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Sunnier Days for the Economy

By Michael Englund There are some days when everything just seems to come into focus. For the U.S. economy, June 15 was one of them. A raft of economic reports released on that date -- covering inflation, the manufacturing sector, and business conditions -- provided important insights into where the economy has been, and where it's headed.

The most important point gleaned from the June 15 data blitz: The springtime "soft patch" in the economy appears to be little more than a fading memory. Action Economics believes that the growth trajectory's hiccup was a concentrated inventory correction in the factory sector that likely drew to a close in May.

PRICE-INDEX CORRECTION. The first of the day's reports found consumer-level inflation in check in May. The consumer-price data revealed downside surprises for the month, as the headline index fell 0.1%, while the core index, which excludes more volatile food and energy prices, rose 0.1%. The lower-than-expected reading on the core index confirmed trends evident in prior reports on producer and trade prices for the month.

Just as most inflation measures posted a seasonal "overshoot" in the first quarter, as we previously warned, these measures are now posting the associated seasonal "undershoot" in the second. We see an even-keel, slow-but-steady uptrend in U.S. inflation as the best guess for actual price pressure through this period, though the markets for now can take cheer from the modest May inflation data.

Three reports unveiled on June 15 offered encouraging news for the manufacturing sector. The first -- the New York Fed's Empire State index on manufacturing conditions -- rebounded in June to 11.6, following readings in the prior two months that trailed other sentiment indicators. We believe that this bounce, combined with a big rebound in vehicle-assembly rates and uptrends in most survey-based measures of optimism from consumers and businesses, suggest the remaining measures for June will show increases as well. If you believe the sentiment measures from the factory sector, the "soft patch" occurred in the April-May period.

SOFT PATCH CONTAINED. A second report, on industrial production for May, revealed a 0.3% upswing for the month, and we expect another solid 0.3% to 0.5% gain in June as well. This will cap a period of weakness in March and April that has restrained this factory-sector measure.

By this indicator, production eased slightly in the first quarter to a 3.5% growth rate, before slowing more significantly to a 1.5% pace in the second quarter. The comfortable May increase, combined with another likely gain in June, implies that we will return to 4% growth for industrial production in the third quarter.

Meanwhile, the April business inventory report showed an increase of 0.3% for the month, following an upwardly revised 0.5% increase in March (previously 0.4%). These figures corroborate that the soft patch has been contained, as any apparent inventory overbuild in the first quarter appears to have been fully corrected in April to leave a more balanced inventory outlook by May.

SOLID ECONOMIC FOOTING. We would also note emerging weakness in construction-related inventories, which may imply improving conditions in related production going forward as producers try to restock shelves. This ripple effect of rapid growth in the small but mighty housing sector allows a magnified upside economic impact via production of building materials, furniture, appliances, and other building-sensitive industries.

The final major release for June 15, the Federal Reserve's Beige Book survey of economic conditions, helped crystallize the bigger picture. The report said the economy expanded in all 12 Fed districts through May. The Fed characterized growth in most districts as "moderate, solid, and well sustained" and reported that labor markets had improved in most districts.

The Beige Book report, along with the other data mentioned above, add to our conviction that the economy is on solid footing, while price pressures remain on a moderate upward trajectory. In total, we're now comfortable with 3.9% forecasts for growth in gross domestic product in both the first and second quarters.

EXTRA INNINGS. As for the upcoming Federal Open Market Committee meeting on June 30, we see the mix of data as consistent with the measured tightening trajectory that the central bank has stuck to since the middle of last year. It now appears that Fed Chairman Alan Greenspan was on target in his remarks earlier this month to the Joint Economic Committee (JEC), suggesting that he thought the Fed needed to continue on its path of "measured" rate hikes for the time being.

Perhaps Dallas Fed President Richard Fisher wants to amend his recent comments that the Fed is already in the eighth inning of the tightening cycle to the possibility that the game will go into extra innings. As the chairman suggested in his testimony before the JEC that "we will know it when we get there" regarding Fed neutrality, little evidence exists that a pause in policy will emerge soon. Englund is chief economist for Action Economics

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