Economic Update
Real GDP appears to have expanded in the first half of the year at a slightly better than 1% pace despite the ongoing housing market correction, a crisis in the financial markets, and surging food and gas prices (see Figure 1). This growth rate is in line with our full-year forecast of 1.5% real GDP growth, but it shows more strength than we expected when we declared the start of a recession at the beginning of the year. We are not changing our recession call because we believe that the economy is exhibiting recession-like characteristics. The economy will probably contract once the temporary lift from the rebate checks fades. Even if the economy does not contract, we expect decidedly sluggish growth to prevail for an extended period. In 2009, we expect GDP growth to barely top 1%.
Optimists, who believe that the economy will regain its vigor early next year, point to the following support factors: loose fiscal and monetary policy, lean inventory and employment levels, little excess capacity in most sectors, and a housing market correction that is already well advanced. We agree with this assessment. Indeed, these supporting factors are embodied in our forecast. However, we think that the prodigal consumer will have to tighten his or her purse strings and keep them tight for an extended period. If so, the economy will be heavily constrained. After all, consumption comprises 71% of GDP (see Figure 2).
Our pessimistic view on the outlook for consumption is shared by consumers themselves (see Figure 3). According to the University of Michigan Index of Consumer Sentiment, overall confidence fell in June to its weakest level since 1980. Meanwhile, the expectations component of the Conference Board Consumer Confidence Index reached an all-time low for the 40-year history of the series. Consumers are facing very stiff headwinds in the form of slowing income growth, declining wealth, surging nondiscretionary expenses, and limited access to credit. Some households are also experiencing rising debt service costs. In the past, consumers have been able to use debt to maintain their spending patterns when real disposable income growth was not sufficient, but in the current credit-restrained environment, cutbacks are necessary.
While we anticipate a recession, we do not anticipate a 1970s-style stagflation period. Granted, there are similarities between now and then, with oil and food prices surging and the dollar depreciating, but core consumer inflation is not headed to a double-digit pace in the current growth-constrained environment. The only scenarios that could bring that about would require a return to protectionism, price controls, wage indexation, and/or financial market controls, and we do not believe that Washington policymakers will go very far down these regressive paths. There is a risk that Washington might approve another round of tax rebates, which could temporarily boost inflation, but we hope that this lesson was learned this summer. There is also a risk that Washington will act in a more protectionist fashion, but we doubt that progress made in recent years will be undone. As realists, we recognize that Washington can surprise us, particularly when "change" could be the mandate after the next election.
We expect core CPI to edge higher toward 2.5% in coming months, while headline inflation rises a point or so to surpass 5% (see Figure 4). We do not expect the Federal Reserve to respond to higher headline inflation with tighter monetary policy, but it will probably continue to send signals that it is prepared to tighten if upside inflation risks start to dominate downside growth risks. The Fed can do little to control the price of commodities, which is now the sole source of inflation. A tightening policy with a goal of destroying U.S. demand in an effort to reduce emerging-market demand and to bring down food and energy prices is nonsensical. A better plan would be for the Fed to use an old style of policymaking called "opportunistic disinflation." In this practice, the FOMC would not raise interest rates when economic growth is already on track to slow to a level that would relieve rising inflation pressure. The Fed is concerned about maintaining its hard-won credibility on the inflation-fighting front. If it does not raise interest rates, and the economy fails to slow enough to keep inflation expectations and wage growth in check, then the Fed risks losing the public's confidence. This could result in inflation becoming embedded, as it did before Fed Chairman Volcker took the helm. Thus, if it becomes evident that the economy is regaining its vigor, the Fed should tighten policy.
Our read on the economy is that there is little risk that economic growth will be fast enough to foster a significant increase in the core inflation rate. Nonfarm employment has fallen in every month so far this year, with an average decline of 73,000. The unemployment rate has risen half a percentage point to 5.5% and is poised to rise to 6% this year. Average hourly earnings have risen less than 3.5% in the last year, which is below the increase in the cost of living. The ISM indices are consistent with stagnation and will probably soon point to a contraction in activity if energy prices remain elevated (see Figure 5).
Barring a sharp drop in gasoline and food prices, we believe that clear signs of a recession will emerge in the second half of this year and that concerns about inflation will dissipate in 2009. Throughout this period we expect the Fed to keep the federal funds rate on hold, unless our pessimistic growth forecast is proved wrong.
- Not All Central Banks Are Created Equal
- Credit Markets Remain Vulnerable Despite Improvement in Second Quarter—Fixed Income Sector Review
- Economic Update
- Investment Performance
Login required - Table of Contents