PRINTMarket Update -- Economic Comment
May 21, 2007
We are rethinking our fundamental view on the economy. The latest jobless claims data showed claims remaining below 300,000 for a second consecutive week, a level consistent with a sharp rebound in net job growth in May to 150,000 from April's sluggish 88,000. If realized, such strength would confirm the economy has emerged from its soft patch.
While it is no secret that the economy slowed markedly in the first quarter, probably to a growth rate of less than 1% once the data are fully revised, it is becoming evident that the slowdown was mostly isolated to corrections in the housing and auto sectors. The rest of the economy remained strong. As these corrections wind down, the economy could be back to 3% GDP growth rates by the end of the year.
A few weeks ago, we got the first real hints that the economy is set to accelerate. New orders for durable goods in March picked up markedly, pointing to a rebound in manufacturing production following several months of depressed output. April manufacturing production data and May regional manufacturing surveys confirmed improvement. A sharp rebound in motor vehicle production is largely responsible, but improvement is also occurring outside of autos. Conditions are certainly not booming, but it appears that problems in the capital goods sector are being worked out.
While the inventory corrections in autos and other parts of manufacturing are nearly complete, the housing market continues to have a surfeit of homes for sale. Fortunately, the worst news appears to be behind us. Housing starts and permits are still falling, but the pace of the decline has slowed materially, which means construction spending will be less of a drag on GDP growth going forward. One risk is that the recent increase in U.S. borrowing rates will weigh on home sales. With real interest rates increasing worldwide, there is a risk that interest rates will continue to rise domestically, impairing the recovery.
At this point, we have not changed our GDP forecast, which looks for growth to average 2.5% for the rest of the year, but we see upside risk to this forecast. The reason we have not changed our forecast is because the May payroll report has yet to be released and could end up coming in short of the 150,000 implied by jobless claims. Also, the economy, despite showing promise, is currently in a weakened state that leaves it vulnerable to an exogenous shock. Such a shock could be in the form of a major weather event, geopolitical problems, a further sharp run up in gasoline or oil prices, or any other event that causes consumers to tighten their purse strings. We are certainly not capable of predicting a shock, so our point is simply that the economy is vulnerable.
We have not changed our monetary policy forecast either. It assumes no change in policy this year but contains a bias that the Fed is more likely to ease than tighten. This bias is due to the risk of a shock. Households are already struggling with record high gasoline prices, high food costs and headwinds from the correcting housing market, so it might not take much of an event to tip the cart. The goods news is that the Fed has scope to ease policy if necessary because core inflation has improved. Headline inflation is still elevated, but this should not prohibit the Fed from easing as long as inflation expectations remain steady. So far, inflation expectations have reacted little to gyrations in price levels; Americans appear to have a lot of faith that inflation will not get out of hand.
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