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Economic Update

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Written by Jane Caron, CFA, Chief Economic Strategist

Former Fed Chairman Greenspan unsettled the investor community last quarter when he said that this economic cycle is “long at the tooth” and that the likelihood of a recession is probably around one-third. Greenspan, despite being at odds with Chairman Bernanke and the majority of Wall Street economists, had quite an impact on the markets. He clearly has not lost his clout.

Investors are divided about the direction of economic growth and monetary policy. Economic data released during the first quarter, which was decidedly mixed, offered no resolution to this debate. The FOMC added more uncertainty by adopting a neutral policy at its March meeting. This move was designed to give the Fed more flexibility and to avoid giving forward rate guidance. For the quarter, Treasury rates covered a wide range as investors vacillated between pricing in and pricing out expected cuts.

Wall Street economists slightly lowered their full-year growth forecasts during the quarter, but few changed horses. Those expecting an official rate increase argued that recent weakness reflects a mid-cycle slowing, while those anticipating rate cuts warned of something more sinister. Nearly all economists expect core consumer inflation to remain above the Fed’s purported 1–2% comfort zone; thus, economists looking for rate cuts believe that the Fed will not feel bound by this soft target (see Figure 1).

Our base case forecast is that economic growth will slow from 3.3% in 2006 to 2–2.5% in 2007, while core personal consumer expenditure inflation will be little changed at 2.2%. Such an environment will not force the Fed to ease policy, but we believe that the Fed will cut interest rates before year-end to reduce the risk of a more serious downturn.
Our view is based on the fact that the economy is vulnerable to an exogenous shock; growth is lopsided, with the consumer being the sole source of strength. We are reluctant to forecast a downturn in consumption, and we are not calling for one. As we have warned before, one should never underestimate the willingness of Americans to spend when they have money in their pockets or access to credit—they currently have both. But the risk is that an event might transpire that upsets consumption. Indeed, there are a number of risks lurking.

The housing and energy markets are the two leading sources of risk. So far, weakness in housing has not undercut consumption growth, but plummeting new-home sales and rapid subprime foreclosure rates point to further weakness in residential construction and ancillary services related to homebuilding (see Figure 2). Existing-home sales and other housing data offer signs of stabilization, but national home prices have probably not reached bottom. Consumers have so far weathered this highly anticipated and well-publicized event, but the risks of contagion have not dissipated.

Higher commodity prices, particularly food and gas prices, do not bode well for consumption either (see Figure 3). Personal income growth was robust in the first quarter, allowing consumers to maintain spending habits, but inflation could accelerate in the second quarter and weigh on consumption. In fact, our energy analyst, Ken Frey, warns that national gasoline prices could surpass last year’s highs, while our retail analyst, Stefanie Bachhuber, warns that food prices are surging.

Another source of risk is the continued sluggish pace of capital goods spending. In the past, such weakness has been a harbinger of a weaker labor market as corporate managers retrench. Most economists, ourselves included, believe that capital goods spending will pick up in coming quarters, but if the slowdown in corporate earnings growth prevents this from happening, we will have to revise our general outlook. Indeed, slower economic output coincident with strong payroll growth in the first quarter implies a larger-than-expected jump in unit labor costs. This does not bode well for corporate earnings growth.

The remaining risks are less clear cut. The current FOMC is less seasoned than the old FOMC, and it could unwittingly make a policy mistake. Fiscal policy mistakes are also possible, particularly now that we have an emboldened Congress with an agenda that may require revenue increases. Congress, moreover, has already moved in the direction of protectionist policy, which could invite tit-for-tat actions that hurt consumers more than they protect manufacturers. Weather could also be a factor this year, with another big hurricane season predicted. Geopolitics, of course, could send confidence indices plummeting if an event takes place. And stumping for the next presidential election could prove more depressing than uplifting for investors.

All of the aforementioned risks suggest to us that fixed income markets will be more volatile this year as investors weigh and reweigh risks relative to returns. Indeed, we think investors will spend an increasing portion of their time thinking about risk. Similarly, we think the FOMC will be discussing risk scenarios in coming meetings and will reach the conclusion that moderate policy easing will reduce downside risk for economic growth without significantly increasing upside risk to inflation, a trade-off that seems worthwhile in this increasingly uncertain environment.