U.S: The Fed Likes The Cooler Data, But So Does Wall Street
The proliferating signs of a consumer-led slowdown and tame inflation are just what the doctor ordered--Dr. Greenspan, that is. But the Federal Reserve Chairman faces a tricky policy dilemma: Softer-looking data are refueling the markets, as investors express decreasing fear of further hikes in interest rates. Cooler growth may be the right prescription, but the Fed will have to guard against a worrisome side effect: The market rally could reignite economic growth later on.
The May data continue to look uniformly softer. The slowdown in retail sales in both April and May, along with tame price indexes at both the producer and consumer levels, are especially important (chart). The consumer sector is the key to an overall cooler pace of growth, and the price data suggest that the Fed is not behind in its efforts to stem future inflation. Wall Street now believes that chances of another rate hike at the Fed's June 27-28 meeting are very small.
Partly because of that new belief, both the credit markets and the stock market have rallied. The rate on top-quality AAA corporate bonds, for example, is down some 50 basis points, from 8.1% in mid-May, and that for lesser-quality BAA issues is down some 60 basis points, from 9.1%. Also, 30-year fixed mortgage rates have fallen some 40 basis points from their mid-May high of 8.7%. Plus, the broad Wilshire 5000 stock index has bounced up some 9%, as of June 14, from its low of late May. As a result, a sizable proportion of this year's financial-market tightening has been reversed.
CLEARLY, THE STOCK MARKET has played an unusual role in consumer spending since 1997. One impact is the wealth effect, with its long-term influence on spending growth. But more than that, the stock market's unusually high volatility has had a clear impact on the ups and downs of spending patterns in the very short term. This relatively high correlation did not exist prior to 1997. Since then, three-month changes in the growth of stock prices explain about one-fifth of the variability in the three-month growth rate of real consumer spending, based on a Business Week analysis.
Interestingly, purchases of nondurable goods, such as sales at department stores, clothing shops, and restaurants, tend to show the greatest short-term correlation, as opposed to big-ticket goods such as cars and appliances. Such fluctuations in the purchase of services show no correlation at all. Over a much longer period, of course, the wealth effect appears to have had an impact across a broad array of consumer buying.
This short-term relationship suggests that at least some small part of the slowdown in consumer spending this spring probably reflects the stock market's downturn since March. However, if the current rally holds up, spending growth could be affected positively later this summer, especially if labor-market conditions stay tight and consumer confidence remains high.
THE MOST STRIKING EVIDENCE that consumers have cut back came from the retail sales data (chart). May retail buying fell 0.3%, and the April data were revised lower to show a steeper 0.6% drop instead of the 0.2% dip originally reported. Real consumer spending in the second quarter is on track to grow in the neighborhood of 3%, at an annual rate. That would be well below the 5.8% clip of the previous four quarters and the slowest quarterly gain in three years.
One note, which could have a policy implication, is the recent split between sales of durable and nondurable goods. Sales of nondurable goods--items sold at department stores and restaurants, plus food, gas, apparel, and drugs--rose 0.2% lin May, after a 0.1% dip in April. That pace was slower than earlier this year. Meanwhile, durable-goods purchases fell 1% in May, on top of a 1.2% plunge in April.
Durables, including cars and housing-related items such as building materials and furniture, are the exact big-ticket purchases that one would expect to see curbed by Fed tightening as a result of higher borrowing costs. But again, the risk to the outlook is that the recent drop in long-term interest rates and a resurgence in equity prices could overwhelm some of the effects of past Fed tightening. If that happens, then overall consumer spending will rev back up.
Another factor weighing on consumers--and they are likely to continue to feel the burden through the summer--is energy costs, especially gasoline prices (chart). Gas prices have surged to nearly $2 per gallon in many areas of the country, and the higher costs are taking a big bite out of households' spending power. Business Week estimates that if gas prices average 33% higher in 2000 than in 1999, or about $1.50 per gallon, then households will have about $50 billion less to spend on other goods and services. Adjusted for inflation, that would subtract some 0.8 percentage points from the yearly growth rate of consumer spending--not a trivial amount.
The recent jump in gas prices partly reflects a lack of inventory, and the rebound in crude-oil prices to nearly $32 per barrel in mid-June will only help to keep them high through the summer driving season. Higher energy costs will begin to hit the price indexes, beginning with the June data.
IN MAY, HOWEVER, both producer and consumer prices were well behaved. Producer prices for finished goods were unchanged from April, mainly because energy costs fell, offsetting rises elsewhere. Excluding energy and food, the core index rose 0.2% in May, lifted mainly by a big increase in car prices, as some dealers cut back on their sales incentives. Over the past year, core finished-goods prices are up only 1.4%.
Moreover, inflation pressures in the earlier stages of production are easing a bit, after building substantially during the past year. In recent months, core inflation for crude and intermediate goods has slowed.
The news from consumer prices is not as flatly reassuring as that from producer prices, but there is no sign that consumer inflation is breaking out in any surprising way. The May consumer price index rose a slim 0.1%, and the core index increased 0.2%. Again cheaper fuels lowered the total.
Still, core inflation is picking up a bit this year. Through May, the core CPI is rising at a 2.7% annual rate, up from 1.9% during all of 1999. Core service prices are leading that pickup. They are increasing at a 3.5% annual rate so far this year, compared to last year's 2.7% pace.
Although relatively tame inflation and cooler-looking data on the economy have sharply cut the chances of a June rate hike, the Fed is likely to reiterate its belief that the risks in the outlook are still weighted toward higher inflation. That will keep Wall Street from getting complacent about the need for future rate hikes--and help to prevent the markets from offsetting the tightening that the Fed has already put in place.