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Solid economic fundamentals will remain supportive of long−term growth

Tue, Sep 23 2008, 10:44 GMT
by BBVA Bancomer Team

BBVA Bancomer

In 2Q08 quarterly real Gross Domestic Product (GDP) expanded at an unexpectedly high 3.3% seasonally-adjusted annual rate. This was mainly the result of strong net exports, which contributed with 3.1 percentage points to total growth. Solid demand abroad boosted exports while imports declined sharply. Personal consumption expenditures (PCE), which were temporarily heightened by tax rebates, increased 1.2%, following 0.6% on average during the previous two quarters. Consumers spent less than half of their extra income in both durable and nondurable goods, and the remainder was mainly used to pay down debt and increase savings. Non-residential investment continued softening as equipment and software declined for the second consecutive quarter. However, this was more than offset by strong growth in non-residential structures.

As suggested by BBVA U.S. Monthly Activity Index, GDP growth for 2H08 and 2009 will decelerate further, mainly as a result of weaker PCE. Ongoing job losses will dampen the pace of real personal income, while falling home and other asset prices are likely to reduce the value of household wealth. Non-residential investment will remain below trend as fi rms scale back production to cope with declining profi ts, on account of slower sales and higher input costs. Although tighter credit standards will exert additional pressures on capital spending plans, corporate balance sheets remain solid. Net exports’ contribution to GDP growth will remain buoyant, though it will edge down as a result of global economic slowdown. As suggested by BBVA U.S. Housing Activity Index residential investment will continue to subtract from GDP growth but could bottom out by mid-2009. The main risk to our outlook is further deterioration of fi nancial conditions.

In 1H08, headline infl ation rose substantially due to a sharp increase in global commodity prices, which in turn pushed up short-term infl ation expectations. However, core infl ation —which excludes food and energy—, remained contained as a result of decelerating shelter and medical costs, limited pass-through from higher non-labor costs, and relatively stable long-term infl ation expectations. Going forward, we anticipate core infl ation to gradually return to its long-term trend, as shown by BBVA U.S. Leading Infl ation Index. This is the result of lower commodity prices and a decline in infl ation expectations, both favored by weaker economic activity.

Since June 25th the Federal Reserve (Fed) has kept its target for the federal funds rate unchanged at 2%. This ended the rate cut cycle that started on September 18th 2007 when the Fed reduced the target rate to 4.75% from 5.25%. In just over seven months, the Fed cut rates by 325 basis points refl ecting a high degree of uncertainty in the economic outlook derived from elevated risks associated with the fi nancial turmoil. During 1H08, increasing concerns on the infl ation outlook prompted the Fed to hold monetary policy steady and adopt a wait-and-see strategy. Going forward, the Fed will be cautious in raising interest rates anytime soon, mainly as downside risks to economic growth persist and infl ationary pressures ease further. In fact, according to BBVA U.S. Recession Probit Model, the probability of an economic recession in the following six to nine months decreased throughout 1H08. Therefore, we expect the Fed to keep its target interest rate unaltered well into 2009.

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Published on  Tue, Sep 23 2008, 10:48 GMT