The Fed's Job Gets Trickier

Action Economics still expects a rate cut of 50 basis points Mar. 18, though the Bear Stearns bailout could alter the Fed policy landscape

The markets saw some good news in two reports released Mar. 14. A report on U.S. consumer-level inflation in February was surprisingly tame, while a nearly unchanged figure on a closely followed gauge of consumer sentiment in March was a relief as well. But the news of a bailout of troubled investment bank Bear Stearns (BSC) trumped the positive developments, with the data taking a back seat to the news. Clearly, market participants may be more focused on whether developments at Bear Stearns will spook investors, depress confidence, and alter the Fed policy landscape.

Fed funds futures rocketed higher Mar. 14 as traders and investors alike ran to the safety of Treasuries and very short-dated securities. Indeed, Wall Street has taken a decidedly fearful view of the Bear Stearns news. Meanwhile, talk of a big, 100-basis-point cut in the Fed funds rate at the Mar. 18 meeting of the policy-setting Federal Open Market Committee (FOMC) is making the rounds. A 75-basis-point cut had been priced in by the market, but news that JPMorgan Chase (JPM), in conjunction with the New York Fed, is working to keep the Bear alive for another 28 days, and the subsequent dive in stocks, indicates that the market believes more forceful action is needed.

The February consumer price index report opened the door for a more aggressive Fed easing, and signs of panic in financial markets into next Tuesday, Mar. 18, would also grease the wheel for an outsize move. Yet, many economists have resisted forecasting a 75-basis-point easing, vs. a 50-basis-point move, on the assumption that a more cautious interest-rate path from here would be more prudent. How the market takes the news coming out of the financial markets after the Bear blowup through Mar. 18 will dictate whether the Fed has room for prudence, however. We will stick with our assumption of a 50-basis-point easing for now, with another 25-basis-point cut to follow in April, though the outlook is obviously fluid and will depend on market conditions through Mar. 17 and early on Mar. 18.

Here is Action Economics' rundown of the Mar. 14 reports:

Consumer Price Index

The U.S. CPI report with its flat February headline reading revealed a sizable drop in the headline year-over-year pace, to 4.0% from 4.3%, that will be welcome in the markets. And better yet, the flat core figure (which excludes volatile food and energy prices) for February translated to a drop in this measure's year-over-year inflation pace to 2.3%, from 2.5%, with a more precise 2.27% reading that was leaning toward rounding down to 2.2%. Though both year-over-year rates remain elevated, the reduced rates of increase despite the preponderance of gains in many commodity price measures should provide some cooling of inflation fears.

Many energy price measures showed small gains in February that suggested modest upside energy price risk to the various inflation gauges for the month. We will now assume a 0.3% February headline producer price index (PPI) gain, to be released Mar. 18, with a 0.2% gain in the core. For the February personal consumption expenditure (PCE) chain price indexes, we now expect a 0.1% gain for the headline and a flat core figure.

Much of the good news for energy prices in February will be reversed in March, as most energy price gauges rose through late February and thus far in March. This suggests another round of difficult inflation readings ahead. Yet, for now the market can enjoy a patch of good inflation news, following a five-month run of particularly nasty inflation figures.

Removing Inflation Pressure from the FOMC

Mar. 14's figures also took the edge off the February retail sales report, which still translates to a 0.1% nominal gain for personal consumption in February, though this now implies a flat "real" consumption figure for the month rather than a small drop. The 1% decline in gasoline service station sales in February was a surprise at the time, though with hindsight it likely reflected the early-month price restraint rather than a cutback in driving and hence inflation-adjusted sales, as some economists speculated. Our first-quarter gross domestic product forecast remains at –0.3%, though we now expect a tiny 0.2% growth clip for first-quarter real consumption.

The February CPI restraint and drop in year-over-year measures will take some inflation pressure off the FOMC next week, though soaring commodity prices suggest another problematic price round in March. Year-over-year inflation figures will remain elevated by the late-April two-day FOMC meeting.

University of Michigan Consumer Sentiment Index

The Michigan sentiment index revealed a downtick in the preliminary March report, to 70.5, following the 70.8 reading for February, marking a new low for this measure in the GDP down cycle of the 2007 fourth quarter and 2008 first quarter. The present situation index managed to rise to 84.6 from 83.8 in February, though the future expectations index fell to a new low of 61.4 from 62.4, as the preponderance of negative news from the financial markets continues to boost fear. Though the inflation-expectations measures often play second fiddle in this report, it's noteworthy that the one-year ahead inflation measure soared to 4.5%, from 3.6%, though the 5- to 10-year outlook dipped to 2.9%, from 3%.

We will assume a small bounce in the March consumer confidence index to 77, from a 75 reading in February.

Confidence declines over the last nine months have outpaced the declines through the various episodes of negativism that have plagued this expansion, just as the pullback in consumer spending, as captured in the Mar. 13 retail sales report, outpaced prior moderations in this expansion. The combination has reinforced the assumption that we have entered a recession.

Yet, nominal (unadjusted for inflation) spending growth is still remarkably outpacing income growth since the market turmoil began in August. Further spending shortfalls beyond February might finally allow the long-awaited uptick in the savings rate beyond the still-lean 0.2% that looks likely for February, following rates of 0.2% to 0.5% through most of the middle months of 2007. For now, however, the consumer is still not a factor "pulling down" GDP. Indeed, given available spending figures, consumer spending continues to modestly outpace income growth to provide a modest buffer to GDP, despite the powerful array of headwinds that are obviously affecting confidence.

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