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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Economists have been warning for months that the recovery, when it began, would not be smooth. Last month’s statistics confirm that prediction providing enough ups and downs to support a bipolar diagnosis.

At least some of the indicators in the “encouraging” category – and there were many – were encouraging not because they increased a lot (or at all), but because they increased more or declined less than anticipated. One example: GDP, the barometer of overall economic growth, shrank by 0.7 percent in the second quarter rather than the 1.2 percent decline analysts had expected. Investment in equipment for the second quarter likewise fell less than feared, while the Index of Leading Economic Indicators rose in August for the fifth consecutive month, marking the longest series of monthly gains since 2004 and supporting the broadening consensus that the recession has ended.

Providing another example of that bipolar pattern, the Institute of Supply Management’s manufacturing index fell to 46.1 in September – slipping below 50 and back into non-growth territory, but the ISM’s non-manufacturing index (representing 90 percent of the economy) bounced from 48.4 to 50.9, beating analysts’ estimates.

The statistics reflect a “slow but certain” recovery, Fred Smith, CEO of FedEx, told Bloomberg News. “Not a straight line up but a zigzag,” he explained, “with a few steps forward and backward.”

The employment stats for September, described almost universally as “ugly,” were a definite zag in the recovery picture. After slowing steadily for several weeks, job cuts accelerated again in September for only the second time this year, as employers shed 263,000 workers — more than the 175,000 cuts analysts had predicted. But October brought a “zig,” as the number of new unemployment claims fell to a nine-month low for the week ending October 3.

The job market continues to cast shadows over the economic forecast, however. Since the recession began in December of 2007, 7.2 million jobs have evaporated – the worst loss since the Depression – pushing the unemployment rate to 9.8 percent. Although economists have predicted, and the Obama Administration has warned – that the unemployment rate will continue to rise, and may exceed 10 percent, the continuing upward trend has still unsettled retailers and housing industry executives, who know that a rebound in consumer spending (and a sustained recovery in the housing market require a brighter jobs picture.

Mohammed El Erian, CEO of Pacific Investment Management Company, the world’s largest bond fund, has warned that it would be a mistake to interpret the high unemployment rate as evidence that employment is the “lagging indicator” it has traditionally been. The employment figures, rather, reflect a “new normal” that will be characterized by persistent high unemployment, signaling “future pressures on consumption, housing, and the country’s social safety net,” El-Erian contends.

Allen Sinai, chief global economist for Decision Economics, agrees that the unemployment rate is cause for serious and ongoing concern. “We have an army of unemployed,” he told reporters recently. “That is telling us a lot, in a leading way, about the picture for the consumer.”

That picture is not bright, at least, not in the near term. Consumer spending increased by 1.3 percent in August, largely on the strength of the Obama Administrations’ “Cash for Clunkers” program, which buoyed car sales for that period. But spending has dipped in four of the past six quarters, and recent polls indicate that consumers intend to keep a tight grip on their wallets.

Only 8 percent of those responding to a Bloomberg News poll in mid-September said they intend to increase expenditures over the next six months; nearly three-quarters said they reduced spending in the past year and 58 percent said they expect no change in their spending patterns; 48 percent said they intend to put more money into savings and 59 percent said they plan to increase their efforts to pay down debt.

Explaining their continuing financial caution, 4 in 10 respondents said their retirement savings have suffered in the past year, 40 percent said their home values have declined and 27 percent said they or someone in their household is feeling less secure about their job. Foreclosures meanwhile topped the 300,000 mark in August for the sixth consecutive month as job losses forced more homeowners into default.

“As long as 15 million Americans are unemployed, record foreclosures will continue,” Morris Davis, an assistant real estate professor at the Wisconsin School of Business, told Bloomberg News.

The consumer financial news is not entirely gray. Household wealth increased by $2 trillion in the second quarter, according to the Federal Reserve, thanks to the stock market rebound, a small gain in home values, and an increase in the savings rate – bad news for consumer spending but good news for household balance sheets.

“We’ve clawed back some of the previous losses in [household wealth],” Nigel Gault, chief US economist for HIS Global Insight, noted in a recent report. Even so, he acknowledged, “it will be a long slog to rebuild the wealth [lost] during this recession.”

Virtually every piece of good economic news, it seems, has a negative, or not-quite-so-positive, statistic to counter it. This may explain why two measures of consumer confidence have produced contrary results. The Conference Board’s Consumer Confidence Index for September fell to 53.1 from an upwardly revised 54.5 in August – disappointing analysts, who had predicted another gain. Both the current conditions and future expectations measures fell, as consumers remain “quite apprehensive about the short-term outlook and their incomes,” Lyn Franco, director of the Conference Board’s Consumer Research Center, said in a press statement. “With the holiday season quickly approaching,” Franco added, “this is not encouraging news.”

The University of Michigan’s Consumer Sentiment Index was considerably more encouraging. Its final reading for September of 73.5 beat both August’s 65.7 and the preliminary September reading of 70.2. Most of the strength was in the expectations index, which rose from 65 to 73.5 – the highest reading in two years. But the current conditions measure also increased, from 66.6 to 73.4. “People are seeing more signs that the economy is turning the corner,” Gary Thayer, macro-strategist for Wells Fargo Advisers, suggested. “If we had lower unemployment,” he told Bloomberg News, “sentiment would be a lot higher.”

A stronger employment picture would no doubt make many things brighter – including the housing market. More ups and downs to report here: New home sales increased in August, registering the fifth consecutive month-over-month, but the slim 0.7 percent increase month-over month gain fell below expectations. Existing home sales fell by 2.7 percent, hitting a bump in a road that had produced four consecutive monthly sales increases. New single-family construction also slipped for the first time since January, as did permits for new construction, which fell by 0.2 percent.

A key question is whether those negative stats reflect a recovery pattern that is uneven but heading in the right direction, or suggest a recovery so tenuous it could be easily derailed. Celia Chen, a housing economist for Moody’s, says she’s “not alarmed” by the August data. “The trend is still very strongly up,” she told reporters recently.

Chen and other optimists can point to plenty of positive numbers to support that optimistic view. Existing and new home sales combined have increased in four out of the past five months; inventory levels have improved significantly in both sectors; and the National Association of Realtors’ (NAR’s) pending sales index, pointing to future sales, increased again, reaching its highest level since March of last year.

Most encouraging to housing analysts, home prices continue to show signs of strengthening. The closely watched Standard & Poor’s/Case-Shiller index gained 1.2 percent in July over Jane – its largest increase since October of 2005, as prices in 17 of the 20 cities on the index increased. Prices in 13 of those markets have increased for three consecutive months. Karl Case, a co-founder of the index, thinks these numbers represent “a major, major turning point for the economy. We’ve got to phase back [federal incentives at some point,” he told Bloomberg Radio, “and this may be a good time to do that.”

That is about the last thing housing industry trade groups want to hear. The NAR and the National Association of Home Builders (NAHB) have cited the recent slippage in sales as evidence of the need to renew the federal tax credit for first-time homebuyers, which is scheduled to expire at the end of November.

Although the NAR’s chief economist, Lawrence Yun, agrees that the housing market is now close to a “self-sustaining recovery,” it’s not there yet, Yun emphasizes, noting that the encouraging pending sales numbers have not translated into equally encouraging closed sales. Delays in processing “short sales” (alternatives to foreclosures) and “complex new appraisal rules” about which Realtors, lenders and others have complained vigorously, are partly responsible for that gap, which, Yun says, the tax credit has helped to offset. The credit holds the key to future sales, Yun insisted in a recent press statement. “All we can say for certain,” he added, “is that sales will decline when the tax credit expires.”

The nation’s builders share that concern, which, industry executives say, is undercutting the improvement in builder confidence levels. Most components of the NAHB’s Builder Confidence Index improved in August, but the sales expectations for the next six months declined by one point. The reason, according to NAHB Chairman Joe Robson: “The window is now basically closed for being able to start a new home that can be completed in time for buyers to take advantage of the credit, and builders are concerned about what will keep the market moving” once the credit expires.

Builders are also concerned about the lack of credit, which continues to constrain homebuilding activity, Robson noted. Nearly two-thirds of the builders responding to a recent NAHB survey said credit availability worsened in the second quarter, 76 percent said lenders have told them they aren’t making any new loans, 75 percent said their lenders have reduced the amount they will lend, 62 percent reported demands for more collateral from their lenders and two-thirds said they are delaying planned projects until financing conditions improve.

”Lenders are cutting off loans for viable new housing projects and producing unnecessary foreclosures and losses” on acquisition and development loans, Robson complained. The lack of financing combined with the impending end of the tax credit, he warned, “threaten to halt any positive developments we have seen in the housing market in recent months. There can be no meaningful recovery,” Robson added, “until the flow of credit is restored to housing.”