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May 05, 2005

Can The Fed Really Stop Soon?
by Chad Hudson

UNEDITED

Economists didn't needed anymore data that showed the economy slowed during the last part of the first quarter, but there was plenty that was released over the past week that helped reinforce that opinion. GDP growth was lower than expected for the first quarter of 2005 and slowed from the fourth quarter of 2004. Consumer confidence fell in April according the survey from the University of Michigan. Finally, both ISM surveys fell from the previous month. While it is clear the economy has slowed, the relevant question becomes how significant is the slowdown and will it led the Federal Reserve to stop raising interest rates sooner rather than later.

We discussed on several occasions that the economic indicators would point to lower economic growth. We also pointed out that this slowdown would not be indicative of a weakening economy, but the natural progression of an economic recovery. Last week, the Bureau of Economic Analysis reported that the economy expanded by 3.6% on a year-over-year basis. While it is the slowest growth since the third quarter of 2003, it should be remembered that the economy grew by 5.0% during the first quarter of 2004. This was the highest year-over-year growth in over ten years. The economy has expanded by 8.8% since the first quarter of 2003. This two-year growth rate is the fastest pace since June 2000. It is also faster than all but six periods during the 1990s. And that is on a real basis. Using current dollars the economy has expanded by 13.4% over the past two years. Amazingly, only the June 1998 to June 200 growth rate exceeded this rate going back to 1990 when inflation was much higher than currently.

As previously mentioned, real GDP was weaker than expected, but the nominal GDP was higher than economists expected. The GDP deflator rose to 3.2, significantly higher than the 2.1% economists expected, which reduced the nominal GDP growth rate of 6.3% to a real GDP growth rate of 3.1%. Economists were worried about the $82.4 billion increase in inventories. Economists point out that building inventories means that merchandise is building up because end demand has eased. Plus the build up of inventories causes orders to decline as inventories are whittled down. While the $82.4 billion increase in inventories is the highest since June of 2000, there are several other reasons that could also explain the increase in inventories. Raw materials prices have been steadily rising for the past year. This has caused companies to stock up on raw materials hoping to avoid higher future prices. Plus, the strained transportation system has caused havoc for those utilizing just-in-time inventory management forcing companies to maintain higher levels of inventory to avoid shortages.

Both the manufacturing and non-manufacturing ISM surveys showed purchasing managers were less optimistic in April. The manufacturing survey dropped two points to 53.3, the lowest since July 2003. Only the production and export orders components rose. The most notable declines were in new orders and employment. New orders dropped 3.4 points to 53.7, lowest since May 2003, and employment fell one point to 52.3, which is the lowest it has been in sixteen months. The non-manufacturing ISM dropped 1.4 points to 61.7. Similar to the manufacturing survey, most components dropped, highlighted by new orders falling 3.3 points to 58.8, lowest since June 2003.

April was a big month for auto sales, except for General Motors and Ford. Overall industry sales came in at a 17.5 million unit rate. The Asian automakers outpaced the rest of the industry by a huge margin. Overall the Asian producers increased sales by 20.1% led by Toyota (up 25.9%), Nissan (up 31.9%), and Honda (up18.0%). The Asian automakers grabbed 37.5% of the market in April, the highest share it has ever garnered.

Overall, sales of the domestic nameplates fell 0.3%. Chrysler was the lone gainer with sales up 9.3% compared to GM's 4.1% decline and Ford's 1.4% slump. General Motors's results were actually worse than its monthly sales suggest. Its retail sales were actually down 13% and its light truck sales fell 17.2%. Sales of European brands were the weakest falling 9.1% in aggregate compared. Volkswagen sales fell 28.1% and BWM sales were off 10%.

There are some indications that the economy continued to trudge along. Companies continue to beat analysts' estimates for first quarter earnings. With 421 of the S&P 500 having reported first quarter earnings, 284 (67.5%) have beat estimates with only 19.7% missing. In aggregate earnings are up 14.1% compared to last year. Challenger job cuts fell to 57,871 from 86,396 in March. This was the fewest number of job cut announcements since November 2000. Over the past six months job cuts have averaged over 100,000. The Bureau of Labor Statistics will release the employment report for April on Friday.

While a significant portion of economic growth is due to inflation, the economy is expanding faster than to justify the current level of interest rates. It is also likely that inflation will continue to work through to consumers. Companies have been able to withstand higher raw material and other input costs over the past year because of contractual pricing and hedging practices that mitigate the immediate effects of rising prices. Prices started moving up about a year ago and now contractual prices have been renewed at higher prices and the cost of hedging has increased.

Higher inflation should also cause the Federal Reserve to be more diligent in achieving an equilibrium level of interest rates. After this week increase in the federal funds rate, it raised to the lowest level reached during the early 1990's recession. While current economic conditions dictate that rates have a long way to go before reaching an equilibrium state, the nature of the current economy makes it difficult to boost rates. The problem with higher interest rates is that US has morphed into a financial based economy and this level of interest rates would certainly play havoc on economic system. Unfortunately, until then its likely that the economy will likely have dramatic ebbs and flows with "hot sectors" experiencing a flood of activity, while other areas of the economy barely tread water. The weaker economic data has allowed investors to postulate that the Fed can stop raising rates after just a few more rate hikes. Any indication that economic activity has picked back up will likely cause long-term interest rates back up.

Chad Hudson
Mid-Week Analysis
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