Housing Cools, Inflation's Up

The latest CPI and a Fed report suggest housing's not improving, and inflation is too high for comfort. Still, the Fed's expected to sit tight

Two economic reports released before the start of Wall Street trading Oct. 17 more or less confirmed the market's expectations on consumer-level inflation: running ahead of the Federal Reserve's comfort zone, and housing: still lousy. The market appeared to take those releases in stride, with equities trading higher for much of the Oct. 17 session thanks to some favorable corporate earnings news.

But the release later in the day of a somewhat downbeat Federal Reserve Beige Book report on economic conditions in recent weeks brought gloomy sentiment to the surface, with major stock indexes turning mostly lower while Treasury prices climbed and yields fell.

Here is Action Economics' rundown of the Oct. 17 reports:

Consumer Price Index

The consumer price index (CPI) rose 0.3% in September, with the core rate, which excludes food and energy prices, up 0.2% as expected, following a 0.1% headline decline in August, and a 0.2% increase in the core. As suspected, energy prices paced the headline strength, rebounding 0.3% after cumulative declines of almost 5% over the prior three months (the year-over-year pace is now up 5.3% after a 2.5% decline).

Gas prices were up 0.4% on the month after declines of nearly 8% over the prior three months, and up 8.7% year-over-year. Food and beverage prices rose 0.5% in September. Transportation and apparel rebounded 0.1% and 0.3%, respectively. Housing costs were up 0.3%.

The report also revealed the expected September year-over-year inflation bounce to 2.8% from the 2% August low point. We should reach a 3.5% rate in October even if we only see a 0.2% monthly headline rise in that month's CPI. The core year-over-year rate remained at 2.1%, which is just above the Fed's 2% "soft" target for this measure.

Over the coming quarter, the full array of U.S. inflation reports should continue to show solid headline year-over-year gains even if core figures appear more contained and commodity prices stall at current high levels, due to hard comparisons.

The September CPI mix, with energy prices boosting the headline, paralleled the more dramatic September pattern in the producer price index. In the PPI report, a big 1.1% headline surge was accompanied by a restrained 0.1% core increase.

We still expect a 0.3% gain in the September personal-consumption expenditure chain-price index, an inflation measure favored by the Fed, with a 0.2% core increase.

If downside economic risks diminish through the fourth quarter, as we expect, policymakers may resume the debate from earlier this year of how sustainable low-core inflation rates are if headline inflation remains stuck well in excess of the Fed's objectives.

Housing Starts

Housing starts plunged 10.2%, to a 1.191 million-unit annual pace in September, from a revised 1.337 million rate in August. Permits fell 7.3% to a 1.226 million pace. Single family starts fell 1.7% while multifamily starts were down 34.3%. Home completions fell 8.2%, while houses under construction dropped another 1.4%.

The starts drop in August from the already-low 1.337 million pace in September leaves the figures well below the 1.37 million to 1.63 million range of the prior nine months, with the big two-month drop attributable to financial turmoil. And the September drop in permits to a 1.226 million rate suggests a decline in starts in October as well, which we will peg at a 1.17 million rate.

We saw a sizable bounce in starts in the Northeast of 45.4% following the 35.3% drop in August, and this sharp swing may reflect the concentrated jumbo loan problem of August that unwound to a large extent in September. In the West we saw a 10.1% September drop following last month's 14.4% decline. The Midwest and South, which actually posted gains in August, showed drops of 28.4% and 11.7%, respectively. The mix of swings in September brought all the regional figures back toward a more balanced pattern of weakness, vs. the coastal pattern in the last report.

Starts under construction revealed smaller declines, however, with a 1.2% drop in September that followed the bigger 1.6% decline in August, due largely to growth in the multifamily segment, where activity actually bounced 1.6% in September after a smaller 0.7% drop in August, which followed a gain of 1.2% back in July. This segment actually grew at a 3.7% rate in the third quarter, leaving weakness concentrated in the single-family figures where the contraction reached a 21.9% rate. This pattern in the under-construction figures is at odds with the headline-starts decline, which was dominated in September by a big multifamily drop.

Given the stronger under-construction figures, we will continue to expect a 20% rate of decline in residential construction in both the third and fourth quarters, following the 11.8% rate of decline in the second quarter. We continue to expect existing home sales to fall by 3.6% to a 5.3 million rate in September, while new home sales fall by 5.7% in September to a 0.75 million pace. We still expect construction spending to fall by 0.2% in September, following the 0.2% August bounce, alongside the 0.1% bounce in September construction hours-worked that followed the big 0.8% August decline.

Beige Book

The Fed's anecdotal report said economic activity continued to expand in September and early October, but the pace of growth "decelerated" since August. Growth was similar to that seen in the prior report in September in seven of the Fed districts, but was slower in five, including Cleveland, Dallas, Kansas City, Mo., Richmond, and San Francisco—remember it was Cleveland, Kansas City (Mo.) and San Francisco Fed officials who requested a 50 basis-point discount rate cut in September. Meanwhile, consumer spending expanded, but it was uneven, and was slower in September and early October vs. August.

Several manufacturing and service firms also reported weaker domestic demand, though it was offset by strong global markets. Residential real estate continued to weaken while commercial markets remained solid. Job growth eased in some regions but labor shortages were reported in others.

There was moderate upward pressure on wages. Upward pressure on input costs was reported by most Fed districts, due to strong demand domestically and internationally. Energy and raw material prices were also factoring in. But the ability to pass on higher input costs remained mixed.

Overall this is a more cautious, slightly more downbeat report than seen previously. The Beige Book clearly leaves the door open for a Fed easing at the FOMC's "Halloween" meeting on Oct. 31, though the bulk of incoming economic data continue to suggest that Bernanke " Co. will stand pat, with an ongoing greater focus on downside economic risks than on upside inflation risks.

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