The week's economic reports

Disappointing retail sales and a report on new home construction showing even further declines in homebuilding highlighted the week's economic reports. Stocks and bonds ended with the S&P 500 Index down 5.4 percent to 1,325, now down 9.8 percent for the year, and the yield of the 10-year U.S. Treasury note fell 16 basis points to 3.66 percent.
Retail Sales: Slowing consumer spending is now a significant concern for the U.S. economy as overall retail sales declined 0.4 percent in December after a downwardly revised gain of 1.0 percent in November. Note that the November-December data was influenced by a relatively early Thanksgiving holiday and heavy retailer discounting that came earlier than usual during the Christmas holiday shopping season.

Even the combined November-December increase of 0.6 percent, however, failed to keep pace with rising consumer prices which gained 1.1 percent over the same period. Gains in retail sales driven by higher prices (and not by a higher quantity of goods) sold was the story for all of 2007 as retail sales gained 4.1 percent for the year and the consumer price index rose by the same amount.

When considering that the government's measure of inflation understates price increases (perhaps by a wide margin), 2007 was more likely a year of declining retail sales in real (inflation adjusted) terms.
Gasoline station sales actually declined in December, down 0.2 percent following a 0.4 percent increase in November, as prices at the pump moderated somewhat. Building material sales fell 2.9 percent, clothing and sporting good sales dropped 2.0 percent, and consumer electronics fell 1.9 percent. For a look at how purchases at home improvement stores such as Lowes and Home Depot were supportive of retail sales in recent years, see last Tuesday's A subprime reading on retail sales.

Overall, this is just one more piece of evidence that consumer spending is slowing. With prices now plunging for both real estate and equity markets along with increasing talk of recession by the mainstream media, where, more than three-quarters of respondents in a recent survey believed the U.S. economy is either already in a recession or about to experience one in the next 12 months, the slowdown in retail sales may be about to intensify.

Consumer Prices: With a slight easing of energy prices during the December reporting period, headline inflation moderated somewhat, up 0.3 percent after the 0.8 percent surge in November.

For the entire year of 2007, overall inflation rose at a rate of 4.1 percent, the biggest increase in 17 years, though this development was not nearly the issue that many in the mainstream media made of it.
Higher annual inflation rates were seen as recently as late-2005 in the aftermath of Hurricanes Katrina and Rita as well as in mid-2006, but it just so happens that the current 4.1 percent year-over-year reading comes during the month of December when everyone can look at the year-over-year rate and easily answer the question, "What was the rate of inflation during 2007?"

Recall that in late-2006, energy prices plunged and many other consumer prices fell back as well, leading many to think that rising consumer prices were just a hurricane induced anomaly that began in 2005 and was exacerbated when the Israel-Lebanon war broke out during the summer of 2006. More recent evidence, however, points to not only higher energy prices for the foreseeable future, but also higher food prices.

Excluding food and energy, the core rate of inflation rose 0.2 percent in December after a 0.3 percent increase in November. For the entire year of 2007, core inflation registered 2.4 percent and even Fed economists are beginning to see the diminishing value of this measure of inflation now that it has diverged from overall inflation for such a long period of time amid increasing complaints that it has little to do with rising prices in the real world.

Housing Starts: The news continues to get worse for homebuilders as housing starts dropped 14.2 percent in December and permits for new construction fell 8.1 percent.

On a year-over-year basis, housing starts were down 38.2 percent and permits declined 34.4 percent as the doldrums in home construction dragged on for a second full year as shown in the chart below. From early 2006 levels, housing starts and permits for new construction have declined by 56 percent and 52 percent, respectively.
During the month of December, declines were led by a 30.8 percent plunge in the Midwest followed by a 25.8 percent drop in the Northeast and a 19.6 percent drop in the West.

The National Association of Homebuilders Housing Market Index showed no signs of improvement in January remaining at all-time lows (below the levels seen in the early-1990s), so, there is little reason to think that things might improve from this point.

While the outlook could indeed darken further, there is some level of homebuilding that is required to keep pace with demand arising from population growth and the renewal of the housing stock, but, with inventory that remains bloated and with prices continuing to plunge, there's no telling where that level might be.

Philadelphia Fed Survey: While regional manufacturing reports generally don't merit much attention, last week's survey of the Philadelphia area manufacturing sector was notable in that the index plunged some 19 points to what is clearly an area associated with recessions, as shown in the chart below courtesy of the always-excellent blog Calculated Risk.
Prior to the reading of -20.9 in January that came on the heels of an already weak -1.6 in December, this index had not been more than a few tenths of a point into negative territory (indicating overall contraction) since the last recession in 2001. New orders plunged to -15.2, its first negative reading in 15 months, and current shipments fell 17 points, from +15.0 to -2.3. Weakness was also seen in inventories that fell to -11.7 and delivery times that dropped to -3.1 while prices continued to rise, from 36.5 in December to 49.8 in January.

Remember that this is a fairly volatile series that is subject to heavy revisions, however, the implications of the January data are clear and will not likely be revised away - there are signs of a major manufacturing slowdown in the mid-Atlantic area.

Summary: While moderating energy prices caused both consumer prices and producer prices to fall within the expected range, there were many other surprises last week, notably, an even worse outlook for homebuilders and more evidence of an American consumer in the process of pulling back.

The Philadelphia Fed Survey was probably the most shocking of all the new economic data, however, it is important to note that the sharp decline in Philadelphia area manufacturing was not confirmed in the New York area report released earlier in the week. The much broader ISM Manufacturing Index, which plunged in December, will now be even more anxiously awaited when it is released during the last week of January along with a raft of other important economic data.

The Conference Board's Leading Economic Indicators fell for the third consecutive month which, despite its dubious construction and the limited respect it gets from financial market analysts, does not bode well for future economic growth.

There were, however, three bright spots last week - solid Treasury International Data Flows, declining weekly jobless claims, and a small rebound in consumer sentiment.

A strong $90.9 billion inflow of capital in November still shows that the U.S. can attract foreign investors, however, there remain serious questions as to how long this will continue. As for the sharp decline in weekly jobless claims to just 301,000 after recent months where 340,000 has been the norm, it appears that an odd side-effect of 2008 seasonal adjustments during the most heavily adjusted month of the year will reveal this to be nothing but false hope for the labor market. Weekly claims in the weeks ahead and the labor report on February 1st will likely prove last week's drop to be a one-off event.

Finally, the small rebound in consumer sentiment was due to a small decline in gasoline prices - consumer sentiment and prices at the pump track each other very closely.

The Week Ahead: The holiday-shortened week ahead will be extremely light on economic data with Thursday's report on existing home sales from the National Association of Realtors' the only significant news.