Markets & Finance

Is the Fed Out of the Picture?


The latest reports on housing and inflation invite the question: What's the Fed to do? The consumer price index (CPI) bucked the gyration in the producer price index (PPI), and posted the expected strength in July that's consistent with other price indicators. The CPI rose 0.4%, with the core up 0.2%, after respective gains of 0.2% and 0.3% in June.

Although some in the markets were relieved at the moderation in the monthly core gain, the figures leave an uptrend in year-over-year core price growth of 2.7% in July. We expect this rate to rise further to 2.8% in August, even if the monthly gain again rounds down to 0.2%.

Meanwhile, U.S. housing starts data were resoundingly weak in July and have established a new downward trend that runs the risk of rippling through the other housing reports. Housing starts fell 2.5%, to 1.795 million in July (and the June numbers were revised lower).

Permits dropped 6.5% for a sixth straight monthly decline, marking the largest percentage drop since September, 1999. Single-family starts dropped 2.3%, while multifamily starts were down 3.4%. Housing completions were down 5.4%.

The housing report sent troubling signs of weakness as we enter the second half of the year, with lean permits data and widespread geographic distribution. We have revised down our other housing forecasts for July, and bumped down the trajectory through the third quarter as well.

THE CORE MATTER. The residential construction component of gross domestic product (GDP) in the third quarter should post a hefty 18% decline. Interestingly, the nonresidential construction sector should post roughly the same rate of increase. Pessimism is making the rounds in the real estate market, and this is likely working back through new home sales to starts.

Yet despite housing sector weakness that might reinforce Fed beliefs that they made the right decision to pause in August, what can they make of the CPI report? While the lean PPI data on Aug. 15 indicated that the Fed might get some early vindication of its claim that "inflation pressures seem likely to moderate over time," the CPI figures bucked this report and revealed the feared uptick in year-over-year core inflation to 2.7% from 2.6% in June.

Prices for shelter continue to march forward, and strength in market prices had the expected headline impact to boot. Energy and building material prices remain on solid growth paths through the first half of August, which suggests ongoing headline price pressure.

DIFFICULT EXPLAINING. And because of a hard comparison, the year-over-year core inflation rate is poised to rise further to 2.8% in August and September. If relief is to come on consumer inflation, it is unlikely to emerge until easier comparisons come into play as we enter the new year. Though the Fed may be right on moderating inflation "over time," there will be some difficult explaining to do to Richmond Fed President Jeffrey Lacker, who dissented in August, at the next FOMC meeting.

In the Fed futures market, traders were focusing more on growth data and signs of cooling in the housing market than on the rise in core inflation. The implied futures market is further taking the Fed out of the picture, suggesting a little less than a 20% chance for a September hike.

The probability for a tightening at one of the two upcoming meetings in September or October is down to about 32%. While there is still one more complete round of data before the Sept. 20 FOMC meeting, at this point the data and market expectations would keep policymakers sidelined.


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