Data May Spur Fed to Maintain Rate Pause

A slide in housing, and lower-than-expected producer-price growth, may boost the central bank's yen to keep interest-rate hikes on hold

As the Federal Reserve prepares for its Sept. 20 policy meeting, two key data releases on Sept. 19 may have solidified the central bank's inclination toward a continuing "pause" from its two-year string of rate hikes. The U.S. producer price index (PPI) and housing starts reports for August have further alleviated pressure on the Fed to take a tough tone in deliberations at the Federal Open Market Committee (FOMC) meeting.

Here is Action Economics' view of each:

Producer price index: The August overall PPI rose 0.1%—well below economists' median forecast of +0.3%—while the core index, which excludes food and energy prices, fell 0.4% (median +0.2%). Energy prices rose 0.3%, despite a 2.2% drop in gasoline prices, as electricity prices and natural gas both rose more than 1%. Food prices surged 1.4%, which was likely related to the drought over the summer.

The big news in the core was another big drop in vehicle pricing, with cars off 2.6% and trucks down 3.4%. The recent commodity price correction may also be getting some traction. Note that we will expect a huge energy-related drop in the PPI in September, which should leave the September headline in the -0.5% area.

For PPI, the surprisingly sharp 0.4% core drop in August allowed for the big decline in the year-over-year measure to 0.9% from 1.3%, thanks mostly to the big vehicle-price declines, which are often volatile in August. But the party for the PPI core measure will prove short, as the post-Katrina year-over-year comparisons over the next four months will be difficult, and the year-over-year rate will rise back to the 1.5% area by November even if core prices rise only 0.2% in each of the next three months—which they will easily do if vehicle prices post the usual bounce.

We still expect the personal consumption expenditure chain price figures, an inflation gauge closely followed by the Fed, to reveal a 0.1% headline gain and 0.2% core gain in August that will leave respective year-over-year gains of 3.0% and 2.5%. This is just below the comparable CPI figures of 3.8% and 2.8%. All of these measures are about 0.2%-0.5% above where the FOMC would like them at the Sept. 20 meeting, and it will be quite a few months before these figures have potential to drop back toward the Fed's comfort zone.

Housing starts: The U.S. housing starts figures for August revealed an even bigger drop than expected, falling 6.0% to a 1.66 million unit annual pace, with fairly even geographic dispersion of the ongoing correction for this sector. And the modest 2.3% decline in permits suggests activity will moderate further to the 1.65 million area in September.

The decline in starts proved bigger than the reported 3.7% drop in the Mortgage Bankers Assn. (MBA) purchase index on the month, but consistent with the ongoing freefall in the National Assn. of Homebuilders (NAHB) composite index through September to a 30 reading.

We will not revise our current forecasts of an August drop of 3.0% in new home sales to 1.04 million, and a 1.2% drop in existing home sales to 6.25 million. It is unclear where the bottom will be in the housing market correction to the frothy performance over the prior three years, though the bounce in the MBA purchase data in September, and lack of interest rate pressure in the markets since July, is encouraging.

Our third-quarter-GDP (gross domestic product) residential construction forecast will remain at -17%, but our construction spending forecast for August has been lowered to unchanged.

Summing up: We expect the FOMC to leave rates steady at 5.25% at the Sept. 20 meeting. The PPI data will help the Fed adopt a more comfortable inflation spin, though the good news on core inflation in the report will be short-lived, and the markets are increasingly compartmentalizing their concerns about housing. The Fed will still need three or four months of comfortable core figures from the consumer price (CPI) and personal consumption expenditures (PCE) indexes to temper the upside bias to policy risk.

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