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U.S. Economy: Not on Highway to Hades, but Inflation is Generating Some Intense Heat
The U.S. economy expanded by a much-slower-than-expected 1.3% during the first quarter of 2007. This was the slowest quarterly increase since the first quarter of 2003 (1.2%), and resulted in a year-over-year growth rate of 2.1%. Two of the largest drags on macroeconomic activity during the first quarter were the net exports of goods and services, subtracting a tad more than 0.5% from the overall pace of growth and, unsurprisingly, residential investment, which dragged about 1.0% from the headline figure. After another two revisions, we expect the first-quarter 2007 growth rate to pop back upwards of 2.0%. Had it not been for these two disappointing components, the report would have been impressive for an economy that is this late into an expansion cycle. Keep in mind that consumers have now registered positive increases in spending for 61 consecutive quarters! We encourage investors not to underestimate the resiliency of the American consumer.
We are certain that the headline figure is not an accurate depiction of the true underlying state of economic affairs. Consumer spending advanced at an impressive 3.8% in the first quarter, which is ultimately a function of full employment. This followed an increase of 4.2% in the previous quarter. If the economy was truly on the verge of rolling over, consumers wouldn’t be out spending at such an elevated pace. Most, if not all, labor market indicators—including the critically important anecdotal reports—imply tightening conditions and rising incomes and wages. That said, we expect consumers to continue to play Atlas and buoy economic growth over the next several quarters. We project overall economic growth to moderate to 2.4% in 2007 from 3.3% in 2006. This pace is a moderation in growth to a less-than-desired pace, not an outright contraction or recession.
Consumer resiliency is the most underrated condition on Wall Street today, and there is very little reason to expect the consumer to toss in the towel now. The unemployment rate is trending lower, currently at 4.4%, job layoff announcements are slumping, and job creation—as measured by both the establishment and household surveys—remains at impressive levels. Anecdotal reports like those mentioned in the Federal Reserve’s Beige Book and those in contained in the quarterly earnings conference calls continue to suggest that businesses are having great difficulty finding qualified and skilled workers. Contrary to the musings in the business press, the key to economic prosperity lies with the consumer, not subprime mortgage holders. Subprime mortgage holders do not drive macroeconomic growth!
Residential fixed investment plunged an annualized 17.0% in the first quarter—the sixth consecutive quarterly contraction. While housing was uglier than most had expected, we believe that actual housing-related conditions were distorted by inclement weather. We’re not making excuses, we just think that activity in the residential arena isn’t as dire as the first-quarter data suggest. We expect some improvement in housing activity over the next few months. The weather should provide an impetus for buyers to get out and look for homes. Furthermore, a good deal of home buyer/seller activity generally transpires in April through September as families try to buy and move during summers to avoid potential conflict or disruptions with school.
Housing market data, including the Mortgage Bankers Association’s weekly applications indices, the new and existing sales (and prices) statistics, and the pace of construction activity, have improved in recent months. Contrary to popular belief, we suspect that homeowners are likely to boost the pace of construction during housing slumps. We’ve argued that while homeowners were indeed reluctant to sell their homes in a downturn, there was an increased likelihood to remodel, renovate, and decorate. Would-be home sellers have the ability and the propensity to fix up their largest asset for sale when the climate turns in their favor. New bathrooms, roofs, furnaces, and kitchens may add as much as an additional $100,000 to the price of an existing home.
We also don’t buy into the argument that those skilled in the construction of residential homes cannot find work. The construction industry possesses the most flexible workforce on the planet. If you are truly unemployed for an extended period of time, you grab your hammer and sniff around construction sites. Sitting idle and collecting unemployment benefits is not the American way. Anecdotal findings suggest that remodeling and renovation activity is booming. What is more, this strength won’t be found in the official government statistics, but in conversations with major contractors that are frequently dipping into the reserve of “off-the-books” labor.
Nonresidential fixed investment (capital spending), exhibited a slight improvement, posting a 2.0% increase in the first quarter that reversed a 3.1% decline in the fourth quarter. This increase was bolstered by a 1.9% rise in equipment and software spending and a 2.2% gain in structures spending. We see several signs of a recovery in this sector: new orders for durable goods and the Institute for Supply Management’s New Orders and New Export Orders are definitively on the rise. The weaker U.S. dollar has sent demand for U.S. manufactures skyward, which has forced manufacturers to fire-up recently idled plants and factories. Inventories are looking pretty lean, so there is a need for restocking. We see the dollar moving sideways from current levels on a trade-weighted basis.
One major concern in the first-quarter GDP report was the 4.0% increase in the GDP deflator—the largest increase since the first quarter of 1991 (4.8%). This surge was undoubtedly the result of sky-rocketing food and energy prices. During the first quarter, nondurable goods prices jumped 5.1%. The closely watched personal consumption expenditure deflator (PCED) increased 3.4% in the first quarter, up from a minus-1.0% posting in the final quarter of 2006. We expect the inflation barometers to step-down to the 3.0% to 3.25% vicinity. Nevertheless, inflation remains our greatest concern for 2007.
A Case for Higher, Not Lower, Short-Term Interest Rates
Currently, we don’t foresee any Fed action this year. It is true that many of the inflation barometers are headed in undesired directions, but the Fed cannot justify raising rates amid the uncertainties in housing and the sub-prime mortgage industry—at least not now.
Inflation appears to be the greatest risk to the economy, and this statement has been delivered by several Fed officials over the last few weeks. And while some of the core inflation reports have been benign, the goings-on in energy and food are hurting the headline figures. They should not be ignored. Once again, the chief culprit in the inflation reports was high fructose corn syrup. Over the last year, high fructose corn syrup prices were up 25%, and the producer price report revealed a 27.4% increase in corn sweeteners over the last 12 months.
Who would have thought that such an obscure material could wreak havoc on the overall inflation picture? But, from small things, big things one day come. The chain of events begins with greater demand for corn for use in ethanol production, and then anything remotely related to corn is affected. Farmers re-allocate their acreage for the more lucrative corn cultivation, and then prices of other grains rise due to smaller harvests and lower stockpiles. This in turn, pushes up prices of all grains, oilseeds, and cereals, which also boosts prices of formula feeds. A wonderful example of how the increase in corn plantings is having an effect on other goods is the barley market. The acreage allotted for barley cultivation is now the lowest since 1866! It should come as no surprise, then, that barely prices were up 4.7% in March, or 70.5% since March 2006. With that being said, Anheuser-Busch was forced to pass along higher prices. We can expect higher prices at stadiums, events, and bars and grills as well.
Over the last year, the producer price index for formula feeds is up 27.4%; poultry feeds (egg-type, broiler, and turkey) are up 34.0%, dairy cattle feeds (26.4%), swine feeds (35.6%), and beef cattle feeds (28.1%) are soaring through the roof. While these price increases have taken place largely on the wholesale level, they are slowly, but surely, making their way to the retail level. Retail prices for meats, poultry, fish, and eggs increased 1.1% in March, or 3.6% over the last year. Meanwhile cereals and bakery products are up 3.6% since March 2006. Alcoholic beverages were up 0.6% in March (2.8% over the last year). This isn’t altogether surprising since practically every beverage maker—alcoholic or non—stated their intention to pass along higher input prices. Nonalcoholic beverages and beverage materials surged 1.7% last month and 4.0% over the last 12 months.
To date, we’ve heard from several companies like Kellogg, General Mills, Wrigley, Cadbury Schwepps, Tyson Foods, Hershey’s, Kraft Foods, Anheuser-Busch, Procter and Gamble, Coca-Cola, and Pepsi about price pass-alongs, and we expect many more to join in as the earnings season continues. Apparently sky rocketing corn demand for ethanol production has boosted more than just the prices of high fructose corn syrup, which is essentially included in every food and beverage we consume, as well as in feed for cattle, chickens, and hogs. Even tortilla prices have increased by about 60%.
Businesses seem to be quite confident in the strength of the consumer and their ability to pay higher prices. The consumer price index increased 0.6% during March, which brought the 12-month inflation rate to 2.8%. Meanwhile, the core rate of inflation advanced a much quieter and less troubling 0.1%. This resulted in a core inflation rate of 2.5%. The Federal Reserve currently has an unofficial preferred range of 1.0% to 2.0% for the core rate of inflation. While this latest reading is undesirably higher than Fed officials would prefer, it is lower than the 2.7% registered in February and the 11-year high of 2.9% posted in September. That being said, we aren’t out of the woods just yet with respect to inflation.
Dining out is getting more expensive as higher-priced food and beverages are making their way into the menus of many restaurants and dining establishments. Comments made from the quarterly earnings season by restaurants and eating establishments suggest that higher menu prices are in the offing. The price of “food-away-from-home” increased 0.1% in March, but advanced 3.3% over the last 12 months. The Bureau of Labor Statistics also reported a 0.2% increase in full service meals and snacks, which is up 3.4% over the last year. The “other food-away-from-home” category, which includes catered affairs and food at colleges, slipped 0.1% in March, but managed to register a 4.6% gain over the last year.
The Fed would like to rein in rising wages, soaring food prices, import inflation from a weaker dollar and uncomfortably high energy prices, but not at the risk of sending the economy into a recession. Inflation would have to climb considerably higher than current levels in order to force the Fed’s hands.
To date, the Federal Reserve has gone out of its way to let the markets know of its concern with rising inflation, and how rising prices is still atop their worry list. The fact that economic growth is definitively on the upswing certainly doesn’t help the case of those predicting a rate cut. In order for the Fed to reduce its benchmark target rate, the economy would be in clear need of stimulus. A rate cut could potentially send the already low unemployment rate lower, which is an undesirable consequence for the central bank. Also, mortgage rates hovering around 6.1% are as stimulative as they’ve ever been and are not likely to do additional good if the Fed were to lower its target rate. Finally, and perhaps the most important of all, consumer spending is already on a blistering tear. The Fed can’t possibly want to boost it from its elevated level. There’s no use tossing an accelerant on an already burning flame—especially if inflation is your greatest fear.
In early April, Fed Chairman Ben Bernanke testified before the Joint Economic Committee of Congress saying, “We have not shifted away from an inflation bias.” You really can’t get any clearer than that. So we will take him at his word. Why the business press decided not to run this as a headline is somewhat disturbing, but not altogether surprising.
There are several reasons supporting the current “paused: policy stance: namely, the unknown magnitude of the housing downturn and the influence of the Fed’s previous 17 rate hikes. Since most of the respected inflation measures are well above the higher ends of the purported comfort zone, energy and food prices are escalating, the labor market continues to tighten, and a weaker dollar could invite unwanted import inflation, we believe there are a number of legitimate reasons for the Fed to boost its overnight target rate. However, at this point we see little-to-no reason for a rate cut. In the event that escalating food prices continue to seep into the broader economy, the Federal Reserve may have to alter monetary policy to the restrictive side. Currently this is not a problem, especially since economic growth isn’t growing at a pace that could engender a compromising inflation picture. But, things could change...
By Richard Yamarone, Director of Economic Research, Argus Research Corp.
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