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September 08, 2005

Will the Fed Pause?
by Chad Hudson

The manufacturing ISM survey indicated that the manufacturing sectors slowed in August. Both new orders and production declined, while prices increased. While the manufacturing sector continued to show signs of slowing, the service side of the economy accelerated according to the Institute of Supply Managers August survey. The index measuring the health of service industries unexpectedly rose 4.5 points last month to 65. Since the index was started in 1997, only April 2004 showed stronger growth. Economists expected the index to drop half a point. Most of the strength came from the 3.9 point increase in new orders. Employment rose 3.4 points to 59.6, tying the highest level set in February this year. While prices fell 3.2 points to 67.1, it remained at very elevated levels.

The labor markets remained healthy in August. The Labor Department reported that nonfarm payrolls increased by 169,000. While this was slightly below estimates, July payrolls were revised higher by 35,000 to 242,000. Korn/Ferry reported earnings this week that were 35% higher than a year ago. Revenue increased 11%, helped by a 44% increase in its Futurestep unit, which recruits employees for multiple job openings for large projects. Last week in an interview with Bloomberg, Joe Griesedieck, vice chairman of Korn/Ferry, said, "I think there is a looming shortage of talent coming. The demand is such that the salaries will go up in all sectors of the market."

On Wednesday the Labor Department reported that unit labor cost rose 2.5% in the second quarter, much higher than the 1.4% increase forecasted and increased 4.2% from a year ago. This was the largest year-over-year increase since December 2000. This higher than expected jump in unit labor costs was due to lower than expected productivity growth combined with the highest compensation growth since October 2000. While slower productivity growth accounts for part of the increase, compensation per hour jumped 6.5% over the past year.

Last week, the Commerce Department reported that the personal savings rate dropped below zero in July for only the second time since the government started recording it in 1959. The other instance was in October 2001 when automakers unveiled zero-percent financing. This time is was also due to incentives from the automakers.

Vehicle sales during August were 16.8 million, lower than the 17.2 million expected. Sales were weaker following the employee-pricing promotion that was launched in July. One reason for the drop off in sales was the lack of inventory. The employee discount pricing caused a sales spike last month and depleted a lot of inventory. That is the reason the average incentive dropped 7.5% in August. Incentives from the domestic automakers were also lower than a year ago by 2.5%, but the Asian automakers increased their incentives by 10% over the past year. The Asian incentives remain less than half what the domestic automakers offer ($1,571 compared to $3,919). The incentive game will be changing for the 2006 vehicles. GM will be lowering the sticker price of vehicles and reducing the amount of incentives offered. GM is also introducing it new truck and SUV models early next year. There is a lot riding on the new models. Trucks and SUVs are the most profitable vehicles GM sells and have been under pressure from the Japanese makers. Analysts are hoping that the new models will enable GM to regain momentum. In a recent research report, Prudential analyst, Michael Bruynesteyn, wrote that, "The upcoming launch of the GMT full-size SUVs is critical for GM." The shift in pricing vehicles closer to transaction price might stifle sales as customers used the large rebates to compensate for the negative equity buyers typically had on their previous vehicle. The higher gasoline prices have caused buyers to re-evaluate whether or not to purchases gas guzzling vehicles. Not only will this be a headwind for new vehicle sales, but has lowered the prices on used vehicles, making owners more "upside down."

Retail same store sales rose 3.6% in August. Considering the easy comparison to last August, Mike Niemira, chief economists of ICSC, said that, "The reality is sales should have been a percentage point or two stronger." In fact, using a two-year stacked growth rate, it was 4.9% which is the lowest growth spanning two years since November 2003. Luxury sales rose 7.3%, outpacing discount stores (up 3.0%) for the fifth consecutive month. The ICSC also monitors total sales for the retailers it its survey. During August, total sales increased 8.4%, which is the slowest growth this year. Last month, retail sales were relatively weak as well, but auto sales were strong. It appears that since auto sales were also lower than expectations, the consumer is starting to show weakness.

These developments over the past week put the Federal Reserve in a difficult position. By most accounts, consumers have slowed spending, labor costs are rising, and companies have indicated that prices have started to increase again.

This week, the Congressional Budget Office said the hurricane could lower growth by 50 to 100 basis points during the second half of the year. Senator Grassley also commented that Katrina could reduce GDP growth by 1%, and added that the Federal Reserve should not raise rates at it September 20 meeting. While the Federal Reserve has historically used these emergencies as reason to be more accommodative, the likelihood that the aftereffect of Katrina will include inflationary pressures is very high. Recent comments from Federal Reserve officials suggest that Hurricane Katrina might pose more of an inflation threat than pose a risk of an economic slowdown. Today Chicago Federal Reserve President, Michael Moskow, said that he is "concerned about core inflation running at the upper end of the range that I feel is consistent with price stability."

In November 2002, Ben Bernanke, the current chief economist for the President and former Federal Reserve governor, said that, "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost." It appears he is turning on the proverbial printing press. On Wednesday, the government said it will distribute gift cards worth $2,000 to each adult victim of the hurricane. Considering almost 320,000 have already applied for disaster aid, this could approach $1 billion.

November fed funds contract closed on Wednesday at 96.150, indicating a yield of 3.84% at the end of November, just about halfway between 3.75% and 4.0%. While the market is almost evenly divided whether the Fed will raise rates in two weeks, 14 out of the 20 primary dealers expect the Fed to raise rates by 25 basis points on September 20. Additionally, 11 out of 15 expect the Fed to raise rates at the November meeting as well. Unfortunately, there will not be a lot of economic data released over the next two weeks to gauge the effects of Hurricane Katrina. It should be notable that the first Fed official to speak following the hurricane highlighted the possible inflationary pressures. Additionally, prices in the ISM non-manufacturing survey increased and that survey was conducted before the hurricane hit the Gulf Coast. Yet, it is hard to believe that Greenspan would pass up an opportunity to be accommodative.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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