Outlook and Market Review - Fourth Quarter 2007

The Bureau of Economic Analysis released its advance estimate of 0.64% annualized real GDP growth for the fourth quarter of 2007. The advanced estimate is well below consensus forecasts, suggesting that the economy came out of 2007 in worse shape than most analysts expected. While growth remained positive, economic conditions took a turn for the worse as subprime loan losses mounted beyond expectations and credit problems became more apparent in other credit markets. Weak jobs growth data in the first months of 2008 signal further problems for households faced with higher energy prices, declining housing values, lower equity wealth, large debt balances, tight credit conditions, and higher mortgage reset rates. Policy makers officially adopted the “recession” terminology to describe the economy for 2008 as both fiscal and monetary responses took shape in the first quarter of 2008.

Predictions of slow growth in the first half of 2008 have been in place for almost a year. Changes from those forecasts to more pessimistic views stem from the growing and yet uncertain magnitude of credit problems that now reach beyond mortgages. Consumer spending is resilient but the “perfect storm” conditions from debt imbalances, low savings, declining asset values, and potential job loss now make it likely that consumer spending will hit a wall. Over 60% of forecasters responding to a Moody’s survey call for a recession in the first half of 2008. Sentiment surveys also hover at the threshold for contraction, with less upside potential than downside risk.

The first half of 2008 may not reach the technical definition of a recession with two successive quarters of negative real GDP growth. Nevertheless, the economy clearly faces a slump with negative or very low growth for the next few quarters. The downturn may not be severe by historical standards due to prompt policy responses, but duration of the slump depends of the severity of credit market losses that continue to unfold. Inflation should be moderate at the core level, ranging from 2.25% to 2.75%. Even so, food and energy prices show no signs of retreating, leaving consumers with less real spending power for core goods. Interest rates are low by historical standards and may need to go lower to stimulate real investment. Unemployment should move up to 5.6% by mid-year from the current 4.9% rate. These expectations are a best-case scenario without added shocks from international sectors or energy markets.