U.S. Chartbook: Recovery Signals Grow Clearer

• The latest data adds to optimism about the economy's momentum in the fourth quarter.
• Falling numbers of initial jobless claims suggest slow improvement in the labor market.
• The modest narrowing in the nominal trade deficit in August may be short-lived.
• GDP is forecast to grow 2.5% at an annual rate this quarter, down from 3.2% from July to September.

Despite some encouraging news last week, the economy is far from springing back. Troubles in the labor market could still challenge the forecast for only a modest decline in real consumption during the final three months of the year. There is also risk that improving data could ease pressure on policymakers to provide additional assistance. Difficult political decisions lie ahead, as both emergency unemployment insurance benefits and the first-time homebuyer tax credit are scheduled to expire in December.

While last week's data brought some cautious optimism about the economy's momentum early in the fourth quarter, GDP is forecast to increase 2.5% at an annual rate in the year's final three months, down from the third quarter's estimated 3.2% growth. While the economy has resumed growing, recovery will be slow and difficult, and additional government assistance may be needed to sustain growth.

Dollar troubles

The dollar's depreciation is reason for concern. After peaking in the first quarter, the Federal Reserve's broad dollar index has fallen more than 10% as risk appetites and the global economy improved. The dollar's decline lends some upside risk to the forecast for subdued near-term inflation. While the greenback is expected to fall gradually through 2010, a sharper decline would drive prices for dollar-denominated commodities higher, putting upward pressure on inflation. The dollar's depreciation helped drive oil prices 2% higher last week.

The dollar's slide has also sent investors to seek safety in gold, which rose 4.6% last week to a record $1,051 per troy ounce. Because gold is often seen as a hedge against future inflation, it is a good proxy for inflation concerns. Nevertheless, the recent increase in gold prices may be sending false signals about market expectations because it is runs counter to other measures.

As measured by the five-year forward five-year break-evens, inflation expectations are at 2.17%, up 8 basis points last week but below their historical average of 2.34%. Inflation expectations have held within a narrow range over the past several weeks and are below their recent peak of 2.54%. The spread between the 10-year Treasury yield and Treasury inflation-protected securities, another measure of inflation expectations, rose 3 basis points last week to 1.78%, below the Fed's soft inflation target of 2%.

Trade deficit narrows, for now

While the dollar's depreciation adds some inflation risk, it also provides support to exports. U.S. exports grew 0.2% in August, compared with the previous month's 2.5% gain. While growth moderated, August marked the fourth consecutive increase in exports, helping to narrow the nominal trade deficit.

Exports in August were constrained by sharp declines in volatile components: Civilian aircraft shipments fell 40% between July and August, while autos increased 7.3%, compared with the previous month's robust 24.5% gain. Imports fell 0.6% in August, offsetting only a small portion of the previous month's 4.9% gain.

Overall, the trade balance narrowed to -$30.7 billion from -$31.9 billion. We had expected net exports to add about 0.2 percentage point to growth, but August data suggests net exports will be a slight drag on GDP. However, our tracking estimate of the percentage change in third-quarter GDP is at 3.2% because of a faster recovery in residential investment.

August's narrowing in the trade deficit may be short-lived. September ISM surveys point toward a widening. The ISM nonmanufacturing survey index on new export orders fell from 54 to 48.5 in September. Meanwhile, the September ISM nonmanufacturing report showed imports above the expansionary threshold of 50 for the first time since October 2008. A regression using import and export indices of both the ISM surveys, points toward a widening in the nominal trade deficit to -$32 billion from August's -$30.7 billion.

Encouraging labor market news

Forward-looking labor market indicators improved last week with initial jobless claims falling by 33,000 to 521,000, the lowest since January. The decline brings the four-week moving average to 539,750, down approximately 25,000 since the September payroll survey week. If last week's decline is not reversed, it will reduce the chance that October's results will echo September's, when nonfarm payrolls fell by 263,000.

Continuing claims for unemployment insurance benefits fell by 72,000 in the week ending September 26. Continuing claims have fallen in five of the past seven weeks and are at their lowest point since March. The insured unemployment rate inched 0.1 percentage point lower to 4.5%, an encouraging sign that nevertheless does not signal a peak in the jobless rate. Initial claims need to fall to 350,000 before the unemployment rate stabilizes. We expect the monthly unemployment rate to peak near 10.5% in the first half of 2010.

Not all the news was good in last week's jobless claims data; the rising number of people filing for extended benefits is troubling. Through mid-September, 465,000 people had filed for extended benefits, up from less than 20,000 at the beginning of the year. This illuminates the difficult hiring environment and may put pressure on lawmakers to extend emergency unemployment benefits, which will help stabilize incomes. Also, fewer hires and job openings indicated in the JOLTS data show the labor market faces a long slog back to net job creation.

Credit conditions slowly improve

U.S. household finances are exceptionally weak but should improve over the next several quarters, as fewer consumers fall behind on their monthly obligations. A sustained improvement in credit conditions would be a positive for the economy as the recovery takes form. If more households stay current on their obligations, there's less risk of an unexpected surge in delinquencies and defaults. Still, with households focused on repairing their balance sheets, real consumer spending will be weak through early 2010. Consumer spending is forecast to lag real GDP growth over the next couple of years.

According to Creditforecast.com—a joint venture between Equifax and Moody’s Economy.com—delinquency rates on loans 30 and 60 days past due fell for the second consecutive quarter. Delinquency rates on loans 90 days past due fell in the third quarter for the first time since 2006. The decline in early-stage delinquencies suggests consumer credit conditions should slowly improve.

Except for the decline in early-stage delinquencies, third quarter data on consumer finances were generally downbeat. Mortgage delinquency and default rates rose further. The foreclosure pipeline is still filling, but not as quickly as in previous quarters. The delinquency rate on first mortgages 120 days past due rose 39 basis points to 3.26%. The ill effect of rising unemployment is evident in the delinquency rate on bank cards, which has increased 1.14 percentage points over the past year to 6%.

Credit conditions will slowly improve, but the outlook hinges on the labor market. If nonfarm payrolls fall more than anticipated, the labor market will fail to generate the income needed to ease credit conditions and lift consumption.