The Economy: The Lazy 'U'

Real gross domestic product unexpectedly rose in the first quarter, casting doubt on the existence and extent of the recession

Although we still believe this is a recession, it now seems likely that it will be shallower, but longer than previously anticipated. Like 2001, there might not be the usual two consecutive quarters of negative gross domestic product (GDP) growth, but it will still be a recession, likely to be officially pronounced as one by the Business Cycle Dating Committee of the National Bureau of Economic Research and certainly one in the minds of most Americans.

Most of the upward surprise in the first quarter came from inventories, which could make the second quarter even weaker as the goods are taken off the shelves. The trade gap improved more than we had anticipated a month ago. Final sales to domestic purchasers dropped 0.4%, offset by exports and inventories. Since the GDP announcement, the data we have received on inventories suggest that the first-quarter accumulation could be moved higher. The revised construction data for January and February also suggest stronger economic growth, not a downward revision.

Although there will be a lot more data released before the next GDP revision on May 29, it seems the first quarter is more likely to be revised upward than downward. The data support the Federal Reserve's decision to cut the federal funds rate only a quarter point, to 2%. We expect the Fed to pause until it sees the result of the stimulus package.

Despite our worries about consumers backing away because of the drop in home prices and high gasoline costs, the signs — other than autos and items tied to home purchases (such as furniture and appliances) — remain strong. Consumer spending rose 0.4% in March, cutting the saving rate to 0.2%. For the first quarter, real consumer spending rose at a 1.0% annual rate, as higher services spending offset weak auto sales and a drop in non-energy nondurables.

The first rebate checks went out the last week of April. The early payment of the checks creates the possibility that more spending will occur in the second quarter, but we think temporary prudence will push more spending into the third. Our forecast assumes that about half of the money will be spent, less than what seems to have occurred with the 2001 tax rebate.

Car sales dropped sharply in April, falling to an annual rate of 14.4 million units (light vehicles). Our forecast was 14.5 million for the second quarter from 15.2 million in the first quarter, so the decline supports our forecast, rather than a reason to revise it even lower.

Higher gasoline prices are pushing Americans to postpone auto purchases and to trade down from large vehicles to smaller ones. Light-truck sales dropped 17% from a year earlier in April, while car sales rose 5%. Dealers sold more cars than light trucks for the first time since 2001.

The fallout from the subprime lending problems might also hurt auto sales as banks and finance companies cut back on loans to individuals with low credit ratings. Although this is likely to hurt used-car sales more than new-car sales, there could be some carry-over into new cars because of an excess supply of unsold used vehicles. We expect the manufacturers to sell only 14.8 million light vehicles this year, down from 16.1 million in 2007 and the weakest year since 1995.

We expect some rise in the saving rate in the medium term. The saving rate is expected to jump in the second and third quarters, reflecting unspent rebate checks. However, it will drop back as the rebates are spent. The medium-term trend is likely to be upward, as Americans eventually realize they can't live beyond their means forever.

The housing reports have been mixed through the first quarter, with sales and starts holding up better than expected, but prices showing a sharp difference between the S&P/Case-Shiller and the Office of Federal Housing Enterprise Oversight (OFHEO) series. Starts, which most directly affect GDP, fell to a 17-year low of 970,000 in March.

The good news is that the decline is more than half over because starts have already dropped more than 50% from their 2005 peak.

Most of the GDP impact is thus behind us. However, we do not think that starts are at the bottom yet; we are forecasting 890,000 starts in 2008, which will make this the worst year since World War II. Starts and sales are expected to hit bottom in the third quarter, near 750,000.

Housing prices will drop through early 2009. Prices usually lag activity because of the inventory of unsold homes that needs to be worked through. The lag is likely to be longer than usual because of regional problems and the inventory of foreclosed homes, which usually sell for well under market price. On the other hand, the drop in housing starts has cut the inventory of new homes.

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