Last updated: Aug. 20, 2010

Modest, but solid, gains in consumer spending suggest that a double dip recession isn’t likely, despite the downgrading of the second quarter’s growth rate from 2.4% to a mere 1.6%. The pleasant surprise is an upward revision in growth in consumer spending to 2% (revised from 1.6%), indicating that consumers aren’t as tightfisted as first thought. This gives credence to the idea that spending will continue to pick up in the coming months. In the second quarter, consumer spending, which accounts for 70% of gross domestic product, rose for a wide range of services, including health care, restaurants and financial services.

We look for GDP to post a gain of 2.8% this year and a bit over 3% in 2011. That’s subpar for a recovery period but much improved over the 2009 decline of 2.6%. After a rousing 2009 fourth quarter (5% annualized growth) and first quarter of this year (3.7% annualized growth), sluggish economic growth has been disappointing, raising fears that the economy will again tumble into recession.

While data on the economy during July show a weak start to the quarter, especially in housing and business investment, several causes of the slowdown are dissipating. These include the bust from the expiration of the tax credit for home buyers and high anxiety about Europe’s financial woes. Moreover, there are good reasons to think there should be improvement in the fall:

• Rock-bottom interest rates and a fiscal policy that remains stimulative.

• The likelihood that businesses that are sitting on a pile of cash will decide to maintain purchases of equipment, software and information technology. Business spending on software and equipment shot up 25% in the second quarter, the strongest quarterly gain since 1983.

• Banks with plenty of capital to lend, once the spigots are loosened.

• An improved pace of consumer spending as more jobs are created.

• A housing sector that, though it remains in the dumps, won’t subtract from growth.

• And exports benefiting from global growth.

Dept. of Commerce: GDP Data

An interest rate hike by the Federal Reserve: No sooner than mid-2011. The rate setting Federal Open Market Committee continues to signal that it will hold its benchmark fed funds rate steady, as there are no signs of inflation and the economy is growing only moderately.

The latest missive from the Federal Reserve’s policy setting committee acknowledged what others have been saying for some time: "The recovery in output and employment has slowed in recent months." While acknowledging these unwelcome realities, the Fed still predicts a gradual return to higher growth with price stability, albeit at a more modest pace in the near term than had been anticipated.

The Fed took a baby step in the direction of addressing those weaknesses. It said that cash proceeds from maturing securities would be recycled back into long-term treasuries. This falls short of what some analysts had proposed -- a new program of securities purchases to push cash into the economy -- but it prevents the Fed from pulling money out of the economy, as would otherwise happen when it cashes out of maturing bonds. In essence, it’s a holding pattern, waiting for new information before committing one way or another.

Looking ahead, the holding pattern should remain in place until the Fed’s November or December meetings. By then, the expansion’s endurance should be clear. At that point, it will cease recycling mortgage backed securities and let the portfolio naturally diminish. Next, perhaps next April or June, it will return to the "exit strategy" with interest rates beginning to ascend. Look for the prime rate to remain at its present level, 3.25%, until mid-2011, but rising to 5% by year-end 2011.

Federal Open Market Committee

The outlook for inflation remains quiescent, despite a 0.3% increase in consumer prices in July, largely on energy related gains. Look for 2010 inflation to wind up just under 1%, with the pace rising to a still low 1.5% in 2011.

The way Uncle Sam’s statisticians treat energy prices is overstating price weakness for now. The first half of 2010 witnessed a 9% rate of increase in energy prices, but the number crunchers expected seasonal patterns to deliver a 19% gain. After wringing out the seasonal effect, the 9% rate of gain turned into a 10% pace of decline, contributing heavily to overall price weakness.

Moreover, seasonal adjustments are likely to overstate inflation trends in the months immediately ahead. If the second half of the year posts a 10% pace of decline in energy prices, as we expect, statistical agencies will translate that into an 8% gain, since seasonal patterns would typically yield an even larger, 18% drop.

The better benchmark of core inflation -- which strips out energy and food prices -- will rise only modestly. Core inflation is up 0.9% over the past year and 1.1% year-to-date. Going forward, we expect more of the same, perhaps with some further softening toward year-end. The reason: Slack in the economy continues to restrict price increases. In housing, for example, a glutted rental market (and the fact that rents tend to reflect market conditions with about a six-month lag), will keep a lid on core inflation more generally.

But deflation at the core level, at least on a sustained basis, remains unlikely. The economy is gradually taking up slack (for example, unemployment is falling, not rising), which leads us to believe that inflation will rise somewhat, but still remain very low, next year.

Consumer Price Index Table
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Dept. of Labor: Inflation Data

Job growth is only likely to get better from here on, with monthly gains exceeding 100,000 by year-end. A 60,000 increase in payroll numbers in August -- after accounting for the loss of 114,000 temporary government workers employed by the Census Bureau -- makes it eight consecutive months of gains in private company payrolls. The midyear economic soft patch is largely to blame for the modesty of the August uptick, as business activity barely crept ahead and employers remained skittish about hiring. While only mildly encouraging, that should help dispel fears of a double-dip recession, which we still view as unlikely.

The modest job gains of recent months will improve going forward. The midyear economic slowdown seems due to a variety of special factors -- the housing downturn and a pullback in consumer spending (both related to sunsetting tax credits) and the loss of temporary Census workers -- that won’t persist.

Moreover, we have now passed the familiar phase of the business cycle where employers can substitute productivity gains for hiring workers. Labor productivity advanced an impressive 6.3% for the year, ending with the first quarter. Over time, however, the ability to eke more out of existing labor resources wanes and labor productivity slows. In fact, we actually experienced a decline in labor productivity during the second quarter, falling at a 1.8% pace. Future growth in output will require employers to add workers.

Note, too, that the rise in unemployment, to 9.6% from 9.5% during June and July, isn’t cause for alarm. As federal funding for the long-term unemployed ran out in May, millions of people dropped off the rolls during June and July. This showed up as a decline in the labor force, presumably as many of them stopped reporting themselves as “looking for work,” a prerequisite for receiving benefits. But as funding was replenished in August and beneficiaries returned to the dole, the labor force predictably climbed. The June/July dip was, therefore, somewhat artificial.

Dept. of Labor: Employment Data

The trade deficit will widen this year and next, the first such back-to-back increase since 2005-2006. With both the U.S. and global economies in recovery mode, however, the pace of that expansion will be modest compared with the first half of the past decade. The deficit will reach about $408 billion, or 2.8% of gross domestic product, in 2010 overall, edging up to $443 billion -- 2.9% of GDP -- in 2011. That compares with $374.9 billion and 2.6% in 2009.

Imports will climb by 12.1% for 2010, thanks largely to a surge in household demand. Consumers are spending more on everything from pharmaceuticals to appliances to diamonds. But while the rise in consumer confidence will cheer retailers, it will also take a bite out of overall economic growth. The relatively strong dollar will help offset the damage by holding down the price of fuel oil and other commodities. Next year, import growth will moderate to 9.1%.

Meanwhile, U.S. exports will rise by 12.9% this year -- credit strong demand from Canada and Mexico. Integrated North American supply chains mean that exports to both North American Free Trade Agreement partners fall and rise with the U.S. economy. Sales to China, South Korea, Taiwan, Brazil and India are also jumping. But many emerging markets are already starting to tighten interest rates -- or in China’s case, restrict bank lending -- to head off inflation. That plus sluggish growth in Europe and Japan will hold export growth in 2011 to 9%.

While the pace of export growth will roughly match import growth this year and next, the absolute value of imports remains considerably larger than that of exports -- hence the rising deficit.

Dept. of Commerce: Trade Data

Look for crude oil prices to trend down after Labor Day, as fuel demand from motorists and truckers eases into the slack season. Prices are likely to slide to around $70 per barrel by early November. By year-end, they’ll hover between $65 and $75 per barrel, barring hurricanes or other significant production or transport problems. But traders remain antsy, and moves of $5 a day in either direction are likely, as markets react to the latest news on economic growth and the euro zone deficit crisis.

Gasoline pump prices will start to ebb even sooner, declining by about 10¢ a gallon, on average, by September, then shedding another 10¢ to 15¢ by the new year. We expect diesel fuel prices to drop by about 30¢ by December to a national average of $2.65 a gallon.

Natural gas will remain a relative bargain with prices holding at around the current $4.50 per million British thermal units (MMBtu) through August, then moving up incrementally to about $5.25 in late fall. That’s around $1 per MMBtu more than during 2009’s deep recession, but almost half the price in 2008.

Dept. of Energy: Price Statistics

As expected, both housing construction and sales are plummeting as a result of the end of federal tax subsidies that helped boost buying earlier this year. Although the descent looks dire, it will take until the fall to assess the true condition of housing after the tax-induced boom and bust.

We continue to think that starts and sales will level off in coming months, gradually improving in 2011 as the economy improves, and that the decline in prices is about over. Increased net job growth is key. Fewer job losses would mean fewer homes heading into foreclosure. The total is now expected to hit about 2 million this year and continue at that level next year. And more hiring would stimulate more home buying, especially with rates on 30-year fixed mortgages at a 40-year low of 4.4%. Those rates won’t rise until the economy picks up -- not in the cards until sometime this fall.

Still, recent squishiness in the economy raises the odds that prices will slip further. With home values about 25% lower than their peak in 2006, roughly one in five mortgage holders owe more on their loan than their house is worth. If the economy doesn’t firm up, more foreclosures -- including some voluntarily by homeowners who can afford to pay but choose not to because they are upside down on their mortgages -- will put more downward pressure on prices.

In any case, it will be 2012 before housing returns to more normal conditions, with housing starts of around 900,000 and annual sales of more than 6 million homes. For at least a few more months, uncertainty about the economic recovery will weigh on the market. Sales of existing homes in July fell 27% from June. Sales of new homes in July fell 12.4%. As a result of scant buying, housing starts of single-family units fell 4.2% in July.

Dept. of Commerce: New-Home Sales
National Assn. of Realtors: Existing- Home Sales
Dept. of Commerce: Housing Starts

Continued high unemployment and an unsteady stock market will keep consumer spending growth modest this fall. Sales growth is steadying out following a surge in the spring and dips in both May and June. But shoppers’ slow start for back-to-school shopping signals they will continue to be cautious in the coming holiday season.

Overall retail sales ticked up in July by 0.4% over June, and core retail sales -- excluding gas and autos -- edged down 0.1% from last month. Core sales rose by 4% over July 2009.

All told, we still expect retail sales to pick up by around 4% this year. Back-to-school sales will pick up by the end of August as more kids return to school and retailers offer more discounts. Online buying, meanwhile, is already seeing better returns -- particularly on weekdays, when many families don’t have time to shop otherwise. We see sales of products such as clothing and books growing by 3%--a definite improvement over each of the last two years, when sales declined.

The back-to-school season -- retailers’ second-biggest -- will be a gauge of shoppers’ willingness to spend on higher-value products like electronics and furniture. But retailers’ biggest stretch -- the holidays -- could wind up giving a clearer picture of how much better consumers are feeling. While growth measures in the first half of this year pitted sales in winter and spring 2010 against dismal winter and spring 2009 figures, by the end of 2009, the economy was on the upswing, providing a more “normal” base for comparisons.

Shoppers’ focus on value and necessities will continue to dominate the retail arena for the rest of the year, benefiting drugstores, grocery stores, discounters and dollar stores. Sales at department stores will be strong as consumers seek out their exclusive product lines in apparel and home furnishings. Shoppers will seek out low prices, but they will spend more -- on products they feel hold value and are worth it. Stores that sell small appliances and home goods, such as curtains and other soft goods, will benefit as consumers replace old equipment. Plus the ease of hunting for deals online will continue to increase spending in e-commerce in the months ahead.

Dept. of Commerce: Retail Data

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