Outlook and Market Review - Second Quarter 2005

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The economy grew 3.4% in real terms during the second quarter of 2005 following a revised first quarter growth rate of 3.8%. Second quarter growth was in line with the first quarter’s Outlook expectation of 3.25% to 3.5%, but it generally came in higher than most analysts expected. Significant improvement occurred on several key fronts. Inflation moderated during the second quarter, largely due to slower employment cost growth. Unemployment edged down to 5% from the 5.2% rate of the first quarter and housing continued to provide a boost to overall economic activity. Manufacturers worked off inventories in the second quarter, setting the stage for slightly higher growth in the second half of 2005. Consumers propped up with increased equity wealth, due to higher housing and equity prices, continued to keep the economy growing. Business inventory investment was soft but increased export growth and consumer spending kept the economy on trend for stable growth with low inflation.

Growth for the second half of 2005 should exceed 3.6% with an upside of 3.7% based on increased strength in manufacturing and inventory rebuilding. Consumers will need to balance strong employment markets, low inflation, and relatively high asset values against a drag caused by high energy prices. On balance, consumers should continue to provide a strong demand for goods and services. Business investment should provide an added boost in the second half of 2005 as inventories are added and manufacturing is expanded. Exports are not likely to help GDP growth in the second half of 2005 to the extent that they did in the second quarter, but the revaluation of the yuan may signal currency realignments that would favor U.S. exports and dampen U.S. imports with China. Inflation is likely to remain moderate at the core level until next year when capacity utilization may exceed the 80% benchmark for anti-inflationary growth.

The Fed continued its march toward a 4% fed fund rate by the end of the year after setting a 3.5% target in July, but long-term rates have not followed suit. The Fed will continue to move short-term rates back to a more “neutral” level close to 4.5% over the next calendar year. The yield curve will continue to be relatively flat as long-term rates respond to relatively low inflation expectations and low risk premiums.