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The Consumer Price Index fell 2.1% in the 12 months ending in July, the sharpest decline in nearly 60 years. Ex-food & energy, the CPI rose just 1.5% over the last 12 months. With many sectors in the economy showing signs of stabilization, the threat of outright deflation has diminished. However, the economic recovery is expected to be gradual and the Federal Reserve will want to keep its options open. Inflation is unlikely to be a problem anytime soon.
The 2.1% y/y decline in the CPI is technically “deflation” (a fall in the general price level), but it is not the type of deflation we worry about (where declines in output and prices reinforce each other in the form of a downward spiral). The y/y drop in the CPI reflects the unwinding of energy prices, which peaked a year ago.
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Core inflation has trended lower. Excluding the rise in tobacco prices this spring, the core CPI would have risen 1.2% in the last 12 months (instead of 1.5%). The moderation in core inflation is partly reflective of the glut in housing, which has reduced rent increases. The CPI measures the shelter value for homeowners, not the price of the home or the mortgage payment – to do so, the BLS constructs a rental equivalent. Owners’ Equivalent Rent (OER) accounts for nearly a quarter of the overall CPI and nearly a third of the core CPI. The OER, which is a six-month moving average (regions are divided into six panels, each sampled twice a year), rose at a 1.4% annual rate in the 12 months ending in July.
The low inflation figures would seem to give the Fed some time before they have to raise short-term interest rates – but remember, the Fed is concerned with future inflation (which it can do something about), not past inflation. Inflation is a monetary phenomenon, but the money supply measures have long been an unreliable gauge for monetary policy. Instead, the Fed looks to resource utilization measures – the unemployment rate, capacity utilization, and commodity prices.
Commodity price increases have a tough time working through to the consumer level. There are processing costs, distribution costs, labor expenses, and so on, at various stages in the production process. The exception is oil, which has a more direct and immediate impact of the prices of consumer energy goods and services. Beyond energy, import prices fell sharply in the second half of 2008, reflecting the collapse of global trade. Global trade has shown signs of improvement in recent months. Import prices are no longer falling, but they’re not putting any upward pressure on inflation.
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The Employment Cost Index rose just 1.8% in the year ending in June. Productivity growth has remained strong. There is no inflationary pressure from the labor market and elevated unemployment should continue to keep such pressures contained for a long time.
With the threat of deflation fading, the Fed does not need to buy Treasury securities. However, inflation is likely to remain low for some time, allowing the Fed to keep short-term interest rates at unusually low levels.
The headline figures from the July Employment report were better than expected, but the details remained relatively weak. Excluding seasonal adjustment issues in the auto industry, job losses remained large and widespread across industries. Yet, the pace of job destruction is not as severe as was seen earlier in the year, which is good news. It’s going to take some time before the labor market improves (as opposed to getting “less weak”), and it will be years before we get the unemployment rate back down to 5%.
Nonfarm payrolls fell by 247,000 in July. That’s the smallest decline since August of last year. The 3-month average, at -311,000, was substantially less than 645,000 average monthly job loss from November to April. However, that’s still very weak by historical standards. The July payroll decline was reduced partly by seasonal adjustment issues in the auto industry. Auto plants shut down for model changeovers in early July. Given the recent weakness in the sector, the layoffs associated with these shutdowns was a lot lower this year, adding about 50,000 to the adjusted figure.
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Still, after accounting for this quirk, the pace of job losses has slowed. As with any recession, job weakness has been more concentrated in the goods-producing sector – not just in production, but also in distribution and sales. Here too, the trend in job losses is significantly less than it was a few months ago.
Average weekly hours advanced in July, which is normally an encouraging sign for employment, as longer hours imply more work, eventually leading to new hiring down the road. However, the hours figure was also boosted by the auto seasonal adjustment (aggregate weekly hours in auto production rose 12.0%).
The unemployment rate edged down to 9.4% in July, vs. 9.5% in June. However, labor force participation dropped from 65.7% to 65.5%. Otherwise, the unemployment rate would have risen to 9.6%, as expected. To be counted officially as “unemployment” (and to receive unemployment insurance benefits in most states), one has to be actively looking for a job. Give up looking, and you’re not counted as unemployed. As unemployment insurance benefits run out, people are more likely to exit the labor force, making the unemployment rate look better. Conversely, an extension of unemployment benefits leads many to reenter the labor force. About 1.6 million are expected to exhaust their benefits by the end of the year, which would put downward pressure on the unemployment rate. If benefits are extended again, which they probably will, the unemployment rate will rise further.
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Fed Chairman Bernanke and Christina Romer, the Chair of the President’s Council of Economic Advisors have been frank in stating their expectations that the job market will likely continue to weaken even as the economy begins to recover. However, better corporate profits, arriving fiscal stimulus, and temporary hiring for the census should lead to job market improvement into the early part of next year. It’s a long road to recovery.
Real GDP fell at a 1.0% annual rate in the government’s advance estimate for 2Q09. Most of the report played out as anticipated. Consumer spending declined moderately. Business fixed investment fell further, but not nearly as much as in the first quarter. A smaller trade deficit added to overall growth. There were a couple of surprises, however. Inventories fell at an even faster pace – a contrast to expectations of a more moderate decline. Additionally, benchmark revisions revealed a steeper rate of decline in GDP over the course of 2008. The report was consistent with the view that the recession is nearing an end and the bigger inventory drawdown implies a more positive contribution to GDP growth over the next several quarters.
The advance GDP report included annual benchmark revisions (updated component data) and comprehensive revisions (changes in the methodology). GDP estimates for recent years were not much different from what was reported previously. However, figures now show real GDP falling 1.9% over the four quarters ending 4Q08, vs. -0.8% before these revisions.
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Inflation-adjusted consumer spending fell at a 1.2% annual rate in 2Q09, vs. +1.4% in 1Q09 and -3.3% over the last two quarters of 2008. A number of special factors, including lower gasoline prices, supported consumer spending in 1Q09. These did not continue in 2Q09, but there was some additional support from the fiscal stimulus package (lower tax withholding in April, stimulus checks to senior citizens in May).
Business fixed investment fell at an 8.9% annual rate in 2Q09, vs. -39.2% in 1Q09 and -19.5% in 4Q08. The second quarter drop was evenly split between business structures and business equipment & software. Firms responded to the panic of last fall by slashing capital expenditures and trimming workforces. Those efforts appear to have paid off, having helped shore up corporate profits, which in turn helps pave the way for a broader economic recovery.
Residential fixed investment (homebuilding and home improvement) fell at a 29.3% annual rate, vs. -38.2% in 1Q09. Recent signs of stabilization in the housing sector suggest that this will be less of a drag on overall growth in the quarters ahead.
Inventories fell at an even sharper pace in the second quarter, a contrast to widespread expectations of a more moderate decline. Note that the change in inventories contributes to the level of GDP. It’s the change in the change in inventories that adds to GDP growth. Inventories don’t have to rise to add to GDP growth – they only have to fall at a slower rate. Inventories will not fall forever. In fact, as inventories simply stop falling, they will add more than three percentage points to GDP growth in upcoming quarters.
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The advance GDP report was consistent with the view that the recession is nearing an end. Indeed, there have been signs of stabilization in a number of sectors. However, the recovery is expected to be relatively soft initially, with further weakness in the labor market (that is, GDP growth is unlikely to be strong enough to generate much job growth). Fiscal stimulus will have a greater impact in the second half of this year and in 2010, and with a weak labor market, the Federal Reserve is unlikely to raise short-term interest rates anytime soon.
The economy still has some financial difficulties to work through. However, conditions have improved. Liquidity is less of an issue. In fact, the Fed has seen reduced demand for many of its special liquidity facilities. Commercial real estate, which tends to lag in the economic cycle, may be an issue for many banks. However, bank lending to consumers and businesses is already becoming slightly less tight. That’s a good sign.
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