January 2007

Modest Growth, Moderating Inflationary Pressures

The latest economic data continue to suggest that the U.S. economy is growing at a modest pace and that inflationary pressures are moderating.

Economic Growth Fell Sharply in the Third Quarter
Real GDP growth in the third quarter came in at 2 percent, 0.6 percentage point lower than in the previous quarter (Chart 1). The contraction in residential investment remained the biggest drag on economic activity, chopping 1.2 percentage points off growth. Declines in net exports further depressed growth by 0.2 percentage point. However, the dip in net exports was more than accounted for by higher oil product imports. With the recent declines in oil prices, this seems to suggest that net exports might be an impetus to real GDP growth rather than a drag over coming quarters.

Housing Market Remains the Weakest Link
To date, housing remains the economy's weakest link, and signs are still mixed on whether the housing market has already reached bottom. Private residential construction fell 1.6 percent in November, marking the eighth straight monthly decline. While total housing starts rose 6.7 percent in November, total permits continued their decline and fell 1.2 percent in November. Over the past few months, total housing starts and permits have declined dramatically to their year 2000 levels. New and existing homes sales dropped sharply from a year ago, and home prices were also down significantly from year-ago levels.

Labor Market Is Tight
The labor market remains tight. December nonfarm payroll employment growth surprised the market on the upside with a gain of 167,000 jobs, and job growth in November and October were also revised upward. In December, payroll employment grew in almost all service-producing sectors, and the manufacturing sector lost only 12,000 jobs, far fewer than the previous two months. Overall, job growth remains solid. The unemployment rate was unchanged in December at 4.5 percent, and other indicators such as initial jobless claims also point to tightness in labor market.

Consumers Are Still Spending…
Consumers continue to spend. Real personal consumption expenditures rose 0.5 percent in November, following a 0.5 percent increase in October. Gains in real disposable income have been solid in the past few months. Consumer confidence remained at high levels, and consumers are still optimistic about economic outlook.

…However, Business Investment Is Slowing
Orders for nondefense capital goods excluding aircrafts declined 1.1 percent in November, following a 4 percent drop the previous month. More detailed data point to an ongoing inventory correction in the manufacturing sector, in particular for automobiles and housing-related materials. On the other hand, private nonresidential construction spending rose 1.4 percent in December to levels 15 percent above those of a year ago.

Inflationary Pressures Ease
Inflationary pressures continue to ease. Both core PCE and core CPI were essentially unchanged in November and were 2.2 percent and 2.6 percent higher, respectively, than 12 months ago (Chart 2). Energy prices are falling, and the core producer price index for finished goods has risen 1.8 percent in the past 12 months.

The combination of less drag from home construction and smaller housing wealth boosts to consumption suggests that real GDP will likely grow at a modest to moderate pace in 2007. The recent decline in energy prices should continue to moderate upward inflationary pressures.

—Tao Wu