Monthly Economic Outlook
The Recovery Will Take Time to Build Momentum
Forecasts for economic growth during the second half of this year
and 2010 have been steadily ratcheted up as most of the monthly
economic indicators have come in better than expected. We have raised
our own estimate modestly. We now see real GDP rising at a 3.7 percent
annual rate, which is 0.3 percentage points higher than one month ago.
Estimates for real GDP growth during the fourth quarter and 2010 are
essentially the same as they were one month ago, and our first look at
2011 calls for real GDP to rise 2.5 percent.
The long string of real GDP gains seems a bit odd coming just as the
unemployment rate approaches 10 percent. Much of the near-term
improvement comes from a narrowing of the trade deficit and a smaller
inventory drawdown. Inventories are "only" expected to decline by
$100.0 billion in the current quarter, less than the prior quarter's
$159.2 billion plunge. The smaller decline will add 1.8 percentage
points to third-quarter growth and 1.7 percentage points to the
There is also some real improvement taking place. Stronger economic
growth overseas is boosting demand for exports, helping further narrow
the trade deficit. Fiscal stimulus dollars are also flowing a little
more freely. Federal government spending is expected to average a 6.0
percent pace for the next three quarters, helping offset continued
weakness of state & local government and the private sector.
The Economy Still Faces Significant Headwinds
The recent moderation in the rate of job losses along with a host of
upbeat reports has raised hopes the recovery might turn out to be
stronger than expected. As much as we would like to join that camp, we
believe the economy still faces significant headwinds that will make it
difficult to sustain the relatively robust gains we are likely to see
over the next couple of quarters. Much of the improvement merely
reflects a bounce back in motor vehicle production and a reduction in
the rate of inventory liquidations. Federal stimulus programs,
including aid to state & local governments, the cash-for-clunkers
program and the $8,000 tax credit for first-time homebuyers, are also
helping drive activity in the near term.
Private final domestic demand, or "core" GDP, remains exceptionally
weak. "Core" GDP is expected to grow at just a 0.5 percent pace over
the next year. The weakness in private demand means overall growth will
decelerate once the inventory drawdown is complete and stimulus
While we are forecasting a substantial deceleration in overall
growth, we do not expect a double dip. Overall growth is expected to
remain in positive territory throughout the forecast period thanks
mostly to continued narrowing in the trade deficit and increases in
federal government outlays. Private domestic demand should gradually
build momentum, but there are a number of hurdles that need to be
overcome before robust growth returns to the private sector.
Consumer spending got a temporary boost during the third quarter
from the cash-for-clunkers program, which helped boost motor vehicle
sales to around an 11.6 million unit rate for the third quarter, up
from a 9.6 million unit pace in the prior quarter. The gain in new
vehicle sales did not carry over into spending for other items.
Spending for nondurable goods likely declined during the quarter, and
outlays for services likely posted only a modest increase. Consumers
are only willing to spend if they are presented with a bargain.
We are expecting a modest payback from the cash-for-clunkers program
and look for sales to slip back below a 10 million unit annual rate
later this year. Spending for other goods and services will also likely
remain exceptionally modest, reflecting a 5.0 percent drop in wages and
salaries over the past year and continuing concerns about job security.
Personal income is holding up better than that, thanks to government
transfer payments. Even when income turns back up, spending will likely
continue to lag. Consumers are still deleveraging and trying to rebuild
savings. As a result, spending will likely lag behind real after-tax
income for the next several quarters.
Residential construction is finally showing some positive signs.
Single-family housing starts have risen in each of the past five
months, which should push real outlays for residential construction
back into positive territory during the third quarter. Home sales and
construction have been helped out a good bit by the $8,000 tax credit
for first-time homebuyers. Once the tax credit program ends, the
rebound in new home sales and construction may level back out.
Even if first-time homebuyer tax credits are extended, there is not
much immediate upside for the housing market. Delinquency rates are
surging for both prime and subprime mortgages. As a result,
underwriting will remain exceptionally tight, while sales and new
construction will remain near historic lows.
The Federal Reserve is expected to keep short-term interest rates
near current levels until it feels confident that there is little risk
of the economy sliding back into recession. Once it feels the coast is
clear, the pace of interest rate hikes will likely be surprisingly fast
until they bring the Federal Funds rate back in line with the core
inflation rate. This means we should see a 1.50 percent Federal Funds
rate by the end of 2010.
Has the Global Economy Turned the Corner?
Following five consecutive quarters of contraction, it appears that
real GDP growth in the euro area is turning positive again. However,
there are a few important countries in the Euro-zone in which consumers
became highly geared over the past few years. Therefore, growth in the
overall euro area could be held back somewhat over the next year or so
as these consumers delever. With inflation benign and the
sustainability of the recovery still in question, the European Central
Bank will likely refrain from tightening policy.
The British economy, which plunged into its deepest recession in
decades, is also exhibiting incipient signs of recovery. Like their
counterparts in some continental economies, British consumers levered
up earlier this decade. Therefore, it seems that a period of consumer
retrenchment is in store. In our view, the Bank of England will also be
on hold well into next year.
If there is a region of the world where recovery has clearly taken
hold already, it would be Asia. China is leading, but most other Asian
economies have also posted positive rates of GDP growth, at least on a
sequential basis. Asian central banks likely will be the first
institutions to hike rates, but policy tightening probably won't get
under way in the region until sometime next year. Inflation is benign
in most Asian economies, and the outlook for many western economies,
which are important trading partners for the region, remains uncertain.
Europe Not Completely out of the Woods Yet
The purchasing managers' indices (PMIs) in the Euro-zone collapsed
late last year, but both manufacturing and service sector PMIs have
recently returned to the demarcation line that separates expansion from
contraction (see graph on front page). Therefore, it appears that real
GDP growth in the Euro-zone is about to turn positive again following
five consecutive quarters of contraction. Does this mean that there is
nothing but blue skies ahead for the euro area?
Although the worst is probably over, we believe that the economic
skies above the Euro-zone will remain partly cloudy for some time. As
we wrote recently, there are a few economies, namely Greece, the
Netherlands, Portugal and Spain, in which consumers are fairly
indebted. (See "Will Debt Restrain Euro-zone Consumer Spending?", which
is posted on our Website.) In our view, lackluster growth in consumer
spending in these economies will help to restrain real GDP growth in
the overall euro area well into next year. This point was reinforced by
the recent release of Euro-zone GDP data for the second quarter as real
consumer spending in Spain plunged nearly six percent relative to the
same period last year (left chart).
Consumer prices in the Euro-zone were down 0.2 percent on a
year-over-year basis in August. Although the collapse in oil prices
over the past year overstates the drop in underlying inflationary
pressures, inflation is just not much of an issue at present. (The
"core" rate of inflation fell to only 1.3 percent in July, the lowest
rate in four years.) The combination of a sluggish recovery and benign
inflation should keep the European Central Bank on hold well into next
Positive economic growth in the United Kingdom appears to be
imminent as well, following that economy's five-quarter slide. Like the
Euro-zone, British PMIs are nearing the break-even demarcation line.
Like their counterparts in some continental economies, British
consumers became highly geared earlier this decade, and a period of
consumer retrenchment appears likely. Therefore, the Bank of England
probably will keep its benchmark policy rate, which currently stands at
only 0.50 percent, unchanged for a considerable period of time.
Bona-Fide Signs of Recovery in Asia
If there is a region of the world where recovery has clearly taken
hold already, it would be Asia. Yes, most Asian economies experienced
significantly slower growth, if not outright contraction, late last
year and earlier this year when global trade imploded. However, the
financial systems of most Asian economies were not leveraged to the
same extent as their western counterparts, so they were not hammered as
badly during the global credit crunch. In addition, most Asian
governments were quick to implement fiscal stimulus programs, which
have contributed to the pick-up in economic activity this year.
The region is being led by China, where the year-over-year GDP
growth rate has risen from 6.1 percent in the first quarter to 7.9
percent in the second quarter. However, even the most open economies in
the region, which were dealt a body blow by the implosion of global
trade, have bounced back. The manufacturing PMI in Singapore has
returned to "normal" territory (right chart). In Taiwan, industrial
production has climbed more than 60 percent from its low in January.
At some point, Asian central banks will begin to tighten policy
again. However, inflation is benign across the region, so policy
tightening is not imminent. Moreover, Asian central banks will probably
want some clarity on the sustainability of the incipient recoveries in
western economies before hiking rates. We are looking for higher rates
in Asia next year.