Risks Still Cloud U.S. Economic Outlook

Oxford Analytica
Risks Still Cloud U.S. Economic Outlook
Oxford Analytica 02.20.07, 6:00 AM ET

The U.S. Federal Reserve on Jan. 14 forecast sustained healthy economic growth in 2007. Most analysts believe the Fed has put the economy on a glide path to a "soft landing" of only slightly below-trend growth, and financial markets have reacted positively. However, disquieting economic data suggests growth may be more fragile than expected.

The White House Council of Economic Advisers' economic forecast for 2007 calls for 2.9% GDP growth. The forecast followed a report that the economy had posted 3.5% annualized GDP growth in the fourth quarter of 2006 in the face of generally slowing inflation. Although the fourth-quarter growth numbers probably will be revised downward, the report produced positive congressional reviews for Federal Reserve Chairman Ben Bernanke's stewardship of monetary policy. However, there are trends in data that could cloud this outlook.

The details of the 2006 fourth-quarter preliminary GDP report reveal soft spots:

--Weak investment spending. While real consumer spending was the positive linchpin of the report, investment spending was surprisingly weak.

--Plummeting residential investment. Residential investment spending declined in the fourth quarter.

--Government spending stimulus. A key boost to growth in the fourth quarter came from a rise in federal defense spending.

--Downward growth revision. Most data releases since the GDP report have come in weaker than expected, which suggests that the government's revised GDP data for the fourth quarter will reduce the quarterly growth estimate to 2.5% to 3.0%.

A number of economic statistics suggest that the U.S. economy is somewhat fragile:

1. Employment. The economy created only 111,000 jobs in January.

While the pace of job growth hit 2.1% year-on-year in March 2006, it eased steadily over the course of 2006, and by last month had slowed to 1.6% year-on-year. Manufacturing jobs declined since the third quarter of last year. All measures of hours worked were weak in January.

One key indicator of future employment growth is the temporary worker category. Recently this has turned flat.

2. Purchasing Managers Index (PMI). This survey is a "diffusion index" that measures whether business conditions in the manufacturing sector are increasing or decreasing. The PMI dropped to 49.3 last month. Readings below 50 indicate that the U.S. manufacturing sector is declining.

3. Yield curve. The "yield curve" is commonly defined as the yield on 10-year government bonds less the interest rate on 90-day commercial paper. An inverted yield curve is taken as a signal that credit conditions are tight and monetary authorities are trying actively to discourage borrowing. The typical reaction to tightened credit conditions is that capital spending and housing weaken--developments now underway:

--Since 1970, there have been six episodes when this measure of the yield curve has been inverted for at least nine months, and all were followed by recessions.

--The lag between the beginning of the yield curve inversion and the onset of recession ranged from three to six quarters.

--The present yield curve inversion began in July 2006, meaning that if the yield curve remains inverted through the end of March 2007 a "recession watch" would start.

4. Mortgage equity withdrawal. MEW is turning decidedly more negative. MEW boosted consumer spending in recent years and helps explain the negative U.S. saving rate. However, with home prices flattening off and declining in many areas, refinancing has slowed sharply, and MEW has softened.

Consumer spending remained robust during the fourth quarter, but this may not continue if MEW remains weak. Meanwhile, rising interest rates and the resetting of many adjustable-rate mortgages have driven the ratio of the median mortgage interest payment to median family income to its highest level in nearly 25 years.

5. Other weak indicators. A series of other measures suggest caution:

--Industrial production fell an unexpected 0.5% month-on-month in January.

--Trucking industry volumes turned weaker in the final months of 2006--this weakness has persisted.

--Large homebuilders continue to report tumbling orders for new homes.

--Automobile industry sales at General Motors and Ford Motor dropped by double-digit year-on-year rates in January.

The market's sanguine estimate of U.S. economic prospects this year may yet be proved accurate. However, given recent mixed economic signals, and the persistence of significant downside risk, U.S. economic statistics bear a close watch in the coming months for further signs of trouble ahead.

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