September 19, 2008

Uncharted Waters

Currently, the U.S. economy is navigating its way through the combined effects of complex financial turmoil and an unfavorable terms-of-trade shock primarily due to elevated energy and commodity prices.

Economy Showing Some Resilience
Growth in real gross domestic product (GDP) for second quarter 2008 was revised up to a 3.3 percent annualized rate primarily due to favorable revisions made to contributions from net exports (0.7 percentage points) and inventory investment (0.5 percentage points). Positive contributions from personal consumption expenditures (PCE) and government spending were also revised slightly upward (Chart 1). This performance suggests that so far the economy has been better able to absorb the challenge of a credit crunch occurring simultaneously with rising oil prices than initially expected.

Growth in real gross domestic income (GDI), however, another measure of overall economic activity, painted a somewhat less-resilient picture, growing at an annual rate of only 1.9 percent in second quarter 2008, following two consecutive quarters of negative growth (Chart 2). GDI, having shown a deceleration in growth one quarter earlier than GDP, has remained below GDP since first quarter 2007.

Durable-goods orders remained a bright spot in July, thanks to strong export demand, rising 1.4 percent. Since then, however, both industrial production and retail sales declined notably in August, and signs of some slowing in export growth have materialized, suggesting that real growth may slow over the coming quarters.

Weaker Job Market
Labor markets weakened further as nonfarm payroll employment shed another 84,000 jobs in August and losses were revised upwards to 60,000 and 100,000 from 51,000 for both July and June, respectively. Since peaking in December 2006, however, nonfarm payroll employment has fallen at less than half the pace of the last two downturns.

The unemployment rate increased 0.4 percentage points to 6.1 percent in August following July’s increase of 0.2 percentage points. In contrast to July, while the unemployment rate for teens remained high, August’s increase was a result of a 0.5 percentage-point jump in the unemployment rate for adults 20 years and over. The unemployment rate for individuals ages 16–19 decreased 1.4 percentage points (Chart 3).

Unsettling Reverberations
Current financial market conditions are both uncertain and unsettling. Shortly following the government takeovers of Fannie Mae and Freddie Mac (government-sponsored enterprises or GSEs), turmoil caused by recurring liquidity issues led to the recent collapse of Lehman Brothers and Bank of America’s announced acquisition of Merrill Lynch. In reaction to these events, the TED spread* spiked, reflecting a flight to quality (Chart 4, green area) and heightened frictions in the interbank market, surpassing those seen prior to the creation of the Term Auction Facility in December (orange area). Both junk and corporate investment-grade bond spreads also jumped wider after having crept up through August and the first week of September. On the other hand, mortgage rates have fallen notably in recent weeks, which may benefit consumers feeling the pains of a credit crunch.

Housing Correction Continued
The current downturn in single-family building permits—already the deepest on record—is now 69.2 percent from its peak in September 2005. In July and August, single-family building permits fell 5.2 and 5.1 percent, respectively. While both existing and new-home sales ticked up slightly in July and mortgage rates have recently come down improving conditions for homebuyers, it is uncertain how close home sales are to bottoming.

Inflation Outlook: Slightly Improved, Highly Uncertain
The U.S. has experienced deterioration in its terms of trade in stages over the past seven years, first decreasing rapidly between 2002 and 2005, when oil prices almost doubled, and then stabilizing during 2006 and the first half of 2007, as oil prices did the same. Following the onset of the current financial crisis, oil and commodity prices soared again in 2008, and U.S. terms of trade declined further. The gap between core and headline inflation narrowed slightly in August as headline CPI inflation fell for the first time since October 2006 due to decreasing oil prices. However, core CPI inflation rose to a 2.4 percent annualized rate and is up 2.6 percent over the past 12 months. (Chart 5).

For an alternative and possibly more telling breakdown of inflation, one can look at national accounts price indexes, specifically those for gross domestic product and gross domestic purchases. As Chart 6 shows, these two measures of inflation have moved in opposite directions at a relatively rapid pace over the past year. The gap that has been created by the divergence is one of the largest on record and is a direct result of increases in commodity and energy prices (Chart 7). While this differential could be dismissed as a temporary aberration that may disappear when commodity and energy prices either fall or stabilize, it could also be a sign of incipient inflationary pressures. The danger, even if one believes it to be a temporary aberration, is the possibility of increased long-term inflation expectations if the duration of the aberration persists. Choosing either interpretation, inflationary pressures are evident, and the outlook is highly uncertain.

—Jessica J. Renier

About the Author Renier is a research assistant in the Research Department at the Federal Reserve Bank of Dallas. Note * The TED spread is the three-month London Interbank Offered Rate less the three-month Treasury bill yield.