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Rate increases stay in the slow lane

By Greg McBride, CFA

The Federal Reserve's rate-setting committee reiterated a desire to raise interest rates at a "measured" pace in its June 30 post-meeting statement. Several pieces of recent economic data -- from manufacturing indexes, the employment report, and a gauge of the servicing sector -- show the economy is not at immediate risk of overheating and could allow the Fed to administer rate hikes at a gradual pace. This was generally received as good news in financial markets, and has ramifications for consumer interest rates, as well.

The manufacturing sector of the economy has long been under the microscope in an attempt to gauge the health of the overall economy, even as the transition to a service-based economy continues. It was the manufacturing sector that first exhibited signs of a slowdown in 2000, and was late in showing any substantive recovery.

National, and even regional, manufacturing indicators continue to garner increased attention. The Chicago Purchasing Managers' Index released June 30, just hours before the Fed statement was issued, fell well short of expectations. The index came in at 56.4, above the 50 threshold that indicates expansion, but below the consensus forecast of 64.0. The theme would be repeated in the days to come.

While the Chicago PMI is a regional indicator of manufacturing conditions in the Midwest, it is released one day before the national index as tabulated by the Institute for Supply Management. The ISM release is the big kahuna as far as manufacturing indicators are concerned, and it is accordingly given significant attention. So the fact that the ISM also fell short of expectations -- albeit slightly -- was not something to go unnoticed.

In the aftermath of a Fed interest rate hike, the manufacturing indexes were likely in the shadows of the week's more notable events. Aside from the scheduled Fed meeting, the other notable event was the July 2 release of the monthly employment report. While the employment report has been supplanted by inflation indicators as the most significant data on the economic calendar, expectations for a continued strong run of job growth were nevertheless quite high. While the unemployment rate remained at 5.6 percent, the growth in payrolls is the real focus of any employment report. In contrast to prior months, but in keeping with the recent trend of economic releases, the results fell short of expectations -- well short. The initial report for June indicates that 112,000 jobs were added, less than half of estimates for 250,000 new jobs. Also, the April and May numbers were both revised lower.

The disappointing report of job growth got the attention of financial markets in a way the previous days' manufacturing releases had not. The idea of the Fed acting aggressively to keep the economy from accelerating suddenly seemed premature. Long-term interest rates dropped sharply as financial markets readjusted expectations of how high and how quickly interest rates would rise. Mortgage rates dropped nearly one-fifth of one percentage point that day.

Further evidence to support the Fed's case of measured interest rate hikes came on July 6, when a gauge of the larger service sector of the economy also came in well short of expectations. Again, the number itself was very positive, just not as good as what had been expected. With much squeamishness about rising interest rates, good economic news can often be seen as bad and bad economic news can often be seen as good. The recent run of mediocre, but ultimately disappointing, economic data corroborates the pledges of a patient Fed. In addition to producing a sharp decline in mortgage rates, it is also holding back the progress in CD yields, if only temporarily. The average five-year CD yield dipped from 3.6 percent to 3.59 percent this week.

If there is one factor that could quickly reverse expectations, it is inflation. Two coming reports both bear watching: the often-delayed Producer Price Index scheduled for July 15 and the Consumer Price Index on July 16. The Fed attributes recent price increases to "transitory factors," a feeling that the phenomenon is temporary and is not the beginning of a troublesome trend. Any surprises here could lead to an equally rapid about-face in rate hike expectations.




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