No Soft Landing

Slower growth in consumer spending lies immediately ahead. Households’ inflation- adjusted spending will advance by only 2.2 percent in 2008.

Due to the deepening of the housing recession and a series of financial shocks, the pace of inflation-adjusted GDP growth will remain subdued in 2008.

What initially appeared to be a near perfect soft landing for the U.S. economy morphed – in mid-2007 – into a protracted landing characterized by turbulence in the nation’s financial markets. Consequently, U.S. GDP will rise by only 2 percent in 2008, nearly the same as the 1.9 percent growth estimated for 2007.

Although U.S. GDP growth will be far below the long-term trend rate of growth of approximately 3 percent, the prolonged cool down will not be harsh enough to qualify as a hard landing. GDP growth of 2 percent is a satisfactory accomplishment for an expansion that is fully mature.

As of January, the current U.S. economic expansion will be 73 months old, which is nearly a year and a half longer than the 57-month average length of the 10 expansions in the post World-War II era. Although I do expect the pace of U.S. GDP growth in 2008 to be similar to the pace estimated for 2007, that regularity masks an increased risk of recession.

Consumer caution will be another major factor behind below-average GDP growth in 2008. I am convinced that slower growth in consumer spending lies immediately ahead. Households’ inflation-adjusted spending will advance by only 2.2 percent, compared to 2.7 percent in 2007 and 3.1 percent in 2006.

The slowdown reflects the worsening of the housing recession, turmoil in the financial markets, home price declines, the expectation of limited appreciation in the stock market, and high levels of consumer debt coupled with the desire to save more out of current income.

My expectation of sub-par growth rather than outright recession hinges on several factors. First, banks are well capitalized and corporate balance sheets are in excellent shape, which reduces the likelihood that serial financial shocks – stemming primarily from the housing recession – will develop into a broad-based credit crunch severe enough to kill the expansion. U.S. export growth will accelerate and import growth will decelerate; net exports therefore are expected to make a major contribution to GDP growth.

Businesses’ spending for new equipment will continue to grow; and spending on nonresidential construction will expand slightly to reach its cyclical peak in 2008. Federal fiscal policy will be somewhat more stimulative in 2008 than in 2007, reflecting increased defense spending; and crude oil and gasoline prices should remain at roughly the same levels.

Finally, slight deceleration in inflation should reassure the bond markets and the Federal Reserve. If most of these expectations are realized, then the U.S. economy will experience continuing slow-paced economic growth, but with a relatively high – 40 percent – risk of recession.

Obviously, the risks to the baseline forecast for the U.S. economy are not well balanced, with downside risks outweighing the upside risks. The major downside risk is that a succession of financial shocks between mid-2007 and mid-2008 could dry up liquidity, deny credit to the credit-worthy and produce steep drops in asset values.

The outcome would be a severe pullback by both consumers and businesses. Because the shocks themselves would be deflationary, the Federal Reserve would have the leeway to ease aggressively. Assuming that the Federal Reserve’s response was to quickly lower interest rates, the recession originating from the “panic” would be mild. It helps that overstaffing is not widespread, which greatly reduces the potential for job losses. Layoffs would be mostly related to temporary declines in demand rather than widespread restructuring.

The slow pace of U.S. GDP growth makes the economic expansion more vulnerable to an oil price shock in 2008 than at anytime over the last several years. Due to tight market conditions, a significant interruption in the supply of crude oil and/or refinery products could make prices climb dramatically. A second energy crunch – one stemming from major supply interruptions rather than robust demand growth – could cause the U.S. economy to fall hard and fast.

On the plus side, productivity gains could be stronger than expected, which would spur U.S. GDP growth while containing both inflation and interest rates.

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