Outlook and Market Review - Third Quarter 2007


The 3.9% advanced estimate for third quarter real GDP growth exceeded expectations by almost a full percentage point. After revisions, second quarter GDP growth was 3.6%. GDP growth for both of the last two quarters exceeded generally accepted targets for sustainable expansion. Private non-housing related industries recently reported jobs growth of nearly 200,000 in October, making up for more modest jobs growth in August and September. The unemployment rate of 4.7% is well below the generally accepted 5% threshold of full employment. Recent upbeat reports on jobs and increased construction spending make it likely that we will see an upward revision in the third quarter GDP growth rate. The surprisingly strong overall performance of the economy has not contributed to high levels of inflation. Over the past year, core CPI inflation increased at a 2.1% rate and the core PCE index grew only 1.8%. The core producer price index increased by only 1.5%. Inflation data are well within Fed targets, allowing the Fed to cut the Federal Funds target to 4.5% in its October meeting. Looking forward, Fed rhetoric suggest that the risk of slow GDP growth is now balanced equally against the risk of unacceptable inflation, making it less likely for the Fed to lower the Fed Fund target in the remainder of this year. Overall, the economic picture coming out of the third quarter looks good, but significant weaknesses continue in housing-related industries and vehicle manufacturing.

Fourth quarter growth is likely to be below a targeted non-inflationary potential of 2.7% due to negative wealth effects from rapid deterioration in housing markets, tight credit conditions for consumers, financial market instability due to the subprime mortgage fallout, and slumping consumer sentiment. GDP growth is likely to be in the 1.5% to 2% range in the fourth quarter with specific weaknesses concentrated in the housing and durable good sectors. The trend for the index of leading economic indicators is flat, consistent with slow growth scenarios. Core inflation should remain moderate in the fourth quarter as consumer spending cools but prices for energy, commodities, and food will continue to grow more rapidly. Lower discount rates and Fed Fund rates over the past quarter improved liquidity, but high credit risk premiums prevent parallel declines in the prime rate and other key consumer borrowing rates