U.S. Chartbook: Global Recovery Takes Shape

• The economy is on track to grow at an annual 3% pace in the current quarter.
• An improved outlook for manufacturing is propelling a global recovery.
• Risk aversion is driving down the dollar and causing equity prices to rise.

Data over the past week indicate the economy is on track to grow near a 3% annual rate in the current quarter. But an expanding trade deficit could shave 0.4% off estimates of the third quarter's growth rate, bringing it down to 2.8% when the next revisions are released. Cooling consumer confidence stemming from a difficult labor market will dampen personal spending through the holiday season.

Global manufacturing picks up

Global trade volumes picked up in September, even as the real dollar goods deficit in the U.S. widened to $41.7 billion. While oil imports played a large role in September's results, trade in capital goods and industrial supplies and materials also advanced. Trade in raw materials and finished goods such as civilian aircraft and computers all suggest that global economic activity is poised for a strong rebound. Recent volatility in monthly trade data is consistent with a turn toward sustained recovery.

Manufacturing has become the bright spot both in the U.S. and globally. The cash for clunkers program, a weak dollar, and expansion in emerging markets, notably China, are behind resurgent growth in goods output. Industrial production in the U.S. has gained traction beyond the policy-induced expansion in auto production and is one of the more encouraging aspects of the growth picture right now.

Business and consumer confidence are keys to making recovery self-sustaining. The Federal Reserve's credit-easing programs revived interbank lending and made credit available to large banks and firms. However, small businesses remain credit-constrained; confidence among these firms trails the upswing in overall activity. Local banks and personal lines of credit are the lifeblood of credit for small firms. Rising defaults on home loans and escalating problems in commercial real estate have kept credit tight for small firms. Although credit standards have stabilized, they remain tight enough to keep small firms from hiring or investing to take advantage of opportunities associated with the early portion of the recovery.

Improvements in financial markets are often a leading sign of growth. Rising asset prices generally bolster investor and business profits and generate positive feedback through the economy. Indeed, risk-taking is on the upswing both in the U.S. and globally. Option-adjusted spreads, a pure measure of default risk, have narrowed significantly, and in Asia, have nearly normalized to precrisis levels. This will support demand for exports of U.S. goods and services.

Expected volatility in financial markets has receded along with the recession. The Chicago Board Options exchange VIX index, which measures stock volatility, has fallen perceptibly in recent months as investor fears of a financial meltdown have eased. Spreads on medium-risk investment grade corporate bonds have normalized but need to improve further. The VIX and corporate bond spreads tend to move in tandem and indicate that flows of capital into riskier assets will continue. Investors and large firms with access to cheap money are driving investment decisions away from cash positions taken on during the height of the crisis and into higher-yielding assets. This should bolster the bottom lines of publicly listed firms and support equity prices, even at elevated levels.

The U.S. dollar came under selling pressure after the International Monetary Fund suggested the greenback is overvalued, and after leaders of the G-20 said accommodative fiscal and monetary policies should remain in place. The Intercontinental Exchange's dollar index closed at a 15-month low earlier in the week, before recovering slightly.

The dollar's slide raised investor concern about holding dollar-denominated assets. Movements away from such assets have affected global financial markets. The greenback' movements remain inversely correlated with equity markets, oil and gold. Speculators have doubled their net long positions on the euro compared with the beginning of 2009. Not surprisingly, the dollar has fallen 15% since March against a basket of the most traded currencies. With currency markets prone to swings beyond fundamental values, the dollar could experience further depreciation.

Market are pricing in expectations that the federal funds rate will remain effectively at zero while a few central banks abroad begin to tighten, thus increasing rate differentials between the dollar and other currencies. In response, some Asian central banks have begun to purchase dollars to try to slow the greenback's decline against their own currencies. A gradual depreciation of the dollar should not disrupt the global economic recovery. But a disorderly fall in the greenback's value would raise U.S. interest rates and jeopardize the fragile recovery.

Looking ahead

Fed Chairman Ben Bernanke this week is expected to reaffirm the central bank's forecast of modest growth in 2010 and subdued inflation. In a speech Monday, Bernanke may seek to bolster the greenback by urging Congress and the White House to make a transparent and credible commitment to reducing the federal deficit, and thus ensure macroeconomic stability.

In the Fed's most recent monetary policy statement, the FOMC indicated it would use the trend in core inflation to guide the timing of its withdrawal from financial markets. Core inflation and headline inflation should modestly increase due to rising energy and auto prices. We expect pricing to firm for the remainder of the year, and begin to weaken again in 2010 as further adjustments in housing prices dampen overall core rates of inflation. Although earnings have improved, competitive pressures and diminished consumer demand have all but eliminated firms' pricing power.