The shape of things to come in the U.S. economy

"Subpar," when applied to upcoming economic growth, is not an epithet businesses like to hear. It doesn't sit very well with consumers either. Unfortunately, however, subpar economic growth is what the country should expect for the remainder of 2006 and 2007, according to Paul Kasriel, senior vice president and director of economic research, The Northern Trust Company. Kasriel recently received the 2006 Lawrence R. Klein Award for Blue Chip Forecast accuracy at a New York City ceremony hosted by the W. P. Carey School of Business.

"Subpar," when applied to upcoming economic growth, is not an epithet businesses like to hear. It doesn't sit very well with consumers either. Unfortunately, however, subpar economic growth is what the country should expect for the remainder of 2006 and 2007, according to Paul Kasriel, senior vice president and director of economic research, The Northern Trust Company.

Though it is tempting to look at the recent record-breaking stock market numbers and dismiss Kasriel's pessimism, it would be unwise, as his economic forecasting acumen garnered him the 2006 Lawrence R. Klein Award for Blue Chip Forecast Accuracy. Kasriel received the award — for having the most accurate economic forecast among Blue Chip survey participants for the years 2002 through 2005 — last week at a ceremony in New York City hosted by the W. P. Carey School of Business. Kasriel was one of 50 economists who submitted forecasts each January in the Blue Chip Economic Indicators newsletter.

"I expect considerably slower economic growth in the next five quarters than what we've been used to in recent years," says Kasriel, citing both the leading economic indicators and his own gross domestic product (GDP) forecasting model — which incorporates real M2 money supply, the spread between yield on 10-year Treasury securities and the Fed funds rate, and the S&P 500 stock market index. Kasriel also believes housing and consumer discretionary spending will bear the brunt of the slowdown, the unemployment rate will drift higher, and overall inflation will moderate over the course of the forecast period.

Looking ahead to 2007, Kasriel expects real GDP growth to total only 2 percent, down from 3.2 percent in 2005 and 2006, and predicts a rise in the unemployment rate to 4.9 percent, up slightly from this year's 4.6 percent average. In addition, the Federal funds rate will dip from 5.0 in 2006 to 4.7 in 2007, and inflation as measured by the consumer price index next year will drop sharply to 2 percent, from 3.3 percent in 2006, he predicts. Fault for the gloomy forecast rests largely on the Federal Reserve's restrictive monetary policy over the last two years — what Kasriel calls a "stealth tightening."

"The Fed raised rates at a gentle pace — a quarter of a percent at each meeting — from the end of June 2004 through the end of June 2006. In isolation, these increases didn't seem like much, but because they raised rates for 17 meetings in a row, it added up to 425 basis points of interest rate hikes," Kasriel explains. "You have to go back to the late 1970s to find a two-year period where the Fed fund rate moved up as much as it did in this period."

Housing takes the fall

This cumulative tightening of monetary policy is dragging down the overall economy, and nowhere is it more apparent than in the housing sector, says Kasriel. The housing boom of the past few years — which made many an average Joe and Jane feel like a real estate tycoon — has turned toward recession, with house prices declining and the inventory of unsold homes piling up.

And it is unlikely that the housing market has bottomed out yet, based on historical performance. "Typically, housing starts fall by about 50 percent from peak to trough [the highest percentage point to the lowest] in a normal cycle. We're only down about 25 percent, so we still have a ways to go," Kasriel explains. Housing affordability, interestingly, has been a mixed bag.

It fell significantly in the last few quarters — thanks to the double-whammy of rising interest rates and the sky-high home prices which were common throughout the nation until recently — but is now starting to improve. Home prices for both new and existing homes are currently down by 3.6 percent year over year.

"Home affordability on a monthly basis is starting to rise because of a decline in house prices, but we have a long way to go," reports Kasriel. Because the housing market loomed so large in the economic expansion of the past few years, Kasriel expects it to have equal weight pulling the economy down in the upcoming quarters. He points to the dollar volume of home sales compared to nominal GDP as a clear example of that relationship.

"In 2005, the dollar volume of home sales was 16.3 percent of nominal GDP, while the normal relationship is about 8.4 percent," he explains. "Housing played a much larger role in this past expansion than in the previous expansion," he adds. As such, it is only natural for housing to have a greater impact on the economic slowdown which Kasriel predicts is lurking around the corner.

Another disconcerting fact about housing market woes is the market's role as a leading economic indicator. It is one of the first sectors to slow down before the rest of the economy, which could be an ominous sign for 2007. "There is usually a two-quarter lag between behavior in the housing market and what happens in the rest of the economy," says Kasriel.

Consumers will lose confidence

The first segment of "the rest of the economy" to feel the effects of this tightened housing market is consumer spending. Over the last few years, consumers have been augmenting their incomes with equity from their homes, splurging on items such as big-screen TVs and luxury cars. But with rising instability in the housing market, this behavior peaked in the third quarter of last year, says Kasriel, and will continue to drop now that house prices are declining.

"Households have been spending more than they earn since 1999 because of the gains in housing, but that is going to slow down. Households may have to start saving more, which has a negative impact on consumer spending," he notes. This one-two punch of a slowed housing market and tightened consumer spending is especially difficult to rally from, because the two make up 75 percent of the U.S. GDP. It would take accelerated growth in the other 25 percent of the economy to make up for the losses in housing and consumer spending, Kasriel explains.

In addition, he points out, these economic forces do not work in isolation. Businesses have become more cautious as well, cutting back on capital expenditures, and working harder to gain consumer business. Wal-Mart, for example, lowered holiday season prices on top items such as household electronics in an attempt to keep the consumer spending spree going. As goes Wal-Mart, so goes the nation …

While many businesses — especially those in the oil industry — have enjoyed a banner year in 2006, "they don't appear to be on the verge of a spending spree to invest in more capital goods," Kasriel says. "What businesses have been doing with their record profits is buying back their own shares of stock to drive up the price."

Though these actions may have helped push the market up to its current record-breaking level, when you dig a little deeper, the market actually shows signs of instability. The large, less risky corporations are the stocks that are trading well now, which is typical at the end of an expansion cycle, Kasriel says. "Also, bear in mind that the stock market peaked in March 2000, and economic activity slowed quite dramatically right after that," he explains — another indicator that 2007 may not be so rosy.

Inflation's impact

One bit of good news from Kasriel's forecast is his belief that inflation has peaked, partly because energy prices peaked a few months ago and are now on the decline. However, the so-called "core" rate of inflation — which excludes food and energy — is what the Fed keeps a close eye on, and that has moved up recently. The culprit, once again, is housing.

"A large part of the increase in the core rate of inflation is the result of rising rents on apartments and imputed rents for owner-occupied housing. This came about because more people moved into the rental market when purchases of housing became less affordable, and that drove up rental prices," Kasriel explains.

The main concern with the rising rate of core inflation is that it may trigger the Fed to once again raise interest rates — a move Kasriel believes could lead to an unhealthy cycle: raising interest rates makes housing less affordable, which pushes up rent rates faster, driving up the core inflation rate again, and leading the Fed to raise interest rates yet again.

"If the Fed continues to raise rates in reaction to rising core inflation, it will, in effect, be chasing its own tail," he says. Perhaps because of a desire to avoid this situation, Kasriel expects the Fed to cut interest rates in early to mid-2007. If the predicted slowing economy materializes, the Fed will have an incentive to provide stimulus for businesses to embrace capital spending once again and for consumers to break out their wallets.

In addition, because overall inflation is coming down and core inflation is nearing its peak, Kasriel sees an inevitable loosening of the Fed's current restrictive monetary policy. His confidence in the economy's health next year depends upon it. "If the Fed cuts rates, I think we'll start to see the economy rebound in the second half of 2007. If they don't, the odds of recession move up considerably," he says.

Bottom Line:

• Paul Kasriel, senior vice president and director of economic research, The Northern Trust Company, recently received the Lawrence R. Klein Award for Blue Chip Forecast accuracy at a New York City ceremony sponsored by the W. P. Carey School of Business.
• In his presentation at the ceremony, Kasriel predicted "subpar" economic growth in 2007, largely due to the Federal Reserve's continued increases in interest rates, as well as a slowing housing market.
• As a result, Kasriel expects consumer spending to slow drastically, while businesses cut back on capital expenditures. He also predicts a slight increase in unemployment, but a moderation of inflation throughout the year.
• If the Fed cuts interest rates in 2007, Kasriel expects the economy to rebound by the second half of the year; if not, he believes we could be headed toward a recession.