Federal Reserve Chairman Ben Bernanke has made it clear that any decision to reduce the pace of monetary stimulus through its quantitative easing program is dependent upon the strength of the incoming economic data. Based upon what we have seen recently, it seems unlikely that a tapering of QE3 is imminent, according to Ameriprise Financial.
The latest news from the manufacturing sector is a case in point. According to the Institute for Supply Management (ISM), manufacturing activity in the U.S. shrank in May for the first time since last November.
This continues the pattern of decelerating activity that began in February. During the first quarter, the ISM index averaged a reading of 52.9, comfortably above the 50 reading that divides expansion from contraction.
Through the first two months of the second quarter, including the contraction in May, the index has averaged a barely expansionary reading of 50.1. And notably, the individual components of the May report were uniformly weak, especially new orders and production.
The national report follows regional reports that were also weak, with the notable exception of the Chicago region, which showed surprising strength, perhaps due to healthy automobile sales and the rebound in housing.
Some of the blame for the slowdown in manufacturing is being attributed to the spending cuts from the sequester, as well as economic weakness overseas. Both are expected to diminish as headwinds to activity in the second half, but that remains to be seen. Manufacturing activity in both China and the Eurozone continued to contract in May as well.
Next significant data point
The next significant data point will arrive on Friday with the May employment report. The consensus is calling for the creation of approximately 175,000 private sector jobs. This would match the gains in April, but fall short of the average first quarter gain of 212,000 per month, as well as the average monthly gain of 232,000 in last year's fourth quarter.
Job gains in May are expected to result in an unchanged unemployment rate of 7.5 percent. Such a result would hardly seem to qualify as the substantial improvement in the labor market that the Fed would like to see.
In addition, the four-week moving average of initial weekly jobless claims has risen in each of the past four weeks.
Even the most recent news on the housing market, a real bright spot in the current expansion, has been choppy lately.
Housing starts plummeted in April, while sales of existing homes were mildly disappointing. Building permits were strong, raising expectations of firming activity ahead, but mortgage rates have also risen recently in response to concerns about the Fed's intentions.
The Mortgage Bankers Association reported that mortgage applications fell last week for the third straight time, after the average rate on a thirty-year fixed-rate conforming mortgage climbed to 3.90 percent, its highest level in a year.
Most of the decline was attributable to refinances, and applications for mortgages to purchase did rise 2.6 percent. But that increase follows two weeks of declines.
Too soon to declare victory
None of this is intended to suggest that the economy is truly deteriorating. On the contrary, there is every chance that the second half of the year will be better than the first. Rather, it is to suggest that the conditions for declaring victory and beginning the withdrawal of QE3 seem decidedly premature.
San Francisco Fed President John Williams said on Monday that with continued improvement in the economy QE3 could be adjusted lower as early as this summer and the program could be ended by year-end. For that timetable to happen, it would appear that activity needs to accelerate starting now, if it is to be considered a sustainable trend before summer comes to an end. That is possible, but whether it is likely is debatable.
The bond market adjusted its own expectations after the release of the May manufacturing report on Monday. Prior to the announcement, the ten-year Treasury note was yielding 2.17 percent. Immediately afterward, its yield plunged to 2.07 percent, before recovering to 2.12 percent at midday.
The dollar was also slightly weaker, as the prospects for slower money creation were diminished. Stocks were flat in response to the report, uncertain whether economic weakness is a good thing, since it makes it less likely the Fed will adjust policy anytime soon, or whether it is a bad thing, inasmuch as it bodes ill for corporate earnings.
How and when the Fed adjusts its policy will come down to data. And lately, that data has been mixed at best.
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