Alex and Dave's Economic "Fore-guess"

Farm Business Management Update, August/September 2006

By Alex White (axwhite@vt.edu), Instructor, Agricultural Finance and Small Business, and David M. Kohl (sullylab@vt.edu), Professor Emeritus, Department of Agricultural and Applied Economics, Virginia Tech.

What kind of a story we can tell about the U.S. economy? Before we go too far, be forewarned that it may not be the happiest story ever told. To be honest, we’re a little concerned about the state of the economy over the next 6 to 9 months. We’ve broken the main indicators into 3 groups – the Good, the Bad, and the Ugly.

The Good

Purchasing Managers Index is still strong at 54.7 but lower than its recent high of 57.3 (April 2006).

• The retail industry is still expecting strong sales but maybe not as strong as they thought a few months ago. The relatively low unemployment rate in the U.S. may be the underlying reason for the relative strength in this index.

U.S. unemployment rate is decreasing, from 4.8% in February to 4.6% in June

• More people in the workforce leads to increased disposable income and usually an increase in consumer spending. Furthermore, to expand production businesses have to pay higher wages to attract competent workers – this increase in wages is passed along to consumers in the form of higher prices. We use 4.5% as the support level for the unemployment rate – anything below that tends to be inflationary in nature.

The Bad

CPI is increasing at an annual rate of 4.3%

• Partially due to increased energy prices, partially due to increased earnings in the work force. Households will start to notice higher prices at the grocery store, the utility companies, and the gas pumps. A natural reaction is to reduce consumption expenditures and the purchase of big-ticket items, especially if wages aren’t increasing in step with expenses.

Capacity Utilization Rate is increasing, up to 82.4% from 80.9% in January

• U.S. manufacturers are trying to expand production and are utilizing more of their production capacity. This change leads to increased labor costs, which are passed along to consumers in higher prices. We tend to get a little concerned when this index approaches 85%, as it tends to signal an overheating economy.

Gold prices are increasing, from $570/oz. in January to $634/oz. in June

• Traditionally, gold is considered to be an inflation hedge. Increased demand for gold is driving up the price. Why is there increased demand for gold? Investors are feeling the inflationary pressures as well, so they are starting to park their money in gold.

U.S. T-Bill yields are starting to fall

• To protect their funds, investors are looking to fixed income investments, such as T-bills and bonds. As demand for bonds increases, the yield of those same bonds decreases. Foreign investors are also a part of the increased demand for U.S. T-bills – worldwide inflation has investors pulling in their horns and getting more conservative. Also the geopolitical risk in the Middle East has individuals seeking safe havens in investments.

The Ugly

Higher oil prices

• Oil prices are up around $68/bbl, driving up the cost of petroleum and related products. This increase has a relatively large impact on household spending. We hate to think what heating oil prices might be this autumn and winter! As consumers spend more on gasoline and heating, they will probably start to spend less on housing and big-ticket items (durable goods). Then, inventories start to pile up, jobs tend to be cut, and a nice little recession might just be in the works.

Core Inflation Index is creeping up – from 2.1% in January to 2.6% in June

• Core inflation does not include energy or food costs. So households will be spending more of their disposable income on “necessities” besides energy and food. Households are already spending more than they are earning as evidenced by the negative national savings rate. The target for the Fed is around 2%. As the Core Inflation Index climbs above 2%, watch for further increases in the Federal Funds Rate and other interest rates.

The yield curve is flattening out even more

• The spread between short-term and long-term bonds is narrowing, indicating that funds are being shifted from short-term to long-term bonds. The spread is narrowing as increased demand for long-term bonds drives down the yield of the bonds, relative to T-bills. This narrowing spread indicates that the conservative bond market is looking to lock-in relatively higher long-term rates in anticipation of lower yields on alternative investments – a strong indicator of an upcoming recession.

So what does this mean to us?

We can expect the Fed to continue to raise interest rates to try to rein in these inflationary pressures. What outcomes are we seeing?

• There is a 60% probability of interest rates reaching 5.50% by year-end and a 20% to 25% chance they will reach 5.75%. Of course, any major disruption of the economy or world events would spur the Federal Reserve to lower rates, so there is a 10% to 15% chance of declining rates.

The Prime Interest Rate is creeping up

• The prime rate has increased from 7.5% in January to 8.25% in June, causing an increase in the cost of borrowed funds for businesses and households. Increased cost of funds should lead to decreased demand for big-ticket items, as well as a disincentive for businesses to expand their production capabilities. An increase may lead to a lack of growth in the overall economy or possibly recessionary times.

Housing starts are decreasing

• Housing starts are down from 2.3 million (annual rate) in January to 1.85 million in June. The construction industry is sensing the inflationary pressures and is starting to slow down the production of new houses. Now, think about the snowball effect – less new houses leads to a slow down in work for carpenters, plumbers, electricians, lenders, insurance agents, landscapers, etc. Less new houses also leads to less purchases from hardware stores, furniture stores, lawn/garden stores, etc. So lower housing starts doesn’t just impact the construction industry – it filters throughout the entire economy. For example, Applebee’s, Outback Steakhouse, and other mid-market restaurants have seen a 2% to 3% decline in sales for the first time.

30-year mortgage rates are decreasing

• With higher consumer prices, higher housing costs, and a concern about the collapse of the housing bubble, consumers are not running to banks looking for long-term mortgages. As demand for these mortgages decreases, the “price” (interest rate) of the mortgage falls. In certain areas of the country like California and Florida, home and condo prices are already declining. Some owners of higher-end homes are offering a new BMW as an incentive to sell their home.

Some indications suggest that a recession is not out of the question. Regardless, this is a time to be more defensive in your spending and purchasing – time to start monitoring your household budget more closely, think about postponing some big-ticket purchases, and start to build up your savings accounts. “But Alex,” you say, “if everyone begins to reduce their spending the economy will start to slow down – you are adding to the probability of a recession by recommending a defensive position!” My point is that if you are facing a cash flow problem, now is the time to get control of your spending and build your liquidity (savings accounts).

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