Outlook and Market Review - First Quarter 2007


Real GDP growth slowed to a 1.3% annualized rate in the first quarter according to advanced estimates by the Bureau of Economic Analysis. The consensus forecast called for a 1.9% first quarter GDP growth rate. Fourth quarter GDP growth was revised downward to a 2.5% rate from the advanced announcement of 3.5%. On a “year-ago” basis the first quarter GDP growth rate was 2.1%. By any measure, first quarter growth fell behind a 3% target considered to be the economy’s sustainable potential growth rate. Real final sales of domestic product, defined as GDP minus the change in inventories, increased only 1.6% in the first quarter compared to a 3.7% increase in the fourth quarter of 2006. Demand for U.S. produced goods and services has not been this soft since the fourth quarter of 2005. Key drivers of a slower growth rate included declining exports, slower consumer spending on durable goods, and lower federal spending compared to the fourth quarter. Real investment in residential construction took another large decline in the first quarter, falling 17% on an annual basis.

The slower real GDP growth rate helped moderate core inflation. The PCE deflator, which excludes food and energy prices, increased in the first quarter at an annualized rate of only 2.2%. The Fed tends to prefer the PCE deflator as a measure of fundamental inflation pressures in the economy. Other indexes followed a similar pattern with relatively low core inflation. Nevertheless, when energy and food prices are included in the indexes, first quarter inflation is much higher. The PCE index with food and energy components increased at an annual rate of 4.07% in the first quarter. Most analysts believe the Fed will be more inclined to consider rate cuts if the core inflation rates remain relatively low going into the second quarter. Inflation remains a problem, but the spike in gasoline prices is not due to higher crude oil prices. When the refining capacity bottlenecks are eased, the key driver of energy price increases should lose steam.

The outlook for the remainder of 2007 continues to be for an economic slowdown with real GDP growth in the 2% to 2.5% rate. A slumping housing market will continue to be a drag on the economy for most of 2007. Consumer spending is likely to be sluggish even though personal income has good growth. Consumers should begin repairing their poor credit conditions and begin to correct negative savings rates. Relatively tight labor markets, reflected by the 4.5% unemployment rate, and relatively high capacity utilization rates provide an upward bias for core inflation if GDP growth exceeds the 2% to 2.5% benchmark. On balance, the economy should generate slower growth without much added inflationary pressure, unless oil shocks occur.