Larry Deboer

The U.S. economy is completing its sixth straight year of expansion. But it experienced its slowest growth since 2003.

Output rose only 1.8% above inflation over the past year, and the unemployment rate fell slightly to 4.6%, though it is unchanged since September. The inflation rate fell to 2.4% after the drop in oil prices last fall, and the core rate of inflation—not counting food and energy—reversed course and began falling. It's now 2.2%. Both short and long term interest rates fell slightly, to 4.8% and 5.0% respectively, and the Federal Reserve left the federal funds rate unchanged at 5.25%.

The housing slump has not yet run its course. Building permits are still declining—down 10% in the past three months. Home price appreciation has slowed to a crawl. Mortgage defaults are up. The drop in residential construction is the principle drag on economic growth. The concern is whether the problems in housing will spread to all investment (will there be a “credit crunch”?) and to consumers (will loss of housing wealth inhibit consumer spending?). On the other hand, the falling value of the dollar and strong growth in the world economy should increase export growth, reducing the trade deficit. All-in-all, expect GDP to rise 2.6% above inflation during the next year. That's more rapid than last year, but modest for an expansion year.

When GDP grows less than about three and a third percent above inflation, the unemployment rate tends to rise. That didn't happen this past year, but it probably will in 2007-08. Expect the unemployment rate to rise to 4.9% by next July. Core inflation may continue to moderate, but both oil prices and food prices are expected to rise. The inflation rate should remain near 2.5% over the next twelve months.

The Federal Reserve still regards inflation as the primary threat to the economy. It has declared, however, that it stands ready to supply funds in volatile financial markets. Perhaps we'll see a quarter-point interest rate cut in the coming year. The short term Treasury interest rate will follow. Expect the interest rate on 3-month Treasury bills to fall to 4.6% by this time next year. Long term rates are more problematic. Investors might use Treasuries as a safe haven from risk. Chinese officials have threatened to sell some of their stock of Treasury bonds. The spread between short and long term rates is small by historic standards. The first of these would reduce long term rates; the other two would raise them. The 10-year Treasury bond interest rate should rise to 5.3% by this time next year.

Will there be a recession? The odds are perhaps one in five. The wild cards are financial shocks. Will there be a credit crunch? Will the Chinese dump bonds? Both are unlikely. The economy is growing slowly, but it's unlikely to stall.

The U.S. economy was in its sixth straight year of expansion in 2006-07, but at its slowest growth rate since 2003. Gross Domestic Product rose only 1.8% above inflation from the second quarter of 2006 to the second quarter of 2007. The unemployment rate stood at 4.6%, essentially unchanged since September. The inflation rate for all goods and services was 2.4% from July '06 to July '07, a substantial drop from the 4.3% rate at this time last year. The core rate of inflation—not including food and energy—dropped as well, but by a smaller amount, from 2.6% to 2.2%. Both short and long term interest rates are virtually unchanged from this time last year.

Gross Domestic Product
Real GDP grew only 1.8% in 2006-07. Growth rates were at 2% or lower for the third quarter 2006 through first quarter 2007. Growth was higher in the second quarter, at 3.4%.

The principle drag on growth was residential investment—housing construction—which fell 16% over the past year. Residential investment fell 9% in the most recent quarter. The decline in investment spending was not general, however. Investment in business structures was the fastest growing component of GDP, at 11.5% over the past year. Exports and durable goods consumption also grew rapidly during 2006-07.

Housing looms large in forecasts for 2008. The decline in home construction is likely to continue. Residential building permits are down 38% from their September 2005 peak. They are down 13% since December 2006; down 10% in the last three months. There's no sign yet that the drop in residential investment has bottomed out. Housing construction is likely to remain a drag on growth in 2008.

The larger questions are, what will happen to investment spending generally, and how will consumers react? Will the troubles in the sub-prime mortgage market cause lenders to pull back from all loans? Recent volatility in financial markets has been blamed on just such a “credit crunch.” Over the past year equipment investment growth dropped to near zero, but business structure investment continued to grow rapidly. Manufacturers' new orders for capital goods (a leading indicator of equipment investment) have not changed much over the past year. Rapid growth in equipment investment seems unlikely, but there's no sign of a big drop either.

Home price appreciation slowed to a crawl in the first quarter of 2007, at a 1.8% annual rate, slower than it's been in more than ten years. The growth in household wealth probably has slowed because of the end of the boom in housing values and the widespread mortgage defaults. This “wealth effect” could reduce the growth in consumer spending. Over the past year spending on services and non-durable goods did slow somewhat from previous years' rates. Consumption spending growth was particularly slow in the most recent quarter, at 1.3%.

The University of Michigan's index of consumer sentiment fell 12% from January to June, but rose in July. Consumers may be more pessimistic than they were last year, but the recent increase may mean that consumer spending growth won't slow much further.

Federal defense purchases increased more rapidly in 2006-07 than in previous years, especially in the second quarter. This may reflect the troop surge in Iraq. Without a further surge defense spending growth may slow. Federal domestic purchases are growing slowly, perhaps restrained by the budget deficit. State and local government budgets are in better shape, so a continued small rise in purchase growth is to be expected.

The value of the dollar has been falling, and world economies are growing. Exports have been growing smartly over the past year, while import growth has slowed. Import spending actually fell in the second quarter. Slower growth in consumer spending may reduce import growth. These trends should continue. The trade deficit (as measured by the GDP accounts) peaked in the fourth quarter of 2005, and is down about ten percent since then. But it's still enormous at 5% of GDP.

Somewhat slower growth in consumption and continued decline in residential investment will work against GDP growth in 2008. Growth in exports and slower growth in imports will favor growth. Expect GDP to grow by about 2.6% above inflation in 2007-08. That's faster than in 2006-2007, but slow for an expansion year.

Unemployment and Inflation

The unemployment rate was 4.6% in July, down from 4.8% a year earlier. The unemployment rate is virtually unchanged since last September, though. Historically, a real GDP growth rate of about 3.4% is needed to hold the unemployment rate steady. The unemployment rate should have increased with real GDP growing only 1.8% in 2006-07. The labor market has performed better than expected. Still, if real GDP grows only 2.6% over the next year, a rise in the unemployment rate must be expected. Not enough new jobs will be created for new entrants into the labor force. Expect the unemployment rate to rise to 4.9% by this time next year.

Twelve-month inflation was running at 4.2% at this time last year. The rate dropped rapidly from August to October as gasoline prices fell from $2.99/gallon to $2.27/gallon. Inflation has stabilized over the past eight months. The July 206 to July 2007 inflation rate was 2.7%.

Last year at this time the core rate of inflation was rising—an ominous sign for inflation. As it turned out, the core rate peaked in September at 2.9%, and has fallen to 2.2% since then. This is probably the result of the slower growth in real GDP over the past year. Can it be that the Fed's interest rate increases of 2004 to 2006 are bearing fruit?

The core rate may continue to edge downward, with relatively slow GDP growth and a rise in the unemployment rate. However, rising oil and food prices probably will keep the overall inflation rate higher than the core rate. The U.S. Department of Energy projects a slight increase in the price of crude oil for 2008. Ethanol demand may keep the price of corn high, causing higher prices for meat and dairy products.

Expect the inflation rate of around 2.5% for the next twelve months.

Will There Be a Recession in 2008?

The odds are against it. The Conference Board's index of leading indicators has fallen in four of the past six months. That's a signal of weak growth, but not recession. The index fell six months in a row just before the 2001 recession started.

Another leading indicator is the difference between the three month and ten year Treasury security interest rates. When the short term rate approaches or exceeds the long-term rate, recession is more likely. This happened from August to December, 2000, just before the start of the 2001 recession. This time, the three month rate was above the ten year rate from August 2006 to April 2007. The ten year rate is now two-tenths of a point higher than the three month rate. That implies a 20% chance of recession: not impossible, just unlikely.

What might go wrong? Perhaps the housing slump will cause a credit crunch. World stock markets have been volatile. Perhaps the value of the dollar on international currency markets will plunge, driving up interest rates. In mid-August it was reported that Chinese officials had threatened to dump dollars in international markets, in retaliation for tariffs threatened by members of Congress.

Both of these threats seem unlikely. Both the Federal Reserve and the European Central Bank have added billions to market liquidity in the past couple of weeks. The actual value of mortgages in default is very small relative to the size of the market. And dumping dollars would threaten the Chinese economy at least as much as it threatens the U.S.

Added to already slow growth, either of these events would push the economy into recession. But neither is very likely.

Monetary Policy and Interest Rates
The Federal Reserve has now kept the federal funds rate at 5.25% for more than a year. In its August 7 statement, the Federal Open Market Committee (FOMC) said

At 4.6% the unemployment rate is less than most estimates of full employment. That's the high level of resource utilization. The Fed would like to see an unemployment rate closer to 5% to be convinced that inflation is not a threat. The core rate has fallen, but is still 2.2% over the past year. The Fed would like a core rate of less than 2%. As a result, the FOMC declared that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.”

This implies that the Fed will not cut the federal funds rate any time soon. But the FOMC is keeping its options open. “Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information,” said its recent statement.

The Fed will respond to market volatility. On August 10 it issued a press release which read

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

When lenders are scared, the Fed must add liquidity just to hold the federal funds rate at 5.25%. That's what happened last week. If market volatility worsens, perhaps the Fed also will respond with a quarter point rate cut or two. Further, it's possible that in a year core inflation will have moderated and unemployment will have risen enough to allow a rate cut.

As of July the three-month Treasury rate was 4.8% and the ten-year rate was 5.0%. Both rates were down only slightly from a year before. The three month rate follows the federal funds rate. If the Fed cuts that rate by a quarter point by this time next year, the three-month Treasury rate will fall as well.

The ten-year rate is more problematic. If markets remain volatile, funds will flow into Treasury securities, and rates will fall. If China sells some of its stock of Treasury securities, rates will rise. The spread between the short and long-term rates is historically low. We should expect it to grow. But perhaps not so much as history might indicate.

Expect the three-month Treasury interest rate to fall to 4.6%, and the ten-year Treasury interest rate to rise to 5.3%, by this time next year.