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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“You’ve got to admit it’s getting better.” An increasing number of economists are beginning to hum that Beatles tune, as the statistics pointing to an improving economy multiply. Economists remain divided on whether the recession has needed or is nearing an end. But a growing consensus holds that the worst of the downturn is behind us. A consensus is also forming around a less encouraging view: The recovery will be painfully slow, made more painful by the expectation that conditions should be better than they are likely to be in the near term.

Consumer spending, or the lack of it, will be a major drag on economic growth, producing a slower recovery than we have seen in the past. Strong savings, a healthy trend (for individuals and the economy) in general, is problematic when a bruised economy dependent on consumer spending is trying to recover. The ratio of net worth to deposable income – now at its lowest level since 1992, suggests a savings rate of between 6 percent and 10 percent, according to an analysis by Goldman Sachs economists. The low end of that range (6 percent) would channel $700 billion into savings rather than spending.

“We’ve never seen a pullback like this,” Jan Hatzius, chief economist for Goldman-Sachs, said in a July commentary. “It’s very painful; there’s a lot of collateral damage.”

Bill Gross, co-chief investment officer for Pacific Investment Management Company, agreed. For much of the world, including the U.S., he told the Wall Street Journal, the operative phrase will be “non appétit, not bon appétit.”

“The economy can recover, even as savings rise,” a WSJ analysis pointed out. But, particularly in the initial stages, “the recovery won’t be as robust.”

Blue Sky

Consumer spending may be a cloud on recovery forecasts, but there is plenty of blue sky visible around it. Improving has become the new by-word, replacing “grim,” deteriorating” and “imploding” as the adjectives of choice in most economic reports.

The National Association of Business Economics found “new evidence that the recession is abating” in its quarterly survey; Federal Reserve Governor Janet Yellen recently described “the first solid signs that the recession is ending;” and Stephen Stanley, chief economist for RBS Securities, told Bloomberg News, “We are on the cusp of stabilization.”

John Silva, chief economist for Wells Fargo was even more emphatic in a recent research note, asserting, “The recession is over, the economy is recovering. Let’s look forward and stop the backward looking focus.”

Play it Forward

Unexpected good news in last week’s employment report is certainly encouraging that forward view. The Labor Department reported that the economy lost 247,000 jobs in July, much better than the projections and the lowest level of losses in almost a year. The number of weekly jobless claims, which some see as an even better indicator of current employment conditions, fell to a seasonally adjusted 584,000, a dramatic improvement over the 658,000 claims reported for the first week in March. Other entries in the expanding list of good statistical news:

  • The index of leading indicators posted its third consecutive monthly increase in June, as 7 of the 10 measures increased.
  • GDP – a measure or overall economic growth – declined at an annual rate of 1 percent in the second quarter compared with a 6.4 percent negative rate in the first quarter.
  • The manufacturing index published by the Institute of Supply Management increased for the seventh consecutive month. At 48.9, this index is still below the 50 mark separating expansion from contraction, but it’s a lot closer to a positive reading than it has been in the last two years.
  • Credit markets continue to ease. The London Interbank Offered Rate (LIBOR) at which banks lend money to each other fell below 0.50% for the first time ever. “I’m not saying the market has returned to normal,” Christopher Rieger, co-head of fixed income strategy for the German banking giant, Commerzank, told Bloomberg News. “But my view is that the systemic risk we saw after the collapse of Lehman last autumn is perhaps gone.”
  • Defrosted, or at least, less frosty, credit markets haven’t produced the strong lending rebound that banking industry critics say the government bail-out of the banking industry should have triggered. But there are some positive signs elsewhere, primary among them: A recent increase in construction spending, which rose 3 percent in June, largely on the strength of new home construction activity.
  • Single-family starts jumped 14 percent in June, according to the Commerce Department, the fourth consecutive gain, more than offsetting a 26 percent decline in multi-family starts. Home construction is still in the cellar – 46 percent below the year-ago pace — but for an industry that has been starved for good news, these statistics are the equivalent of a high-energy drink. The National Association of Home Builders’ confidence index jumped 17 points in July, reaching its highest level in 10 months. Sales of new homes increased 11 percent in June – the biggest jump in eight years — while existing home sales registered a 3.6 percent month-over-month gain. Existing home sales have increased 9 percent since January.

Hope for Housing

Stronger sales have pushed inventories down – at the end of June, the National Association of Realtors reported a 9.42 month’s supply of existing homes for sale, nearly 15 percent below the year-ago level and “another hopeful sign,” according to the NAR’s chief economist, Lawrence Yun. The association’s index of pending home sales increased by 3.6 percent in June, beating predictions of a more modest 1.5 percent rise and continuing a five-month upward trend.

Analysts were even more encouraged by the May S&P-Case-Shiller housing index. That closely watched barometer of home price trends was essentially flat in May, the first time since early 2007 the index has not declined. Even more encouraging, 8 of the 20 cities in the index reported tiny gains, up from 4 in April.

“Now, take a deep breath and exhale. The worst is over,” USA Today proclaimed recently. ‘By every measure except foreclosures,” this article concluded, “the housing market has stabilized and many areas are recovering.”

Foreclosures: More to Come

Unfortunately, foreclosures represent a rather large “except for” in that upbeat analysis. The delinquency rate for home mortgages hit 9.12 percent in the first quarter and the share of loans entering foreclosure reached 1.37 percent – the highest levels reported in both categories since the Mortgage Bankers Association began compiling this data in 1972. RealtyTrac reports that 1.5 million owners – 1/84 households – received a foreclosure filing notice in the first half of this year. The increase reflects a surge of filings following the end of the foreclosure moratoria lenders instituted a few months ago, while awaiting the details of the Obama Administration’s foreclosure assistance programs. An increase in foreclosures will mean more downward pressure on home prices, Mark Zandi, chief economist at Moody’s cautions. “In all likelihood, the house price declines are not over,” he told the Washington Post. “The distressed sales will pick up.”

Notwithstanding the spots of good news in the labor market reports, the unemployment rate remains high and hiring remains anemic. Even the most optimistic analysts agree that it will be at least a year, if not longer, before this picture improves significantly. And that represents “a huge cloud hanging over the housing market,” Guy Cecala, publisher of Inside Mortgage Finance, told the Washington Post. “We can no longer blame the [foreclosure] problems on bad mortgage products. It’s now about people losing their jobs, and that’s an even tougher problem for the government to address.”

“This thing (the housing market upturn) is still fragile,” Joseph LaVorgna, chief US economist for Deutsche Bank Securities, noted recently. “We’re barely pushing the housing bottom.” Still he told Bloomberg News, “It’s not premature to talk about home prices bottoming. There is a light at the end of the tunnel.”

Skeptics suggest that the light could be attached to an oncoming train, but Ian Sheperdson, an analyst with High Frequency Economics, prefers a more optimistic aviation analogy: The housing market, he told Bloomberg, “was like a plane that was aimed at the ground. [We’ve] been pulling hard on the joystick, and now it seems to be leveling out.”