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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If you’re looking for one word to describe the economic climate, try “confusing.” Every day seems to bring a different statistical report accompanied by conflicting interpretations of what it means. One recent headline neatly conveyed this statistical schizophrenia: “Indicators Point to Firmer Economy – More Layoffs Ahead.” Translation: The economy, measured by rising GDP, declining factory inventories and resurgent manufacturing activity —is emerging from the recession, but it is leaving unemployed workers behind.

At least, that has seemed to be the consensus view: That a recovery –but a jobless one – is under way. But just when you think the trends in the economic tea leaves have become clear, new data suggest a different picture.

Consider the dismal employment forecasts that have dominated the economic forecasts for most of the year. Few questioned the assumption that the job picture would get much worse before becoming even marginally better – until last week, when the Labor Department reported that employers cut only 11,000 jobs in November – far fewer than the 1235,000 losses the most optimistic analysts had predicted. The unemployment rate also fell to 10 percent from 10.2 percent - another bit of unexpected good news that also included:

  • Declines in both the number of initial unemployment claims and the four week moving average of continuing claims; and
  • Increases in the number of temporary workers hired and in the average work week, which recorded its largest gain (from 33 to 33.2 hours) since March of 2003.

This good news shines a bit less brightly against a backdrop of 15.4 million workers who are unemployed – a number that doubles if you add those who are working reduced hours or are only able to find part-time work.

“Strong, Strong, Strong”

But even with these discouraging caveats, the most recent employment report was still “strong, strong, strong,” according to Carl Riccadonna, senior U.S. economist for Deutsche Bank. “We’ve still got a long way to go,” he told USA Today, “But the good news in this report provides important positive momentum” for the economy going forward.

The significant, and largely unexpected, decline in the pace of job losses is unquestionably good news, but the slow pace of job creation just as clearly is not. Economic growth has turned positive – signaling an end to the recession. But the growth rate (around 2.8 percent in the third quarter) isn’t generating enough heat to fuel the job creation needed to absorb significant numbers of unemployed workers, or to build a fire under currently tepid consumer spending activity. With consumers expected to remain hunkered down through the holiday season and beyond, analysts are saying we will be depending far more on spending by businesses rather than consumers to drag the economy out of the ditch and keep it on a recovery path.

That confidence may be well-placed. After-tax business profits increased at a 13.4 percent rate in the third quarter, up from 0.9 percent in the second, and business spending on computers and software increased at an annualized rate of 1.1 percent, following a dismal 36.4 percent decline in the first quarter.

The Federal Reserve’s quarterly “Beige Book” analysis found that economic conditions “improved modestly” in the third quarter, strengthening in eight regions and remaining “little changed” in four. The Fed’s description of “steady to moderately improving” manufacturing activity was undercut a bit by the decline in the Institute of Supply Management’s manufacturing index, which fell from 55.7 in October to 53.6 in November, disappointing analysts who had expected another gain. But the reading is still above the mid-point (50) signaling expansion, noted Ethan Harris, an economist at B of A-Merrill Lynch Global Research, who told Bloomberg News that the November dip is “more of a mid-course correction” than an indication of weakness ahead.

Yen and Yang

Sifting through the statistical yen and yang, it becomes clear that conclusions, positive or negative, are often based on comparisons with what economists had expected. Bad numbers are good if they beat expectations, and good numbers become bad, or less good, if economists had predicted better. For example: Industrial production and the Index of Leading Economic Indicators both increased, but less than anticipated, triggering concerns that the fledgling recovery was stumbling. But the Institute of Supply Management’s Business Barometer surprised in a different direction, with a 56.1 reading in November that beat October’s 54.2 and confounded analysts, who had predicted a decline to 53.

It is little wonder that consumers are confused. The University of Michigan’s Consumer Sentiment index fell in November, mainly reflecting a steep drop in the view of current conditions, which fell by 5 percent. But the Conference Board’s Consumer Confidence Index increased slightly to 49.5 from 48.7 in October. In addition to surprising economists, who had been predicting a decline, the reading reversed the November results, when the Conference Board’s index was down while the University of Michigan index was up.

Not surprisingly, analysts’ interpretations of these inside-out numbers differed. Mark Vitner, senior economist at Wells Fargo, took a half-empty view, suggesting that a close look at the positive consumer confidence reading reveals that “the underlying data is abysmal. Fewer people think thinks will get worse, which isn’t very comforting,” Vitner told CNN ”You’d have to be a real pessimist to think things will get worse than they already are.”

Ken Mayland, president of ClearView Economics, disagreed, arguing that the positive confidence reading (questionable underlying data, and all) points accurately to an improving consumer mood. “Don’t count consumers out,” he insisted in an interview with MSNBC. “They are making a contribution to the recovery.”

Lending Complaints

That is more than can be said about financial institutions, according to critics, who continue to complain, loudly, about weak lending activity. Loan balances at the nation’s depository institutions declined by 2.8 percent ($210.4 billion) in the third quarter, according to Federal Reserve statistics – indicating that small businesses especially are being starved of the credit they need to expand.

“There is no question that credit availability is an important issue for the economic recovery,” Sheila Bair, chairman of the Federal Deposit Insurance Corporation (FDIC), told reporters following a Congressional hearing on the issue. “We need to see banks making more loans to their business customers,” she added.

Industry executives complain that they are getting mixed and ultimately irreconcilable messages – both to increase lending and to reduce lending risks and strengthen their capital position. “The choice for banks is very stark,” an article in Fortune Magazine noted. “You can repair your balance sheet or you can build your loan portfolio, but you can’t do both at the same time.”

The housing market, which depends hugely on the availability of credit, is showing definite signs of its near-coma. Existing and new home sales and the index of pending sales all increased smartly in November – but not enough to persuade many analysts that the recovery is based too much on the artificial stimulus provided by a temporary home buyers’ tax credit, and not enough on the fundamentals required to make the sales gains sustainable.

Stable but Fragile

“The housing market is still very fragile,” Celia Chen, senior director of Moody’s, told the New York Times. The statistics provide some evidence of stability, in both sales and prices, she conceded, “but that stability can be easily broken, even if affordability is very high.”

The employment picture remains a concern for the housing market, but not the only one. One in four homeowners was underwater in the third quarter, burdened with mortgages worth more than the depressed value of their homes. That means 10.7 million homeowners are in a negative equity position, according to First American Core Logic, which estimates that 5.3 million homeowners are at least 20 percent in the equity hole. Negative equity is “the outstanding risk hanging over the mortgage market,” Mark Fleming, Chief Economist of First American Core Logic, believes.

The concern focuses not just on owners who will be unable to make their mortgage payments but on those who decide it is no longer in their financial interests to do so. One recent study estimated that 588,000 borrowers defaulted “strategically” on their mortgages in 2008, double the estimate for the year before.

The prospect of rising rates also clouds the housing outlook, but that risk, at least, seems relatively small in the near term, as the Federal Reserve shows no sign of altering its view that economic conditions warrant keeping rates “exceptionally low” for “an extended period.”

That leaves the lingering question about the extent to which the housing market’s continuing recovery depends on the homebuyer tax credit and aggressive government efforts to liquefy the secondary mortgage market. “When we do kick those crutches out from under the housing market, will it be able to stand on its own?” It’s really hard to tell,” Mark Fleming, chief Economist of First American Core Logic, told reporters recently.

Don’t expect a clear answer to that question any time soon.