The Federal Open Market Committee (FOMC), the monetary policy arm of the Federal Reserve, has communicated that it is quite content to hold the federal funds rate at 5-1/4 percent for an extended period, despite four consecutive quarters of sub-par real economic growth and a moderation in core consumer inflation (i.e., excluding food and energy components).
Why is the FOMC content to remain on hold? Because it has a forecast calling for enough of a rebound in economic growth later this year to avoid a recession and it desires further moderation in core inflation. We believe the FOMC will get its wish with regard to core inflation, but are less certain that its forecast of Gross Domestic Product (GDP) growth will pan out.
One of the reasons we doubt the FOMC’s forecast will pan out without a little interest rate “self-help” is that it never has since 1960. Since 1960, every time year-over-year real GDP gets around where it is now, 1.9 percent, the FOMC has engineered a federal funds interest rate cut. Sometimes these funds rate cuts have come in time to revive the economy. Other times the cuts have come too late to prevent a recession.
This time, according to the FOMC and numerous economic forecasters, it will be different: we will experience an immaculate economic recovery. But we doubt it.
In our May economic update, we had assumed the FOMC would begin paring the federal funds rate in early August and finish at the end of October, for a cumulative cut of 75 basis points. As a result, we believed this would start to tilt the “nose” of the economy up by the fourth quarter of this year. Our real GDP growth forecast for 2007 on a Q4/Q4 basis in May was 1.9 percent.
We now are lowering that forecast, in part because of the downward revision to first-quarter growth and in part because the FOMC is likely to delay cutting the federal funds rate. We do not see the first cut in the federal funds rate coming until Oct. 31. Because of this delay in dropping the federal funds rate, we have lowered our second-half real GDP forecast to 1.7 percent vs. last month’s 2.25 percent. On a Q4/Q4 basis, our 2007 real GDP forecast is now 1.6 percent. Because of our lower real GDP forecast, we have now penciled in a cumulative decline in the federal funds rate of 100 basis points, with the last 25 basis points coming in mid-March 2008.
New estimates of inventories played a large role in the Commerce Department’s downward revision of first-quarter real GDP growth to 0.6 percent from its advance estimate of 1.3 percent. And we expect inventories to play a large role, along with federal government defense spending, in accounting for the pick-up in second-quarter growth to about 2.3 percent.
However, we see sharp deceleration in the growth of real personal consumption expenditures to 2.0 percent in the second quarter from 4.4 percent in the first quarter. We believe the recession in the housing market is slowly spilling over to consumer spending as a result of slower employment growth and slower home-equity appreciation.
With regard to consumer spending, growth in the real spending for consumer durable goods slowed to 1.94 percent annualized in the three months ended April. This compares with growth of 12.36 percent in the three months ended January.
Officials at U.S. auto makers have said the recession in the housing market is beginning to brake demand for their products. Light motor vehicle sales have been stair-stepping downward since the beginning of the year. Durable goods related to housing, such as furniture and household equipment, also have seen the rate of growth in their purchases tail off. Even growth in spending on clothing and shoes, which tends to be somewhat discretionary, has slowed sharply in the past three months.
Households have been funding their deficit spending by selling assets – including selling their direct and indirect holdings of corporate equities back to corporations – and by borrowing the equity in their houses. Although there are no signs of a slowdown in corporations buying back their shares (although there is a sign that profit growth is slowing), there are definite signs that the home equity growth is slowing due to the national decline in house prices.
The recession in housing is beginning to have a negative impact on employment growth. You might think that with the rise in energy and industrial commodity prices in recent years, and the fall in the foreign exchange value of the U.S. dollar, that prices of consumer goods would be rising at a faster rate. But you would be incorrect.
In conclusion, we believe the housing recession has not yet run its course and that its fallout is spreading relentlessly to other parts of the economy, most notably, the consumer sector. The second-quarter economic-growth rebound, feeble as it likely will be, will represent a false dawn.
In the interim, increases in the prices of core consumer goods and services will moderate further. On Oct. 31, the day the FOMC meets, the Commerce Department will release its advance estimate of third quarter real GDP. Our bet is that third-quarter growth will be on the low side of the FOMC’s expectations. Of course, the FOMC will have evidence suggesting that prior to Oct. 31. But with the official evidence in hand on that date, we believe the FOMC will commence cutting the federal funds rate.
