December 14, 2007

Economy Slowing After a Strong Third Quarter

Third Quarter GDP Revised Upward
Real GDP growth in the third quarter was revised up from 3.9 to 4.9 percent, with 0.6 and 0.4 percentage points of the improvement owing to upward revisions in inventory investment and net exports, respectively. All major categories posted gains, with the exception of residential investment, whose declines intensified and cut more than 1 percentage point from overall GDP growth (Chart 1).

Slow Start to Fourth Quarter Growth
Both forward-looking indicators and early quarter reports suggest that growth slowed considerably in the fourth quarter. The index of leading economic indictors has declined a cumulative 1.3 percent since July (Chart 2), reflecting weakened domestic demand in the wake of the financial and credit market turmoil that erupted in August. Indeed, manufacturing output fell in October, suggesting production cutbacks may have been under way early in the quarter in an effort to reduce excess inventories amid signs of slower gains in consumer spending. Business investment appears to be growing more slowly, as suggested by some softness in October nondefense capital goods orders (excluding aircraft).

Financial Frictions Continue to Emerge
Junk, investment-grade, commercial paper and London Interbank Offered Rate (LIBOR) spreads have all risen over recent months. Specifically, both commercial paper and junk bond spreads have jumped sharply in recent weeks, with junk bond spreads surging above their post-1987 averages (Chart 3). Asset-backed commercial paper outstanding has continued to decline, falling by about one-third since midsummer. Additionally, after easing in late October, LIBOR spreads have noticeably widened, implying higher costs for banks to fund loans, especially business loans whose rates are indexed to the LIBOR. Ten-year Treasury bond yields fell further in November, while investment-grade corporate yields and interest rates on conforming 30-year fixed-rate mortgages barely budged.

October brought evidence of further tightening of credit standards. While senior loan officers at banks reported tightening credit standards for real estate loans before the late-summer financial turmoil, a notably higher number reported doing so in October. Likewise, whereas few banks reported tightening credit standards for commericial and industrial (C&I) loans and only some for consumer loans over the three months leading into July, a higher number indicated doing so in the October survey. It is unclear whether this result is merely a one-time reaction to financial market turmoil that might unwind quickly or if it will be longer-lasting.

Housing Market Continues to Deteriorate
So far, overall weakness in the economy remains concentrated in manufacturing, housing and mortgage-related industries. While new-home sales ticked up 1.7 percent in October, the slight improvement was dwarfed by a 7 percent downward revision to September levels and a sizable downward revision to August as well. Single-family building permits and construction have continued on a steep decline (Chart 4), and multifamily permits have continued to trend lower over the past year. Many housing indicators point to further deterioration in this sector, with increased evidence of home price declines. Outside of housing, indications of declining demand for and tighter credit standards on commercial real estate loans suggest deceleration in the growth of commercial construction may also continue.

Employment Growth Sagged Slightly in November
The unemployment rate remained unchanged from September’s 4.7 percent, and average hourly wages have continued rising at around a 3.8 percent pace from a year earlier. Recent data on continuing and initial claims for unemployment suggest that firings had not notably increased through late November, but hiring may have slowed some. Payroll employment rose 94,000 in November following an increase of 170,000 in October and a downwardly revised gain of 44,000 in September. Payroll growth has been especially muted in the private sector, where three of the last four months have posted numbers under 100,000 (Chart 5).

Reflecting further weakness in homebuilding, employment in housing and mortgage-related sectors showed notable declines of about 51,000, with job losses of 20,000 in home construction, 13,000 in credit intermediation, 11,000 in real estate and 7,000 in wood products. Further declines in construction jobs are suggested by the downslide in the number of homes under construction.

Net Exports May Cushion Slowdown
Private domestic demand growth has slowed in recent quarters, as reflected in the year-over-year growth of GDP excluding government spending and net exports (Chart 6). On the other hand, one major bright spot for overall GDP growth has been an improvement in the trade balance. Indeed, 0.4 percent of the 1 percent upward revision to real GDP growth in the third quarter was due to a revision in net exports. Nevertheless, it is unclear to what degree net export growth will be able to offset a slowing of private domestic demand in late 2007 and early 2008.

Core and Trimmed Mean Inflation Steadied Near 2 Percent
While overall PCE and CPI year-over-year inflation rates surged in October, core and trimmed mean inflation rates appear to have steadied near 2 percent in recent months. Although there has been some recovery in productivity growth, it is unclear whether further progress in reducing inflation in the near term will be possible in the face of higher commodity and oil prices coupled with downward pressure on the dollar (Chart 7). Various measures consistently indicate that expected long-term inflation remains in a range between 2 and 2.5 percent.

—John V. Duca and Jessica J. Renier

About the Authors Duca is a vice president and senior policy advisor and Renier is a research assistant in the Research Department at the Federal Reserve Bank of Dallas.