Outlook and Market Review - Second Quarter 2006

Summary: 

Advanced reports show that the economy grew at a 2.5% real rate in the second quarter of 2006 following a revised growth rate of 5.6% in the first quarter. A preliminary analysis of inventory data and construction growth suggests that the 2.5% growth rate is likely to be revised upward. Nevertheless, growth slowed in the second quarter of 2006 as expected. The unemployment rate, which has been steadily falling over the last few years, inched back up to 4.8% on the heels of weaker than expected job growth. The housing market continued to cool off and auto sales took a big hit in July. The inventory to sales ratio held steady but the dollar value of inventories reached a relatively high level. Any sales slump will result in an immediate curtailment of factory orders in the third quarter.

Inflation pressures continue to build on several fronts. The seasonally adjusted consumer price index increased 4.1% on a year-over-year basis in June. Core consumer prices, excluding more volatile food and energy components, increased 2.69% on a year-over-year basis in June, exceeding the 2.5% upper limit of the Fed’s comfort zone. The producer price index for intermediate goods grew at a 7.2% rate for the year ending in June. Producers have not fully passed on the intermediate good prices to consumers due to a favorable profit cycle and low unit labor costs. The potential for significantly higher inflation exists if corporate profits weaken. Signs of increases in unit labor costs are already developing. Employer costs increased .9% in the second quarter, surpassing analyst expectations. On a year-over-year basis, employer costs increased 3% in the second quarter following an increase of 2.8% in the first quarter. The higher trend in labor costs suggests a potential for more wage-induced inflation pressure in the third quarter.

The economy continues to perform within or close to acceptable ranges of growth and inflation. The recent unexpected increase in the unemployment rate will moderate inflation expectations somewhat and weak jobs data prompted many analysts to lower the chances for another fed fund rate hike at the August 8 FOMC meeting. Nevertheless, a careful analysis of the data suggests that the biggest threat to the economy continues to be inflation. Given the problem of slowing inflation once it is firmly rooted in the economy, a move of the fed fund rate to 5.5% is warranted. Central banks in Japan and the Euro zone are also likely to move to higher interest rates. China is likely to allow an appreciation of the yuan in response to their over-heated economy. Global inflationary pressures should not be ignored for long.