Three prominent economists share their outlooks on the factors that will shape the course of the U.S. economy in 2007
By Paul Kasriel, Milton Ezrati, Stephen Stanley
This can’t last forever, but does it need to end just yet? That’s the question facing economists as they take a final look at 2006’s combination of solid growth, surging corporate cash and profits with an eye on prospects for 2007. Broadly speaking, economists predict a slowdown in all three, but opinions vary widely on how sharp a deceleration to anticipate. According to the December Blue Chip Economic Indicators report, the consensus of 54 economists calls for gross domestic product growth of 2.4% in 2007, the slowest expansion since 2002. That compares with the estimated 3.3% for 2006. The group predicts a substantial slowdown in corporate profit growth—5% in 2007 versus the heady 19.8% in 2006. “The two biggest drags on the economy for the last couple of quarters have been the recession in housing and in automotive,” says Randell Moore, executive editor of the Blue Chip Economic Indicators. Whether those sectors contract further will be key for how much of a slowdown the nation experiences. As for the outlook for recession, the consensus placed the odds at a low 28% for the coming 12 months. Treasury & Risk has asked three Wall Street economists to spotlight the factor that they believe will be most influential: Paul Kasriel from Northern Trust Co., Milton Ezrati from Lord Abbett & Co. and Stephen Stanley from RBS Greenwich Capital.
SPENDING IS SO LAST YEAR By PAUL KASRIEL
Led by the recession in the housing sector, U.S. economic growth has decelerated to a rate below its potential and is likely to remain below potential throughout most of 2007. The weakness in housing already has and will continue to have a negative impact on many sectors of the economy, but none more important than its effects on consumer spending.
The housing slowdown is felt on two fronts. Firstly, the boom in housing played a large role in job creation during the current economic expansion. Employment growth will now be retarded by the housing recession, which, in turn, will slow the growth in consumer spending. Secondly, with house prices now falling, the growth in home equity will slow. Because mortgage equity withdrawal has supported household deficit spending in this cycle, the reduced growth in home equity also will slow the growth in consumer spending. Given that businesses failed to embark on any kind of a real capital-spending spree earlier in this expansion when households were, it is difficult to argue that businesses can now fill the void created by contracting consumer spending.
More concerning, the behavior of residential investment expenditures tends to lead the behavior of the rest of the economy by about two quarters. This means that the full effect of the housing recession has not yet filtered through the rest of the economy.
When making its monetary policy decisions, however, the Federal Reserve takes into consideration not only the outlook for economic growth, but also the outlook for inflation. In the past two years, the inflation rate has moved up, thanks in large part to a spike in energy prices. But inflation, unlike housing, is a lagging economic process, and with growth in the aggregate demand slowing and expected to remain subdued in 2007, the rate of inflation also would be expected to pull back, as well. In fact, it already has. With energy prices off their cyclical highs, various measures of consumer inflation appear to have peaked on a year-over-year basis back in September 2005.
Still, the Fed has indicated that its policy decisions are geared more toward containing the so-called core rate of inflation—that is, the rate of inflation excluding the more volatile energy and food price components. One factor that has played an important role in putting upward pressure on core inflation of late has been the rent of shelter—the explicit rent on dwellings, as well as the imputed rent on owner-occupied dwellings. Rent of shelter tends to rise at a faster pace as the purchase of homes becomes less affordable because more people are forced into the rental market. In a sense, then, past Fed interest rate hikes, by making home purchases less affordable, have contributed to the rise in core inflation. The six-month percent change in the index of Leading Economic Indicators (LEI) is a reliable guide to both the cyclical behavior of the economy and the Fed’s interest rate policy. In the past, when the LEI has started to contract, the Fed has switched from raising its interests rate policy to cutting it (see chart above). With the LEI now contracting, I expect the Fed to begin cutting interest rates in the first quarter of 2007.