2007 Market and Economic Outlook – Lower Profits & No Recession
submitted by CrossProfit; author Richard Hoey
The Federal Reserve has gradually shifted its policy stance from stimulation to the upper part of the neutral range. Our most likely case is that Fed policy has begun a “long pause and delayed easing” pattern but it is too soon to rule out a “pause and resume” pattern. From the perspective of the overall economy, we believe that the Fed has stopped at the border between a neutral policy and a restrictive policy. The yield curve is slightly inverted, real yields have finally normalized and risk spreads are narrow but gradually widening.
From the perspective of the housing sector, Fed policy is restrictive. However, the affordability problem in housing is less linked to the current mortgage rate than to the past rise in house prices. The housing sector is suffering from a hangover from hyper stimulation monetary policy in prior years. We expect that the lagged spillover effect from weak housing to the overall economy will eventually generate below-trend GDP growth in 2007, triggering a delayed easing in monetary policy near mid-2007.
The stance of Federal Reserve policy is designed to slow U.S. economic growth so that the current acceleration of inflation will prove to be temporary rather than the beginning of an upward shift in trend inflation. If there is a rise in the risk of an upward shift in trend inflation due to tight labor and goods markets and a greater pass-through of high energy prices, a shift to a more restrictive policy may be required, especially if inflation expectations soar. On the other hand, if the emerging housing recession threatens to trigger a broader recession, Fed confidence in a future slowing of inflation would increase and its policy would shift to an “early easing”. We place low odds on an “early easing” scenario, which would erode the credibility of both the Fed and the dollar since the core inflation risk is unlikely to drop quickly.
The central bank’s policy is forward-looking, so that shifts in its growth and inflation forecast for 2007 will be critical to its decisions. Its central tendency forecast for the four quarters of 2007 are for 5.00% to 5.50% for nominal GDP growth, 3.00% to 3.25% for real GDP growth and 2.00% to 2.25% for the core PCE inflation rate. Our view is that there is modest upside risk to their inflation forecast and downside risk to their real GDP forecast for next year. We believe that the transition from an economic boom to slower economic growth has already occurred, but that near-trend growth is likely for the balance of 2006. We expect about 3% real GDP growth for the last three quarters of 2006 and about 2.5% real GDP growth in 2007. We expect the 12-month inflation rate to peak near 2.6% or 2.7% for core PCE and near 3% for core CPI.
We believe that the most likely outlook is for a “long pause and delayed ease” pattern in the Federal funds rate with a long pause at 5.25% followed by a delayed ease near mid-2007. We expect the Fed to rely on a long period of borderline restraint rather than an aggressively restrictive policy to restrain inflation. This will probably work.
While the “long pause and delayed ease” pattern is most likely, there is some risk of a “pause and resume” scenario. This could occur if consumer and business confidence stabilizes during a pause and the Fed concludes that core inflation pressures are rising enough to require further tightening to ensure that core inflation “steps back down” in 2007 and 2008. Our view is that (1) economic growth will decelerate, but only gradually, (2) financial liquidity is still ample, but no longer excessive and (3) core inflation will remain under moderate upward pressure in the coming months due to tight labor and goods markets.
While the Fed faces upward pressures on core inflation this year, the intensity of this uptrend is moderate relative to past core inflation cycles due to globalization, strong productivity growth and weak bargaining power for labor. Because the inflation challenge is limited, the risk of a major monetary overkill that would trigger a full scale recession appears to be lower than in past cycles. However, we believe that the U.S. is in the early stages of a housing recession, which is likely to contribute to a period of below trend overall economic growth in 2007. The severity and spillover effects of the housing recession are the key to potential recession risk. We believe that below trend growth in 2007 is the most likely outlook, with the odds of full-scale recession only about 15%. Recession risks would be higher if the Fed resumes tightening, contrary to our expectations.
Chairman Bernanke, a long-time advocate of inflation targeting, is now heading the Federal Reserve and he is now being joined on the Board of Governors by Frederic Mishkin, his co-author of a book on inflation targeting. The market has begun to treat the 1% to 2% “comfort zone” for core PCE as a soft inflation target, one that the Fed has begun to miss. Chairman Bernanke’s approach to inflation targeting is likely to be less responsive to past inflation than it is to be forward-looking, aiming for a multiyear average inflation rate over the medium term.
We regard the Fed’s 2007 core PCE inflation forecast (2.00% to 2.25%) as a form of “inflation guidance” from a central bank drifting gradually from a soft inflation target towards a more explicit inflation target. We believe that the Fed’s forward-looking policy will prove more forecast-dependent than data-dependent. Shifts in the Fed’s own forecast of future inflation are likely to be a key factor to its policy moves. The flow of current evidence should prove significant primarily when it shifts the medium-term inflation forecast of either the Fed or the market.
Under Chairman Greenspan, core PCE was selected as the Fed’s preferred inflation measure. One reason that core PCE was selected by Chairman Greenspan instead of core CPI was that it has a weighting on the controversial “owners’ equivalent rent” (OER) that is about one half as large as does the CPI. The logic of choosing some form of a core measure excluding food and energy was that these prices are volatile from month to month and make the overall inflation rate noisier in the short run than the underlying trend of inflation. However, energy prices have not shown a pattern of trendless volatility in recent years, but have trended persistently higher. As a result, overall inflation has been higher than core inflation for nearly four years. The concept that core PCE inflation is a reliable measure of the underlying inflation trend is therefore vulnerable to challenge, especially since inflation measured by core PCE has been lower than nearly all other inflation measures: overall CPI, overall PCE, core CPI, GDP deflator, median CPI and trimmed mean CPI. Of the significant inflation indicators, only market-based core PCE inflation (which excludes imputed prices) is lower than core PCE inflation.
Over the last 18 months, the Fed has been forced to repeatedly revise upwards its expectations for core inflation. The Fed’s “central tendency” forecast for core PCE inflation for the four quarters of 2007 was recently raised from 1.75% to 2.00% at Chairman Bernanke’s February 2006 testimony to 2.00% to 2.25% at his July 2006 testimony following three successive increases in the core inflation forecast for 2006. While a gradual glide path back to an inflation target or “comfort zone” is consistent with standard central bank practice, the Fed is running some risk to its credibility if inflation significantly overshoots its forecast once again in 2007.
Long-term expectations in the markets are slightly above the upper end of the Fed’s “comfort zone.” Assuming core CPI tends to run about 30 basis points higher than core PCE, the implied comfort zone for core CPI is 1.3% to 2.3%. Medium-term, the assumption is that core CPI inflation will tend to approximate overall CPI inflation. Long-term inflation expectations measured by the TIPS Spread, Michigan survey and the Philadelphia Fed’s survey of economists are roughly one quarter to one half of 1% above the upper end of the implied “comfort zone,” and three quarters to 1% above the midpoint of that zone. However, these expectations have been relatively stable. So far, inflation expectations have been “well-anchored” at a medium-term inflation rate somewhat above the Fed’s “comfort zone.” Central banks place a high value on ensuring that long-term inflation expectations remain “well-anchored.”
The Fed’s forecast for core inflation is only 25 basis points lower for 2007 than for 2006. There is a good chance that the Fed can outwait inflationary pressures with a near restrictive policy but there is little margin for error. Based on its current forecast, we believe that the Fed can maintain a forward-looking policy that holds the Federal funds rate near the border between a neutral policy and a restrictive policy.
Chairman Bernanke testified that he was surprised that compensation hadn’t yet accelerated, but that even if it did so in response to tight labor markets, there should be two potential offsets: (1) productivity growth and (2) a profit margin squeeze. As Chairman Bernanke testified on July 19, 2006, “Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation on price inflation would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher costs.”
Despite the tighter labor markets, there is little reliable evidence of a major rise in wage inflation so far. Pessimists about inflation have pointed to a rise in the 12-month growth rate of average hourly earnings to 3.8%. However, this indicator is not a good measure of wage inflation per worker. Much of the recent acceleration is attributed to a faster growth of high-wage workers than of low-wage workers, which can impact the reported growth rate even if there is no change in underlying wage inflation. Strength in hourly earnings contributes to strong income growth but is not a reliable signal of wage acceleration.
The Employment Cost Index is a better measure of wage and benefit inflation. It covers a larger number of employees, is mix-adjusted and includes benefit costs as well as wages and salaries, for a better measure of total compensation costs. Over the last five years, the progression of the four-quarter growth rate of private industry compensation through June of each year for private industry has been 4.0% in 2002, 3.5% in 2003, 3.9% in 2004, 3.1% in 2005 and 2.8% for the last four quarters. The wage and salary component was 3.6% for the first period, followed by 2.6%, 2.7%, 2.5% and 2.8%. Wage and salary cost trends have been basically stable for the last four years. Benefit costs have declined on a volatile path, in a pattern of 4.8%, 5.8%, 7.3%, 4.7% and 2.7%. With higher price inflation in the last 12 months, private wage and salary compensation has lagged inflation by 1.5%, creating some pressures for catch-up wage increases. Given the tighter labor market and the probable difficulty of generating further reductions in benefit inflation below 2.7%, we do expect some upward pressures in compensation costs over the next year.
We expect high productivity growth to persist on a long-term secular basis. However, there is likely to be some cyclical slowdown in productivity growth as the pace of economic growth slows. Second-quarter productivity growth was weak and unit labor costs rose. The growth rate over the last four quarters for the non-farm business sector has been 5.7% for compensation, 2.4% for productivity and 3.2% for unit labor costs. While this is a substantial acceleration, the non-financial data (less current but more reliable) were 190 basis points better for productivity and 180 basis points better for unit labor costs than were the non-farm data for the most recent period that both were available. Despite the confusing conflict between different measures of productivity and unit labor costs, we believe there has been a cyclical normalization of productivity growth. Productivity and unit labor cost trends have deteriorated from the exceptional results of recent years. This should somewhat reduce the disinflation impact of strong productivity growth.
The second factor that could help mitigate the inflationary impact of tight labor markets, according to the Chairman’s testimony, is the prospect of a squeeze on profit margins, which are currently at multi-decade highs. We believe that a key objective of Fed policy is to weaken the growth rate of aggregate demand enough to force some absorption of inflationary pressures into a stall or moderate squeeze in profit margins. There are early signs of success in these efforts as forward earnings guidance has begun to weaken for a variety of cyclical companies. Since sales should continue to grow, a moderate squeeze on profit margins is more likely to generate a slowing in the rate of profit growth than a profit decline.
The Fed focuses on the core PCE inflation rate, which is less influenced by owners’ equivalent rent than is the core CPI. The overall 12-month inflation rate (including food and energy) has run at 4.1% for the CPI through July and at 3.5% for the PCE through June. The core inflation rate (excluding food and energy) has run at 2.7% for the CPI through July and 2.4% for the PCE through June.
Core inflation growth rates should shift higher over the next several months to a 12-month growth rate of about 2.6% to 2.7% for the core PCE and about 3% for the core CPI. In part this reflects the rolling off of low inflation months from the summer of 2005 from the 12-month calculation. We doubt that there is substantial further upside above these inflation rates. Some of the recent acceleration in the rate of core inflation is due to the controversial “owners’ occupied rental equivalent” (OER). While it is a theoretically valid measure of inflation in housing services, it has several peculiarities. Cyclically, it tends to rise when interest rates increase enough to weaken home sales and increase the demand for rental property. In addition, the split between the core inflation rate and the energy inflation rate is influenced by the six-month rate of change of utility prices, notably natural gas. When natural gas prices drop as they have until recently, the result is to push up the core inflation rate. The reverse should occur as natural gas prices rebound.
After four years of the strongest world economic growth rate for three decades, leading indicators of economic growth have begun to cool somewhat. As a result, moderate slowing in the growth rate of world industrial production is likely within a continuing coincident worldwide economic expansion. Central banks abroad have begun to raise rates, but most are still at an earlier stage of monetary policy than the U.S. They are only now shifting from stimulation to neutral. Thus world monetary policy is still accommodative of continued global economic expansion.
In the U.S., recent benchmark revisions show that the average real GDP growth from the fourth quarter of 2002 to the first quarter of 2006 was 3.6% (a downward revision of 0.2%). Estimates of the past inflation rate have been revised upwards. The tradeoff between economic growth and inflation may have deteriorated somewhat. If so, a real GDP growth rate slower than 3% may be required to ease resource utilization pressures. As a result, the Fed is likely to welcome rather than resist a transition to slower economic growth in the U.S. This is one reason we expect monetary easing to be delayed even as the economy gradually slows.
The evidence that the housing sector has passed its cyclical peak is persuasive, with declining home sales, rising inventories and a sharp drop in the NAHB survey measures. The fundamental cause of housing weakness is an erosion of affordability due to a combination of past price increases and higher mortgage rates. Housing-related employment has stalled in recent months and should be declining over the next 18 months. The main debate about the housing sector is not whether it has moved into a sector recession but rather whether the housing recession will drive the overall economy into recession.
The most negative analysts on housing expect a downward spiral of house prices triggering major weakness in consumption spending and the overall economy. We expect a housing recession to generate only moderately below-trend GDP growth for several reasons. First, only a small fraction of total mortgage borrowers are financially vulnerable, despite a major rise in the risk profile of recent mortgage borrowers. Second, interest rates have moved higher, but are not that high in absolute terms. Third, the labor markets remain tight, which should support income growth. Fourth, weaker housing demand should be partially volume-adjusting through a fall in housing starts and completions as the profit margins of builders drop. This slowdown in new supply is likely to mitigate the magnitude of downward pressures on housing prices. Fifth, the lagged positive wealth effect of past house price increases should initially offset part of the negative impact of a nationwide stall in house prices.
Some Wall Street economists argue that the slower “mortgage equity withdrawal” in prospect for the balance of this year will have a severe and immediate impact on consumer spending, especially in an environment of high gasoline prices. In contrast, some traditional econometricians argue that it is a slower process and the lagged impact of past wealth increases should not be ignored. Our view is that the sector has begun a housing recession that may not bottom until the last half of 2007 and that the negative effect of the housing weakness is likely to be more intense in 2007 than in 2006 as the lagged benefit of past wealth increases slowly wear off. Housing-related employment has stalled but major declines have been postponed by the shift of labor to non-residential construction and the need to complete residential projects under construction. A more substantial fall in housing-related employment is likely in 2007.
We believe that the odds of full-scale recession in 2007 are only about 15%. The yield curve is now slightly inverted. Some models using the yield curve as a key input are estimating a substantial risk of a recession in 2007. Chairman Bernanke expressed some hesitancy about putting too much weight on the yield curve as a reliable forecast indicator in his March 20, 2006 speech entitled “Reflections on the Yield Curve and Monetary Policy,” and we agree with his analysis. In the past, inverted yield curves have preceded economic recessions and profit recessions.
There are two reasons for this. One is that the marginal profitability of extending credit by banks and other financial intermediaries tends to dry up as the yield curve inverts. This effect has been muted in this expansion by the increased use of market-based financing which is not intermediated by the banks. A variety of credit risk spreads in the marketplace remain low, indicating continued availability of credit. According to the Fed’s own July 2006 Senior Loan Officer Survey, “… domestic and foreign institutions indicated that they had eased lending standards and terms on commercial and industrial (C&I) loans somewhat further. Domestic banks, however, reported that they had tightened lending standards on commercial real estate loans over the previous three months, while foreign banks noted that standards on such loans were unchanged…In the household sector, a small net fraction of domestic respondents indicated that they had eased credit standards on residential mortgages over the previous three months, while standards and terms on consumer loans were reportedly little changed. Significant net fractions of domestic institutions noted that demand for both mortgages to purchase homes and consumer loans had weakened further.”
Our argument is that while we expect some cooling in the demand for credit in response to the uncertain housing outlook, the supply and availability of credit remains ample so far. We would be more reluctant to advance this argument if the yield curve were substantially inverted in an environment where risk spreads had widened in a major way. In such a case, the credit supply from both the banks and the markets would tend to be more restricted and the risks to the economy would be greater.
The second reason why inverted yield curves have been good forecasters of future recessions is that they embed the market expectations about future short-term rates. When the yield curve is significantly inverted, it reflects a market consensus that short-term rates will be lower in the future than they are today, presumably due to expected economic weakness. While we would regard a severely inverted yield curve as a valid signal of a major economic slowdown in the future, slight inversions of a few basis points are likely to be consistent with only a mild future deceleration in the growth rate of the economy. We expect that the U.S. yield curve will be slightly inverted over the course of 2006, anticipating a deceleration in economic growth in 2007.
Our view is that (1) the U.S. economy is in the cyclical phase of rising core inflation, (2) the core inflation cycle is occurring within a band of moderate inflation, (3) some of the inflation acceleration so far is attributable to portions of the indicators which may be over-representing the intensity of inflation risks, (4) the moderate but persistent upward pressure on core inflation will eventually ease, but only gradually, (5) the housing sector has entered a housing recession which should contribute to below-trend economic growth in 2007 and (6) there are good odds that the Fed is correct to forecast that past tightening will generate an economic slowdown but not a recession and will eventually lower the core inflation rate.
We believe that the most likely monetary policy scenario is “long pause and delayed easing,” with the first Fed easing postponed until mid-2007. This would reflect a balance between downward pressures on housing and upward pressures on core inflation. In that scenario, there would be gradual erosion of financial liquidity, economic momentum and eventually inflation. The next most likely scenario is “pause and resume” in response to persistent inflationary pressure. That would result in a more abrupt decline in financial liquidity with the risk of greater weakness in the U.S. economy and greater risk stresses. Less likely is an “early easing” scenario. While that would have a positive impact on the securities markets, it would create major credibility problems for the Fed and the dollar. We believe that a “long pause and delayed easing” is most likely, followed by a “pause and resume,” with lower odds of an “early easing” scenario.
Disclosure: This article represents the consensus of CrossProfit.com. Mellon Financial Corporation is not affiliated with CrossProfit. Richard B. Hoey is chief economist and senior vice president of Mellon Financial Corporation, as well as chief economist and chief investment strategist of The Dreyfus Corporation.
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good effort but where
will i find the time
to review this?