Fed Put Inflation Skepticism Above Credit Concern (Update5)

By Scott Lanman

Aug. 28 (Bloomberg) -- Federal Reserve officials put aside concerns about the rising cost of credit at their Aug. 7 meeting because they weren't convinced a slowdown in inflation would last, minutes of the gathering said.

Ten days before the Fed was forced to cut a key interest rate, the Federal Open Market Committee was given lower growth forecasts by staff economists, and noted that ``strains in financial markets'' jeopardized the expansion. Further turmoil might require a response, the panel acknowledged, though that sentiment didn't appear in the statement after the meeting.

``Policy makers would need to watch the situation carefully,'' the central bank said. ``For the present, however, given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern.''

The records don't include the Aug. 16 emergency video conference when the FOMC reversed course and lowered the discount rate, saying that risks to economic growth had ``increased appreciably.'' The benchmark lending rate was kept unchanged at 5.25 percent.

Policy makers underestimated the contagion from subprime credit markets to less risky borrowers, the minutes showed.

``Funding had become more costly and difficult to obtain for riskier corporate borrowers, but there had been little net change in the cost of credit for investment-grade businesses,'' the Fed said.

Borrowing Costs

The yield premium investors demand to buy investment-grade corporate bonds compared with benchmark Treasury securities had jumped almost a quarter of a percentage point in the two weeks before the Aug. 7 meeting. The gap widened to 1.47 percentage points on Aug. 21, the highest in four years, Merrill Lynch & Co. data show.

``The mistake the Fed made is that the market was clearly coming unglued prior to the meeting,'' said Scott Minerd, who helps oversees $24 billion of stocks and bonds at Guggenheim Partners LLC in Santa Monica, California. By maintaining the inflation bias, ``it telegraphed to the market that this Fed was really out of touch with how severe the credit dislocation was.''

At the same time, the minutes showed officials may have given more weight to economic-growth risks than their statement suggested.

JPMorgan View

While the Aug. 17 statement acknowledged such dangers ``increased somewhat,'' the minutes go a step further by alluding to the possibility of an interest-rate cut and noting that policy makers would monitor the situation, Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York, said in a research note.

Stocks extended declines after the report. The Standard & Poor's 500 index closed down 2.4 percent at 1,432.36 in New York.

Chairman Ben S. Bernanke may offer insight on the Fed's current assessment of the economic outlook when he speaks on Aug. 31. Bernanke will address the Kansas City Fed's annual symposium in Jackson Hole, Wyoming, traditionally attended by most Fed governors and district-bank presidents.

As of three weeks ago, policy makers ``expected a return to more normal market conditions, but recognized that the process likely would take some time,'' the minutes showed. They noted that ``mortgage loans remained readily available to most potential borrowers,'' and the ``supply of credit to finance real investment did not appear significantly diminished.''

Traders and economists expect the Fed to lower its benchmark rate at or before the next meeting, on Sept. 18, according to futures traded on the Chicago Board of Trade.

Inflation, Growth

As policy makers gathered three weeks ago, reports showed inflation had slowed while economic growth had accelerated in the second quarter. Gross domestic product rose at a 3.4 percent annual pace in April to June, the fastest in more than a year.

On inflation, ``meeting participants believed that the readings for the past few months likely had been damped by transitory factors and did not provide reliable evidence that the recent level would be sustained,'' the minutes said.

Officials kept the target rate for overnight loans between banks, the main policy tool, at 5.25 percent for a ninth straight meeting. While the Fed conceded that ``downside risks to growth have increased somewhat,'' citing tumult in financial markets, officials reiterated in the Aug. 7 statement that inflation was the ``predominant'' policy concern.

Assessment Faulted

That disappointed some investors and observers, who argued a balanced assessment was warranted by increasing signs of stress in financial markets, sparked by an exodus from securities backed by subprime mortgages.

The S&P 500 Index fell 5.7 percent from its record high on July 16 through Aug. 6. The premium on investment-grade corporate bond yields compared with benchmark Treasuries on July 25 jumped the most in five years, data from Merrill Lynch & Co. showed. Sam Molinaro, the chief financial officer of Bear Stearns Cos., where two hedge funds failed in June, said Aug. 3 that the fixed-income market was in the worst shape in 22 years.

Fed officials ``still saw moderate economic expansion in coming quarters as the most likely outcome but that the downside risks to growth had increased,'' according to the Aug. 7 minutes.

Fed staff economists said the U.S. economy would grow at a ``somewhat'' slower pace in the second half of 2007 and in 2008 than previously anticipated. They cited figures released July 27 showing the economy expanded an average 3.2 percent from 2004 through 2006, revised down from 3.5 percent. That prompted the staff to judge the economy's speed limit had fallen.

Cash Injection

Three days after officials met, the Fed pumped $38 billion into the banking system -- the most since the 2001 terrorist attacks -- in its first effort to contain the credit crunch. The effort failed to quell the upheaval, as the amount outstanding of commercial paper, a key short-term financing tool for some finance companies, slid the most in six years.

The following week, with borrowing continuing to dry up, the Fed took steps unprecedented in recent years: it cut the rate on direct loans to banks and issued a new outlook that recognized economic risks had risen ``appreciably'' and omitted any mention of inflation.

Minutes of the FOMC's Aug. 16 videoconference will be included in records of the Sept. 18 meeting, to be released Oct. 9. The Board of Governors' separate decision to cut the discount- lending rate to 5.75 percent from 6.25 percent will be detailed in another report, around Oct. 16.

Japan's Industrial Production Probably Slipped After Earthquake

By Lily Nonomiya

Aug. 29 (Bloomberg) -- Japan's industrial production probably slipped in July after an earthquake disrupted output at Toyota Motor Corp. and Honda Motor Co.

Production fell a seasonally adjusted 0.3 percent from June, according to the median estimate of 42 economists surveyed by Bloomberg News. The Ministry of Economy, Trade and Industry will release the report at 8:50 a.m. on Aug. 31.

Riken Corp., Japan's largest maker of piston rings, shut a factory for a week following the July 16 quake, cutting off supplies for automakers and forcing them to temporarily close plants. Rather that dwell on July's output decline, the Bank of Japan is expected to focus on whether the U.S. housing-market crisis will affect demand for Japanese goods in coming months before deciding to raise interest rates.

``The slip in production will be modest and won't be looked at that closely,'' said Naoki Iizuka, senior economist at Mizuho Securities Co. in Tokyo. ``The BOJ needs to confirm that the subprime issue isn't hurting demand before it can raise interest rates.''

Separate reports on the same day may show consumer prices fell for a sixth month in July, unemployment stayed at a nine- year low and household spending gained for a seventh month.

Global stocks plummeted and the yen surged this month after losses on U.S. subprime mortgages drained liquidity from markets. Central banks in the U.S., Europe and Japan pumped more than $350 billion in the banking system and the Federal Reserve cut the rate at which it lends to banks to prevent further turmoil.

Subprime Effect

Bank of Japan Governor Toshihiko Fukui and his policy board voted 8-1 to keep the benchmark overnight lending rate unchanged at 0.5 percent last week. The bank needs to watch how the subprime collapse might affect the U.S. and global economies, Fukui told reporters after the decision.

Investors are scaling back expectations for a September rate increase. At 8:38 a.m. today they saw a 30 percent chance of a move at the Sept. 18-19 meeting, down from 36 percent at the end of last week, according to Credit Suisse Group calculations based on interest payments.

Riken had to halt production last month after the magnitude 6.8 quake in Niigata prefecture damaged its engine-parts plants. Honda, Japan's second-largest carmaker, cut output 11 percent, the biggest drop in two years. Bigger rival Toyota pared manufacturing 8.4 percent, also the largest decline since 2005, the companies said on Aug. 28.

Automakers pledged to increase production this month to make up for the cuts in July, though slower U.S. consumer spending may force them to scale back those plans.

U.S. Demand

``We're already seeing that U.S. demand is stalling,'' said Seiji Adachi, a senior economist at Deutsche Securities Inc. in Tokyo. ``Exports are going to take a hit if weaker consumer spending translates into poor auto sales and demand in Japan isn't going to be strong enough to offset that.''

Exports, which drove more than a third of Japan's growth last year, are already showing signs of cooling. The trade surplus narrowed for the first time in six months in July as overseas demand for automobiles slowed.

Shipments abroad were a drag on economic growth in the second quarter after leading the expansion in the first three months of 2007. The economy grew at an annual 0.5 percent in the April-June period, slowing from 3.2 percent in the first quarter.

Meanwhile, consumer prices excluding fresh food fell 0.1 percent in July from a year earlier, a sixth monthly drop, according to the median estimate of 40 economists.

An increase in the tobacco tax in July 2006 offset the thrust from recent gains in gasoline prices, said Takuji Aida, chief economist at Barclays Capital in Tokyo.

``If gasoline prices stay around current levels, core prices will probably turn positive in the fourth quarter,'' Aida said. ``We still see a chance the Bank of Japan will hike the key rate in September or October.''

Fukui repeated on Aug. 23 his argument that consumer prices will resume rising over the long term as the economy expands.

The following table shows forecasts for the percentage changes in July factory production from the previous month and a year earlier.

U.S. Economy: Confidence Weakens by Most in Two Years (Update4)

By Bob Willis

Aug. 28 (Bloomberg) -- Americans' confidence dropped by the most since Hurricane Katrina two years ago, in the first report to reflect the credit-market turmoil in August.

The survey underscores the Federal Reserve's concern that risks to the six-year economic expansion have ``increased appreciably.'' Separate figures showed home prices suffered the biggest decline since at least 2001.

The New York-based Conference Board's index retreated to 105 this month, from 111.9 in July. Economists had forecast a reading of 104, according to a Bloomberg survey. Property values in 20 metropolitan areas decreased 3.5 percent in June from a year earlier, according to a report today by S&P/Case-Shiller.

``Consumers are obviously paying attention to what's going on and are a little worried by it,'' said Adam York, an economist at Wachovia Corp. in Charlotte, North Carolina. ``We are not expecting them to spend the way we thought they would a few months ago.''

Wachovia economists accurately predicted the confidence figure for this month, which declined from a near six-year high in July.

The housing recession is making it harder for Americans to tap home equity to finance the spending that accounts for 70 percent of the economy. A slowdown in hiring and slimmer pay raises may further weaken consumer sentiment and buying power.

``The things that are weighing on the consumer are getting pretty imposing,'' said Gregory Miller, chief economist at SunTrust Banks Inc. in Atlanta, which last week announced job cuts. ``The equity that he's generated in his house over the years has been undercut'' by falling prices.

Stocks Weaken

Stocks declined for a second day after Merrill Lynch & Co. analysts said tighter credit markets will hurt bank earnings. The Dow Jones Industrial Average fell 280 points, or 2.1 percent, to 13,041.85. Treasury bills rose for the first time in six days.

Fed policy makers believed ``strains in financial markets'' jeopardized the expansion and further turmoil might require a response, according to the minutes of their Aug. 7 meeting issued today. Still, they put aside concerns about the rising cost of credit because they weren't convinced a slowdown in inflation would last.

The Case-Shiller report also showed that prices nationally dropped 3.2 percent in the second quarter from a year before. That compares with a 1.6 percent year-over-year drop the prior quarter.

Survey Details

The forecast drop in confidence reflected the median estimate in a Bloomberg survey of 73 economists from an originally reported July reading of 112.6. Estimates ranged from 99 to 108.

The Conference Board's measure of present conditions fell to 130.3 from 138.3 in July. The gauge of expectations for the next six months dropped to 88.2 from 94.4.

The share of consumers who said jobs are plentiful declined to 27.5 percent in August from 30 percent in July. The proportion of people who said jobs are hard to get increased.

The proportion of people who expect their incomes to rise over the next six months slipped to 19.1 percent from 19.2 percent. The share expecting more jobs fell to 13 percent from 13.8 percent.

The Conference Board's index tends to be more influenced than other sentiment gauges by consumer attitudes about the state of the labor market, economists said.

Other confidence measures have also showed declines.

Other Measures

The Reuters/University of Michigan preliminary index of consumer sentiment fell to its lowest in a year this month, it reported Aug. 17.

The ABC/Washington Post Consumer confidence index fell to minus 20 in the week ending Aug. 19, its lowest level since October 2005.

Plunging stock prices in the wake of a global credit crunch helped undermine consumer sentiment. The Standard & Poor's 500 index fell as much as 9.4 percent from its July 19 historic high to Aug. 15, when it started to recover.

The labor market, while resilient, is showing signs of weakening. Unemployment rose in July to 4.6 percent from 4.5 percent, still near the lowest in six years. Job growth slowed to 92,000 last month from 126,000 the prior month, down from last year's average of 189,000 a month. Growth in hourly earnings slowed to 3.9 percent in July from a year earlier, down from a nine-year high of 4.3 percent in December.

Stable Spending

Consumer spending growth will probably average a 2.5 percent pace in the second half of 2007, unchanged from the first six months, according to economists surveyed by Bloomberg News. That's down from a 3.4 percent pace in the last half of 2006.

The worst housing recession in 16 years is weakening consumer spending and costing jobs. Sales of previously owned homes fell in July to the lowest level in almost five years, while the glut of unsold homes rose to a 16-year high, the National Association of Realtors reported Aug. 27.

As global credit markets seized up on concerns over the pricing of funds backed by subprime mortgages, the Fed on Aug. 17 announced a surprise cut in the discount rate. The Fed said downside risks to growth had ``increased appreciably,'' in a statement interpreted by investors as signaling a move away from its tightening bias.

The credit crunch is costing jobs. San Diego-based Accredited Home Lenders Holding Co. on Aug. 22 said it would close more than half its operations and fire about 1,600 people.

Bank Firings

Two days before, Atlanta-based SunTrust Banks Inc. said it planned to cut about 2,400 employees this year as profit from retail and commercial banking declines.

Weaker home prices translate into slowing car sales, said Michael Jackson, chief executive officer of AutoNation Inc., the largest U.S. auto retailer, said in a July 26 interview from Fort Lauderdale, Florida.

``There is a direct link between housing and the distress it creates around consumers for big-ticket items,'' said Jackson.

Still, falling gasoline prices have provided consumers with some relief. Prices of regular unleaded gasoline fell from as high as $3.05 a gallon last month to $2.78 a gallon on Aug. 22. Prices are still up 30 percent from their lows for 2007 of $2.14 a gallon on Jan. 24.

China Inflation, Currency Pose Problems, Central Banker Says

By Zhang Dingmin

Aug. 28 (Bloomberg) -- A Chinese central bank official said a stronger currency, growing trade surplus and accelerating inflation are potentially ``destabilizing'' to the world's fastest-growing major economy.

Zhang Tao, deputy international department director of the People's Bank of China, said today in Beijing at the Third Beijing-Tokyo Forum that failure to deal with them may lead to an economic ``turning point.''

China's economy expanded 11.9 percent in the second quarter, the fastest in more than 12 years. Central Bank Governor Zhou Xiaochuan has raised interest rates four times this year, trying to curb price growth, ballooning asset values and overcapacity in manufacturing.

U.S. lawmakers have pushed China to allow faster gains in its currency, which they say is undervalued to give Chinese exporters an unfair advantage. The renminbi, as the currency is also known, has gained 9.5 percent since the end of the fixed exchange rate in July 2005.

``We want the renminbi's exchange-rate system to be more flexible and more responsive to market demand and supply,'' Zhang said today. ``But the exchange rate doesn't determine everything.''

China's trade surplus surged 67 percent in July from a year earlier to $24 billion, helping send the country's foreign- exchange reserves to $1.3 trillion. Consumer prices rose by 5.6 percent, the highest rate in more than 10 years as money supply climbed 18.5 percent, the most in more than a year.

The government is setting up a new investment company that will buy $200 billion of reserves from the central bank to seek higher returns. China wants to ``explore a road different from the traditional way'' in managing the reserves, Zhang said without elaborating.