Saturday, August 05, 2006

From GS Chief Economist

1. Let's step back a bit from all the near-term excitement for a minute. As the housing market turns down, the US economy is in the most vulnerable position since 2000. Then and now, the private sector -- households and businesses taken together -- was running huge financial deficits. Then and now, the bubble that had driven the deficit in the first place was bursting. Then and now, the necessary spending adjustment was likely to depress private sector demand (relative to trend) by several hundreds of $billions. This is why we have been expecting a fundamental downshift in growth in the course of 2006, which now is clearly underway.

2. But I think there is one important difference compared with 2000. This is that the current slowdown is consumer led, while the 2000-01 downturn was business led. A consumer led slowdown -- even a big and fundamental one -- tends to be gradual because consumers try to maintain their standard of living if given half a chance, whereas businesses slash spending first and ask questions later when the going gets tough. So while the total size of the adjustment is similar, I suspect it will play out over a longer period of time than it did in 2000-2001. I expect sluggish domestic demand for a multi-year period, but not the steep descent we saw in late 2000/early 2001. In the current environment, a recession is possible if there is an outside shock (energy is an obvious candidate), but it's not the base case.

3. In our forecast, the slowdown does imply that the current inflation pressure -- and it's looking much more like genuine pressure following the upward revisions to the compensation numbers last Friday -- will abate in 2007, opening the door to significant rate cuts. These cuts are an integral part of our base case of no recession next year. We expect a fed funds rate of 4% by the end of 2007.

4. But doesn't this mean the Fed has to pause/stop next week? That's clearly the market's view post the payroll numbers, though we are still holding steadfast as some of the last remaining members of the flat earth society. The ball is now in the Fed's court if they want to change expectations over the weekend -- and frankly there are some good reasons for them to do so:
a) I think the message that the Fed will take away from the employment report is that the economy has slowed from an above-trend to basically a trend pace, but not that we are on the cusp of a real downturn. Payrolls are growing at a pace very close to trend and the guts of the household survey are stronger than the 0.15pp increase in the unemployment rate would suggest. Meanwhile, average hourly earnings have accelerated to a 4.4% annualized pace over the last 6 months, and unit labor costs are picking up.
b) If the FOMC really believes its own forecast -- and it's their forecast, not ours or anyone else's that matters -- the economy still needs more restraint. They expect the economy to grow at its 3% long-term trend and the unemployment rate to stay stable over the next 18 months. So in their forecast, hardly any "slack" opens up that would push down inflation over time. Unless they are happy with a core PCE deflator of 2.4% yoy and unit labor costs at 3.5% yoy (that's the likely Q2 figure following last Friday's GDP revisions), that means higher rates are needed under the assumptions of their forecast.
c) In the Handbook of Good Central Banking, you can argue that now is the time for one additional hike. The inflation data have been bad, and there have been some questions about Bernanke's resolve. Why not use this to signal that inflation is your first priority, and thereby inoculate yourself against possible upside inflation surprises in coming months, which are very possible. After all, there is a reason why most Fed rate cycles have ended with one last move that ultimately turned out to be unnecessary.

5. If they decide to pause, the statement is likely to be fairly similar to its predecessor and might even retain the sentence that "[t]he extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Given the recent inflation and labor cost data, I think no hike and an all-clear is very unlikely.

6. Market views. No strong views on the direction of rates -- the medium-term outlook is bullish for bonds as the economy is slowing and inflation should tend to ebb (our 10-yr note yield forecast remains at 4.5% in early 2007), but I think there is considerable risk of a near-term correction as things decelerate more gradually than the market is discounting. The big issue is getting the timing of the eventual Fed rate cuts right. Since it's hard to be sure, options may be the way to go -- especially at the current still-low volatility levels. In equity land, I still like the idea of being short growth, housing, and the consumer. All these trades have stalled in recent weeks as the markets have moved towards pricing a soft landing. I suspect that view could come under renewed pressure in coming months.