Outlook and Market Review - First Quarter 2007


Real GDP growth in the second quarter of 2007 exceeded expectations. Revisions of the 3.4% advanced estimates by the Bureau of Economic Analysis may occur in the future, but a big rebound from the revised .6% first quarter growth rate clearly occurred in the second quarter. Real GDP increased 1.8% on a year-over-year basis, which is well below the 3% real GDP growth rate targeted by the Fed and believed to represent the economy’s non-inflationary growth potential. Second quarter growth was not fueled by consumer spending, which is a more normal form of expansion. Inventory adjustment, non-residential investment, and increased exports all provided a boost to second quarter GDP growth. Consumer spending, which is normally a large part of growth, softened in the second quarter and declining residential investment was a major drag on the economy. The housing sector should continue to weigh down the economy as the second leg of the slowdown works through the economy in the last half of the year. Consumers budgets are absorbing higher energy costs and are highly levered with debt, making it unlikely that consumer spending will rebound anytime soon. Growth for the remainder of the year depends on continued export growth and non-residential investment spending.

The unemployment rate edged up to 4.6% in August following a stable 4.5% rate in the prior months. Labor markets remain tight but the employment cost index remains in check. On a year-over-year basis the employment cost index increased 3.5%. Capacity utilization remains high across all sectors leaving little room for expansion without price pressure. By most measures, inflation appeared calmer in the second quarter, especially based on core index numbers. The economy-wide GDP deflator increased 2.7% in the second quarter while the consumer price index (CPI) increased 2.7%. The core GDP deflator increased only 1.7% and the core CPI was up 2.2%. However, the personal consumption expenditure index (PCE) posted a 4.3% annual rate of increase in the second quarter. The PCE is the Fed’s preferred measure of inflation. At the last Federal Reserve Board meeting, the minutes suggest that the Fed has an upward bias toward inflation. Chances are now remote for a Fed action to ease rates and soften the credit crunch linked to the subprime lending.

Looking forward, financial markets are balancing worries over higher energy prices and credit defaults against good corporate earnings and stable interest rates. Consumers are not likely to pick up spending due to a large overhang of consumer debt, falling housing asset values, lack of refinancing opportunities, and tight credit conditions. The housing market will continue its slump throughout the remainder of 2007. Refining capacity has improved, but the market price of crude oil is on track to set new record highs. Production and manufacturing picked up in the second quarter, but much of the gains were due to inventory adjustments. The overall picture is for continued slow growth in GDP with inflationary pressures that will keep the Fed on the sidelines with respect to interest rates. The risk of recession remains low, but real GDP growth is likely to be in the 1.5% to 2.0% range without a boost from government spending. Equity markets are most likely to be choppy with a higher degree of risk aversion. Corporate bond yields will continue to trade at a relatively large spreads above Treasuries as risk premiums widen.