Economist: More pain ahead

Real gross domestic product (GDP) annualized growth for the first quarter was revised up from its advance estimate of 0.6 percent to 0.9 percent in its preliminary estimate – a relatively insignificant revision.

The major revisions were to imports and to business inventories. Annualized growth in imports was revised from +2.5 percent to -2.6 percent. Lower imports, all else the same, increase GDP.

The change in business inventories was revised from +$1.8 billion to -$14.4 billion. A reduction in inventories, all else the same, decreases GDP. It would appear that some of the reduction in inventories was a result of reduced imports.

Despite the marginally positive real GDP growth in the first quarter, we continue to believe that the economy has entered a recession. The basis of this belief is that all four of the components of the index of Coincident Economic Indicators – nonfarm payrolls, real personal income less transfer payments, industrial production and real business sales – appear to have peaked.

Housing starts increased marginally in April due to the multi-family component. New home sales also were reported to have increased in April. However, it would be premature to suggest that the housing recession is near a bottom inasmuch as there remains an elevated inventory-to-sales ratio for combined new and existing single-family homes.

This excess supply of houses continues to put downward pressure on home prices. The Case-Shiller house price index for 20 metro areas fell by 14.35 percent in March 2008 vs. March 2007. The March 2008 level of this house price index has fallen back approximately to where it was in October 2004.

Consumer spending continues to weaken due to the fallout from the housing recession and elevated energy prices. Real personal consumption expenditures were flat in April vs. March. What is boosting real personal consumption in recent months are expenditures on consumer services, which includes the implicit rent on owner-occupied housing.

Real personal expenditures on consumer goods have contracted for six consecutive months. Especially hard hit has been the sales of motor vehicles. The annualized unit sales rate of light motor vehicles slowed to 14.3 million in May – the slowest sales rate since July 1998.

A sharp weakening in truck and SUV sales, in part because of the increased price of gasoline, is largely responsible for the sluggish sales in total light motor vehicles in recent months.

If there is one sector of the economy that is exhibiting signs of stabilization, it is manufacturing. The new orders index increased in the May manufacturing Institute for Supply Management report. New orders for exports appear to have played a major role in the May rebound in total new manufacturing orders.

Despite high food and energy prices, year-over-year growth in the CPI for all items, although uncomfortably high, is moderating. As mentioned at the outset, the Federal Reserve is concerned that a further weakening in the dollar would lead to further increases in the rate of change in the prices of imported goods.

Import prices of consumer goods have been increasing at a faster pace in recent months. Perhaps as a result of this, the CPI for goods excluding food and energy is now beginning to post year-over-year increases. Although these CPI increases are still quite small, in 2007, the CPI for consumer goods ex food and energy was falling.

There are tentative indications that a slowing in global economic activity is beginning to weaken prices of industrial commodities. Industrial metals prices have broken down of late.

Another encouraging sign for a moderation in inflation is the behavior of unit labor costs – labor compensation adjusted for productivity. On a year-over-year basis, growth in unit labor costs has been declining – up just 0.7 percent in the first quarter of this year.

Given our forecast of a further significant rise in the unemployment rate over the remainder of this year, growth in labor compensation would be expected to moderate. Thus, there appears to be little likelihood that unit labor costs will put upward pressure on inflation.

Liquidity conditions are improving and credit risk premia are being reduced in the fixed income markets. The interest spread between three-month Libor and three-month T-bills finished May at about 80 basis points – down considerably from the recent highs and only about 20 basis points higher than what it was at the end of May 2007.

Yield spreads in the residential mortgage market are declining but remain elevated.

It is interesting that credit risk premia are shrinking as delinquency rates are rising in debt categories other than residential mortgages. Delinquencies are rising on credit card and commercial real estate loans. Smaller commercial banks hold a high concentration of commercial real estate loans.

It also is interesting that credit risk premia are shrinking as an index of bank stocks is hitting new cycle lows. We would have assumed that in the current environment, declining prices of bank stocks might be somehow related to continued credit problems with banks’ earning assets.

Although liquidity may be improving and credit risk may be receding, short-term credit creation is slowing. Bank credit growth remains relatively high, but this appears to be because commercial banks are taking on the credit formerly being provided via commercial paper issuance.

Growth in the combined aggregate of commercial paper outstanding and bank credit has slowed sharply in recent months.

Our current forecast is for real GDP growth to contract through the end of 2008, with barely positive real GDP growth beginning in the first half of 2009. We also expect that inflation will begin to moderate significantly in the second half of 2008 as energy prices recede and price increases for consumer discretionary goods and services increase at a slower pace.

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