Fed Watch: Push the Rate Cut Further Ahead

Tim Duy with a Fed Watch. Tim looks at recent data on the economy from the Fed's perspective:

Push the Rate Cut Further Ahead, by Tim Duy: Sometimes, you get it right and virtually no one knows about it. Thursday I sent an email to a long-time contact:

Note:

Productivity undershot because hours worked rose 1.6%, more than the 0.6% increase we (and, evidently, other analysts) expected based on the monthly hours data," Ian Shepherson, chief U.S. economist at High Frequency Economics, wrote in a note to clients.

I thought the same - 0.6% increase in hours. The higher than expected numbers suggest upward revision in recent NFP figures.

Just a hunch...

Would have been a good day to blog. Still, plenty of material to work with today. So much, in fact, that a quick summary is more efficient:

1. The upward revisions to NFP numbers imply greater underlying economic momentum in Q3 than is implied by the GDP report.

2. The declining three month trend, 230k, 148k, and 92k, suggests an easing of that momentum going into Q4.

3. Given the recent pattern of upward revisions, the October number is suspect – maybe less easing of momentum than appears on the surface.

4. The average duration of unemployment dipped by a week as long term (27+ weeks) unemployment fell back to summer levels. The median duration remained unchanged.

5. Job losses were concentrated in the expected sectors – construction, manufacturing, and retail. Manufacturing hours edged up.

6. Temporary help employment jumped by 15k, returning to summer levels and staving off year-over-year declines (for now).

7. Aggregate private hours work jumped at a 3.4% annualized pace. Workers were busy in October!

8. The drop in the unemployment rate – although a lagging variable – cannot be ignored.

Overall, a positive report. The impact of the housing slowdown is – for now – mitigated by growth in other sectors of the economy. Quite honestly, I am not surprised, nor will the Fed be surprised by the decline in manufacturing employment. Regardless of the cyclical behavior of the economy, it seems likely that manufacturing hiring will continue its slow bleed for the foreseeable future. Manufacturing productivity is growing near 4% y-o-y for the second year in a row; for durable goods, the average y-o-y growth is 6.1% this year! Tough to see how demand can keep up with those productivity growth rates.

Perhaps point 8 sums it up for monetary policy: The Fed is NOT going to think about cutting rates with the unemployment rate falling. Before Fedthink shifts to rate cutting, the unemployment rate needs to stabilize, at a minimum. As noted by Mark Thoma, the Fed is thinking that such stabilization is consistent with NFP near 100k. Consequently, one month at the 92k mark is not going to convince Fed policymakers that stabilization has arrived. And a hawk like Richmond Fed President Jeffery Lacker is probably readying his “I told you so” speech as I write.

The weak overall productivity numbers – it’s a whole different world outside of manufacturing – will also play into the hawk’s hands. It will help keep the Fed on hold given the inconclusive nature of incoming data. But the Fed won’t panic; as knzn cautions, it would be premature to read much beyond potential cyclical movements into the productivity trend (in contrast, Dean Baker is a bit more nervous). And with the economy slowing, for now the Fed will think they got ahead of any problem that might be brewing.

And what of the remaining data? This week, a mixed bag.  The headline number in the October ISM release was somewhat below expectations and revealed, unsurprisingly, continued slowing in manufacturing activity. The question remains: Slower than the Fed’s expectations? Moreover, growth remains in positive territory, and the Fed usually doesn’t get nervous until the ISM comes in below 50 for 2 or 3 consecutive months.

Interestingly, orders backlogs in the ISM index fell for the second consecutive month. Through September, the orders backlogs continued to grow in the durable goods report. Are these numbers about to reverse? In particular, I keep my attention on the backlogs for nondefence, nonair durable goods orders for a signal of business investment strength. The downturn in core durable goods activity that I would expect to be consistent with a hard landing has yet to occur – but perhaps it is about to.

Also on the weak side of the coin was the September read on construction – growth in private nonresidential (meager growth) and public construction were no match for the decline in residential construction. On the surface, given the decline in housing investment reported in the 3Q06 GDP report, I can’t really believe this was much of a surprise. But it does once again draw attention to the depth of the decline in housing activity. I have trouble believing that housing is going to level off soon:

Commenting on the report, NAR chief economist David Lereah said, "the present level of home sales is relatively high in historic terms, and we can expect generally minor movements around this level."

"We don't expect to see any changes of note until early next year when we're likely to see a modest lift to home sales," he added.

I suppose someone has to be paid to say it. More likely, I think, is that rising home vacancy rates (via Dean Baker) suggest that it will take some time to work off excess housing stock. I am counting on a negative contribution from housing for at least two more quarters.

In the current environment, the brighter news tends to get lost. Monday saw the release of the September personal income and outlays report. Of course, given the GDP report, one could back out some of the details. Still, it is worth nothing that disposable personal income made a healthy 0.5% gain in nominal terms. And, with inflation working in the consumer’s favor for a change, the real gain was 0.8%. Spending did not keep pace, suggesting that the consumer has some extra pocket change heading into Q4. This would be consistent with the uptick in October consumer confidence as measured by the University of Michigan. Of course, in today’s world of mixed data, the Conference Board’s reading on consumer confidence sagged in October. I have a preference for the UMich index, but am not married to it either.

But will consumer spending hold up as the housing market downturn eats into equity withdrawals? Calculated Risk brings us insights from Northern Trust economist Paul Kasriel, who identifies the slowdown in consumer spending to below 3% y-o-y, positing that it may reflect weakening housing conditions. I am skeptical about that – the sharp jump in energy costs over the past year could easily account for the spending slowdown. My skepticism is increased after reading CRs later post regarding record cash out financing in 3Q. Instead, I think we have to look down the road to mid-2007 to see the impact of housing on consumer behavior. Assuming that inflation stabilizes/trends downward, it seems realistic that consumer spending will ease into the 2-3% range (I find that range consistent with the readings on consumer confidence), below the 3-4% range of recent years and consistent with hiring softness. That is the soft landing scenario of the type the Fed is foreseeing; it requires that job growth pulls back but doesn’t collapse – similar to the October trend. Calculated Risk worries that this is optimistic.

Another bright spot arrived late in the week – the rebound of the ISM nonmanufacturing index to 57.1 from 52.9. Given that this represents the bulk of economic activity in the US, the report gives the optimists some breathing room. Undeterred by any of the day’s numbers, Nouriel Roubini doubles down (again) on the recession call, including:

We are not yet in a service sector recession but we are getting close to it. Wal-Mart's sales number were not only awful for October; they expect their sales to be flat in November, the worst performance in a decade. The troubles of Wal-Mart - in spite of much lower oil prices - are also the troubles of most other retailers as the figures yesterday for most major retailers' same store sales were mediocre and disappointing. Thus, the expected pick-up in sales for the holiday season is now fizzling away. The sorry state of the retail sector is also signaled by falling employment levels in this sector in October. And even today's services ISM report was much worse than the headline figure was showing. The headline was up but the details of it were worrisome: the indeces for new orders, employment, and the order backlog all fell sharply while the price index shows lessened pricing power by service sector firms, consistent with the weakening of the overall service sector.

"Fell sharply" I suppose is a matter of interpretation. You be the judge:

	New Orders	Backlogs of Orders	Employment	NFP Increase
Oct-06	51.5	56.5	51.0	92k
Sep-06	53.0	57.2	53.6	148k
Aug-06	49.5	52.1	51.4	230k
Jul-06	56.0	55.6	54.5	123k

Recent numbers look consistent with non farm payroll increases anywhere from 100k to 230k (loosely based on the old "eyeball econometrics"). Also, the price index is "[p]rices paid by non-manufacturing organizations for purchased materials and services" – it speaks to inflationary pressures and margins, not final output pricing power. Note too that exports were up "sharply" with a 4.5 point gain (up 10.5 points since August), while imports were up as well. A bit of an increase in inventories, though.

The sorry state of the retail sector may be something of an exaggeration:

"Put it all together and you have a decent picture," said Michael Niemira, chief economist at the International Council of Shopping Centers, a trade group based in New York. "But it's a tale of two consumers: the department-store shopper is buying like there's no tomorrow, but then you have everybody else."

Niemira is a long time player in the business – I don’t recall him leading me astray.

In short, I continue to remain skeptical that the Fed is seeing much they didn’t expect. Of course, as with any downshift in activity, they are likely paying close attention to the downside risks, especially given the sea change in housing. Still, I doubt that they are in the same place as many market participants. My position remains that the incoming data is of a sufficiently mixed nature (speaking conclusively to neither permabulls nor permabears) to keep the Fed on hold for the foreseeable future. They will want a more decisive downturn in the data before shifting into the rate cutting mode.

Comments

[wcw]

Must say I agree. While like CR and Roubini I cannot look at the housing market, mortgage equity withdrawal, inventories and incomes and see anything other than trouble ahead, for the moment the data all look merely mixed.

One specific note: the retail employment rate (per civilian, noninstitutional population) has been dropping at greater than -1% year-over-year for just over a year now. The retailers may be wrong, but I am unsurprised to see the International Council of Shopping Centers call it a "mixed picture". If it were unmixed, they'd be hiring.

Good one as ever; thanks for collecting all the tidbits I missed.

[CalculatedRisk]

Professor, thanks for the thorough analysis - I appreciate the effort you put into these posts!

You note: "I doubt that [the Fed] are in the same place as many market participants." Actually I think the Fed is in agreement with the overwhelming consensus. The Blue Chip consensus is for a rebound in Q4 and slightly below trend GDP growth in '07.

It just seems that many people are bearish, because the relatively few bears are very noisy and ubiquitous lately (mostly because they have been more right, over the last 6 months, than the consensus).

Just because it's the consensus, doesn't make it wrong. In fact I've found the consensus is usually pretty good, except at turning points. The good news is I think we will know soon if the housing slowdown seriously impacts the general economy - like within the next 3 quarters.

On mortgage equity extraction - Freddie Mac reported the highest percentage of borrowers cashed out in Q3 since 1990, but the amount extracted was probably below the record levels of 2004 and 2005 (we won't know the final number until the Flow of Funds report is released).

Great piece!
Best Wishes.

[calmo]

Such moderate (you be the judge of "Fallen Sharply" Roubini) detailed (1% y/y drop in Retail employment) posts.

You know I'm here to put an end to that.

Nouriel, every bear's hero, is going to wave that government hires stat back at the judges. (Maybe ups the ante to "Plunge".)
I'm not sure that 1% Retail Employment drop is "unmixed" or not. Why is it that we expect technological advances to lower manufacturing employment somewhat, but not retailing? Don't more people shop on-line now? At this time of year, do we trust the SA numbers to take care of the Xmas shopping? I do think that distinguishing between hi-end and low-end retailing gives a better picture of the demand picture, esp with the housing market fade.
Do the energy savings across the board (roughly, everybody uses the same amount of fuel) compensate for whatever MEW losses (for that portion, less than everybody, but more than a few)[Kasriel says 3% less spending y/y] as a result of the housing sag? I'm parking my butt with Kasriel on this one because although the totals might be the same order of magnitude, the distribution is different and those that were used to MEWs were not thrifty (they will never be able to save that much from cheaper gas).
Other than that I appreciate Tim's shove back at King Nouriel.
So judicial.

[Emmanuel]

LOL, TD. Given the increased frequency at which you like to second-guess Nouriel Roubini, your regular feature might change from the "Fed Watch" to the "Nouriel Roubini Watch". In any event, it's good to hear your informed opinion as an alternative viewpoint.

[spencer]

The one data point not noted in this outstanding review is that while nonfarm unit labor cost is now rising at a 5% rate -- about the highest since the 1970s -- the nonfarm deflator is only growing at a 2% rate. This spread between unit labor cost and prices is an outstanding leading indicator of corporate profits and strongly implies that the consensus forecast of continued strong profits growth in 2007 is just too over optimistic.

[dryfly]

This spread between unit labor cost and prices is an outstanding leading indicator of corporate profits and strongly implies that the consensus forecast of continued strong profits growth in 2007 is just too over optimistic.

Depends on how much of that labor is arbitraged going forward. I'm personally seeing no slow down in production & services going offshore... it isn't happening plant at a time so much as cubicle & work cell at a time.

For example - this Friday I have a meeting with a buying team of a Fortune top 100 firm... the meeting will be in the Midwest but the key contact (Global Commodity Mgr) is out of Monterrey MX - he will be in on the meeting via conference call... if I get the orders (won't know for almost a year) then that is where I'll be going to support the sale.

This is happening more and more.

The difference between hiring a Mexican professional vs US isn't quite as large as say an Indian or Chinese - but it is at least half the cost and maybe as low as a third the cost of a comparable American or Canadian.

Working with the commodity manager in Monterrey is his support team plus the Logistics, AP and Quality middle level managers & their support staff too. Engineering is in the process of locating there.

Their mfg'ing function is spread all across the Maquilla corridor from GOM to Pacific Ocean... it makes all the sense in the world to locate the middle management there also... and as for head count, that is where the real numbers are, not at corporate in the Midwest.

This company has a parallel structure in the Asian theater too - slightly different product line but identical strategy.

I can easily see this trend accelerate as domestic wage pressure increases... resulting in slow growth overall due to slow job growth... but rock solid profit growth as overall cost are kept low by this offshore 'safety valve'.

Eventually one would think the slow job growth would bite into NAFTA Zone top line growth... but if the credit bubble continues (and we remain awash in liquidity)... that could take a while.

[calmo]

Point taken spencer. That is, it is an excellent review (as usual from Tim) and we (you know I only speak for me) bumble bees are not going to change the direction of that freight train (well, *that* experience with the Fed and more)[not like we mere buzzers and fussers; we know our place; mostly...]
And that other point about those increasing labor costs which translate to reduced profits and poorer earnings...I'm getting it (finally).
Thank you (no small train yourself). So better productivity growth as increasing labor costs alway exerts downward pressure on labor hours?