Outlook and Market Review - Third Quarter 2009

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The third quarter advanced estimate of 3.5% GDP growth exceeded expectations. Stimulus fed growth was robust partly because it bounced from such a low level. Revisions will bring the rate back closer to 3%. The initial GDP report assumed an $8.4 billion drop in nondurable goods inventories while the fall in inventories has already been revised to more than twice that amount. This revision with respect to third quarter inventories will deflate third quarter growth and help bolster fourth quarter growth numbers. Even though consumer spending is likely to be sluggish in the fourth quarter, business spending may pickup as firms commit to productivity enhancing capital investment rather than hiring. The 11% rise in core capital goods orders last quarter suggests that business spending is about to pickup.

Effects from government spending earlier in the year will continue to be seen in the fourth quarter. Real growth in the 2.4 to 2.7 percent range is most likely. Unfortunately, unemployment will not show much if any improvement other than temporary hiring for the holiday season. Any employment data improvement is more likely to show up in the average work week, which is currently at only 33 hours a week. Layoffs are slowing but net new job creation is lagging improvements in other areas of the economy. Interest rates will likely remain low throughout 2009 and into 2010 with a gradual increase in the second quarter of next year.

Inflation is not a concern at the present even though money supply growth has been massive. The core PCE deflator, which excludes food and energy prices, was up 1.4% at an annual rate
in the third quarter. Consumer demand remains too weak to drive price increases. Capacity utilization is currently only 70.5%, far below the threshold of 81% that normally defines the point where bottlenecks lead to inflation. While spiraling inflation is not likely to drive interest rates higher, the glut of government securities in the market will push real interest rates higher sometime into next year. The Fed will soon begin to wean the Treasury from artificial market conditions created when the Fed buys Treasury securities. Without help from the Fed, market clearing yields of government securities will be driven up (prices down). Overall market rates will follow the direction of higher Treasury yields.