Inflation Data Right on Target
A lack of surprises in the economic news produced a fourth straight week with little volatility in mortgage markets. The highly anticipated Consumer Price Index (CPI) inflation report matched the forecasts exactly for both the headline number and the core rate, which excludes the volatile food and energy components. While the 2.8% annual rate of increase in core CPI was above the Fed’s comfort zone of 1.0% - 2.0% and marked a five year high, these elevated levels had already been priced in by investors. The response to the news was actually slightly positive as the lack of bad news was enough to produce a small rally in mortgage markets on Friday, leaving the net change for the week close to zero.
An offshoot of the consensus matching CPI report was that investors had no reason to alter their expectations for Fed monetary policy. Any rate change at the FOMC meeting next Wednesday would be a huge shock. Financial markets currently indicate a small likelihood for one more 25 basis point rate hike prior to the end of the year, before the implied odds shift in favor of a rate cut in 2007. In the past, the outlook has shifted dramatically many times, though, and investors will remain data dependent along with the Fed.
In another take on the prospects for the economy, the latest National Association for Business Economics (NABE) outlook showed expectations for slightly weaker economic growth and slightly stronger inflation. They predict that the Fed will hold rates steady until late in 2007 when the next move will be a rate cut. The survey placed the chance of a recession by the end of 2007 at 25%, with energy prices, interest rates, and home prices posing the biggest risks to the economic expansion. Overall, their economic outlook changed little from the prior survey in May.
For the week, average 30-year fixed rates increased by 0.01%, as measured by the Fannie Mae Required Net Yield. In other news, a major government agency released its comprehensive quarterly update on the housing market. OFHEO reported that US home prices rose 1% in the second quarter of 2006 and were 10% higher than one year earlier. This represented the slowest quarterly rate of increase since 1999. The director of OFHEO attributed the slowdown to most of the usual factors including higher interest rates, a drop in speculative activity, and rising inventories of homes.
Also Notable:
• The August core rate of inflation came in at the highest level in 5 years as
expected, but the trend is heading down
• Many major US equity markets are approaching multi-year high levels
• Oil prices fell to $63 per barrel, down from a recent high of $78 per barrel
Week Ahead
Without a doubt, the main event next week will be the FOMC meeting on Wednesday. Although investors believe that the chance of a rate hike is nearly zero, the message from the Fed will still be vitally important, and the statement which will accompany the announcement will be scrutinized carefully. At this point, there are two minority camps looking for support for their views: those who think that another rate hike this year is not out of the question and those who feel that the first rate cut will take place in the not too distant future. In any case, the statement from the Fed may not change much from the prior meeting.
Two big economic reports on Tuesday will make up the bulk of the data next week. After last week’s tame Consumer Price Index (CPI) report, mortgage markets will have smooth sailing if the Producer Price Index (PPI) also lacks any unexpected bad news on inflation. PPI would probably have to miss by a wide margin to have much impact. Important housing market data will also be released that day in the Housing Starts report. The magnitude of the slowdown in that sector is a major issue for the health of the economy.
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