Outlook and Market Review - Third Quarter 2006

Summary: 

The economy grew at a real rate of only 1.6% in the third quarter, according to preliminary data released by the Commerce Department. Weak third quarter growth followed moderate growth in the second quarter of 2.6% and strong growth of 5.6% in the first quarter of 2006. Slower growth is largely due to the slumping housing market where a 17.4% decline in residential construction resulted in an estimated 1.1% reduction in third quarter growth. At the same time, the unemployment rate fell to a five-year low of 4.4% in October, suggesting very tight labor markets. Inflation moderated as energy prices fell. The Fed’s favorite inflation barometer, the Personal Consumption Expenditure Index (PCE), increased 2.5% at an annual rate in the third quarter. The core PCE, excluding the volatile energy and food components, increased 2.3%. When taken together, the data offer a mixed picture for the economy. Slower growth with more moderate inflation met expectations, but the strength of the labor market runs counter to the slowdown scenario. Wage and benefit pressures remain in the system. If energy prices or a random shock to commodity prices enters the picture, the inflation picture can develop even with GDP growth running below its full potential.

Financial markets took note of strong earnings, lower inflation, and a halt in the Fed’s policy of incremental interest rate increases in the third quarter. Financial market optimism will wane somewhat going into the fourth quarter due to strong job market data. Repercussions from the weak housing market, consequences from the overhand of variable rate financing behind many mortgages, and falling housing prices will be a drag on fourth quarter GDP growth.

Meanwhile, the Treasury yield curve remains inverted with short term yields in the 4.93% range while five-year rates are 4.68% and ten-year rates are 4.71% at the time of this writing. Most analysts interpret this inversion to be a result of market expectations for lower interest rates in the future combined with a strong demand for longer-term Treasury securities by foreign investors, driving longer-term Treasury prices up and driving yields lower. Consumer spending and seasonal shopping will be weaker than expected, largely due to the large outstanding debt burden of consumers coupled with the erosion of wealth linked to declining housing values.

Fourth quarter GDP growth is shaping up to be in the 2.3% to 2.6% range with inflation remaining close to the 2.5% annual rate experienced in the third quarter. Most analysts believe the Fed will continue a pause in interest rate increases, but a decrease in interest rates is probably now off the table with the latest strong jobs market data. Business investment must remain strong to keep the economy on a path above 2%.