Soft Landing with Turbulence Ahead

While the U.S. economy appears to have seamlessly downshifted to a soft landing, we suspect that there will be turbulence ahead. To be sure, we are not forecasting a recession, but the glide path of the economy is about to get bumpy as the housing market continues to deteriorate. We expect a sustained period of 1.5- 2% real growth, and before it is over there will be more than a hint of stagflation in the choppy air.

Specifically our forecast calls for real GDP growth to average 1.8% in the three quarters beginning in Q306 and ending in Q207, while core CPI will be increasing at an average rate of 3.2%. In this environment the unemployment rate would rise to 5.1% by the end of 2007, above the current level of 4.7%.   While not a recession, it is hardly a pretty picture. The combination of sluggish growth and rising prices will have the look and feel of a low level stagflation. Although the term stagflation conjures up images of the mid-1970s, when output declined and inflation rose, the current cycle will appear rather mild. Nevertheless policy makers will have a great deal of trouble grappling with it. As we noted last quarter, the Fed remains in a box trying to simultaneously deal with weak output growth and an inflation rate higher than what it would like.

Thus we expect only a modest decline in the Federal Funds rate to 4.5% from the current 5 ¼% by mid-year 2007. We do not view our prediction of a rate cut in early 2007 to be all that bold. As of early September the very liquid Eurodollar market was pricing in a 50 basis point rate cut by September 2007. Because core inflation will remain stubbornly high, we do not anticipate the 10-year U.S Treasury note to drop much below 4 ½%.  Rate cuts along with still strong business investment, an improving trade picture,  and some easing in oil prices along with an end to the free fall in housing construction, will enable the economy to avoid recession and return to a 3.5+% growth path in 2008.

The Downshift

After growing a very strong 5.6% in the first quarter, real GDP growth slowed to 2.9% in the second. Although consumer spending remained strong over the summer, employment growth decidedly slowed. While gaining an average of 171,000 jobs a month from December 2003 to March 2006, employment growth declined to an average of 119,000 jobs per month in the five months ending in August. (See Figure 1)

Source: Bureau of Labor Statistics

Moreover, business equipment spending, after surging 15.6% in the first quarter suddenly declined by 1.6% in the second. That along with a 9.9% decline in residential investment was the major source of the deceleration. Partially offsetting the weakness were gains in nonresidential construction, up a stunning 22% and an improvement in net exports. The growth in nonresidential construction is being fueled by an apparently insatiable demand for commercial real estate by investors throughout the globe. We anticipate continued strength in this sector over the next year, albeit the pace will likely cool from the blistering growth of the second quarter.

Housing in Free Fall

When David Lereah, chief economist of the National Association of Realtors, says “I’m hoping for prices to drop,” you know the housing market is in big trouble.[1] With existing home sales off 12% and housing starts off 26% from their record peaks, it has become obvious that the housing market is in major cyclical decline. (See Figures 2 and 3) Moreover, real home prices have undergone their most precipitous decline in the history of the series and are now down from a year ago. (See Figure 4) In our opinion it is only a matter of time before nominal home prices are down on a year-over year basis. Indeed according to the still illiquid house price futures market on the Chicago Mercantile Exchange indicates about a 5% decline in prices by next spring. Only a year ago is was practically unthinkable that home prices would actually decline.

Source: Department of Commerce

Sources: National Association of Realtors, UCLA Anderson Forecast

For some time we have been forecasting that housing starts will bottom out in the 1.5-1.6 million unit range. In our view that range represents a normal, not a depressed, level for housing activity. Because even this “normal” level of activity is still well below current levels, it is likely to drive the economy to a below trend growth rate of 2%. The flight path from here to there will be turbulent.

If there is a risk to our housing forecast it is that housing will be worse rather than better than what we now expect. How so? As we noted last quarter housing declines typically run in excess of 50% from peak to trough. We are projecting a decline of around 30-35%. A housing start decline in excess of 50% by the end of 2007 could very well cause an actual recession. However, for modeling purposes we are assuming that starts bottom in the 1.5-1.6 million unit range as modest rate cuts and continued, albeit modest, employment growth dampens the decline.

The Fed’s Box 

After raising interest rates by 25 bps for 17 consecutive meetings the FOMC finally called a halt to rate increases at its August meeting. We suspect that we have seen the last hike in the Fed Funds rate for a long time and in fact the next move will be to cut rates in early 2007. However, the Fed cannot only focus on the economic weakness that we, and for that matter their staff economists, are projecting, it also has to be wary of a persistent inflation that appears to be above what is consistent with price stability. Simply put a long period of monetary ease combined with rising commodity prices, especially oil, and rising unit labor costs have put a whiff of inflation into the air. (See Figure 5) To be sure the forces of globalization have dampened its effect, but core inflation as measured by the consumer price index of the personal consumption deflator will be above 2% for quite some time. (See Figure 6) The core CPI is running higher because it has twice the weight for the accelerating owners’ equivalent rent component than the deflator.[2]

Sources: Bureau of Labor Statistics and Department of Commerce

The bond market has sensed the Fed’s conundrum by inverting the yield curve with the 10-year U.S. Treasury note dropping to a recent low of 4 ¾%.  (See Figure 6)  All market maturities are trading below the 5.25% funds rate. Put bluntly, the market now believes that the Fed is done and there are easings ahead of us. Indeed, as we noted above in early September the Eurodollar market was pricing in 50 bps of easing by September 2007. However, because inflation will remain higher than what the Fed would like, those easings will be small and grudging. Similarly the 10- year Treasury note will have trouble sustaining a rally below 4 ½%.  The Fed will be on a tightrope because if they a make a mistake here, it will be much harder to ring inflation out of the economy later in the decade. The worst case would be policy still too tight to avoid the below trend growth in output, but too loose to lower inflation.

One factor making life simpler for the Fed has been the recent decline in oil prices.  The price of oil has dropped about $15/barrel since its early summer peak. Should the price stay at around its current $60-65/barrel level or decline even further, it would make it  far easier for the central bank to deal the slowdown in economic activity as lower oil prices would be both stimulative in of itself and it would relieve the pressure on headline inflation. (See Figure 7)

Source: Global Insight

Source: Global Insight

In summary we forecast the economy is about to enter a period of several quarters of sluggish growth with inflation above the comfort level. The Fed will respond by gradually cutting the funds rate to 4 ½%.  Although not a recession, the unemployment rate will modestly increase and those sectors of the economy tied to residential construction will be in a cyclical decline. More than a few commentators will call it stagflation. In time continued strength in business investment and trade along with a bottoming of the housing market will work to return the economy in 2008 to a 3-4% growth path.