March 14, 2008

• Weakness in U.S. data seal the deal on additional Fed rate cuts
• Central banks increase liquidity injections in efforts to stave off further deterioration in credit markets

With oil prices pushing past $110 barrel, a very soft retail spending report and news of the collapse of a major U.S. hedge fund, the timing of Friday’s consumer price report could not have been better. While U.S. Treasuries rallied on the expectation that softening inflation seals the deal on at least another 50 basis points in rate cuts when the Fed meets on Tuesday, the response in equity markets was crowded out by yet more bad news from financials - this time with Bear Stearns announcing it was seeking emergency funding to avoid a major cash crunch. In Canada, on the other hand, signs that the domestic economy continues to fire on all cylinders emerged from another strong housing market report. And in a timely speech on financial market turbulence, Bank of Canada governor Mark Carney noted that while better risk management practices have shielded Canadian financial institutions from the worst of recent U.S. outcomes, we are not immune to problems south of the border.

U.S. retail sales show consumer on the brink

If any further proof was needed that U.S. consumers are buckling under the weight of a slowing job market, falling home prices and rising energy costs, February’s retail sales report may just have provided the smoking gun. Total retail sales fell 0.6% in the month with declining purchases of durable goods from automobiles to home furnishings and electronics and appliances responsible for much of the drop. Perhaps even more telling than the month-to-month decline is that nominal retail sales are now up only 2.6% from a year ago. With CPI inflation still running above 4% this implies that in real terms sales are likely now declining. With the housing market showing few signs of bottoming and continued problems in credit markets, the outlook for consumer spending will remain grim over the next several months. And while the rebate checks, being mailed out in May and June of this year, will provide some support, slackening prospects for income and household net-worth suggest that the windfall will be saved or used for debt reduction rather than towards priming the economy through spending.

One concern surrounding aggressive past and future Fed easing has been elevated consumer prices. Given the situation facing consumers, Friday’s inflation reading could not have found a better time to surprise on the downside. While consensus had been calling for a 0.2% increase in the headline reading and 0.3% in core inflation, both headline and core remained steady in the month. Though the reading was unambiguously positive, the U.S. is not out of the inflation woods yet. Inflation expectations have risen significantly in the last several months with the market-based measure (based on the spread between inflation protected and nominal Treasury securities) showing 2.8% on a year-over-year basis, its highest reading since 2004.

Net-trade improves in Canada, deteriorates in the U.S.

This week also featured international trade reports for January for both Canada and the U.S. In Canada, the report was modestly positive as exports rebounded by 3.6% after falling 3.8% in December. Unfortunately, price effects were responsible for much of the gains and in real terms exports showed a negligible 0.3% gain, while imports fell 0.4%. Real exports of automotive products continued to plummet in the month, falling 14.7% - the largest decline in over a decade. With the U.S. consumer’s spending on durable goods stalling, automotive exports are unlikely to see much improvement in the near future. Exports in the U.S., on the other hand, continued to leverage the weak U.S. dollar to reasonably strong gains in January. However, as imports were also up and are significantly larger than exports, the net result was a deterioration in the trade balance. Nonetheless, net trade is likely to be the one source of strength to the U.S. economy over the next several quarters. But, given that it represents a small piece of the overall U.S. economy net export growth is unlikely to be able to fully offset the considerable weakness in domestic demand.

With problems in financial markets percolating and continuing to threaten outcomes in the real economy, the Federal Reserve (in coordination with a number of central banks, including the Bank of Canada) made another attempt to counter mounting liquidity problems by announcing a further expansion in its term lending facilities. The Fed announcement made available $200 billion in 28-day Treasury Bills in exchange for a widened list of collateral including agency-backed mortgage securities. Prior to the announcement short term lending markets looked to be freezing up and spreads between Treasuries and inter-bank lending rates had risen several basis points on the heightened level of risk aversion. The Fed’s action should help to shore up short term lending markets and will also take pressure off dealers holding mortgage securities backed by government sponsored enterprises. Recently investors have pushed up yields on agency-backed securities, which given the complete drying up of the subprime mortgage market, remain one of the last sources of mortgage credit available. As the Fed has recognized, if conditions in housing markets are ever to improve these sources of funding must remain available. Though these moves generated an immediate rise in equities and sell-off in fixed income, developments later in the week served to largely unwind these gains.

Carney emphasizes the importance of effective risk management

Bank of Canada governor, Mark Carney also had liquidity on his mind this week and in a speech in Toronto commented extensively on recent market turbulence. Along with a discussion of the main causes of the current credit crunch - mispricing of risk, inadequate transparency and misaligned incentives - he spent a significant amount of time discussing the official sector’s role in cleaning up the mess, most specifically by ensuring adequate liquidity exists in financial markets. In his comments, the governor emphasized the need for adequate liquidity management but also reiterated the central bank’s commitment to broaden the ability of the central bank to support market liquidity. On the broader subject of monetary policy, contagion from the U.S. will likely continue to call for more monetary stimulus and we continue to expect an additional 50 basis points in easing at each of the next two Bank of Canada fixed announcement meetings.

James Marple, Economist
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