reporting declines and more are reporting gains,” Sara Johnson, chair of the NABE’s Survey Committee, observed.
  • Many of the positive signs analysts are spotting are in what have been the most serious stress points in the economy, the credit markets primary among them. The LIBOR –OIS premium – benchmark for the rate banks charge to lend money to each other – fell to 0.85 in early May compared with an average of 1.16 in April and 2.51 percent six months ago. The TED spread, measuring the difference between LIBOR and the three-month Treasury bill, was 96 basis points in April compared with 4.64 in October. Bond sales, meanwhile, have totaled $468 billion so far this year. Some analysts view all of these statistics as evidence that the federal government’s varied bail-out efforts are beginning to thaw frozen credit markets.

Employment: Less Grim

Employment statistics, while far from cheery, are also looking somewhat less grim. The economy shed another 491,000 jobs in April, according to ADP Employment services – a marked improvement over the 708,000 jobs lost in March and much better than the 645,000 loss economists surveyed by Bloomberg News had expected. Initial unemployment claims totaled a seasonally adjusted 631,000 in the week ending April 25th, 14,000 fewer claims than the week before, in what is “beginning to look increasingly like a peak” in this area, Ian Shepherdson, an analyst with High Frequency Economics, told Fortune. Supporting that conclusion, the outplacement firm Challenger, Gray & Christmas reported that employers announced 132,590 job cuts in April – 12 percent fewer than in March. That is still 47 percent higher than the same month a year ago, but the lowest total since October of last year.

“Job cuts are still at recession levels, but the fact that they are falling is certainly promising and may suggest that employers are starting to feel a little more confident about future business conditions,” John Challenger, CEO of the company, said in a press statement accompanying the report.

Possibly responding to these hints of a strengthening job market, consumer confidence jumped 13 points in the April Conference board survey, reaching 39.2 vs. 26 in March. That represents a five-month high and the largest increase in nearly four years. Nearly half (48 percent) of respondents to another April survey said they think the economy is on the right track, compared with 44 percent who think the country is heading in the wrong direction – the first time in four years that the optimists have outnumbered the pessimists in this poll.

In another sign that the collective mood may be brightening, consumer spending increased at a 2.2 percent annual pace in the first quarter following a 4.1 percent decline in the fourth quarter of last year. That wasn’t enough to prevent a sharper than expected 6.1 percent annualized decline in the nation’s Gross Domestic Product (GDP), but some analysts managed to find a glimmer of good news even in that unsettling number. Most of the growth decline, they suggested, reflected shrinking inventories, providing the foundation on which a recovery can be built.

Credit Markets: Signs of a Thaw

Providing more evidence that Larry Summers’ “green shoots of spring” may be taking root, the Federal Reserve’s first quarter senior loan officers’ survey found that the number of banks that have tightened credit standards fell below 50 percent for the first time in more than a year. For commercial real estate loans, 65 percent said they have tightened compared with 80 percent in January – the first time since October of 2007 that this number has fallen below 70 percent.

The Fed survey also found signs of a nascent housing recovery, as more than half the lenders reported an increase in mortgage demand for the first time in nearly two years. On the down side, more than half also said they have tightened standards for prime mortgages in the past three months, slamming the door on many of these would-be buyers.

The housing statistics reflect those credit constraints. New home sales for the year-to-date are running nearly one-third behind last year’s pace as builders struggle to compete with the combined effects of tightening credit, a shaky employment picture, and the foreclosed properties that lenders are marketing aggressively in an effort to cut their losses. New home sales, which represented 16 percent of total sales at the peak of the housing boom in 2005, represented only 7 percent of the total in the first quarter. New home starts declined by a steeper than expected 10.8 percent to an annual pace of 510,000, according to the Commerce Department – the second-lowest rate in the 50 years the government has been tracking this statistic. Building permits, an indicator of future activity, fell by 9 percent.

But even in the still-struggling new home sector, there are some positive signs. The inventory of available new homes fell to 10.7 months in March from 11.2 months in February, “a welcome sign that the market is stabilizing,” Joe Robson, chairman of the National Association of Home Builders (NAHB) said in a press statement.

Home Builders: Less Depressed

Builders, mired in the doldrums for nearly two years, are beginning to feel a little better about the outlook. The NAHB’s confidence index rose five points in April to its highest level since October of 2008 as the gauge of expectations for the next six months surged by a robust 10 points. “That’s a very encouraging sign we are at or near the bottom of the current housing depression,” David Crowe, the NAHB’s chief economist, believes.

But being at or near the bottom is not synonymous with “recovering,” many analysts caution. “Conditions are a little less bad,” Michael Larsen, an analyst with Weiss Research, told USA Today. “But nothing [in the current data] suggests an imminent [housing] recovery.”

Industry executives seeking signs of a housing recovery were equally hard-pressed to find them in the sales of existing homes, which declined by 3 percent to a 4.57 million annual rate, following what had been viewed as an encouraging jump in February. The March numbers were “a little disappointing,” Lawrence Yun, the NAR’s chief economist acknowledged. But a significant rebound in the hardest-hit Western states suggests that “the worst may be over,” at least in part of that region.

Providing more concrete fodder for optimists, the NAR’s pending sales index increased by 3.2 percent in March to 84.6 from 82.0 in February, pushing this index 1.1 percent above its year-ago level. “This could be the leading edge of first-time buyers responding to very favorable affordability conditions,” Yun said. The $8,000 first-time-buyer tax credit included in the federal stimulus bill Congress approved last year may also be fueling some of this activity, Yun noted.

Economists: Divided

Economists looking at this collection of better, less bad and still-not-so-good economic reports differ, predictably, on how to interpret them. Some see persuasive evidence that the worst of the recession has ended, with a recovery, albeit a slow one, in sight; others insist that any optimism at this point, however cautious, is premature.

In the optimists’ camp, or on the edge of it, the NABE’s Sarah Johnson thinks the economy is “at an inflection point, but has not yet reached a turning point. Key indicators are still declining,” she notes in a recent report, “but the breadth of the decline is narrowing.”

“The economy right now is in a healing process,” Jonathan Basile, an economist at Credit Suisse, concludes in a recent research report. “We’re stabilizing first; the rebound comes later.”

As these comments suggest, optimists, like the first buds in an early spring, are hopeful but tentative. Pessimists, by contrast, aren’t tentative at all in their view that the recession’s grip remains tight. “Is the worst behind us? In a word, no,” analysts at Moody’s assert in a recent report. “It is too soon even to be sure of a turnaround, let alone a return to rapid growth….Complacency is perilous,” this analysis cautions. “These are still early days.”

Paul Krugman, the Nobel-prize-winning economist and columnist for the New York Times is even more adamant about the dangers of premature elation. In a recent column, he cites four arguments against proclaiming the recession over or nearly so:

  • Key trend lines are still heading down.
  • Some of the “good news,” such as the “surprisingly good” earnings reported by banks, “isn’t convincing.”
  • There could be more bad news to come.
  • Unlike past recessions, this one was triggered not by excess inventory but by excess debt, making the odds of a strong, v-shaped recovery fueled by pent-up demand, slim.”Nobody is in the mood for a new burst of spending,” Krugman suggests. Complacency, he agrees, represents a huge risk for policy makers, who could exacerbate and prolong the downturn if they ease up on government assistance efforts too soon. Krugman’s advice: “Don’t count your recoveries before they’re hatched.”