United States

World Economic Prospects, Mar 2008

Highlights and Key Issues

* Recent economic indicators continue to indicate deteriorating economic conditions. Consumer demand has been hit by declining payroll employment, rising energy prices, record levels of mortgage delinquency and falling wealth. Both ISM indexes are showing mild contraction, and orders have been disappointing. And there is still no end in sight to the rout in the housing sector. Home prices are falling and sales are too weak to reduce the inventory of homes for sale. All of this has resulted in another downgrade of our forecast for H1 2008. We now expect a mild contraction of GDP in Q1 followed by a small increase in Q2.

* However, we continue to expect a rebound to above-trend growth in the second half of the year. This will largely be due to the combination of monetary and fiscal stimulus in the pipeline. The Federal Reserve is expected to cut another 75 basis points from its target for the federal funds rate in addition to the 150 bp reduction already implemented since September. The impact of those cuts should be felt by the summer. In addition, the large fiscal stimulus package now signed into law will put significant rebates in consumers' pockets, which could impact spending as early as Q2 and certainly by Q3.

Overview

GDP will probably decline in Q1...

* Our recent forecasts have shown GDP growth for 2008Q1 as a very small positive number, little different from zero. However, conditions have continued to deteriorate and we now expect GDP to shrink slightly in Q1. Some of that deterioration is expected to be in consumer spending, which has not grown at all in real terms in January and February.

* But there are also signs of weakness in the business sector. Both ISM indexes, for the manufacturing and nonmanufacturing sectors, were below the 50 level in February, indicating contraction. The gaps were small, however, and for the nonmanufacturing index, a significant improvement from the previous reading. Nonetheless, the readings below 50 reflected weakness in orders, employment and production. And while the continued contraction in residential construction in January was expected, nonresidential construction fell as well after a long period of very strong growth.

* The final key source of Q1 drag will come from trade. Real net exports were very strong in Q4, with exports up 4.8% and imports falling 1.9%. Exports are expected to continue at a similar pace in Q1, but the decline in imports is unlikely to be sustained, cutting trade's contribution to growth from nearly a full point to a slight negative.

...but while concerns remain...

* There is, of course, no lack of problems besetting the economy at present. The most dramatic recent bit of bad news came with the February employment report, which not only showed a decline of 64,000 jobs in February but also revised down the previous two months' data. The decline in payrolls so far is very mild but, with hourly earnings failing to keep pace with inflation, real disposable income is probably falling. Real disposable income is also being constrained and will continue to be eroded by rising energy and, to a lesser extent, food prices.

* In addition, household wealth fell for the first time in several years in 2007Q4. The decline in real estate wealth was expected, but the decline in financial assets was more surprising. Furthermore, wealth is likely to continue to fall - home prices have several more quarters of decline ahead, and the stock market is down more than 12% since the beginning of the year (equities and mutual funds make up about 20% of financial gross assets). Consumers are likely to curb spending to restore their asset levels.

* The housing sector also remains under pressure. Despite significant declines in home building, the stock of homes available for sale remains extremely high. There will be no recovery in home building or home prices until the inventory overhang is cleared.

* And the uncertainties in the financial markets are not clearing. Large write-offs of hard-to-value securities held by financial markets persist, the creditworthiness of bond insurers remains in question, lending remains constrained, even for qualified borrowers, and the spreads between government and market interest rates remain very wide.

...we still expect a rebound in H2

* Nonetheless, we continue to expect an improvement as the year progresses. Households should begin receiving their tax rebates in May, with the bulk of them in consumers' hands by July. This temporary boost to disposable income is expected to support consumer spending in Q2 and Q3, though there is likely to be some letdown in Q4 when the stimulus is withdrawn.

* In addition, the stimulus from the Federal Reserve's series of policy easings should begin to be felt by the summer. To be sure, one of the key channels by which monetary policy typically acts on the economy, residential construction, will be relatively unresponsive at least until some of the overhang of available properties is eliminated. But the other channels, through consumer durable goods and business investment should respond well. The Fed has cut rates by 150 basis points since September and, with concerns about on growth far outweighing possible upward pressure on inflation, we believe another 75 bp easing is likely over the next couple of meetings.