Reports Illustrate Fed's Challenge

Inflation and housing data give a mixed picture of the economy. So despite the Bernanke-inspired rally, interest rates aren't safe just yet

As Federal Reserve Chairman Ben S. Bernanke began his semiannual monetary-policy testimony before a Senate panel on July 19, two economic reports for June released before his appearance illustrated the tricky task the central bank head faces. The U.S. consumer price index (CPI) data for the month turned up the inflation heat for Bernanke, as it implies the need for a tightening at the August Federal Open Market Committee (FOMC) meeting. But a weaker report on housing starts spotlighted a slowing U.S. economy.

Where do these two reports leave the Fed? Initial market reaction to Bernanke's written testimony—namely, rallies in stocks and bonds—indicated that Wall Street thought that Bernanke's testimony was less hawkish than expected. ( will publish a separate analysis of Bernanke's July 19 appearance.) But we don't think it takes the Fed out of play at its August policy meeting. Additionally, it will be incumbent on upcoming data to get the Fed to pause its rate hikes in coming months.

Here's a look at the reports in question:

CPI rose 0.2% in June, and the core rate, which excludes food and energy, was up 0.3%, after respective gains of 0.4% and 0.3% in the previous month. On a year-over-year basis, the headline index accelerated to 4.3% from 4.2%, while the core climbed to 2.6% from 2.4% previously. The latter is on the hotter side of expectations, and brings this measure above the Fed's perceived 1.5%-2.5% "comfort zone."

Energy prices fell 0.9% on the month, with gasoline prices down 1.0%. The housing index edged up 0.2% (0.3% in May) while the owners-equivalent rent measure was up 0.4% (0.6% in May). A 0.8% rise in tobacco added to the strength in the core.

The strength in the CPI year-over-year measures for June roughly parallels the pattern in the July 18 producer price index (PPI) report for the month, as well as the strength seen in the June trade price report released July 14. If Bernanke is to reference his 3-month and 6-month core CPI inflation figures in his testimony, he will have gains of 3.6% and 3.2%, respectively, which clearly exceed the 2.6% 12-month rate. Four consecutive monthly core gains of 0.3% also leave a noticeable strengthening trend. The personal consumption expenditures (PCE) chain price and core figures, both overall and market-based, are now each more likely to print at 0.3% than 0.2% in June, which will also be troublesome for the Fed.

Housing starts fell 5.3% to a 1.850-million-unit annual rate in June, giving back some of May's 6.6% gain to a 1.953-million pace (revised from 1.957 million). Permits dropped another 4.3% for a fifth straight monthly decline. Single family sales were down 6.5%, while multifamily sales were up 0.3%.

The starts figures for June were weaker than expected, as the sector continues to drop back from the frothy levels of 2005. The weakness in recent months has been geographically broad-based, and includes a drop in permits to levels consistent with starts at the low end of the 1.8 million-1.9 million range.

"Under construction" figures remain stronger than the aggregate figures, as do completions, which may suggest a greater drop in speculative permit and start activity that builders may or may not intend to build near-term depending on market conditions and financing availability. With still-strong construction-material prices and uncertain demand, builders are giving back some of their risk-taking ways of 2005.

We will continue to assume a 0.3% gain in construction spending in June, and a 10% rate of real contraction in the residential construction component of second-quarter GDP. The drop-back in housing starts in the March-June period from lofty readings early in the year have closed the gap between generally robust production indicators for the housing sector at the start of the year and the sharp first-quarter moderation in sales and prices in real estate markets.

Overall, still-low interest rates despite Fed tightening, a solid economy despite a slowdown, and continued solid growth in income and profits are providing support for the housing sector in 2006, the slowdown notwithstanding. Yet a cooling in the production data for the residential sector is now clearly under way, and was particularly abrupt in the second quarter, just as the drop in sales activity was sizable in the first. The sector is continuing to adhere to the "soft landing" scenario for the year despite the second-quarter adjustment.

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