July 3, 2008
- Even though US quarterly GDP has yet to contract and is not set to do so in this (the third) quarter, there is little doubt that the economy is weak.
- The federal tax rebate checks are doing a good job boosting consumer spending, but the stimulus will fade.
- A weak employment market will sap consumer spending power.
- A weak housing market coupled with rising mortgage rates will also suppress consumer spending.
- The Federal Reserve’s current and significant monetary stimulus should start gaining significant traction this summer (given historical delays). However, the Fed will soon act to fight inflation by raising rates; doing so will mean imperiling short-term economic growth.
- US economic growth in the second half of the year will be noticeably better than the first half, but it will be a struggle to achieve trend-like growth (2.5-3.0%).
- There was no recession in 2007 and there will be no recession in 2008 (using the standard definition of two consecutive negative quarters of GDP growth). However, in our May 5, 2008 article “Not a Recession, But Still Lousy” we forecasted a recession with the somewhat tongue-in-cheek date of 2010 (it is impossible to forecast such things). Regardless of the accuracy of the date, a recession (a true one – not some sort of debatable mid-cycle slowdown) is extremely likely to occur within the next few years.
Sum of Federal Reserve Comments: Economy getting better, inflation getting worse
Last week the Federal Open Market Committee (FOMC) surprised no one by holding the federal funds rate steady at 2%. Since the credit shock came out of nowhere last summer, this was the first FOMC meeting where rates were not reduced. The reason for holding off on further cuts was because, as growth re-enters the US economy, policy makers perceive inflation to be a greater concern than a potential recession. Although the Fed’s change in concerns, from growth to inflation, does not technically shift them to a tightening bias (i.e. more likely to raise interest rates than to reduce rates), it has certainly become fairly clear that we have reached the end of this cycle’s easy-money policy.
Partially based on this change in Fed rhetoric and partially based on the encouraging news flow that influenced the Fed rhetoric, many folks have recently come out to explain why their collective call for the economy to enter a recession in 2007 and/or 2008 was wrong (or, in some instances, at least explain what they really meant). While we appreciate their new found bullishness on the economy, we here at Berkshiredo not believe that growth is as robust as many are now indicating. Because of that, we believe that the Fed will put off any interest rate hikes until at least their December 16th meeting. That resistance to tighten monetary policy will remain even in the face of expected (and perhaps actual) higher headline inflation just because the economy is still that fragile.
No Contraction in GDP Yet, but Still a “Common Sense” Recession
Last week two reports ended the argument about whether or not GDP, the broadest measure of economic activity, declined. Final first quarter GDP confirmed that the economy grew at 1% in the first three months of the year. And this quarter the stimulus checks significantly lifted consumer spending, staring in May. Also, core capital goods shipments (nondefense, excluding aircraft) appear to be strong for this quarter. Final numbers (if not the advanced numbers) for the second quarter should be slightly higher than the first quarter.
Although the economy has avoided a negative GDP report, the economy has been “lousy” (an adjective we have used to describe the economy since January) for the average American household. And although there are now many folks coming out of the proverbial woodwork to describe the gangbusters growth they expect to see for the rest of the year, we are tempering our earlier forecast. In our Economic Outlook 2008 report, we predicted a lousy first quarter (got it), a slightly better second quarter (got that, too) and then for the economy to rebound to a rate above trend-like growth (2.5-3.0%) in the final half of the year. On the subject of above trend expectations, we have heard some predictions for a 5% quarter to occur in one of the next two. However, we have slightly revised our expectations to nothing better than trend-like growth for the second half.
The reason for the downgrade, even if slight, is due to the rapid rise of inflation, especially energy prices. For example, at the beginning of the year the average cost for a gallon of regular grade gasoline was about $3.10. Today it is about $1 more per gallon. That translates to about a $100 billion “tax” on the US consumer. Rising prices are eroding real (i.e. after inflation) purchasing power.
Additionally, wealth creation has reversed. There has been an estimated cumulative loss of more than $3 trillion of house prices (according to the Case-Shiller Index), and that could grow closer to $5 trillion. Studies show that people eventually spend about five cents of every dollar increase in their overall net worth (the “wealth affect”), but it also works in the opposite direction. The loss typically has to be lasting to translate to any permanent changes, but even on a temporary basis that still translate to about $150 billion reduction in spending, even before any further real estate losses.
Note: approximately $5 trillion of household wealth disappeared during the 2000-2002 stock market crash; over that period growth in consumer spending slowed sharply but did not contract. Other threats to consumer spending are tighter credit (mortgage rates keep creeping up even with the backdrop of profoundly slower home sales) and a weak job market. There have been about 400,000 jobs lost this year, which is grinding away at consumer purchasing power. All of these factors translate to restrained consumer activity.
Bottom Line: This is uncharted territory for a lot of younger and newer homeowners (the folks who tend to be the most prolificate in their spending habits) whose worst memories of recessions might only be the fairly mild 1990-1991 and 2001 recessions. The spigot of cash from home equity is gone. And even for those lucky enough to still have a job (or are at least not yet worried if their job will be the next to disappear), inflation is pinching discretionary spending.
We are aware that the second half of this year, economically speaking, will be better than the first half. And we realized that most professional forecasters have offered augmented predictions for the rest of the year. Nonetheless, real income (nominal income minus inflation) has fallen in each of the past three quarters. The aforementioned headwinds suggest that this painful trend will continue to persist and will push the US toward a recession.