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Economic Update

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Written by Jane Caron, CFA, Chief Economic Strategist

Recap—Fed Policy Has Worked Well So Far
The close of the second quarter marked the one-year anniversary of a 5.25% federal funds rate, a policy that worked well. During the last year, real GDP growth slowed to a moderate rate, and core inflation slipped back into the Fed's comfort zone of 1%–2% (see Figure 1). When the Fed stopped tightening a year ago, inflation was high and still rising, while the economy showed signs of overheating. The housing market was entering a downturn, however, so Fed policy makers gambled that they could step aside.

One year later, the economy is in decent shape. The housing market is still in a downturn, but real GDP growth should average 2.75% in the final two quarters of 2007, and it should grow between 2.5%–3% next year. Annual core PCE inflation, currently at 1.9%, should end the year little changed before drifting higher in 2008. In such an environment, the Fed can leave policy unchanged.

This placid forecast rests on some key assumptions. First, we assume that the housing market correction will remain a sideshow. We also assume that the current reduction in global liquidity will not turn into a credit crunch. Furthermore, we assume that oil prices will continue to trade in a $60 to $80 range. These are very reasonable assumptions, but the impact will be significant if any of them prove incorrect.

Economic data in the second quarter showed marked improvement compared to first-quarter reports. The ISM manufacturing index rebounded 6.7 points to 56.0 in June, up from the weak January reading of 49.3. Similarly, the June ISM nonmanufacturing index also rebounded to its highest level in more than a year at 60.7, compared to 52.4 in March. Strength today contrasts with earlier weakness caused by slowing demand and bloated inventories, and this raises the question of whether strength will continue once inventories are rebuilt. Nonetheless, the rebound in the ISM indices have displaced earlier concerns that the economy is in a downturn (see Figure 2).

Commercial construction also accelerated in the second quarter because of broad-based demand for hotel rooms, office space, power plants, etc. Real spending on commercial structures probably increased at an annualized pace in excess of 15% in the second quarter, a very impressive yet unsustainable pace. Real capital goods spending also improved in the second quarter but remained muted near a 4% rate. This sector should show more strength in the quarters ahead.

Employment growth, the linchpin of the economy, remained steady in the second quarter, with the average monthly payroll gain near 150,000 and the unemployment rate little changed at 4.5%. Most economists, including us, thought employment growth would be slower in 2007 in light of residential construction layoffs, but such expectations have not been fulfilled. Instead, income growth has been strong, and this bodes well for sustained consumption growth.

View—Focus on Housing Sector and Global Liquidity
The one sector of the economy that gives us pause is the housing market. Home sales peaked in the fourth quarter of 2005, and building starts peaked a few months later. Since then, declines have been precipitous: starts have fallen to mid-1990s levels; new home sales are back to 2001 levels; existing home sales are back to 2003 levels. Inventories of homes for sale have surged to levels not seen since the 1990–1991 recession. National home-price inflation, which has already decelerated sharply, appears set for a period of no appreciation or even deflation. The risk of a deeper downturn is significant, particularly if the labor market falters.

The subprime mortgage market is feeling serious pain. Loose lending standards have allowed many people to enter into loans that were beyond their servicing capability. Foreclosures are now increasing rapidly as adjustable rate mortgages reset and owners discover that they cannot sell their houses or refinance without difficulty. The reset calendar is ominous for the next few quarters, and this bodes poorly for the sector (see Figure 3).

Problems in the subprime mortgage market are not spilling over to the prime market or the general economy, but they are causing reverberations in the finance world. Prices for subordinated tranches of bonds linked to subprime mortgages are down sharply, and this has led to margin calls and forced selling. Such routs occasionally happen in financial markets; they often amount to nothing more than tempests in teapots despite the severe level of angst. This may prove to be the case this time, but we worry that something more sinister is afoot. Perhaps we know too much about this event, given that we have been studying the collateral under these bonds for years.

Even if subprime problems fade away unnoticed—which is not our expectation—we think that this event is indicative of the more widespread problem of adjusting to a world of lower liquidity (defined as the availability of funds for investment or consumption). A few years ago, the Fed, along with other major central banks, brought interest rates down to unusually low levels in hopes of stimulating demand. This liquidity rush, coupled with the global savings glut, soaring commodity demand, and the advent of new financial instruments, helped stimulate global markets and economies. Indeed, it became a virtuous circle of easy money, strong growth, low volatility, and soaring returns. The problem is that traditional fixed income yields fell to such low levels that investors lost touch with conscionable levels of risk as they stretched for yield.

Starting last year, the tide of global liquidity began to turn. At first, the decline was hardly perceptible, but it became noticeable in 2007 as global central bankers pushed borrowing rates up to levels that are no longer accommodative. Additional policy tightening will push global interest rates into restrictive territory. With inflation at the upper end of most central bankers' tolerance zones, such tightening is likely.

Microliquidity also started to decline this year, as evidenced by events in the subprime, bank loan, and high-yield markets. Microliquidity is dependent on financial participants' willingness to commit capital and assume risk. Increasing volatility, as we saw in the second quarter, tends to weigh heavily on the creation of liquidity. If volatility settles down again, liquidity should pick up. We sense a sea change, however, in investors' willingness to accept risk: they are now demanding to get compensated for it. This is evidenced by wider swap spreads and the renormalization of the Treasury curve, where 10-year yields now command a term premium over 2-year yields. This change in attitude, along with increased volatility, is reducing microliquidity.

So far, the shift in liquidity has been damaging to a few market participants and individual subprime homeowners, but it has not damaged the overall economy. As long as the reduction of global liquidity occurs at a slow, controlled pace, the economy should adjust without serious consequences. The risk, however, is that the reduction in liquidity might turn into a credit crunch. This could happen if central banks unexpectedly increase their pace of tightening, or if the microsuppliers of capital and leverage suddenly cut off the supply. Either event would have damaging repercussions to U.S. economic growth.

In such situations, the Fed prides itself on riding to the rescue. The Fed has long practiced a laissez-faire policy when it comes to market risk. They have used "buyer-beware" clauses in speeches to remind market participants about risk, but the Fed has not made a practice of trying to stop reckless behavior. Instead, they prefer to pick up the pieces after a crash.

We think that the economy is on a moderate growth path that is consistent with contained inflation and a steady Fed. The risks to this outlook favor a policy easing over a policy tightening, but with inflation still at the upper end of the Fed's comfort zone, the hurdle for a policy easing is high. It would take a serious market event to bring in the Fed at this time, which is not likely in our view.