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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The economy is looking a lot like a seesaw. Manufacturing activity, which had been up, is down; housing, which had been not just down but subterranean, is now ascendant, and other sectors are tilting one way or the other, sliding up some months and down in others, without moving very far in either direction. The resulting picture reflects an economy with sufficient energy to sustain a recovery (albeit, as modest one), but with enough areas of weakness and uncertainty to make additional action by the Federal Reserve likely and probably imminent.

“The economic situation obviously is far from satisfactory,” Fed Chairman Ben Bernanke said at the Fed’s annual conference in Jackson Hole, Wyoming. Citing the need to “achieve further progress, particularly in the labor market,” Bernanke said the Fed “will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Bernanke’s comments came before the Labor Department announced a smaller than expected gain of only 96,000 jobs for August and a downward revision in the gain reported for July. The unemployment rate fell slightly, from 8.3 percent to 8.1 percent, reflecting an increase in the number of discouraged workers who have abandoned their search for jobs.

Analysts agreed that the disappointing report will strengthen the arguments for the Fed to undertake additional efforts to boost employment and strengthen the economy – not that Bernanke appears to need much convincing. In his speech at Jackson Hole, the Fed chairman noted, “The stagnation of the labor market in particular is a grave concern.” Persistently high unemployment, he added, “will wreak structural damage on our economy that could last for many years.”

Tepid employment growth isn’t the only weak spot. The Fed and many economists are concerned about: Manufacturing activity (which has been declining), consumer confidence (also weakening in recent reports); and an overall economic growth rate – 1.7 percent for the second quarter – that remains sluggish and vulnerable to financial jolts in the U.S. and Europe.

Still on Edge

“The national psyche remains on edge, and the economy remains vulnerable to anything else that may go wrong,” Mark Zandi, chief economist for Moody’s Analytics, told the Washington Post.

Consumers are clearly edgy. The Conference Board’s confidence index slid nearly five points in August, to 60.6 -- the lowest reading since November and the fifth decline in the past six months, interrupted by a slight uptick in July.

The Thomson-Reuters confidence index moved in the opposite direction, increasing by a little more than a point in August to reach its highest level since May. But both consumer surveys reflected growing concern about the longer term outlook for the economy.

In the Conference Board survey, 16.5 percent of the respondents said they expect business conditions to improve over the next six months, down from 19 percent in July and 23.4% of those surveyed in August said they expected the economy to produce fewer jobs in the same upcoming period, up from 20.6% the month before. Consumers are more optimistic about their own prospects, however; 15.7 percent expect to see their incomes rise in the next six months compared with only 14.2 percent in July.

That may explain, at least in part, why consumer spending increased in July by the most in five months, even though consumer income grew by only 3.1 percent in the second quarter. Retail sales increased by nearly 1 percent for the month, the largest gain in that sector since February.

Manufacturing Weakness

Continuing weakness in the manufacturing sector provided a negative counterpoint to that relatively upbeat retail report. The Institute of Supply Management (ISM) factory index declined for the third consecutive month in August, falling to 49.6 from 49.8 to post its lowest reading in a year – a disturbing trend in the sector that has provided the major source of strength for the recovery.

The service sector picked up some of that slack. The ISM’s non-manufacturing index reached a three-month high in August, increasing to 53.7 from 52.6 in July and remaining well above the 50 mark indicating growth.

But orders for capital goods, new factory orders and, crucially, business spending projections all declined, indicating to many analysts that the looming “fiscal cliff” is sapping business confidence. As these analysts see it, fear that Congress will not reach the agreement needed to avoid automatic increases in taxes and reductions in government spending are making executives reluctant to expand their payrolls or invest in equipment.

Housing Stepping Up

As the manufacturing sector falls back it appears that housing may be stepping up to play its traditional role as the primary driver of the economic recovery.

“Housing is the area where you’ve got the most positives,” Nigel Gault, chief U.S. economist at IHS Global Insight, told the Washington Post. Housing indicators that had been trending uniformly and incessantly downward have begun moving more or less consistently in the opposite direction.

Home prices, which had shown encouraging signs of stabilizing, have begun to increase. The closely-watched Case-Shiller index increased by 0.5 percent in June, posting its first year-over-year increase in more than a year. A separate index published by CoreLogic increased by 3.8 percent in July – its largest gain in more than 6 years. Excluding distressed sales, the index jumped by 4.3 percent.

"We are aware that we are in the middle of a seasonal buying period, but the combined positive news coming from both monthly and annual rates of change in home prices bode well for the housing market," David Blitzer, chairman of the index committee at S&P Dow Jones Indices, said in a press statement announcing the latest Case-Shiller reading.

More Positive Indicators

Also boding well – and possibly very well – for the housing market: Asking prices for homes listed for sale increased for the seventh consecutive month in August, according to a Trulia index, which reported year-over year gains in 68 of the 100 largest metropolitan areas.

Inventories of both new and existing homes have also been declining steadily all year. The inventory of existing homes, at 6.4 months, is nearly 24 percent lower than it was a year ago; the 4.6 month inventory of new homes hasn’t been this low since 1963.

Time on market – another key indicator of home buying activity – has been trending downward as well, and distress sales represent a declining share of the market as lender efforts to modify loans have reduced foreclosure rates in many markets.

Existing home sales were up 10 percent year-over-year in July (in Massachusetts, the increase was more than 25 percent); new home sales reached an annual rate of 372,000, two-year high, beating the year-ago level by 25.3 percent. Construction starts fell a little in July compared with the previous month, but building permits —a less volatile and thus better indicator of future activity – increased by 6.8 percent compared with June, 30 percent above the same month last year and a four-year high.

Pending sales of existing homes – another good indicator of future activity – also increased, pushing that National Associations of Realtors gauge to 101.7 in July – 12.4 percent above the year-ago mark and the highest reading in two years.

Builder confidence, as measured by a National Association of Home Builders’ Housing Market Index, increased for the fourth consecutive month, reaching its highest level in five years. The index has added 22 points in the past year. For July, all three components – current sales, the six-month sales forecast and buyer traffic — notched double-digit year-over-year improvements.

With inventories shrinking and sales reviving, if not soaring, supply is exceeding the supply of for-sale homes in some markets, pushing prices up in many communities and triggering bidding wars in a few, “and in some instances, [resulting in] sales in which buyers are paying more than the asking price for some highly prized properties,” according to a recent article in Forbes.

“We seem to be witnessing exactly what we needed for a sustained recovery — monthly increases coupled with improving annual rates of change,” S&P’s Blitzer, noted in his press statement. “The market may have finally turned around.”

“This is just what the housing market ordered,” another analyst said of the positive home sales and price trends.

It may turn out to be just what the economy has ordered as well.