More Employment Weakness Likely, Lehman Brothers Says

Mon. August 04, 2008; Posted: 10:05 PM

(RTTNews) - We expect the non-manufacturing ISM index to improve slightly in July to 48.8 from 48.2 in June, say the analysts at Lehman Brothers. The index fell sharply in January (by nearly 9 points), but almost completely reversed that fall by April, when it stood at 52. The index remained essentially unchanged in May before slipping back below 50. The service sectors have generally performed better than the manufacturing sectors this year, and the tax rebates are likely to give some additional near-term support to services activity. The most recent Federal Reserve's Beige Book report suggested that demand for services was mixed, and that "most services contacts expected flat activity going forward." Employment has been the weakest component of the survey, falling throughout the year - a trend we anticipate will continue in July. Conversely, prices paid have been steadily rising over the past two years, and we expect June's record high reading of 84.5 (since the survey's inception in July 1997) to be equaled or surpassed in July.

The Federal Open Market Committee is likely to keep the Fed funds rate at 2 percent when it meets on 5 August. Recent speeches by some regional bank presidents suggest they favor higher interest rates given elevated inflation risks, but they remain in the minority. The minutes from the previous meeting in June characterized the outlook as "very uncertain," which accounts for much of the disagreement among voting members. We anticipate two dissenting votes, although there is some possibility for as few as one or as many as three.

We expect the statement to reflect a more balanced assessment of risks, similar to Chairman Bernanke's Humphrey-Hawkins testimony in mid-July, rather than the characterization of downside growth risks as "diminished" in the statement from the June meeting. The retreat of oil prices in recent weeks from their highs, and the stabilization of inflation expectations in the more recent surveys, may have eased some of the risks to the inflation outlook. Meanwhile, the Fed extended the TSLF and PDCF liquidity facilities through January 2009, suggesting that concerns about financial stability have returned to the fore. We view the Fed as extremely unlikely to raise interest rates at the same time as it invokes continuing "unusual and exigent" circumstances in financial markets.

Personal income inched up 0.1 percent in June, following a rebate-driven jump of 1.8 percent in May. Compensation rose by 0.2 percent while proprietors' income increased 0.6 percent. This was partly offset by a 1.1 percent decline in transfer payments (government social benefit payments), reflecting a smaller fiscal payout in June than in May. The government delivered a total of $27.9 billion in June versus $48.1 billion in May (in the form of transfer receipts and tax rebates). The change in the pattern of rebate payments had an even bigger effect on disposable personal income, which fell 1.9 percent after jumping 5.7 percent in May. Excluding the rebate, disposable income would have increased 0.3 percent in June and 0.4 percent in May.

Personal consumption rose by 0.6 percent in June, following a 0.8 percent increase in May. However, all of the gain was due to higher pricesâ€”real consumption actually fell 0.2 percent. As expected, the weakness was concentrated in real durable goods which fell 1.6 percent, driven lower by dismal auto sales. Nondurable goods fell 0.4 percent while services rose 0.2 percent (adjusted for inflation). Despite the fiscal stimulus, consumers are starting to pull back under the weight of tight credit, falling home values and a weakening labor market. We expect this trend to continue.

On the inflation front, the PCE deflator -- the Fed's preferred inflation gauge - moved up to 4.1 percent y-o-y in June from a revised 3.5 percent in May. Most of the stronger-than-expected reading was due to revisions to earlier months, however, which were made available in the Q2 GDP report last Thursday. On a month-over-month basis the PCE index increased by 0.8 percent, roughly as expected. The core PCE deflator rose by 0.3 percent m-o-m (0.266 percent unrounded), close to our expectations. The y-o-y rate increased to 2.3 percent from a revised 2.2 percent. On balance, this was a negative report showing a slowdown in spending and acceleration in inflation. We expect consumption will continue to weaken, especially as the rebate effect fades. The slowdown in the economy should tame inflation, bringing the core PCE deflator back within the Fed's implicit target zone by the end of the year.

Factory orders jumped by 1.7 percent m-o-m in June as the increase in oil prices during the month raised the nominal value of petroleum orders. Shipments surged 1.6 percent m-o-m on similar factors. Manufacturing inventories rose by 1.0 percent m-o-m, significantly more than the Commerce Department assumed in its advance estimate of Q2 GDP. The report therefore implies a slightly upward revision to GDP growth for the preliminary release of 0.1 to 0.2 pp.

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