Monday, 10 September 2007

Fed rate cut looks imminent, recession probably not yet

The United States economy lost jobs in August. This makes it likely that the Federal Reserve will cut interest rates in September.

On 7 September, the US Labor Department reported that non-farm payroll employment fell by 4,000 in August. This was the first decline since August 2003. In addition, the number of jobs gained in June and July were revised lower by a cumulative 81,000.

The weak employment report sparked fears of a recession and caused stock markets and bond yields to plunge. On the day of the report, the Standard & Poor's 500 Index fell 1.69 percent to 1,453.55. The 10-year US Treasury yield fell 15 basis points to 4.37 percent and federal funds futures show traders fully pricing in a rate cut by the Federal Reserve in September.

The picture of a deteriorating employment situation is supported by other reports to varying degrees. The household survey data released by the Labor Department on the same day showed a loss of 316,000 jobs in August. A report from ADP earlier last week showed that private employers added just 38,000 jobs in August. Other data from the Labor Department showed that initial claims for unemployment insurance were higher in August compared to July, having risen to a weekly average of 325,750 for the four weeks ending 1 September from an average of 306,000 for the four weeks to 28 July.

Despite the market reaction, however, it is probably too early to say that the US economy is headed for a recession. One month's payroll number, especially one that is very likely to be revised subsequently, is seldom very significant. Furthermore, even with the decline in August, employment remained higher than in the second quarter, suggesting that the US economy probably still continued to expand in the third quarter. And the reported 19,000 fall to 318,000 in initial claims for unemployment insurance for the week ending 1 September provides some hope that the situation may have stabilised recently.

If the US economy is not already in recession, then leading economic indicators show that it is not likely to fall into one very soon, although growth is likely to slow. The Conference Board's US leading index increased by 0.4 percent in July and by 0.1 percent in the six-month span through July. The Organisation for Economic Co-operation and Development's (OECD) composite leading indicator (CLI) for the US was unchanged in July while its six-month rate of change decreased.

The surveys of purchasing and supply executives by the Institute for Supply Management (ISM) also tell similar stories. The ISM's PMI for the manufacturing sector fell to 52.9 in August from 53.8 in July, indicating continued but slower growth in the sector. The ISM's index of business activity in the non-manufacturing sector was unchanged at 55.8 in August.

The high-frequency Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) was also up in the week ended 31 August but the annualised rate of growth declined to 0.6 percent, the lowest growth rate since November 2006, from 1.3 percent in the prior week. Lakshman Achuthan, managing director at ECRI, had this to say: "With WLI growth at a 43-week low economic growth prospects have clearly dimmed, but not yet in a recessionary way."

So the indicators show that the US economy is very probably not facing imminent recession. However, there has also clearly been some loss of momentum in economic growth even though the economy has probably not felt the full impact of the recent tightening in credit markets, which could bode ill for the economy further out in time.

Therefore, the market expectation for a cut in the federal funds rate this month looks realistic. What remains uncertain is how far the Federal Reserve needs to cut to avoid or, if already unavoidable, to roll back a recession.

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