Our basic forecast has changed little since last month’s update. Reported annualized real gross domestic product (GDP) growth in the second quarter was revised up from 1.6% to 2.2%. However, real final domestic demand growth was revised down marginally – from 2.2% to 2.1% . We continue to expect sub-2% annualized real GDP growth in the final quarter of this year and have revised down our first-quarter 2007 forecast to 1.8% from 2.0% -- not much more than a rounding error. In addition to the fifth consecutive quarterly decline in real residential investment expenditures, we expect a considerable deceleration in the growth of real business expenditures for capital equipment and software in the fourth quarter, based on the weak October shipments data for nondefense capital goods excluding aircraft. Whereas motor vehicle sales helped accelerate growth in real personal consumption expenditures in the third quarter, declines in both October and November unit sales will brake consumption growth in the fourth quarter. In order for the fourth-quarter average of unit motor vehicle sales to just equal that of the third quarter, December unit sales would have to come in at an annualized pace of 17.7 million, which would be 1.7 million units above November’s pace. The highest annualized unit sales rate this year was January’s 17.5 million.

Based on the excesses of the past real estate boom, the considerable supply overhang and the typical peak-to-trough behavior of residential investment expenditures, we continue to expect that the trough of the housing recession is not near at hand. Chart 1 shows the history of peak-to-trough declines in real residential investment expenditures. The average decline is 25%; the median decline in 22%. Through the third quarter of this year, these expenditures are down only 7.9%. 

Chart 1

We continue to hear that the weakness in housing has not spread to other parts of the economy. To that we say “Not so” and “You ain’t seen nothin’ yet.” As Chart 2 shows, the year-over-year growth in combined real personal consumption and business equipment/software expenditures, at 3.1% in the third quarter, is the slowest since the second quarter 2003 and is down 130 basis points from its year-ago growth. That takes care of the “not so.”Chart 2

With regard to the “you-ain’t-seen-nothin’-yet” argument, take a look at Chart 3. You don’t have to examine it closely to see that the year-over-year behavior of residential investment expenditures leads the behavior of the rest of the economy. If you did look closely, you would see that the lead time tends to be about two calendar quarters. This implies that even if the trough of the housing recession is at hand, the full ripple effects from the weak housing sector have yet to lap up on the shore of the rest of the economy. Moreover, if the housing-recession trough lies ahead, the wave action from this sector will continue through most of 2007.

Chart 3

Another reason we believe the recession in housing will have a lingering retarding effect on economic activity concerns its impact on the “home ATM”, i.e., mortgage equity withdrawal (MEW). With home prices either falling or advancing more slowly, depending on the price series used, it stands to reason that growth in homeowners’ equity would be slowing. This is exactly what Chart 4 shows. After peaking at an annualized rate of 14.50% in the second quarter of 2005, growth in homeowners’ equity slowed to only 0.53% in the third quarter this year. So, the home ATM is not refilling as rapidly as it has in recent years. The slower growth in home equity along with the higher level of mortgage and home equity loan interest rates is slowing MEW, an important source of funding for household spending in recent years. Chart 5 shows that after peaking at an annual rate of $730.5 billion in the third quarter 2005, MEW has slowed to an annual rate of $214.2 billion in the third quarter this year.

Chart 4

Chart 5

Of course, corporations continue funding household deficit spending. In the third quarter, corporations “retired” a record $566 billion of their equities at an annual rate, which represented a record 5.9% of disposable personal income. Why has the stock market been rising as economic growth weakens? Because corporations have been reducing the supply of their equities at a record pace. A lot of the so-called “liquidity” sloshing around in the stock market is record profits that are being used to finance stock buybacks and acquisitions of competitors rather than to expand the scale of operations of corporations in the aggregate. The retirement of corporate equities is being used to expand the spending of households beyond their current after-tax income.

Chart 6

What does all this imply for near-term Federal Reserve interest rate policy? On a year-over-year basis, we are forecasting real GDP growth of only about 2% in each of the first three quarters of 2007. As Chart 7 shows, since 1960 - with only one exception -whenever the year-over-year growth in real GDP slowed to 2%, the Fed started cutting the federal funds rate. The only exception was 1974, when inflation was soaring. With overall consumer inflation already well below its cyclical peak (September 2005) and with core inflation now behaving as though it is near its peak, 2% year-over-year real GDP growth in the first quarter 2007 would likely induce the Fed to cut the funds rate at that time.

Chart 7

Another relatively reliable forecaster of Fed interest-rate cuts is the ratio between the Institute of Supply Management (ISM) manufacturing new orders index and the ISM manufacturing inventories index. As shown in Chart 8, the Fed usually begins cutting the federal funds rate when this ratio falls below 1.0. In November, this ratio did slip below 1.0 for the first time since March 2001, the date of the peak in the last business expansion.

Chart 8

Speaking of ISM indexes, there is now a distinct divergence between the behavior of the manufacturing vs. non-manufacturing indices. For example, in November the ISM manufacturing new orders index dipped below the 50 level to 48.7, its lowest reading since April 2003. In contrast, the ISM non-manufacturing new orders index increased by 0.6 points to 57.1. But as Chart 9 shows, the ISM manufacturing new orders index gave a much earlier warning of impending economic weakness before the 2001 recession than did the ISM non-manufacturing new orders index. The goods-producing sector, i.e., the manufacturing and construction sectors, are the most cyclically sensitive sectors of the economy. If you want to know what cyclically lies ahead for the economy, keep an eye on the ISM manufacturing report and the behavior of goods-producing employment – both of which are weakening now.

Chart 9

In sum, we believe that sub-par economic growth lies ahead, inflationary pressures are subsiding and the Fed most likely will begin a cumulative 100 basis point decrease in the federal funds rate with a 25 basis point cut at its March 21 meeting. The Fed is unlikely to signal that a funds rate cut is imminent at next week’s December 12 meeting, but it will likely issue a somewhat less “hawkish” statement with the announcement that it is holding the funds rate steady at 5.25%. However, at its January 31 meeting, the Fed is likely to hint that it is contemplating a rate cut.

*Paul Kasriel is the recipient of the 2006 Lawrence R. Klein Award for Blue Chip Forecasting Accuracy