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July 02, 2007

Bad News Bulls

From the Wall Street Journal (page A2 in the print edition):

Economic growth in the U.S. is likely to recover as the year goes on, but that might not be an entirely good thing, according to the latest Wall Street Journal survey of forecasters.

The Journal's seers are feeling rather chipper about the near-term prospects for economic growth... 

Having run a veritable gantlet of threats to its health, the nation's economy is in a better place than it was just a few months ago...

The 60 economists who took part in the survey, conducted in mid-June, offered a mostly upbeat outlook for an economy that has recently sustained declines in both manufacturing and business investment, and that still faces a deepening housing slump.

With consumer spending holding up, a weaker dollar propelling U.S. exports and a pickup in production and investment, they expect real gross domestic product -- a broad measure of economic activity, adjusted for inflation -- to grow at an annualized rate of 2.6% in the second half of this year and 2.9% in 2008. That is down from 3.3% in 2006, but much better than the 0.7% pace of the first quarter of 2007.

... but worry that the Fed might ruin the party:

Forecasters, however, also see a mounting risk: Thanks to longer-term shifts in the U.S. and global economic landscapes, even a little growth could lead to a resurgence of inflation, which would be painful for American consumers and could cause the Federal Reserve to ride the brakes by keeping short-term interest rates higher.

The real-side rationale is pretty straightforward:

With consumer spending holding up, a weaker dollar propelling U.S. exports and a pickup in production and investment, they expect real gross domestic product -- a broad measure of economic activity, adjusted for inflation -- to grow at an annualized rate of 2.6% in the second half of this year and 2.9% in 2008. That is down from 3.3% in 2006, but much better than the 0.7% pace of the first quarter of 2007.

It is probably worth pointing out that the survey was conducted over the period from June 8th through  the 18th, before last week's run of negative news in the housing market.  And looking at the most recent spending data, Calculated Risk -- not a member of the survey panel as far as I know -- is skeptical that consumer spending is "holding up":

You can use the monthly series to exactly calculate the quarterly change in PCE [Personal Consumption Expenditures]. The quarterly change is not calculated as the change from the last month of one quarter to the last month of the next (several people have asked me about this). Instead, you have to average all three months of a quarter, and then take the change from the average of the three months of the preceding quarter...

... in general, the two month estimate is pretty accurate. Maybe June was exceptionally strong, or maybe April and May will be revised upwards, but the two month estimate suggests real PCE growth in Q2 will be about 1.5%.

That seems entirely plausible, but month-to-month and quarter-to-quarter changes in specific categories of spending tend to jump around:

Pce    :

Thus, to CR's initial question on perusing the May PCE numbers...

Is this just a one quarter slowdown? Or is this the beginning of a housing related slump in consumer spending?

... I'd side with those saying not slumpy enough to cause real problems -- at least not so far as we can tell at this point.  No, what the Journal's experts really seem concerned about is the price picture:

An increasing number of economists worry that the battle with inflation isn't over, despite the benign message sent by recent data. As of May, the Fed's preferred measure of inflation -- the "core" index of personal-consumption prices, excluding food and energy -- was up only 1.9% from a year earlier. That compares with 2.4% as recently as February.

It seems to me that The Skeptical Speculator has about the right take on the issue:

The Federal Reserve Bank of Dallas publishes two other measures of inflation based on personal consumption expenditures. The first is the overall personal consumption expenditures price index that is already reported by the Commerce Department. The other is the trimmed-mean price index that excludes components of personal consumption expenditures that have the highest and lowest rates of change.

The latest data provided on the Dallas Fed website show that these other measures of inflation remain above the Federal Reserve's comfort zone. The 12-month inflation rate based on the overall PCE price index was 2.3 percent in May and the inflation rate based on the trimmed-mean measure was 2.2 percent...

Based on this observation the Skeptical One draws this conclusion...

...  with the economy expected to recover from the second quarter onward, further moderation is likely to be limited. In fact, many economists think inflation will re-accelerate as the level of resource utilisation in the economy remains high despite the recent slowdown.

... an opinion that is shared by the WSJ panel:

In the survey, one in five forecasters saw a resurgence of inflation as the greatest risk facing the economy. That is more than twice the proportion who saw it as the No. 1 risk six months ago. As a result, they now see little chance that the Fed will lower its target for short-term interest rates from the current 5.25% by December. They do, however, lean toward a cut to 5% by June 2008. Six months ago, they were betting the Fed would cut rates to 4.75% by December.

December is, of course, a long way away.

July 2, 2007 in Exchange Rates and the Dollar, Federal Reserve and Monetary Policy, Forecasts, Inflation | Permalink

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Comments

Maybe we need to ask the question, what does a 2.5% growth forecast mean?

Is it a forecast of sub-par growth?

Or is a forecast that given weak productivity and sluggish labor force growth that this is the best the economy can do?

I'm not sure, but lean towards the later case. If so it implies that the system will not have sufficient excess capacity to prevent wages, unit labor cost and inflation from accelerating. If so it implies that the fed will not ease and that we are just seeing a pause before fed funds start climbing again.

Do others disagree that 2.5% probably is the best the economy can do right now?

Posted by: spencer | July 03, 2007 at 07:30 AM

Spencer -- "is that the best the economy can do right now?" is a tricky question. I have a real business cycle heart beating deep within, so I make a distinction between short-run potential growth and long-run potential growth. I do think that 2.5% is below the long-run potential -- the 2.9% forecast for 2008 is getting closer. However, I'm less certain about the balance of the year. I suspect that there is still a fair amount of resource reallocation to pass through as a result of the housing market travails -- that could certainly damp potential growth in the short-run. On the other hand, I lean against the rote assertion that higher-than-expected growth necessarily brings inflationary pressure. Given the stance of monetary policy, I suspect that any acceleration in economic activity will be associated with a productivity pick-up, which I would lose no sleep over at all.

Anyway, darn good question.

Posted by: Dave Altig | July 03, 2007 at 11:33 AM

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