Introduction
After an increase of 2.9% for the full year 2006 and an increase of 2.1% in the fourth quarter 2006 (revised), real gross domestic product (GDP) exhibited significant weakness in the first quarter 2007 with an increase of only 0.6%. Real GDP showed marked improvement in the second quarter, increasing by 3.4% based on advance figures. This weakness in real GDP growth has most likely been the result of continued deterioration in the housing markets and the attending impact of higher interest rates on the mortgage markets as well as elevated energy prices.
Gross Domestic Product
Overview
Advance estimates[i] released by the Bureau of Economic Analysis (BEA) indicate that real GDP increased at a revised annual rate of 2.1% during the fourth quarter (as compared to advance estimates of 3.5%). First quarter 2007 real GDP was initially estimated to have increased by 1.3% but was revised lower to 0.6%. For the second quarter 2007, advance estimates of real GDP growth indicate an increase of 3.4%. In the first and second quarters 2006, real GDP increased 4.8% and 2.4%, respectively[ii].
Economic growth during the second quarter was above the consensus forecast of 2.4% annual growth in real GDP anticipated by fifty-three forecasters surveyed by the Federal Reserve Bank of Philadelphia[iii]. The consensus forecast is for a 2.6% increase in real GDP in the third quarter and an increase of 2.1% for the full year 2007. The May 2007 Survey of Professional Forecasters indicates the following with respect to the outlook for GDP growth.
…Growth in 2007 is most likely to fall in the range of 2.0 to 2.9 percent, just as the forecasters estimated in the last survey. However, compared with their estimates three months ago, the forecasters see a much higher chance that growth will fall in the lower range of 1.0 to 1.9 percent. In 2008, the forecasters are assigning the highest probability to growth in the range 2.0 to 2.9 percent. Previously, the highest probability was assigned to growth in the range 3.0 to 3.9 percent…
The forecasters have not much altered their assessment of the risk for a quarter of negative growth in real GDP, even though they have cut their estimates for growth in 2007. The forecasters see an 11.75 percent chance of negative growth in the current quarter, down slightly from 13.14 percent in the last survey.
Personal Consumption Expenditures
Real personal consumption expenditures, the bulk of economic activity and a factor that largely supported the robust growth in the domestic economy in 2005 and early 2006, showed signs of weakness over the first half of 2007, with growth moderating from an increase of 3.9% in the fourth quarter 2006 to 3.7% in the first quarter 2007 to 1.3% in the second quarter. Following an increase of 8.8% in the first quarter, purchases of durable goods increased by 1.6% in the second quarter 2007. This lower rate of increase in purchases of durable goods during the second quarter was attributable to a decline in purchases of motor vehicles & parts along with lower expenditures on furniture and household equipment. Personal consumption expenditures on nondurable goods followed a similar but more pronounced weakening trend, increasing by 4.3% during the fourth quarter 2007, by 3.0% during the first quarter 2007, and declining by 0.8% in the second quarter.
Nonresidential Fixed Investment
Real nonresidential fixed investment decreased 1.4% in the fourth quarter 2006 but rebounded during the first half of 2007 with an increase of 2.1% in the first quarter and an increase of 8.1% in the second quarter. The improved performance was attributable to robust investment in nonresidential structures, which increased 6.4% in the first quarter and 22.1% in the second quarter, and improving activity with respect to equipment and software investment (an increase of 2.3% in the second quarter as compared to an increase of 0.3% in the first quarter).
Following an increase of $17.4 billion in the fourth quarter 2006, private businesses increased inventories by $0.1 billion in the first quarter and by $3.6 billion in the second quarter 2006. The weak activity in the first quarter may have been intended to allow stocks that may have accumulated during the fourth quarter to be gradually drawn down. The lower rate of investment in inventories during the first quarter subtracted 0.65% point from the real GDP figures. The second quarter real change in inventories added 0.15% to the change in real GDP. The slower pace of inventory production as compared to late in 2006 may suggest that businesses still believe a period of lower production is necessary in order to draw down inventories to levels more in line with projected demand for the second half 2007.
Residential Fixed Investment & Related Residential Data
Real residential fixed investment continued to decline with a decrease in the first and second quarters of 2007 of 16.3% and 9.3%, respectively. Real residential fixed investment decreased in 2006 by 4.6%. This illustrates the ongoing fall out from the bursting of the real estate bubble and is consistent with the continued weakness in general real estate markets evident throughout the country in the first half of 2007.
Data on new residential construction from the U.S. Census Bureau and U.S. Department of Housing and Urban Development indicated that activity during the first and second quarters 2007 continued to exhibit marked weakness from the prior year. For the first quarter 2007, new privately-owned housing units authorized by building permits declined in January to 1,566,000 before falling to 1,541,000 in February and increasing to 1,569,000 in March[iv]. On a year-over-year basis, these figures represent declines of 28.7%, 28.2%, and 24.8%, respectively. For the second quarter, new privately-owned housing units authorized by building permits fell to 1,457,000 in April, increased slightly to 1,520,000 in May, and dropped again in June to 1,406,000. On a year-over-year basis, these figures represent declines of 26.2%, 21.9%, and 25.2%, respectively.
Privately-owned housing starts followed a similar pattern of general decline, falling to 1,403,000 in January and rebounding to 1,487,000 in February and 1,491,000 in March. On a year-over-year basis, these figures represent declines of 38.1%, 30.3%, and 24.4%, respectively, for the first quarter. For the second quarter, privately-owned housing starts fell to 1,485,000 in April and to 1,440,000 in May then increased to 1,470,000 in June. These figures represent year-over-year declines of 18.9%, 25.9%, and 19.2% for April, May, and June 2007, respectively.
Sales of existing homes mirrored the data related to new home construction, continuing to exhibit weakness during the first half of 2007. Data from the National Association of Realtors (NAR) indicates that existing home sales increased from 6.44 million in January to 6.68 million in February before falling steadily to 6.15 million in March, 6.01 million in April, 5.98 million in May, and 5.76 million in June at seasonally adjusted annual rates. The June figures represent the slowest pace of sales since late 2002, prior to the rapid inflating of the real estate market bubble. Concurrently, the inventory of existing homes increased further in 2007. At the end of 2006, the inventory of existing homes was 3,450,000 or a 6.6 months supply. By the end of the first quarter, the inventory of existing homes had increased to 3,806,000 or 7.4 months supply. In June, the inventory of existing homes stood at 4,368,000 or 9.1 months supply.
Thirty-year conventional mortgage rates, according to Freddie Mac[v], rose overall during the first half of 2007. Thirty-year rates started 2007 at roughly 6.18% and rose to a first-quarter high of 6.34% in early February before retrenching to end the quarter at 6.16%. During the second quarter, thirty-year mortgage rates rose steadily to a high of 6.74% in mid-June before falling slightly to end the quarter at 6.67%.
Fifteen-year mortgage rates increased from 5.94% at the beginning of the year to 6.06% in early February then fell back to 5.86% by the end of the first quarter 2007. By the end of the second quarter, fifteen-year rates had risen steadily to a quarter high of 6.43% before ending the quarter at 6.34%.
Exports & Imports
After a weak first quarter with a 1.1% increase, real exports of goods and services for the second quarter increased at a rate of 6.4%. Real exports of goods and services increased 14.3% in the fourth quarter 2006. For the first and second quarters, the increase in exports added 0.13% and 0.73% to the change in real GDP, respectively. Imports, a subtraction from GDP, increased 3.9% in the first quarter 2007 then decreased 2.6% in the second quarter. Imports increased 1.6% in the fourth quarter 2006. The increase in imports in the first quarter subtracted 0.63% from real GDP; however, the decrease in imports in the second quarter added 0.45% to the second quarter real GDP.
Federal Government Consumption Expenditures
After a 6.3% decrease in the first quarter, real federal government consumption expenditures increased by 6.7% during the second quarter. A 9.5% increase in national defense spending in the second quarter helped to in increase real GDP for the quarter. In the first quarter, national defense spending decreased 10.8%. Nondefense spending increased by only 1.3% in the second quarter as compared to a 3.8% increase during the first quarter.
The Federal Reserve
The Federal Reserve’s Federal Open Market Committee (FOMC) continued to hold its target for the federal funds rate at 5¼% for the first half of 2007. At its January 31, 2007 meeting, the FOMC recognized that economic growth seemed to have firmed based on various indicators although the Committee judged that some inflationary pressures likely remained. This prompted the FOMC to maintain a policy tightening bias as indicated in its press release that stated the following:
The Committee judges that some inflation risks remain. The 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.
The FOMC held rates steady again at its meeting on March 21, 2007. The Committee continued to express concern that inflationary pressures could fail to moderate and indicated that despite a continued adjustment in the housing market economic activity continued to expand at a moderate pace. The FOMC maintained this same position at the May 9, 2007 meeting and left rates unchanged.
At the June 28, 2007 meeting, the FOMC remained optimistic on the moderate pace of economic activity and the minimal impact of the ongoing adjustment in the housing sector. However, the FOMC seemed to be more concerned that the moderation in inflationary pressures had failed to be “convincingly demonstrated.” Despite this, the FOMC maintained a target for the federal funds rate at 5¼%. The Committee’s concern regarding inflationary pressures was illustrated in the press release following the conclusion of its two-day meeting.
In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.
In his semi-annual testimony before the Congress to discuss the Monetary Policy Report to the Congress (February 14, 2007 and July 18, 2007), Chairman Ben Bernanke maintained a favourable outlook for U.S. economic activity whilst noting the significant risks posed by the correction in the housing market and the attending impact upon the broader economy. In his February 14, 2007 testimony before the Committee on Banking, Housing, and Urban Affairs in the U.S. Senate, Chairman Bernanke offered the following assessments:
Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven…
…the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past six months, and the unemployment rate, at 4.6 percent in January, remains low.
Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation–that is, inflation excluding the prices of food and energy–have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated.
Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3-1/2 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous three years. Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation–as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index–rose at an annual rate of around 3 percent in the latter half of 2006.
The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house-price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about four-and-a-half months’ supply in 2005 to nearly seven months’ supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially.
Some tentative signs of stabilization have recently appeared in the housing market: New and existing home sales have flattened out in recent months, mortgage applications have picked up, and some surveys find that homebuyers’ sentiment has improved. However, even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to more-comfortable levels.
Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom generation, and an apparent leveling out of women’s participation rate in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer jobseekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home-equity appreciation by saving more out of current income.
The business sector remains in excellent financial condition, with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures (such as office buildings, factories, and retail space) increased rapidly through much of the year after several years of weakness…Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors–most notably at motor vehicle dealers and in some construction-related manufacturing industries–rose over the course of last year, leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year.
Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts–which are based on the information available at that time and on the assumption of appropriate monetary policy–is for real GDP to increase about 2-1/2 to 3 percent in 2007 and about 2-3/4 to 3 percent in 2008…The civilian unemployment rate is expected to finish both 2007 and 2008 around 4-1/2 to 4-3/4 percent.
The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected…
Though the assessment regarding the economy during the first half of the year and the prospects for economic growth remained favourable at the July 18, 2007 testimony before the Committee on Financial Services in the U.S. House of Representatives, Chairman Bernanke continued to note the risks stemming from the downturn in the housing sector and the potential adverse impact this could have upon economic activity in the coming quarters.
After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4-1/2 percent…
To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year
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The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that–despite the recent increase–remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time.
Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases.
The Board of Governors’ and Federal Reserve Bank presidents’ expectations for economic activity moderated from the projections that were part of the February 2007 Monetary Policy Report to the Congress to the July 2007 report. The central tendency for real GDP growth fell to 2¼%-2½% for 2007 as compared to a central tendency of 2½%-3%. For 2008, the initial central tendency was for real GDP growth of 2¾%-3% but was reduced to a central tendency of 2½%-2¾% in the July 2007 report. The central tendency for the personal consumption expenditures price index excluding food and energy (the Federal Reserve’s preferred measure of inflation) for 2007 was 2%-2¼% in the February 2007 report and remained unchanged in the July report. For 2008 the PCE price index excluding food and energy was projected at 1¾%-2% in both the February and July reports. The 2007 and 2008 projections for the civilian unemployment rate had a central tendency of 4½%-4¾% in both reports.
To be sure, the impact of the continued correction in the housing markets has yet to be fully felt in the economy. The spillover effects of this marked slowdown in real estate activity may well be significant and of such a magnitude as to push the economy towards a recession in the second half of 2007. This, coupled with sustained elevated energy prices, is likely to place significant adverse pressures on the entire economy. The impact of these factors on economic activity in other sectors as well as energy prices’ impact upon the outlook for inflation is likely to continue to manifest in the third quarter. Inflation may well feel continued upward pressures; the FOMC expressed this concern at each meeting in 2007. This places the rate-setting FOMC in a precarious position of confronting higher inflation during a period of slowing economic growth.
The Beige Book Data
The Federal Reserve Beige Books[vi] released on January 17, 2007, March 7, 2007, April 25, 2007, June 13, 2007 and July 25, 2007 indicated mixed results in economic activity throughout the twelve Districts[vii] during the first and second quarters. Excerpts from The Beige Book for each release are included below:
January 17, 2007
Most reports from the Federal Reserve District Banks indicated that economic activity expanded at a modest pace since the last report…
Districts generally reported modest increases in retail sales, and vehicle sales were sluggish in several Districts…Manufacturing activity continued to expand in most Districts, with weakness reported mainly for products supporting the residential construction industry. Nearly all Districts reported a continued softening in housing markets, and high inventories of new homes have generally led to a slowing in residential building. In contrast to the housing sector, commercial real estate markets continued to see strong activity in most Districts…Energy production and exploration remained at high levels, and the alternative energy sector increased…
District reports generally described labor market conditions as tightening and cited examples of some businesses having difficulty finding qualified workers. Despite expanded hiring, Districts reported relatively moderate gains in wages; however, some Districts noted certain business lines that experienced wage increases and have concerns about increases in the benefit portion of compensation. District reports indicated moderate price increases overall as prices for energy and a number of materials eased and competition kept prices for final goods in check.
March 7, 2007
Most Federal Reserve Districts reported modest expansion in economic activity since the last report, but several Districts noted some slowing.
The majority of Districts reported steady growth in retail sales, while vehicle sales remained sluggish…Manufacturing activity was steady or expanding, despite continued weakness in production related to the construction and auto industries. Almost all Districts reported that housing markets remained weak, but signs of stabilization were noted in several Districts. In contrast to the housing sector, commercial real estate markets continued to firm or remained solid…
Most Districts noted further expansion in labor markets and continued tight supply of skilled and professional workers. With rising demand for many types of workers, wage pressures increased slightly in several Districts, although pay increases generally remained moderate overall.
Most Districts characterized price pressures as little changed. Energy and construction-related materials prices fell, but food input costs increased in several Districts.
April 25, 2007
Most Federal Reserve Districts noted only modest or moderate expansions in economic activity since the previous report…
Reports on retail sales across the Districts were generally positive, although vehicle sales were mixed in several Districts. Most Districts reported that manufacturing activity was slow, with many reports of weakening among manufacturers that support the residential construction sector. Economic activity in the services sector continued to increase across most Districts, especially for firms serving business customers…Residential real estate activity continued to weaken, with sales declining in many Districts and flat in a number of others…Several Districts also reported declining homebuilding activity…
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Most Districts reported continuing tight labor market conditions, especially for skilled occupations. Several Districts noted faster wage growth for skilled workers, but only modest overall wage increases. Consumer prices remained generally stable, with some Districts experiencing only modest price increases. Most Districts, however, reported rising prices for inputs and energy.
June 13, 2007
Reports from the twelve Federal Reserve Banks indicated that economic activity continued to expand from mid-April through May…
Consumer spending and retail sales were generally up in late April and May, with a number of Districts reporting that luxury items were selling better than lower-end merchandise. On net, there was little change in auto sales across the Districts, and dealers are about evenly split on whether there will be any pickup in sales over the summer…Manufacturing activity was up in a majority of Districts. There was weakness among manufacturers producing for the residential construction industry but strength among machinery and equipment manufacturers in several Districts.
There was continuing weakness in residential real estate and construction but increasing strength in the commercial real estate sector, including both office and industrial space…
Hiring activity picked up in late April through May, especially for workers with specialized skills. But most Districts reported that overall wage pressures do not seem to have increased. There have been significant price increases for energy-related products and selected raw materials, but the prices of some raw materials have remained stable.
July 25, 2007
Reports from the twelve Federal Reserve Banks indicated that economic activity continued to expand in June and early July…
On balance, consumer spending rose at a modest pace, although a number of Districts indicated that sales were mixed or below expectations. Several reports indicated that capital spending increased, and expenditures for most business services continued to rise. Employment increased further in most regions and in many sectors of the economy. Most Districts said that residential construction and real estate activity continued to decline. Commercial construction and real estate markets were generally more active than during the previous reporting period. District reports indicated that manufacturing activity continued to expand during June and early July…
Contacts generally reported ongoing input cost pressures, particularly for petroleum-related inputs, while prices at the retail level continued to increase at a moderate rate…Many Districts described overall wage gains as moderate and/or similar to the previous reporting period.
The Business Sector
Industrial Production & Capacity Utilization
Industrial production, as compiled by the Federal Reserve[viii], decreased at a revised annual rate of 1.5% during the fourth quarter of 2006 but increased by 3.7% for the full year 2006. For the first quarter 2007, industrial production increased by a revised annual rate of 1.1%. For the second quarter, industrial production rebounded with an increase of 3.3%. For the twelve months ending in January, February, and March, industrial production increased by 2.6%, 3.4%, and 2.3%. For the second quarter, industrial production increased by 1.9%, 1.6%, and 1.4% for the twelve months ending in April, May, and June.
Manufacturing production, which decreased at an annual rate of 1.7% in the fourth quarter of 2006, experienced weakness in the first quarter of 2007 with an increase of only 0.8%. Manufacturing production improved in the second quarter with an increase of 3.9%. The weakness in manufacturing in the first quarter is likely the result of weakness in manufacturing related to the construction industry. This is confirmed by anecdotal evidence contained in The Beige Book releases from the Federal Reserve, which indicated generally favorable manufacturing activity albeit at tempered levels throughout the twelve Districts during the early part of the year. The rebound in manufacturing activity in the second quarter is also in line with the reports included in the Beige Book releases. The pickup in manufacturing may be the result of a weaker dollar in foreign exchange markets, which has made U.S. products less expensive to foreign consumers than their domestically produced counterparts.
Durable consumer goods production, which declined at an annual rate of 4.0% in the fourth quarter of 2006, declined by 0.7% in the first quarter but rebounded strongly in the second quarter with an increase of 12.7%. Nondurable consumer goods production, which increased by 1.2% in the fourth quarter, advanced at an annual rate of 4.7% in the first quarter but decreased at an annual rate of 0.7% in the second quarter.
On a quarterly basis, capacity utilization declined to 81.5% in the fourth quarter of 2006. Capacity utilization declined again slightly in the first quarter of 2007 to 81.3% before increasing to 81.6% in the second quarter. These levels are slightly above the 1972 to 2006 average of 81%. Manufacturing capacity utilization decreased from 80.1% in the fourth quarter 2006 to 79.8% in the first quarter but rebounded to 80.2% in the second quarter. The 1976 to 2006 average is 79.8%. At these levels of resource utilization, there appears to be enough slack in the productive capabilities throughout the United States to prevent an unwanted rise in inflationary pressures resulting from the inability to supply enough products to satisfy demand.
Retail Sales
The Department of Commerce’s[ix] advance monthly sales for retail trade and food services increased from $370.3 billion in December 2006 to roughly $372.9 billion in March and to $373.9 billion in June 2007[x]. Total retail sales increased from the December 2006 level of $333 billion to $336 billion in March and $336.7 billion in June. For the first quarter, advance monthly retail and food service sales increased 3% on a year-over-year basis. For the second quarter, advance monthly retail and food service sales increased 3.9% from the same quarter a year ago. On a year-over-year basis, advance sales for retail trade and food services increased 1.4%, 3.6%, and 4.1% in January, February, and March, respectively. In the second quarter, sales for retail trade and food services increased 2.8%, 5.0%, and 3.8% on a year-over-year basis in April, May, and June, respectively.
Retail sales increased 2.9% in the first quarter as compared to the first quarter 2006 and increased by 3.7% in the second quarter of 2007 as compared to the same quarter in 2006. Total sales excluding motor vehicles and parts increased 3.4% in the first quarter over the prior year and by 4.1% in the second quarter on a year-over-year basis.
Inflation
The consumer price index (CPI) [xi] increased 4.7% for the first quarter of 2007 at a seasonally adjusted annual rate and 5.2% for the second quarter. For the twelve months ending in January, February, and March, the CPI increased at an annual rate of 2.1%, 2.4%, and 2.8%, respectively. For the twelve months ending in April, May, and June, the CPI increased at an annual rate of 2.6%, 2.7%, and 2.7%, respectively. For the six months ending in June 2007, the CPI increased by 5.0%. The CPI increased by 3.3%, 3.4%, and 2.5% in 2004, 2005, and 2006, respectively.
For the first quarter of 2007, the energy index increased by 22.9%, as a result of continued elevated energy prices. For the second quarter, the energy index increased 32.9%. For the first half of 2007, the energy index increased by 27.8%. For the twelve months ending in March and June, the energy index advanced by 4.4% and 4.6%, respectively. For the first and second quarters of 2007, the food index advanced at an annual rate of 7.3% and 5.2%, respectively. For the six months ending in June 2007, the food index increased 6.2%. For the twelve months ending in March and June, the food index increased by 3.3% and 4.1%.
Removing the effects of food and energy, the core CPI increased by a seasonally adjusted annual rate of 2.3% in both the first and second quarters. For the six months ending in June 2007, the core CPI increased by 2.3% as well. For the twelve months ending in March 2007 and June 2007, the core CPI increased 2.5% and 2.2%, respectively. This may tend to indicate that producers have been slow to pass along increased costs resulting from higher energy and food prices to consumers.
In addition to the CPI, the price index for personal consumption expenditures (PCE) from the Bureau of Economic Analysis[xii] increased 2.3% in the first quarter of 2007 as compared to the first quarter of 2006. In the second quarter, the PCE price index increased 2.3% on a year-over-year basis. For 2006, the PCE price index increased 2.8% on a year-over-year basis. The price index for PCE excluding food and energy prices increased 2.4% and 2.0% on a year-over-year basis in the first and second quarters of 2007.
It appears that the increase in core inflation in the first half of 2007 may have been muted as compared to prior quarters. However, headline inflation as measured by the CPI indicates that inflation was higher in the first half of 2007 due to increases in energy prices and food prices. As energy prices are expected to remain firm, further upward inflationary pressures may be more likely as producers attempt to begin the process of passing along cost increases to consumers. Any unexpected increase in core inflation may result in higher inflation premiums in the markets that would tend to suppress economic growth.
Labor Market
The unemployment rate held steady at 4.5% in the first and second quarters[xiii]. The unemployment rate was also 4.5% for the fourth quarter of 2006. Total nonfarm payroll employment increased by 162,000 in January 2007, by 113,000 in February, and by 150,000 in March, for a first quarter average of 142,000 monthly job gains. As a result of these gains, total nonfarm payroll employment increased by 425,000 during the first quarter of 2007 as compared to an increase of 590,000 during the first quarter of 2006. In the second quarter, total nonfarm payroll employment increased by 446,000 or a monthly average of 149,000 job gains. Total nonfarm payroll employment increased by 124,000 in April, 190,000 in May, and 132,000 in June.
Manufacturing employment continued to fall during the first half of 2007 with a loss of 41,000 jobs in the first quarter and a loss of 43,000 jobs in the second quarter. This equates to roughly 14,000 jobs losses per month in manufacturing. Construction employment experienced considerable weakness given the generally soft real estate market conditions. Even after losing 61,000 construction jobs in February, the industry managed to gain a net 8,000 jobs for the first quarter. For the second quarter, however, construction employment declined by 11,000 or nearly 4,000 jobs per month. Service providers including professional & business services, education & health services, leisure & hospitality, and government saw considerable payroll gains in the first half of the year with employment increasing by 450,000 in the first quarter and by 493,000 during the second quarter. As a result, service providers increased employment by nearly 1 million jobs in the first half of 2007.
The continued downturn in the real estate markets along with competitive forces resulting in manufacturers moving production to lower labour cost countries will likely have a further negative impact upon job creation in the second half of the year. However, should service providing industries continue to add to payrolls at a rate comparable to that of the first half, the impact of the downturn in construction and manufacturing may not be as pronounced from an overall perspective. Should economic activity slow in the second half of the year, as is likely, payroll employment gains in the coming months may well be muted. This may be more pronounced should businesses reduce payrolls to compensate for lower demand expectations. As such, a drop in the unemployment rate is currently unlikely. A rising unemployment rate would likely ease the shortages of skilled workers that have been noted throughout the nation. As a result, any wage pressures that may have attended the shortage of skilled workers would also likely ease.
Equity Markets
The Dow Jones Industrial Average (DJIA) ended 2006 at roughly 12,400[xiv]. The S&P 500 and the NASDAQ composite ended 2006 at 1,400 and 2,400, respectively. During the first quarter of 2007, the DJIA was roughly flat with a slight decline of 1.4% (through March 28th) to 12,300. The NASDAQ and the S&P 500 were also flat, ending the quarter at roughly 2,417 and 1,417, respectively. The second quarter saw the markets increase from the tepid performance of the beginning of the year, perhaps spurred on by expectations for more favorable activity in the second half of the year. The DJIA increased roughly 9% to end the quarter at roughly 13,427. The NASDAQ composite and the S&P 500 also rose during the quarter by 7.8% and 6.3%, respectively, to roughly 2,605 and 1,506. From January to the end of July, the DJIA rose by roughly 7.8%, the NASDAQ composite rose by 7.5%, and the S&P 500 rose by 6.3%.
The rebound in the equity markets during the second quarter may be the result of renewed optimism in economic prospects, strength in corporate profits, and a perceived value of equity prices relative to other risky asset classes particularly in light of the continued slowdown in the real estate markets. This diminishing opportunity for superior returns in the real estate markets may have prompted investors to continue to return to the equity markets and other asset classes.
Oil Prices
West Texas Intermediate (WTI) oil prices, which ended 2006 at roughly $61 per barrel, rose throughout the first half of 2007. For the first quarter, oil prices dropped to as low as $51 per barrel in mid-January before increasing steadily to end the quarter at roughly $63 per barrel. During the second quarter, WTI oil prices remained in a relatively tight band between $62 and $64 per barrel until early June at which time prices began to rise steadily. By the end of the second quarter, prices had risen to roughly $69 per barrel.
The rise in prices during the first half of 2007 may well have been the result of OPEC members’ cut in production by 500,000 barrels per day effective February 1, 2007. This decision to cut production was made at the 143rd (Extraordinary) meeting of the OPEC conference in Abuja, Federal Republic of Nigeria on December 14, 2006[xv]. No action was taken to increase or decrease production at the cartel’s 144th (ordinary) meeting in Vienna, Austria, on March 15, 2007. The decision was based on the conclusion that economic activity was expected to remain firm in 2007 but lower than in 2006 due to a higher interest rate environment in the United States. In his opening address to the 144th (ordinary) meeting of the OPEC conference, Mohamed Bin Dhaen Al Hamli, President of the Conference and Minister of Energy of the United Arab Emirates, indicated the following[xvi]:
…[W]e are watching developments on world stock markets, to assess their possible impact on the global economy and, in particular, on energy demand. Also, we remain concerned about the continuing weakness of the US dollar against other major currencies, notably the euro and the pound sterling, because this is having a significant effect on the purchasing power of oil-producing developing countries in many parts of the world.
The inaction from OPEC in the first half of 2007 continues to suggest that the cartel is comfortable with an oil price in excess of $60 per barrel (WTI). Continued sharp rises in demand from rapidly growing economies such as China and India could place further upward pressure on already high oil prices. Given this and OPEC’s recent production cuts, it is likely that energy prices will remain at elevated levels throughout 2007, which could further temper economic growth. Continued geopolitical risks could create an additional premium in the price of oil. Furthermore, the degree to which speculative activity in the oil markets will ultimately impact the price of oil has yet to be fully demonstrated. Therefore, as in previous assessments, the risks to economic activity stemming from higher energy prices remain weighted towards conditions that may perpetuate further economic weakness in the coming quarters.
Economic Outlook
Based on our current assessment of a number of economic factors discussed herein, economic growth appears to have finally been weakened by the adverse systemic impact of continued elevated energy prices, rising inflationary pressures, and protracted weakness in the real estate market and the attending impact upon mortgage markets. Persistently high energy prices have contributed to a rise in inflationary pressures, particularly in food products. Economic activity remains weak despite the continued pause in the Federal Reserve’s removal of monetary policy accommodation. The Federal Reserve remains concerned regarding inflationary pressures and the potential impact this could have upon economic activity in the coming quarters. As a result, economic activity could yet become more tempered in the second half of 2007. These factors suggest that the risks to the economy remain weighted heavily towards weaker economic activity in the coming quarters.
Previously, we did not believe that the preponderance of evidence pointed to a recession. However, we believe that the risks are now balanced between a recession and economic growth at a much more tempered pace in the second half of the year.
Our assessment of the current state of the economy indicates the following:
- Despite the Federal Reserve’s pause in removal of accommodative monetary policy, higher mortgage rates have likely restrained real estate activity and contributed to the further removal of the speculative froth that had developed in many markets in the preceding two years.
- The higher interest rates coupled with declines in house prices have led to increased foreclosures during the first half of this year. This trend is likely to continue into the second half of 2007 as investors and homebuyers who purchased properties beyond their means are removed from the market. Rising default rates on mortgages are likely to have an adverse impact upon the banking sector, mortgage markets, and real estate markets.
- Oil prices are likely to remain at elevated levels throughout 2007, which could prompt further slowing of economic activity globally and in the U.S.
- Inflationary pressures are likely to remain at levels above recent trends, which would be consistent with slower economic growth.
Our expectations for the economy include:
- In the absence of the economy slipping into recession in the second half of 2007, we anticipate real GDP growth of 1 ¾% – 2 ½% for the full year 2007 and 2 ½% – 3% in 2008.
- The next likely move by the Federal Reserve is an easing of monetary policy. The federal funds rate should end 2007 at roughly 4 ½%.
- Inflation is likely to increase in 2007 with the core CPI increasing by roughly 2½% – 3 ¼%.
- Continued geopolitical concerns, increased demand from developing countries, and refining capacity issues will likely result in sustained increases in oil prices. As OPEC has cut production during the first half of 2007, it is unlikely that the cartel will increase production in the second half of 2007. Oil prices (WTI) are likely to remain in the range of $68-$75 per barrel for the rest of 2007.
Conclusion
Economic activity slowed significantly in the first quarter of 2007 with real GDP increasing at an annual rate of only 0.6%. Real GDP increased by 3.4% in the second quarter based on advance estimates from the Bureau of Economic Analysis. Personal consumption expenditures, which had performed well during the first quarter, slowed markedly in the second quarter, perhaps as a result of a squeeze on personal finances caused by higher energy prices and continued weakness in the housing market. These factors may create continued uncertainty regarding future economic growth in the coming quarters. Inflationary pressures were evident with the CPI increasing by 5.2% at an annual rate for the second quarter. The core CPI (all items less food and energy) increased by 2.3% in the second quarter. Based on our assessment of the state of the economy in the second quarter, conditions are likely to remain unfavourable for economic activity during the second half of 2007. As such, the risks are weighted equally between growth at lower rates with an accompanying higher level of inflation and recession during the second half of the year.
[i] The BEA press release on January 31, 2007 states the following with respect to advance estimates: The Bureau emphasized that…“advance” estimates are based on source data that are incomplete or subject to further revision by the source agency.
[ii] Quarterly data is expressed at a seasonally adjusted annual rate. Real estimates are in chained (2000) dollars.
[iii] Survey of Professional Forecasters, Research Department Federal Reserve Bank of Philadelphia, May 14, 2007.
[iv] With respect to trends in housing data, the U.S. Department of Commerce/U.S. Census Bureau and the U.S. Department of Housing and Urban Development state in the new residential construction press releases
In interpreting changes in the statistics in this release, note that month-to-month changes in seasonally adjusted statistics often show movements which may be irregular. It may take 4 months to establish an underlying trend for building permit authorizations, 6 months for total starts, and 6 months for total completions.
[v] Data from Freddie Mac Weekly Mortgage Market Survey
[vi] The press release states the following: This document summarizes comments received from businesses and other contacts outside the Federal Reserve and is not a commentary on the views of Federal Reserve officials.
[vii] The Twelve Districts of the Federal Reserve system include: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
[viii] Industrial production data from the Federal Reserve’s Industrial Production and Capacity Utilization statistical release.
[ix] Press release from the Department of Commerce.
[x] Adjusted for seasonal, holiday, and trading day differences but not for price changes. Removing the impact of prices changes/inflation, the growth figures would be lower. For example, if total retail sales increased by 6.2% on a year-over-year basis and the twelve month inflation rate, based on the CPI, was 3.4%, this would imply a real growth in total retail sales of roughly 2.8%.
[xi] Based on data from the Consumer Price Index press releases by the Bureau of Labor Statistics, United States Department of Labor.
[xii] Bureau of Economic Analysis.
[xiii] Bureau of Labor Statistics, United States Department of Labor, The Employment Situation press release.
[xiv] Based on data from The Economist.
[xv] OPEC press release following the 143rd (Extraordinary) Meeting of the OPEC Conference in Abuja, Nigeria on December 14, 2006.
[xvi] OPEC press release following the 144th (Ordinary) Meeting of the OPEC Conference in Vienna, Austria on March 15, 2007.
Business Valuations By Highland Global 