Upside Risks
by Deutsche Bank AG Global Markets Research
Overview
(May 28, 2004) The economy continues to expand at above-trend rates, with business spending taking on an increasingly important role as the engine of growth. Consumer spending growth has softened a bit, partly as a consequence of higher oil prices, but continued job growth should generate enough income to keep consumer demand sufficiently buoyant to encourage businesses to increase capacity and inventories. While our near-term growth forecast may be a bit too high, our inflation forecast seems too low. On net, the picture remains one pointing to at least a measured process of Fed tightening starting at the end of June, with the risk to that path still balanced to the upside.
Engine Of Growth
Incoming economic data continue to support a picture of above-trend growth in real GDP in Q2, following a modest upward revision to 4.4% in Q1. Shipments of non-defense capital goods excluding aircraft have continued their robust expansion, indicating that business spending on equipment has clearly become the engine of growth in demand (bearing in mind that CAPEX is not independent of firms' expectations about other spending). A surprisingly strong Chicago PMI report suggests that manufacturers continued in May to benefit from rising investment outlays, and many of our sector analysts confirm that the outlook for business spending in the near term is bright.
Consumer Spending Growth Has Softened
Although CAPEX looks solid, the expansion of consumer spending has taken a bit of a breather in recent months, suggesting that the risks to our above-consensus forecast of 6% Q2 GDP growth are tilted to the downside. To achieve GDP growth noticeably in excess of 5% this quarter, real consumer spending, which got off to a moderate start in March and April, will have to expand more briskly in May and June. Such a pickup is still achievable. Increased incentives offered by manufacturers may stimulate auto purchases, and the advance in household real disposable income in recent months (at a 5% rate in April and a 4-1/2% rate over the first four months of the year) will provide a boost to spending. With both employment and real compensation per worker picking up, we look for real disposable income growth to remain in excess of 4% for the balance of 2004, more than enough to keep consumer spending growing at a decent pace while allowing for some further rise of the personal saving rate that is beginning to recover from very low levels.
The Oil Factor
The recent softening of consumer spending growth no doubt reflects some drag from higher prices of gasoline and other fuels. Certainly, that factor, along with ongoing geopolitical concerns, has weighed on consumer sentiment, which took another step down in May. Our theme piece this week takes a look at a couple aspects of the oil market, but unless geopolitical events take a substantial turn for the worse and seriously threaten world oil supplies, we do not expect developments in the oil market to derail either the above-trend expansion or significant Fed rate hikes to come.
PCE Inflation Moving Higher
While the risks to our above-consensus growth forecast are running to the downside, we nevertheless still see the risks to inflation as tilted more to the upside of our expectations. The market-based core PCE inflation rate came in at 1.5% in April, and the 3-month rate moved up to 2.4%. Both were above the overall core PCE, but the Fed pays closer attention to the less volatile market-based data. The core PCE (both market based and overall) is running well below the core CPI for at least two reasons. First, the PCE gives substantially lower weight to owners' equivalent rent, which has run above average core inflation and has accelerated recently. Second, the PCE gives medical costs a substantially higher weight and measures them differently from the CPI; the PCE's medical costs have been running far below the CPI's in recent months.
Inflation risks on the upside. We see several reasons why inflation risks lie significantly to the upside of our current forecast for only a moderate pickup in y/y core PCE (to 1.6% by year end). First, PCE medical cost inflation looks low, it was revised up late last year and could well be revised up again in months to come. Second, owners equivalent rent could accelerate above its recent pace of 3.5% y/y as rents begin to catch up to the rapid increase in the price of homes in recent years. Third, prices of consumer goods have accelerated sharply, and even more rapid increases in prices of crude and intermediate materials could be moving downstream in the months ahead. Our sector analysts have noted a widespread increase in the inclination of firms to pass higher costs on to their customers, now even at the retail level, consistent with survey findings by the NFIB and the NABE. Finally, from a cost perspective, unit labor costs could well accelerate into the 1%-2% range this quarter as productivity growth slows and labor compensation accelerates. In any event, as a point of arithmetic, if core inflation were to average 0.2% per month in coming months, the 12-month rate of core PCE inflation rate would reach the upper end of the Fed's apparent comfort range, 2%, by September.
Implications For The Fed
We still see a measured pace of tightening by the Fed, commencing in late June, as the most likely course of events. The risks are still tilted toward the upside of this outcome for rates, with the Fed more likely to become aggressive than to go on hold. But that tilt has weakened just a bit, as the upside risks to our moderate inflation forecast are now partly balanced by some downside risks to our strong growth forecast.
May 28, 2004
Peter Hooper
Joseph A. LaVorgna
Deutsche Bank AG
Global Markets Research
60 Wall Street, New York, New York
212-469-8000
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