Outlook and Market Review - First Quarter 2005

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The economy grew at a less than expected 3.1% rate in the first quarter of 2005 following a 3.8% GDP growth rate in the fourth quarter of 2004. The economy softened late in the fist quarter, largely due to higher energy prices and slumping consumer confidence. Inflation measures were higher than expected, raising concerns that Fed policies might vary from a slow and predicted upward movement of Fed Fund rates. The CPI increased at a 3% annual rate in the first quarter while the PCE index moved up at a 4% annual rate. However, core inflation measures were considerably lower. Higher oil prices were largely responsible for the higher than expected inflation numbers. Modest increases in the employment cost index helped moderate inflation. Unemployment remained at a low 5.2% level. Housing continues to be a strong sector of the economy, largely due to the resistance of long-term interest rates to short-term interest rate increases.

The relatively low level of economic performance in the latter stages of the first quarter is likely to carry over into second quarter performance. Consumer sentiment remains low and durable good orders are likely to remain soft as interest rates increase. Oil prices should reverse the upward trend of the first quarter, helping set the stage for improved economic performance in the third and fourth quarters of 2005. GDP growth is likely to be in the 3.25% to 3.5% range in the second quarter with stronger growth in the 3.75% to 3.9% range over the remainder of the year. Unemployment should remain close to 5.2% with moderate wage gains. Inflation rates will ease to something closer to the 2.5% target rate if oil prices move closer to $42 per barrel. The Fed should close in on a 4% Fed Fund rate by the end of the year, causing short-term rates to increase about 125 basis points. Longer-term rates are not likely to respond in full to the short-term rate increases, with only a 125 to 150 basis point spread for long term bonds yields over two-year bond yields.