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Inflation Clouding Interest Rate Outlook Amid Weakening Consumer Fundamentals

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The consumer confidence readings released in the past week portend a very bleak economic outlook. The Conference Board's June survey showed that consumers continued to be less upbeat over the prospects of the economy. The consumer confidence index dipped to 50.4 in June from 58.1 in May. While the present situation index fell nearly 10 points to 64.5, the expectations index declined 6.3 points to an all time low of 41. Meanwhile, the University of Michigan's consumer sentiment slipped to 56.4 in June from 59.8 in May. Inflation expectations a year ahead stayed at 5.1%, while expectations five to ten years forward was at an elevated level of 3.4%.

Notwithstanding the plunge in consumer confidence, real consumer spending has slowed only slightly. The current levels of consumer confidence are consistent with negative consumption growth, while the economy, though stuttering, has deftly avoided negative growth in the first half of the year. However, the resilience of the economy will be put to real test when the effect of the tax rebate stimulus wears off. Lehman Brothers believes that the receding consumer confidence reflects a broader deterioration in economic fundamentals. It is widely believed that weakening consumer confidence will act with a lagging effect on spending.

The June Fed meeting's policy statement offered little comfort to the Street. While acknowledging that the economic environment is fraught with risk, the central bank did not delve much into actions that could be taken to help the economy emerge out of the woods. The Fed is of the view that inflation will moderate later this year and next, though believing that the upside risks to inflation and inflation expectations have increased. The fact that the Fed has changed its timeline for the moderation in inflation from 'the coming quarters' is perceived as a sort of confession that the central bank will not act hastily even inflation surges in the coming months due to adverse base year effects.

On growth, the apex body commented that the downside risks to growth appear to have diminished somewhat. Commenting on the Fed action, Lehman Brothers said the Fed is trying to buy some time in the face of major conflicting signals.

On the housing front, the S&P Case Shiller house price index showed a 15.3% year-over-year decline. All the twenty cities showed year-over-year declines, marking the first time that has happened.

The final first quarter GDP report showed that economic growth for the period was revised up 0.1 percentage point to 1%. The action reflected upward revisions to consumption, business fixed investment and exports, which were partly offset by stronger import growth and weak inventories. On a negative note, the core price consumption expenditure index was revised up to show 2.3% year-over-year growth from 2.1% estimated previously.

Consumer spending climbed solidly in May, rising 0.8% in nominal terms and 0.4% in real terms. The reading supports a 2.5% increase in consumer spending in the second quarter, which in turn has the potential to keep real GDP growth in positive territory. Meanwhile, personal income growth was aided by tax rebates in the form of personal current transfer receipts.

The unfolding week, although shortened by the public holiday on Friday on account of 'Independence Day', has its fair share of economic releases. Traders may pay particular attention to the Labor Department 's monthly non-farm payrolls report for June. Investor focus is also likely to remain on the May construction spending report of the Commerce Department, the results of Institute of Supply Management's manufacturing and non-manufacturing surveys for June, the NAPM-Chicago's purchasing managers' June survey and the factory goods orders report for May. Additionally, the regularly scheduled weekly jobless claims report and EIA's weekly oil inventory report may also elicit some reaction in the markets.

The non-farm payroll report for June is expected to show another month of job losses, given the elevated levels of weekly jobless claims. The economy has lost jobs in the first five months of the year. Wachovia Securities expects a short-term pullback in the jobless rate in June, though it expects the rate to trend towards 6% over the coming quarters.

The ISM's manufacturing index, which remained below the contraction zone for the fourth straight month, is set to extent its lean patch, if it toes in-line with the results of the other regional manufacturing surveys. Both the Empire State and Philadelphia Fed manufacturing indexes declined in June, with the weakness mainly due to soft new orders activity. That said, the prices paid index may look to break the April 2004 peak.

Construction spending for May is likely to reveal a drop, pressured by continuing weakness in residential construction. Nevertheless, some strength in non-residential construction could cushion the drop.

Monday

The results of the National Association of Purchasing Management-Chicago's business survey for June are scheduled to be released at 9:45 AM ET on Monday. Economists expect the business barometer index, based on the survey, to be 48.5.

The May survey showed that manufacturing activity in the Chicago region contraction for the fourth straight month. The manufacturing purchasing managers index rose to 49.1 in May from 48.3 in April. The survey showed that the production index moved to the neutral zone, while the backlog of orders index contracted at a slower rate. Signaling pricing pressures, the prices paid index remained above 80 for the fourth time this year.

Tuesday

The Commerce Department's construction spending report to be released at 10 AM ET on Tuesday is expected to show a 0.6% decline in spending for May.

The construction spending report for April showed a 0.4% decline, a smaller decline compared to the 0.6% drop estimated by economists. On a year-over-year basis, construction spending declined 3.9%. Spending on private construction eased 0.5% on a monthly basis, reflecting a 2.3% drop in residential construction that was partly offset by a 1.6% increase in non-residential construction. Public construction spending declined 0.3% from the month-ago period.

The results of the manufacturing survey of the Institute for Supply Management, which are based on data compiled from purchasing and supply executives nationwide, are due out at 10 AM ET on Tuesday. Economists expect the index to show a reading of 49 for June.

The manufacturing purchasing managers' index, though up 1 point to 49.6 for the month of May, was still in the contraction zone. The new orders and production indexes also increased 3.2 and 2.1 points, respectively to 49.7 and 51.2. However, the backlog of orders index tumbled 5.5 points to 46, suggesting more weakness ahead. The employment index was up marginally to 45.5. Meanwhile, the prices index climbed 2.5 points to 87, marking its highest reading since April 2004.

Atlanta Federal Reserve President Dennis Lockhart is due to speak about the U.S. economy at 6 PM ET on Tuesday.

Wednesday

The ADP National Employment report, which is a measure of non-farm private employment, is scheduled to be released at 8:15 AM ET on Wednesday. The report is usually released two days prior to the Labor Department's employment report.

The Commerce Department is due to release a report on factory goods orders for May at 10 AM ET on Wednesday. Orders for manufactured goods are likely to have increased 0.6% in the month.

In April, new orders for non-manufactured durable goods rose 1.1% following a 1.5% increase in March. Shipments were up 2.2% and unfilled orders rose 0.9%. However, inventories declined $0.1 billion.

Meanwhile, the May durable goods orders, which makes up the bulk of the factory goods orders, rose slightly following an upwardly revised 1% decline in April. Economists looked forward to a flat performance by the durable goods orders for May.

Transportation equipment orders showed strength, rising by 2.6%, helping to offset the softness in orders for the rest of the goods. Excluding transportation orders, news orders declined 0.9%. Non-defense equipment orders, excluding aircraft eased 0.8%, reversing some of the gains in the previous month.

The Energy Information Administration is scheduled to release its weekly petroleum inventory report at 10:30 AM ET on the same day.

Crude oil stockpiles increased by 0.8 million barrels in the week ended June 20th to 301.8 million barrels. The inventories are now near the lower boundary of the average range for the year.

Distillate inventories rose by 2.8 million barrels, while gasoline stockpiles edged down by 0.1 million barrels. Refinery capacity averages 89.1% over the four-weeks ended June 20th compared to 88.9% in the previous week.

Federal Reserve Governor Frederic Mishkin is due to speak about the financial markets and economy at 12 PM ET on Wednesday.

Thursday

The European Central Bank's Governing Council is scheduled to meet at 7:45 ET on Thursday to determine its interest rate policy. Any change in policy is announced immediately after the meeting, while a statement is read out at a press briefing about 45 minutes after the meeting, followed by a Question & Answer session.

At its June meeting, the European Central Bank retained its main refinancing operations minimum bid rate at 4%. The bank also maintained its marginal lending facility and deposit facility at 5% and 3%, respectively. The central bank has been in a hold mode since it raised interest rates to 4% on June 7th, 2007. The inflation rate in the euro zone region rose to a record 3.6% in May, well above the central bank target of 2%, preventing the central bank from reducing interest rates despite the downside risks to growth.

The Labor Department is also scheduled to release its monthly non-farm payroll report at 8:30 AM on Thursday. The report sheds light on the number of paid employees working part time or full time in the nation's business and government establishments, the number of hours worked in the non-farm sector, the basic hourly rate for major industries and the number of unemployed as a percentage of the labor force. Economists estimate that the U.S. economy lost 50,000 jobs in June and look for an unemployment rate of 5.4%.

The Labor Department is due to release its customary weekly jobless claims report at 8:30 AM ET on Thursday.

Jobless claims came in at 384,000 for the week ended June 21st, unchanged from the previous week's revised figure of 384,000. Economists had expected jobless claims to slip to 375,000 from the previous week's initial estimate of 381,000.

The less volatile four-week moving average rose to 378,250 from the previous week's revised average of 376,000. Continuing claims in the week ended June 14th rose to 3.139 million from the preceding week's revised level of 3.057 million.

The ISM is scheduled to release the results of its non-manufacturing survey at 10 AM ET on Thursday. The non-manufacturing index is likely to show a reading of 51.5 for June.

In May, the non-manufacturing index declined to 51.7 from 52 in the previous month. Evidence of a build-up in inflationary pressures increased, as the price paid index showed a 4.9 point-increase to 77. The production and the new orders index rose 2.7 points and 3.5 points, respectively, while the exports orders index climbed to 48.5 in May from 54 in April. On the flip side, the employment index fell below the cut-off mark of '50' to 48.7.

by RTT Staff Writer

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