• Interim high. Despite the financial market turbulence – real GDP growth in the third quarter of 2007 should have been pretty strong on both sides of the Atlantic. The global economic slowdown is, however, already under way. Rising oil & commodity prices and the aftermath of the subprime crisis are taking their toll.

  • US. Tangibly higher consumption expenditures and exports should have kept US growth above potential in Q3 2007. However, in the current quarter it will tumble to only 1½%. And it should remain below trend also in the coming year – despite a substantial increase in government spending (pages 2-4 & 5-7).

  • Europe. Germany and Italy should also have posted solid growth this summer. The momentum has, however, already peaked. The downward trend in corporate sentiment points to a cyclical slowdown for the quarters to come (pages 8-10 & 11-12 and chart below).

  • Central banks. Weaker growth will allow the Fed and above all the Bank of England to cut rates before the end of this quarter, while the ECB will have to wait until Q3 next year before it can resume tightening against the background of tangible inflation risks.

  • Further topics:

  • – Eurozone: Will the growing mountain of debt force consumers to their knees (page 13)?

  • – Data outlook: Ifo business climate to deteriorate further; US home sales to continue to plummet (page 17).

  • – Market outlook: The normalization on the EUR money market should continue; EUR heading for new highs (page 25).


Revised US GDP forecasts: better Q3, sluggish Q4, uneven 2008

  • Newly available data indicate that growth in Q3 2007 was on the order of 3.2% p.a., higher than our earlier estimates. Stronger PCE and improved net exports have offset another sizable drag from residential construction.

  • However, Q4 real growth is likely to be no better than 1.5% per annum, about a half percent lower than we had thought. The continued housing market problems, plus higher food and energy prices, will strain household budgets and suppress consumption spending growth.

  • 2008 real GDP growth is forecast to be about 2.5% or a little higher. But that moderate outcome is dependent on a significant injection of government spending. Household spending will remain impaired.

  • The Federal Reserve will be confronted with an ongoing dilemma, as risks of higher inflation and sluggish growth both escalate over the next year. But for now, Fed officials agree that downside growth risks are more serious, so they will probably lower the Fed funds rate by 25 basis points at the next FOMC meeting later this month.


Why Q3 turned out so well

Unanticipated strength in consumer spending: Ever since the housing boom screeched to a halt about a year ago, it has been apparent that residential construction would subtract from US economic growth. The housing recession has lasted longer and been more severe than anticipated. The main question all along has been to what extent the weakening in the housing market would lead to an outright decline in home values and thus a reduction in household wealth that would crimp consumption spending. Indeed, growth in real personal consumption expenditures did slow down noticeably in the second quarter of 2007. However, despite the continued softening in home prices, the rise in personal incomes during Q3 2007 was sufficient to support a strong rebound in consumption expenditures. While all the data are not in yet, it now appears that personal spending grew by a robust 3.5% p.a. in the July-September quarter. Motor vehicle purchases were especially strong, stimulated by a new wave of price discounts and financing incentives. A heat wave in August and continued warm temperatures in September led to heavier than usual demand for electricity to run air-conditioners. Spending on a range of services picked up as well. In sum, personal consumption expenditures contributed about 2.5 percentage points of the 3.2 percent p.a. real GDP growth rate that we now estimate for Q3 2007 (cf. chart next column).

Improved real net exports: For some time, growth in US real exports has been greatly stimulated by the lower value of the dollar plus strong economic expansion in the rest of the world. But partial data for Q3 2007 suggest that the growth of real exports accelerated sharply this past summer to an annualized 12%. Unlike past export drives, the source of this pick up was not concentrated in the commercial aviation sector. Instead, a variety of product categories posted large volume increases, including capital goods and industrial materials. The reduced real trade deficit contributed an estimated 0.7 percentage points to growth.


Prospective deceleration of growth

Consumption adjustment only postponed, not averted: Personal spending depends most sensitively on changes in real disposable income, and forces are already at work tending to limit growth in real incomes. While average hourly earnings have continued to edge higher, increases in payroll employment have slowed. There is a high probability of higher layoffs in some industries, notably finance, real estate, manufacturing, and construction. And consumer prices have begun to accelerate strongly because of increasing costs of food and energy. While the Fed continues to focus on core inflation as a measure of underlying inflation trends, from the perspective of individual families, it is the overall inflation rate that matters for spending decisions. Moreover, budget constraints are becoming more stringent. Housing prices are continuing to decline. Lenders are tightening terms on extending additional mortgage-related credit. These adverse developments will limit the ability of many homeowners to borrow against the equity in their houses to fund purchases of autos or costly home improvements. As a result, we anticipate growth in personal consumption spending will slow down to just 1.5% p.a. in Q4 2007 and average only slightly more than 2% in 2008.

Housing woes will spread to commercial real estate development: The prospects for an early end to the housing market slump have receded in recent weeks, although the kind of collapse signified by the awful September figures on housing starts and permits is unlikely to be repeated. But there are growing signs that the problems in housing are about to spread to the non-residential construction sector, which up until recently has been a key source of support for GDP and income generation. For example, the sector contributed an astonishing 0.6 percentage points to overall real GDP growth in Q2 2007. The downshift in non-residential construction reflects several new developments. A number of local markets have been overbuilt and vacancy rates are starting to rise for offices, shopping malls, and other commercial buildings. In addition, banks are likely to set tougher terms on commercial real estate loans, which up until now were freely available. Securitization of commercial mortgages and construction loans has become more difficult, and banks are reluctant to divert them into SIVs, which are under a cloud. As a result, we foresee no growth in private construction of commercial structures in Q4 2007 and only modest expansion in 2008.

US business investment in equipment and software will be restrained: Throughout the current business expansion, US corporations have benefited from strong profitability and high levels of liquidity. Thus, until very recently financing constraints have played little or no role in disciplining capital expenditures. That will change, however, as slower economic growth increasingly squeezes earnings performance. Investment will not shrink. But companies will trim capital expenditure programs or bring them on stream more slowly. As a result, we anticipate growth of business investment in equipment and software of only about 3% p.a. on average through the end of 2008.

Export growth will taper off: There is a good reason to suspect that global growth will be slower in 2008 than it has been. Higher energy and other commodity prices will raise business and consumer costs. Anticipated slowing in sales to US buyers will lead to greater caution in adding to industrial capacity. Credit will be more expensive and less freely available, especially in China, where the authorities are giving greater priority to curbing domestic inflationary pressures. While the US dollar may continue to trend lower on a tradeweighted average basis, the scope for generating higher export sales will be commensurately less. As a result, after the extraordinary surge in Q3 2007, we predict US real exports will expand by only about 3-4% over the next year and a half.

Inventory rebuilding will help support growth: The auto industry is working hard at the moment to work off unwanted inventories and appears to be making progress. Inventory accumulation in other sectors has been irregular. We expect moderate increases in inventory investment over the rest of this year and throughout 2008 that will contribute a little under 0.2 percentage points to overall real GDP growth during that period.

Government spending likely to expand: The US Treasury just reported a USD 163 bn deficit for the just-ended fiscal year and based on a moderate growth outlook for fiscal year 2008, the deficit is likely to stay well below USD 200 bn on current policies. We doubt that current policies will be retained, however. There is already some evidence that spending on the Iraq occupation and counter-insurgency will lift the defense budget. In addition, past experience suggests that an outgoing administration is capable of securing budget authority to fund a variety of public-sector projects, both at the federal level and, in cooperation with state and local government officials, at the regional level. We are forecasting an increase in real government outlays of just over USD 40 bn. That will contribute about 0.4 percentage points to 2008 economic growth of 2.5%.


Implications for monetary policy

The Federal Reserve must decide whether growth between 2% and 2.5% is likely and whether it is sufficient to maintain employment and hold down the unemployment rate. We suspect that 2% is achievable with current policies, but that a moderate fiscal stimulus program will be sufficient to raise the growth rate to the upper end of that band (cf. chart).

Inflation is rising and will likely drift higher under these circumstances, further dampening the Fed’s enthusiasm for a vigorous policy of monetary accommodation.

The bottom line is that non-inflationary economic growth is not easy to attain when an economy is operating in the neighborhood of full employment, as is the case for the United States, especially when one engine of growth, notably the construction sector, is substantially impaired (cf. Research Note by Harm Bandholz).