Dr. Martin Regalia: ECON 101

 

After a year of growing at a very slow 1.5% pace, the economy grew at a robust 3.4% real growth rate in the second quarter of 2007. However, despite this strong showing, the growth was unbalanced and the prospects for economic growth in the second half of the year remain subdued. High gasoline and oil prices and the continued malaise in the housing sector have finally begun to weigh on the American consumer, and uncertainty over the future course of economic activity continues to produce anemic business investment. Although the weaker dollar and strong growth abroad have brought a welcome improvement in net exports, it is unlikely that this sector will offset weakness elsewhere in the economy.

 

Consumption, the driving force behind much of our economic growth for the last four years, faltered in the second quarter, increasing a paltry 1.3% at an annual rate. At this point, it is hard to tell whether the weak showing reflects the initial impact of higher gasoline prices and the decline in housing markets or is merely a hiccup in an ongoing positive trend. The data support both conclusions.

 

 

On the downside, sales for both new and existing homes were down again in July, and the months' supply of homes for sale remains elevated. On a slightly brighter note, home prices, especially for existing homes, have begun to stabilize, and the monthly average for housing starts in the second quarter was actually above that of the first quarter. Housing affordability has also improved since the beginning of the year.

 

While delinquency and foreclosure rates in the subprime mortgage market continue to climb, the same measures for traditional loans are up only slightly. Moreover, the decline in residential investment in the most recent quarter, although substantial, was less than half the rate of decline witnessed at this time last year. My take on the data is that the housing sector is still in decline, but the speed of descent has moderated. We probably have another few months of nail-biting data before a very gradual improvement begins early next year.

 

Business investment is another area of the economy that is troubling but hasn't received the same amount of press as the housing sector. After rising at a miserly 0.3% pace in the first three months of the year, business investment in equipment and software grew at a still weak 2.3% rate in the second quarter. With corporate profits remaining relatively strong and industrial production showing modest gains of late, we are expecting (should I say, hoping for?) some strengthening in the second half of this year and into the early part of 2008.

 

However, while businesses appear to have the financial wherewithal to undertake more capital spending, there seems to be a hesitancy to make the commitment. Economic uncertainty and the rash of corporate takeovers may have put businesses in a defensive mood, preferring to buy back stock rather than invest and grow. When we last saw such timidity in the business community in 2002 and 2003, the administration goaded businesses into action with a significant tax cut. But the current Congress seems highly unlikely to adopt such a strategy.

 

Investment in structures jumped at more than a 22% annual rate in the second quarter of this year, more than three times the prior two quarters. With the capacity utilization rate running just under 82%, we are likely to see some continued expenditure in this area, although it is hard to believe that commercial building will stay anywhere near this strong.

 

International trade is one area where we can expect some continued help. With a weak dollar and robust growth abroad, exports surged in the second quarter, and import growth slowed, providing a noticeable improvement in the trade balance. With both conditions expected to maintain in the second half of the year, trade should continue to provide some support for GDP growth.

 

Job growth remained steady, if unspectacular, throughout the first half of 2007 with the economy adding 863,000 jobs-about 70% of last year's pace. Despite the slowdown in job creation, the unemployment rate remains a relatively low 4.6%, and the initial claims for unemployment insurance continue to hover just above the 300,000 level. We expect the current pace of job growth to continue through the second half of the year, with the result that the unemployment rate should rise slightly but remain below 5%. This slow growth should help alleviate some of the pressure in labor markets and help mitigate the Fed's fear of inflation.

 

Speaking of inflation, overall price increases have accelerated of late with the uptick in gasoline and oil prices. But core rates of inflation have moderated over the first half of the year and currently remain at the upper limit of the Fed's announced "comfort range."

 

With inflation reasonably well behaved, and the economy clearly growing below its long-run potential, some financial market participants (Chicken Littles?) are beginning to clamor for a Fed interest rate cut. According to this group, recent volatility in equity markets, together with the well-documented problems in the subprime mortgage market, is a clear indication that the economy is faltering and in dire need of easier monetary policy.

 

Regardless of where I come down on the efficacy of this issue, I don't think that the Fed is on the verge of cutting interest rates because the economy just turned in a 3.4% real growth rate; the unemployment rate remains a historically very low 4.6%; the core CPI is hovering around 2.0%, the upper end of the Fed's target; and the Fed as a rule does not respond to weakness in a single sector such as the subprime mortgage market.

 

So where does that leave the economy and the dreaded "R word"? While it certainly is no slam dunk that the economy will avoid a recession, I think that the American consumer still has a bit of spending left to do. And if we can get a little stronger business spending and maintain the improvement in the trade balance, we should squeak through until the housing sector starts to improve. As I said, it is no slam dunk, but I would put the odds at about 60/40 that we make it.