Reflections on the U.S. economy

2006-12-21

The U.S. economy is, without question, at a transition juncture. We’ve seen lots of widely divergent viewpoints in the markets--- from market economists, market practitioners to the policy maker---the Fed.

Regarding the outlook in 2007, most market economists seem to agree that, in the first half, the economy shall be continuously moderating with the downturn of housing market and the Fed shall sit on the sideline with respect to the rate policy. However, the economists seem to be widely divided with respect to the outlook and Fed’s potential actions in the second half of 2007. One of the camps predicted that, after keeping the Fed Funds Rate unchanged for the 1st half, the economy shall rebound starting from the second quarter and the Fed will return to the tightening mood again in the second half. JP. Morgan’s Chief Economist, Bruce Kasman seems to lead this optimistic camp. His arguments include: the current housing downturn seems to be very narrowly based—just a sector-related shock, which have not yet spread to other financial markets and the labor market; the backdrop of the healthy global economy shall not be ignored; he foresees that 2% and plus of the core inflation rate won’t go away in 2007 due to higher unit cost of labor.

On the other side of the augment, the economists tend to underline the spillover effects from the housing market in the next year. They noticed the labor market had started to be negatively affected, especially in the housing related areas and some manufacturing sectors. Moreover, as the economy slows down, the inflation shall diminish further.

The markets seem to support this view, at least, at this juncture. The Fed Funds Future market, so far, predicted zero percent chance that the Fed will raise rate for the whole 2007. However, it did show 23%-42% possibilities of rate cuts between May and the end of 2007. As for the Treasury yield curves, the inversion has been existent between 3-month and 10-year with averaged 32 bps from August to November in 2006, which reflected that the fixed income market has been betting a further slowing-down going forward as well.

The bond market’s Guru---PIMCO’s Bill Gross even predicted the Fed would cut the rate by up to 1% for 2007. In his view, over time, the U.S. housing market downturn would exert more downward pressure on the overall U.S. jobs market and consumer spending, potentially pushing up the jobless rate.

In my personal view, for the most part, the recent softness in this US economy has been confined to the housing and automotive sectors where weakening demand created an excess of inventories that hindered the order flows and in turn let to cutbacks in production. The key question to be answered here is---- whether the housing market slump will remain to be barely sector-based or will it spread to other sectors and consumer spending and, hence, dent the overall economy?

Interestingly enough, up to now, the growth in the much larger service sector remains relatively strong; the labor market still stays healthy. I noticed that the data-dependent Fed tried to balance its bias between the economic slowing-down and inflation in its recent FOMC minutes. In this regard, I would think the Fed will hold the rate for a while and watch the data very closely. All in all, I think the strength of the job market in 2007 will be more and more important on Fed’s radar screen. I also think, as the economy paces down, the inflation shall continue to retreat, potentially providing an opportunity for Fed to re-evaluate its rate policy.