Outlook and Market Review - First Quarter 2008


The economy grew .6% in real terms during the first quarter of 2008 based on preliminary announcement by the Bureau of Economic Analysis. First quarter growth almost matched the .58% revised growth of the fourth quarter of 2007. The two back-to-back quarters of anemic growth are not likely to be the end of the slowdown. The housing sector remains weak and financial institutions have yet to repair balance sheets from the damage sparked by declining housing values. Current unemployment of 5% does not reflect the fundamental weakness in the labor market where hiring is slowing and wage gains are modest. Consumers face uncertain job prospects, declining home equity values, rapidly rising energy prices, higher food prices, strict credit conditions, and low levels of confidence for the future. Slower consumer spending limits the growth potential of the economy. Business investment is not likely to pick up the slack, especially with the large inventory accumulation of the first quarter. Government spending will pick up as rebate checks are spent in the second quarter, but this one-time stimulus is not likely to carry much momentum into the last two quarters of 2008. Trade will turn to a positive factor for growth as the weaker dollar and slow domestic economy lead to fewer imports.

Inflation remains moderate, even with rapidly rising energy prices and upward pressure from food and commodities. Moderate wage growth and rising productivity have kept labor costs down. Weak consumer spending will keep aggregate demand in check. Going forward, there are reasons to be worried about inflation pressures. The weak value of the dollar and rising import prices feed domestic inflation and allow domestic producers to increase prices. There is little evidence of high energy prices feeding into core product prices at this point, but spillover effects from higher oil prices may develop. The combined effects of Fed policy to bring down short-term interest rates and fiscal policy moves to stimulate the economy through deficit spending may lead to an inflation bias over time. Consumer, business, and investor pessimism presents an important obstacle to improved growth. Sentiment index data and consumer surveys paint a picture of low and downward trending confidence in employment, inflation, and economic activity. While the depth of this economic slowdown to date is much less than in past recessions, sentiment data reflect lower levels of confidence today than in those prior periods. To some extent, improved sentiment must be part of any recovery from the current economic slowdown.

Economic growth in the final two quarters of 2008 will be modest (around 1%) as financial institutions repair balance sheets and homeowners work out mortgage obligations. Housing and durable goods sectors are not likely to improve much in the remainder of this year. The more important issue will be the extent to which the fundamental problems initiated by the housing sector spillover to other sectors. Consumer credit now finances a disproportionate amount of spending, making it possible for the same credit default issues to emerge in other credit markets. Inflation is likely to remain under control but will edge above the year over year 2.5% target for core measures. Baseline measures, including volatile energy and food components, are likely to be in the 3.5% neighborhood. Further easing by the Fed through lower Fed Fund targets is not likely. The current target of 2% already offers negative real interest rates to borrowers. More specific changes in regulation and capital formation guidelines are likely.