Q2 Growth Revised Up to a Robust 4.0% in U.S., But Outlook Has Darkened

Before the Storm

The revised second-quarter GDP figures show an economy swinging up in the second quarter, ahead of the financial turbulence that erupted in August. Of course, the outlook has changed in the light of these financial events, but the more momentum the economy was carrying, the better its chances of weathering the storm. The 4.0% growth rate in the second quarter followed just a 0.6% growth rate in the first. It seems likely that the second-quarter figures overstated the economy's momentum, while the first-quarter figures understated it, so the average rate for the first half of the year (2.3%) probably better captures the underlying momentum.

Non-residential construction surged higher in the second quarter (up 27.7%), while exports gained 7.6%. However, residential construction was still falling sharply (down 11.6%) and consumer spending rose just 1.4%. These two sectors remain the economy's Achilles' heel. The report also included the first estimates of second-quarter profits growth. Profits from current production increased 6.4% on the quarter and 4.5% on the year. The year-on-year (y/y) change is actually up from the 2.1% pace for the first quarter, but does not mark a new acceleration. Given the sluggish outlook for GDP growth, low single-digit profit gains are the best that we can hope for.

The View from the Fed

The revision to the core personal consumption expenditure (PCE) deflator (the price index watched most closely by the Federal Reserve) was favourable for the second quarter, taking that index down from 1.4% to 1.3% on a quarter-to-quarter basis. But the y/y change remained at 2.0%, still at the top end of the Fed's 1–2% "comfort zone". The Fed faces a tricky decision at its meeting on 18 September (if it does not feel compelled to act sooner). Second-quarter growth looked strong, while inflation has not yet fallen within its comfort zone on a sustained basis. Nevertheless, it has acknowledged that the financial turbulence has increased the downside risks to growth "appreciably". We believe that the weaker growth outlook justifies lower interest rates, with reductions likely to ultimately be 50–100 basis points. If the Fed does not deliver on 18 September, we believe this would merely postpone the rate reductions.

Outlook and Implications

In the third quarter, the economy will probably maintain a similar pace to the first half—in the 2–3% range—but the outlook is darkening for the fourth quarter and beyond. The tightening mortgage market will send housing construction down even further, while tighter credit conditions and falling house prices will restrain consumer spending. From the fourth quarter of 2007 through mid-2008, we expect growth to dip into the 1.5–2.0% range.

A Closer Look at the Forecast Implications of the Financial Turmoil

Financial markets were already showing signs of strain when we completed our last baseline economic forecast on 7 August, but the turbulence that began on 9 August has taken the turmoil to another level, which poses a bigger threat to the outlook for the U.S. economy. The trigger for the latest convulsions was the news that BNP Paribas had suspended redemptions on three funds backed by U.S. sub-prime mortgages. This event reminded markets that there are huge losses in U.S. mortgage securities, probably running into hundreds of billions of dollars, and that they do not know who is holding the losses. Securitisation has spread risks, but since it is not clear where the risks are, nobody can be sure who is a "safe" borrower.

With the financial turmoil still not settled, it is difficult to make judgements about the ultimate consequences for the economy. Nonetheless it is clear, as the Fed has acknowledged, that the downside risks for growth have increased "appreciably". The next scheduled update of Global Insight's U.S. forecast is not due until 6 September, but we have prepared an alternative simulation, the "Sub-Prime Fallout Scenario", which incorporates our initial thinking on the possible impact of the financial turmoil. That thinking will continue to evolve over the next two weeks as market conditions change and as new economic data are published. However, this simulation is suggestive of the changes that are likely in the September forecast. It is not intended as a "worst-case" outcome: far from it—the economy continues to grow, albeit sluggishly. In addition, we assume that the rest of the world is largely unscathed. It is intended to be a plausible downside alternative to the August baseline forecast in the light of recent events in the markets.

Key features of the simulation:

• Real GDP growth holds at the August baseline in the third quarter, at 2.3%, but drops below 2.0% in the fourth quarter and remains in the 1-2% range until the third quarter of 2008. The average growth rate in 2008 comes in at 2.0%, compared with the August baseline's 2.5%.
• The sharp tightening of conditions in the sub-prime, Alt-A, and jumbo prime mortgage markets (which accounted for more than half of all mortgage originations in 2006) will mean another, probably steep, downturn in home sales and housing starts, and will drive house prices down further. Housing starts drop to a low of 1.14 million in 2008, compared with 1.32 million in the August baseline.
• Consumer spending growth slows to an average 2.3% over the next three quarters, but we have not assumed a worst-case outcome (in which the saving rate climbs sharply amid a severe consumer retrenchment). The saving rate rises, but gradually.
• The simulation assumes limited spillover to business fixed investment spending, apart from that resulting from the lower growth rate of final demand; that is, it assumes no corporate or small-business credit crunch.
• The simulation assumes limited spillover to the rest of the world, taking only 0.1–0.2 of a percentage point off overseas growth rates in 2008, although the spillover is larger for Canada and Mexico, two key destinations for U.S. exports. Limited global spillover is a crucial assumption, because exports are becoming increasingly important as a support for growth. Without the contribution from foreign trade, growth would be only 1.4% in 2008.
• The unemployment rate gradually climbs to a peak of 5.1% in the second half of 2008.
• Core PCE inflation edges down to 1.8% in 2008 (compared with 1.9% in the baseline), further within the Fed's 1–2% comfort zone.
• The Federal Reserve responds to the freezing-up of financial markets and to the gloomier outlook for the economy by cutting the federal funds rate by a total of 75 basis points (we assume a 50-basis-point cut on 18 September, and a 25-basis-point cut on 31 October). We have assumed that the Fed moves in a pre-emptive fashion, to forestall a deeper slowdown, and before the worst news on housing is in—but when it is clear that bad news is on the way. That said, the timing of the cuts is up in the air—a rate cut of even 25 basis points on 18 September is not a done deal. The Fed may need to see more concrete evidence of slower growth before easing.
• The stock market dips about 5% further from its current level, but revives in 2008, helped by lower interest rates, more settled financial conditions, and an economy that avoids recession.

Find out more about Same-day Analysis