July 2008 Quarterly Forecast
> The Subprime Economy
By David Shulman
Although the economy will likely avoid falling into a formal recession, the economic outlook through the end of 2009 is decidedly subprime. In contrast to activity based recessions/slowdowns which are largely triggered by the tightening of monetary policy,
recessions/slowdowns that are induced by asset price deflations are less sensitive to an easing of monetary policy and tend to have very long tails in the sense that it takes the economy a long time to fully recover. As a result, we forecast that growth in real GDP from 2007:3Q to 2009:4Q will average a tepid 1.2%.
In this environment, we envision the unemployment rate will reach 6% by the end of 2009. Should the 5.5% unemployment rate reported for May be confirmed by similar data in June, then our forecasted 6% unemployment rate would come much sooner. Moreover, because both headline and core inflation will remain uncomfortably high over the next several quarters, we believe the Federal Reserve has ceased cutting interest rates and that the next change in policy will be to increase the Federal Fund rate starting in mid-2009.
The Fed in a Box
Although the 2007-08 credit crisis is far from over, the Federal Reserve appears to be shifting its attention away from rescuing the financial system to dealing with its more traditional concern of inflation. To be sure the Federal Reserve sponsored rescue of Bear Stearns and the opening of the discount window to Wall Street investment banks has permanently changed the role of the Federal Reserve in the economy.
However, regulatory reform is next year’s business. This year the Fed is facing the impact of higher commodity prices leaching into inflationary expectations. With headline inflation running at a 4% rate and core inflation in excess of the Fed’s informal target of 2%, policy makers, despite the weak economy, are becoming increasingly concerned that inflation might not be as quiescent as previously thought. Moreover, inflation as measured by the producer price index will exceed 10% this year for the first time in a generation.
What is worrying the Fed is that real interest rates are lower now than they were during the deflation scare of 2003-04. Most observers now believe that it was the very low real interest rates of that period that set the stage for the housing and credit bubbles that came later. As a result, we do not believe that the tepid economic growth we are forecasting will prevent the Fed from raising interest rates in mid-2009.
To sum up, the witch’s brew of the popping of the housing bubble, a wounded financial system, and increasing inflationary pressures coming from rising commodity prices will keep the economy on a subprime growth path for the next several quarters. If there is any good news here, it is that the economy thus far has avoided into falling into an outright recession. With any luck that downside eventuality will be avoided. Why? The recovery in net exports is adding just under 1% to real GDP growth. Despite all of the political trash talk attacking trade policy, it is reduced domestic demand for imports and booming exports that are keeping the economy out of recession. It seems that at least some of the contractionary forces have been outsourced to our trading partners.
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