Is an 'Insurance' Rate Cut Necessary?
Could Oct. 31 tell a tale of two economies? On the same day that Federal Reserve policymakers will debate a rate cut to avert a possible U.S. recession, we expect an advance report on third-quarter gross domestic product (GDP) that will confirm another quarter of solid growth. The Fed will be discussing recession insurance as the U.S. and global economies continue to exhibit solid growth.
The U.S. economy may or may not be poised for a slowdown that requires a preemptive policy strike, but there will be little evidence of weakness in the third-quarter GDP report. Both nominal (unadjusted for inflation) and real (adjusted) GDP growth should subside in the third quarter from the outsize gain in the second quarter, but the decrease will prove modest. The source data we use for our third-quarter forecast leaves only limited downside risk in our expectation of 3.4% real growth and a 1% gain in the report's chain price index, a widely followed inflation measure.
Source data thus far are also showing little further slowing as we enter the fourth quarter despite fears of a downturn, and the chain price index is poised for a bounce in the fourth quarter and the first quarter of next year.
The solid third-quarter GDP outlook is driven by the lack of any meaningful slowing in the monthly consumption spending and retail sales figures through September. Nominal consumption grew above trend in the first and second quarters and has corrected modestly, but real spending has shown inverse swings with gasoline prices, with an outright boost in the third quarter as gasoline prices subsided.
Perhaps the biggest downside risk to growth beyond the third quarter comes from the business sector, as talk of credit turmoil may have prompted a wave of business caution that could curtail fourth-quarter spending. We do expect a moderation in business fixed-investment growth in the third quarter following the pop in the second. The outlook for the fourth quarter remains uncertain.
But there is little evidence in available source data for the two business fixed-investment subcomponents—equipment and software spending, and nonresidential construction—that a significant slowdown is underway. The business construction figures soared in the second quarter and remained solid in the construction spending reports through August, and the factory goods figures imply a 2% to 3% third-quarter real gain in equipment and software spending that could easily be repeated in the fourth quarter.
Headline orders weakness in August and September helped to sustain market fear of a downside surprise in the equipment and software figures in the fourth quarter. Yet temporary downswings in these volatile figures during tumultuous periods such as August and September are hardly unusual. And third-quarter earnings reports from many of the high-tech firms have bucked fears of a pullback in this barometer of business investment. The moderation in various factory sentiment indicators has proven modest thus far as well, and capital spending plans gauged in these surveys have shown little reaction to market turmoil.
Factoring In Housing Decline
The inventory component of business investment provides another downside risk to GDP beyond the third quarter, stemming from a possible surge in business sector pessimism. But since the inventory downturn of late 2006 and early 2007 took much of the slack out of inventories, there is limited room for a further downswing in the fourth quarter this year. For the third quarter data, a fairly flat inventory reading is already in the cards given the monthly business inventory reports through August.
Of course the outlook for residential construction remains bleak, and we have factored in jumbo 20% rates of decline in the third and fourth quarters that easily reflect the weakness in available source data. As we often note, the single-family residential construction sector is only 3% of GDP, so weakness here has little potential, on its own, to have an impact on overall GDP growth.
The key to housing sector significance for the overall business cycle and GDP remains how the slump will ultimately affect consumers' willingness to spend on goods and services.
And finally, the U.S. net export figures are likely to provide a solid floor for GDP growth over the foreseeable future, given the combination of robust world economic growth and a plummeting dollar. Soaring oil prices will again boost the nominal trade gap figures, though real trade is improving at a dramatic rate through the most recent trade deficit report, and this pattern should continue.
Commodity Prices to Surge
Though global trade tends to be more sensitive to world economic growth than exchange rates, the sheer magnitude of the recent dollar downturn suggests substantial upside risk to U.S. export growth as we enter 2008, as well as restraint in real import growth.
The outsized overshoot of the quarterly GDP chain price index in the first quarter, and additional gain in the second, allowed a lull in the third quarter that will carry into the fourth. This mostly reflects that domestic gasoline prices soared through the first half of the year but then paused through September, while oil prices were restrained through the first half of the year but soared in the third quarter. Since imports enter the GDP calculation as a "negative" entry, surging oil prices temporarily depress the quarterly chain price figures now that they are not translating to gasoline price increases. Of course, this good luck won't last much longer.
We expect that soaring commodity prices should start having a significant impact on GDP chain price gains by the first quarter of 2008. Given rapid growth in wage costs and tightening global capacity constraints, the risk is that the recent lull in many of the "core" inflation measures will dissipate as well. (Core inflation measures exclude volatile food and energy prices.) Though the Fed sets its inflation goals in terms of a core measure because it is less volatile and hence a better tool for rhetorical purposes, it is overall inflation that matters for the economy and the Fed, and there is little evidence that U.S. inflation is subsiding from the general 3% pace thus far in the expansion. Indeed, inflation as measured by the consumer price index is now poised to return to the 3% to 4% range typical of the high-growth years of this expansion.
Addressing Downside Risks
Of course if the Fed announces a Halloween easing, as we now assume, it will be addressing the downside risk of a slowing economy even if policymakers see the risk as small. The parallel of the current circumstance to the Fed "insurance" easing in the aftermath of the Long-Term Capital Management crisis in 1998 and the stock market crash of 1987 are clear. In both cases, though the Fed eased in response to the perceived near-term "risk" of a slowdown, the policy easings ultimately contributed to a boost in growth and inflation over the ensuing three years.
Though we believe that the Fed is likely committed to a policy easing at the Halloween FOMC meeting, detractors will have plenty of material to support the view that an unchanged policy stance would be the better choice.