August 12, 2008

Economy Struggling but Still Expanding

Recent data point to a surprisingly resilient economy in spite of financial turmoil and troubles in the housing sector. Of growing concern, however, are increasingly significant upside risks to inflation and continued downside risks to growth.

Growth Picks Up in Second Quarter 2008
Growth in real gross domestic product (GDP) accelerated to a 1.9 percent annualized rate in second quarter 2008, largely due to growth in personal consumption expenditures (PCE) and net exports. The jump in net exports was a result of a sharp increase in exports (1.16 percentage points) and a sharp decrease in imports (1.26 percentage points). Inventory investment was the largest drag on second quarter growth, while the drag from residential investment was smaller than in the past few quarters (Chart 1). Although PCE growth for June was positive, growth in nominal personal consumption expenditures and income was more than offset by inflation.

Durable-goods orders continued to be a bright spot, likely thanks to strong export demand. Excluding transportation, new orders for all manufactured goods increased 2.3 percent. According to the Institute for Supply Management (ISM) index, which measures the degree of expansions or contractions in the manufacturing industry, the manufacturing industry has continued to tread water, neither expanding nor contracting. Despite an uptick in the ISM nonmanufacturing index from 48.2 to 49.5, it still indicates contraction in the service sector, as it sits below 50.

Housing Still Searching for Bottom
While the rate of decline in residential investment appears to be decelerating according to recent GDP numbers, the current downturn in single-family building permits—perhaps a timelier indicator of the housing market than quarterly GDP contributions—is the deepest since monthly records began in the early 1960s, having fallen 65.7 percent from their peak in September 2005. The 4.5 percent increase seen in April that followed 12 straight months of declines was unwound in May and June by 2.2 and 3 percent declines, respectively (Chart 2). Both existing and new-home sales also continued down in June, suggesting that home sales have not yet hit bottom.

Financial Markets Still Stressed
Financial markets have remained under considerable stress. Mutual mistrust persists unabated in the interbank loan market and credit conditions are tight. Both junk and corporate investment-grade bond spreads widened in July, and friction continues to be felt in the interbank market. The TED spread, which is the three-month London Interbank Offered Rate less the three-month Treasury bill yield, widened some in July, apparently in reaction to the events surrounding Fannie Mae and Freddie Mac and the seizure of IndyMac by the FDIC.

Generational lows in consumer confidence and consumer sentiment have continued to drag down the stock market. Ongoing financial turmoil, weaker consumer spending and slowing growth abroad—which may weaken the one strong leg on which the economy currently stands—all suggest that real growth may slow over the coming quarters.

Labor Markets Remain Soft
Labor markets have continued to soften. The unemployment rate increased 0.2 percentage points to 5.7 percent in July after being unchanged in June, following an increase of 0.5 percentage points to 5.5 percent in May. These increases reflect a particularly tough job market for teens as the unemployment rate for individuals 16–19 years old has risen by 3.2 percentage points since the start of the year. In contrast, that for individuals age 20 and older has only risen by 0.6 percentage points. Nonfarm payroll employment fell by 51,000 in July, following June and May figures that were revised to smaller declines of 51,000 and 47,000, respectively, showing a continued slow bleed of jobs.

Since peaking in December last year, nonfarm payroll employment has fallen by 0.34 percent over the past seven months—about half the size of the declines seen in the first seven months after payroll employment peaked in both 1990 and 2001 (Chart 3). This suggests that job losses have not yet reached typical recessionary levels.

High Inflation with Uncertain Outlook
Inflation rose notably in June. Core PCE inflation increased to a 3.2 percent annualized rate and is up 2.3 percent over the past 12 months. Slightly higher, trimmed mean PCE inflation increased to a 3.3 percent annualized rate and is up 2.6 percent from a year ago (Chart 4). Driven by large increases in energy and commodity prices, headline PCE inflation came in at a 9.5 percent annualized rate, the biggest one-month increase—excluding Hurricane Katrina—since 1981. Headline PCE inflation is up 4.1 percent from a year ago, a level approaching that of the '80s, if sustained. When considering some elevated indicators of both short- and long-term inflation expectations, such as the University of Michigan surveys, the inflation outlook is uncertain.

—Jessica J. Renier

About the Author Renier is a research assistant in the Research Department at the Federal Reserve Bank of Dallas.