U.S. Chartbook: Lower Expectations

• The economy clearly slowed late last quarter.
• There have been few indications of improvement in July.
• The wider real trade deficit will have taken a bite out of second quarter growth.
• Though the trajectory for spending heading into this quarter looks weaker, it is not terrible.
• The forecast for third quarter real GDP has been revised downward to 2% from 2.5%.
• A weakening economy will push core CPI lower and unemployment higher.

Data last week showing the recovery losing some steam prompted a cut in our forecast. Reports on trade, retail sales and business inventories suggest real GDP grew closer to 2% in the second quarter than the nearly 3% pace of the first quarter, and well below the 5% in the fourth quarter of 2009. A weak trajectory for final sales heading into the third quarter supports a reduction in the forecast for real GDP growth to 2% from 2.5%. The forecast for 2011 was revised modestly lower, mostly for the first half of the year.

The economy clearly slowed in June, and July has brought few signs of improvement. Both the New York and Philadelphia Fed manufacturing surveys weakened, and mortgage applications fell 3.1% in the latest week. Mortgage applications have fallen in nine of the past 10 weeks to their slowest pace since 1996, foreshadowing a difficult summer for home sales. The pace of future home sales will hinge on an improvement in the labor market.

Reduced demand has put the brakes on residential construction, with little indication of a near-term rebound. The NAHB homebuilder index has fallen for two consecutive months, shedding 2 points in July to 14.

With the economy expected to operate below potential for the remainder of this year, the unemployment rate will drift back toward 10%, and year-over-year growth in core consumer prices will remain pinned near 0.5%. Inflation reports last week were broadly consistent with this forecast.

Second quarter growth revised lower

The May international trade report showed the nominal deficit widened unexpectedly, from $40.3 billion to $42.3 billion, and excluding petroleum, it widened from $16.3 billion to $20.8 billion. The real goods deficit was $46 billion, compared with April’s $44.2 billion. Trade now looks to have shaved close to a full percentage point from growth last quarter.

The U.S. dollar's appreciation over the past two months, combined with the slowdown in the global recovery, may hurt exports more than expected in the second half. Trade is expected to be a slight positive for growth in the second half, but Europe's troubles add downside risk to the forecast, particularly as they appear to be hurting business confidence. The Moody's Economy.com business confidence survey has weakened substantially over the past few weeks, with notable declines in Europe and Asia.

Business inventories and retail sales also contributed to the downward revision to our second quarter growth forecast. Gains in business inventories appear to have slowed, rising 0.1% in May following a gain of 0.4% in April and 0.7% in March. Second quarter inventories are now running lower than expected and look to be expanding at a $40 billion annual rate, unchanged from the first quarter. Inventories will have provided little if any support to second quarter growth.

Consumer fatigue

Consumer spending weakened substantially late last quarter and may have fallen further since then. Retail sales declined 0.5% in June following May’s 1.1% drop. Excluding gasoline, control retail sales increased a marginal 0.2%, an improvement from May’s 0.2% drop. Any enthusiasm about the gain was tempered by downward revisions to prior months, which lowered the tracking rate for second quarter real consumption from 2.7% to 2.2%.

Performance varied across retail segments; gasoline was a large drag, while abnormally warm weather in June boosted sales at apparel and department stores. Sales at building materials stores declined for a second consecutive month, falling 1% in June, bringing the cumulative decline over the past two months to 10%. Despite the sharp fall, building material sales remain fairly high. As government incentives for appliance and home purchases fade, additional declines are likely over the next few months.

Because payback for the government's earlier subsdidy program has occurred slowly, it will be a bigger drag on real spending this quarter than previously expected. Our forecast for the contribution from durable goods sales to third quarter real spending has thus been revised lower, from 0.3 of a percentage point to zero.

Though the trajectory for spending heading into this quarter was weaker than we had hoped, we don’t expect consumption to decline outright. Consumer confidence has soured, but a number of conditions—including gains in disposable income—are in place to ensure that spending ekes out modest gains over the new few months.

Manufacturing loses momentum

Factory output declined 0.3% between May and June, less than feared. The details of the June employment survey showed a sharp drop in manufacturing overtime and aggregate hours worked. Despite the decline in output, manufacturing industrial production rose 8.3% at an annual rate, compared with 7% in the first quarter. This pace is unsustainable, and factory output is forecast to weaken in the second half.

What couldn’t be gleaned from the June industrial production data is the trajectory for manufacturing heading into the third quarter. The July regional manufacturing surveys therefore took on added importance, and were disappointing. Both the Philadelphia and New York Fed manufacturing surveys weakened in July, and the details were unfavorable for future production.

On an ISM-composite basis, which takes into account the five most important components of the index, both the Philadelphia and New York surveys fell in excess of 3 points in July. This points to a decline in the national ISM manufacturing survey, which would be consistent with our forecast for a slowdown in factory output.

Disinflation vs. deflation

Three price reports last week show inflation essentially nonexistent, with further slowing in prices likely ahead. After being essentially unchanged in the first five months of the year, the core CPI accelerated 0.2% in June. This was larger than expected but doesn’t warrant a change to the forecast, as some components were at odds with recent trends. Apparel prices rose 0.8% in June, an acceleration from May’s 0.2% and the most since February 2009. The bulk of the gain was in men's and boys' apparel, which posted its largest gain since 1947. For the second consecutive month, tobacco prices increased about 1%, measurably stronger than the 0.2% average monthly gain between January and April.

However, the gain in core consumer prices doesn’t remove the threat of deflation. There are indications that prices will soften further. For example, nonfuel import prices were down 0.6% in June following May’s 0.5% gain. This suggests the U.S. dollar's appreciation will keep nonfuel import prices muted over the next few months. Also, the first two regional manufacturing surveys for July show a decline in prices received, which suggests pricing power is minimal. Because the economy has weakened and consumers will spend more cautiously, discounting may intensify to preserve sales at the expense of inflation.