Friday, July 27, 2007

Market May Force Fed to Shift From Prices to Growth


By Rich Miller (Bloomberg)

July 27 (Bloomberg) -- The week's turmoil in financial markets casts doubt on the Federal Reserve's forecast of a gradual U.S. economic recovery in the second half, raising the odds it will need to shift its focus to spurring growth from fighting inflation.

The turbulence, as stocks suffered their worst drop in five months while corporate borrowing costs soared, threatens a triple whammy for the economy. It robs investors of spending power, makes business investment more expensive and may prolong the housing recession.

``The risks have shifted to the downside,'' said Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions.

Traders are betting that the fallout will force Fed Chairman Ben S. Bernanke and his colleagues to cut rates by the end of the year. Federal fund futures prices on the Chicago Board of Trade suggest traders see a 100 percent chance the Fed will trim its target rate a quarter-point to 5 percent at its December meeting, up from 44 percent odds two days ago.

The shift in market sentiment comes just as new evidence arrives showing the economy regained strength in the second quarter. The question now is whether that can be sustained.

Lowered Forecasts

Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts, said he'll probably lower his forecast for second-half growth. He also sees the Fed shifting rhetoric away from fighting inflation as growth slows.

The government reported today that the economy grew at a 3.4 percent annual pace in the second quarter after expanding 0.6 percent in January to March.

The consensus forecast, inside and outside the Fed, calls for growth to keep up for the rest of the year at a pace of 2.5 percent to 3 percent.

``We have a healthy economy in the U.S., transitioning from an unsustainable level of growth to one that is much more sustainable,'' Treasury Secretary Henry Paulson said in an interview yesterday.

As recently as May, traders were certain of a rate cut by the end of 2007, only to be dissuaded by continued growth in employment and comments by Fed officials that recession isn't likely. Some economists said traders may again be getting ahead of themselves.

``The Fed should be pretty happy with these numbers,'' said David Wyss, chief economist at Standard & Poor's in New York, referring to the second quarter figures for gross domestic product. ``I don't think the Fed does anything this year.''

The trouble-free second half that economists forecast rests on moderate consumer-spending growth, stronger business investment and a diminishing drag from the housing market. Market turbulence poses a risk to all three.

Consumers Suffering

Consumers are already suffering from rising gasoline prices and sagging home values. The average price of regular gasoline shot up to $3 a gallon last quarter, from $2.34 in the previous three months, according to the American Automobile Association.

Home values in 20 U.S. metropolitan areas fell by the most in at least six years, making it harder for homeowners to borrow against their equity to fund purchases.

Auto dealers are bracing for the fallout. Sales last month were the lowest for June since 1997, says Autodata Corp. of Woodcliff Lake, New Jersey.

``There's real stress in this economy beyond just housing,'' Michael Jackson, chief executive officer of Fort Lauderdale, Florida-based AutoNation Inc., the largest U.S. auto retailer, said in an interview yesterday.

Stock Market's Drag

Economists had been counting on rising stock prices to help offset the hit to household wealth from the depressed housing market. That bet is off if stocks continue to decline.

``The stock market may bounce right back, but if it doesn't, you won't have stock prices offsetting the drag from housing,'' said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York.

Companies are also feeling a pinch as borrowing costs rise. The extra yield investors demand to own investment-grade corporate bonds instead of U.S. Treasuries jumped July 25 by the most for a single day in five years, according to index data from Merrill Lynch & Co.

More than 40 companies have reworked or abandoned bond offerings in the past three weeks as investors, stung by losses from subprime mortgages, balked at absorbing more risky debt.

The tougher borrowing environment threatens to curb capital spending at a time when companies are already showing signs of turning more cautious on investment.

Non-defense capital goods orders excluding aircraft, a proxy for future business investment, fell 0.7 percent in June, after decreasing 1.5 percent in May.

Home Sales

Housing looks even worse. Sales of new homes declined 6.6 percent in June while building permits fell to their lowest level in a decade. The slump has left seven homebuilders nursing losses of $1.80 billion.

Angelo Mozilo, chief executive officer for Calabasas, California-based Countrywide Financial Corp., the biggest U.S. mortgage lender, said July 24 he expects ``difficult housing and mortgage market conditions to persist'' through year's end.

As financial turbulence spreads, Treasury securities benefit as investors seek the safety of risk-free debt. Treasury yields yesterday fell the most since 2004.

That should help lower mortgage rates. The benefits to housing though will be limited, Crandall said, because lenders are tightening standards so much that some prospective home buyers can't get credit.

``Housing has a long way to go, the consumer is slowing and capital spending is only growing at a moderate pace,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``The idea that we're going to get a pickup in the second half is wishful thinking.''

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