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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Stop the presses! We’ve found some good news peeping through the economic headlines in recent weeks. The grim reaper news still dominates, to be sure, but more upbeat – or at least, less downbeat – comments and statistics are altering the tone, if not the substance, of the economic discussion.

Among the encouraging headlines: “The Worst Is Over.” That welcome assessment came from Treasury Secretary Henry Paulson, Jr., commenting on the recent rebound in the stock market (“We are closer to the end of this problem than we are to the beginning”) and from Sheila Bair, chairman of the Federal Deposit Insurance Corporation, who said on CNBC’s “Squawk Box,” “We’re getting over the [subprime] hump in terms of the credit turmoil and the under pricing of risk.” Paulson, notably, was still insisting last spring that the ballooning subprime mortgage problems would be “contained,” so his optimism may be a tad suspect. But Bair has been consistently blunt in her assessment of the seriousness of the subprime problem, so her suggestion that matters are improving carries some weight.

The Bank of England shares Bair’s view, arguing in its most recent “Stability Report” that current conditions in the credit markets overstate the losses the financial system and the world economy are likely to sustain. “While there remain downside risks,” John Gieve, deputy governor of the bank, said, “the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

Good Numbers

That assessment is dramatically at odds with the view of most financial analysts, including the authors of the International Money Fund’s (IMF’s) economic outlook, whose recent warnings of a severe and prolonged global slowdown might have single-handedly boosted worldwide demand for Prozac. But the Bank of England’s optimism finds some support in recent statistics. For example, the Labor Department reported that the economy shed a smaller-than-expected total of 20,000 jobs in April after a larger-than-anticipated decline of 81,000 in March. The unemployment rate didn’t change much, but at least the move (from 5.1 percent to 5 percent as in the right direction, which means “the rate of change isn’t getting worse,” Stephen Stanley, an analyst at RBS Greenwich Capital, wrote in the Wall Street Journal’s interactive blog. Other economists commenting on the unemployment data shared his view that while the numbers weren’t good, “they could have been worse.”

That’s hardly a pop-the-cork-and-release-the- balloons conclusion, but in the spirit of an old song (“been down so long it looks like up to me”), after months of unremittingly depressing reports, bad news that isn’t as bad as it might have been, feels like good news, even if it really isn’t.

There are those who insist on pointing out the flaws in that thinking, however. Ian Shepherdson, an analyst with High Frequency Economics, is among them, suggesting in his posting on the WSJ blog that even the whiff of improvement attributed to the employment data may be overstated. Only the service sector reported a (slim) net jobs gain, he notes, while the hemorrhaging continued in construction and manufacturing, which lost 61,000 and 46,000 jobs, respectively. The total number of hours worked declined as did overtime logged, Stephenson adds, warning that we should “expect much weaker headlines in May.”

Good Moves

As expected, the Federal Open Market Committee (FOMC), the Federal Reserve’s policy-making arm, lowered interest rates last week by one-quarter-of-a-percent, also as expected, bringing the Fed Funds rate down to 2 percent. The accompanying comment described the Fed’s actions to date (seven consecutive rate cuts totaling 3.25 percent, a much-publicized bail-out of the investment banking firm Bear Stearns and aggressive loans to banks) as “substantial,” which some analysts interpreted as an indication the Fed will likely pause and probably end its rate-cutting actions. But others read a different message between the Fed’s lines, noting that the FOMC did not state unequivocally, as some had expected, that this rate cut would be the last. In fact, the Fed’s assessment of the relative risks of depressed growth and inflation was not much different in this statement, still tilting toward concerns about growth.

Even so, some analysts say the Fed’s actions have earned some breathing room and some praise. “The Fed moves did work,” Christopher Whalen, managing director of Institutional Risk Analytics, told American Banker. “They took the pressure off the market in a particularly bad moment and they convinced everyone that everything is ok.”

“They prevented the market from having a complete meltdown and you have to give them credit for that,” Adam Schneider, an analyst at Deloitte Consulting LLP, agreed, adding, “Investors are spending money, and that’s exactly what the Fed wanted to happen.”

The Water’s still Rising

Arguably one of the most beneficial results of the Fed’s rate-cutting has been to reduce the rate at which many adjustable rate mortgages (ARMs) are re-setting, keeping the payment increases within reach for at least some borrowers who might otherwise have faced foreclosure. That may at least partly explain recent statistics, compiled by the trustees managing mortgage-backed securities, indicating that the number of subprime delinquencies increased at a slower rate in April – the third consecutive month in which the rate of increase in delinquencies has declined.

The bad news bears will point out that foreclosures are at record levels and still rising, with falling home prices, sagging home sales and bloated inventories contributing to that trend. Against that backdrop, a slower rate of increase in delinquencies is good news for borrowers and lenders only in the sense that a decline in the speed at which a listing boat is sinking is good news for the passenger and crew – increasing their prospects of being rescued, but only if help is on the way and able to arrive in time. On that point, Congress is trying to construct a financial life raft for struggling borrowers; we should know soon how large that vessel will be, how fast it will travel, and most important, whether it will float at all.