WEEKLY ECONOMIC COMMENTARY:  WEEK OF JULY 18 , 2008

With a nod to the poet Robert Burns, when it comes to economic forecasting the best-laid plans of policymakers often go awry. Recall that in his semiannual policy report to Congress last February, Fed chairman Bernanke presented a neat blueprint for the economy, as well as an implied course for monetary policy. At the time, the prevailing thinking was that the nation was going through a painful adjustment in response to the debilitating housing meltdown and credit squeeze that would lead to a near stagnant growth rate in the first half of the year. But thanks to the Fed's aggressive interest rate cuts and liquidity injections as well as Washington's fiscal stimulus plan, Bernanke believed that the economy would pick up speed during the second half of the year. Although not explicitly stated, the forecast contained an implied message that the second-half rebound would allow the Fed to rescind some of the rate-cuts to stave off energy-induced inflationary pressures.

That was then. In the second version of the semiannual report delivered this week, Bernanke didn't exactly exclaim oops! but acknowledged that things aren't working out precisely as planned. Simply put, the economy turned in a better first-half performance than expected, although it was hardly a barn-burning experience, While the preliminary results for the second quarter will not be known until the end of this month, it does appear that the growth rate during the period exceeded 2 percent, about double the first-quarter's pace. Again, that's hardly a muscular showing, but it is considerably better than the near-stagnation - and even contraction - that most economists anticipated throughout the spring months.

It is not difficult to pinpoint the reasons why the economy held up better than expected in the first half, despite the challenging financial environment that dominated the headlines. First and foremost, the tax rebates clearly had an earlier impact than expected. When the Economic Stimulus Act of 2008 was enacted in February, the prevailing thinking was that the rebate checks would boost consumer spending late in the second quarter and mostly in the third, jump-starting the growth rebound in the second half of the year. But the administration, sensing the economy's vulnerability, accelerated the rebate mailings, which arrived in household bank accounts sooner than planned. Secondly, it appears that consumers spent the rebates faster than expected, drawing down credit lines in anticipation of the checks' arrival. Hence, the projected spending strength in the third quarter was pushed forward, giving a nice lift to the economy's growth rate in the second quarter.

But now the economy is facing a payback that may turn the Fed's plan on its head. For one, the impact of the rebates on household behavior is already fading. In contrast to the upbeat perception stemming from last week's chain store sales reports, it appears that the strength in consumer spending in June did not extend much beyond discount stores and clothing merchants. Households cut back sharply on big-ticket discretionary purchases, including autos, electronics, building materials and appliances. Just about the only cash registers that were ringing loudly could be heard at gasoline stations and grocery stores, where higher prices siphoned off a big chunk of the consumer dollar.

Overall, retail sales edged up by a disappointing 0.1 percent last month, bringing the 12-month increase through June to 3 percent. Since that's well below the inflation rate, the real volume of merchandise moved over the period has declined, something that is dramatically evident by the plunge in auto sales. Another theme that is strikingly evident in the numbers is the growing fraction of household budgets that is being gobbled up by higher gasoline purchases. Indeed, stripped of purchases at gasoline stations, retail sales actually declined by 0.5 percent in June - and that's in nominal, not real dollars. As the chart shows, the annual increase in both total retail sales and the total less gasoline station sales is firmly ensconced in recession-like territory.

No doubt, some lagged effects of the tax rebates may be felt in July, but the impact should be far less than the spending boost imparted in May and June, when more than 85 percent of the checks were received. As households reach the limits of their outstanding credit lines, they will have a far smaller reservoir of purchasing power to draw on in coming months. Together with a weakening job market that is generating ever-slimmer income gains, it is doubtful that spending will be maintained at the second-quarter pace over the remainder of the year. Keep in mind too that the Economic Stimulus Act also provided tax incentives to businesses that injected some strength into capital spending during the second quarter. Those incentives are also expiring, which along with diminished demand prospects, may undercut investment outlays in the second half of the year.

Simply put, the likelihood that the Fed can start rescinding its interest-rate cuts anytime soon is looking more remote with each passing day. Instead of picking up speed in the second half of the year, momentum is waning, as evidenced by the slowdown in retail sales last month. Meanwhile, the headwinds that the rebates and borrowing binge helped overcome in the second quarter remain very much in force, creating a much bigger growth hurdle for the economy to surmount in coming months. Not least of these headwinds is the housing depression, which shows no signs of reversing anytime soon. Yes, housing starts spiked up by 9 percent in June, according to this week's Commerce Department report. But that was a fluke reflecting a new construction code for multifamily construction in New York City, which gave a temporary jolt to building activity in that region. Excluding the Big Apple, the debilitating housing story remains very much intact.

For example, excluding multifamily construction in the Northeast, housing starts plunged by another 4 percent in June. What's more, the all-important single-family sector remains in a free-fall. Single-family starts slid 5.3 percent to an annual rate of 674 thousand units, which is the lowest level since January 1991. Single-family construction has now fallen in 11 out of the past 12 months, and with permits continuing to decline no rebound can be expected in the foreseeable future. That's not surprising, given the unwieldy pyramid of unsold homes on the market, a high fraction of which is vacant, that is depressing prices and keeping prospective home buyers on the fence. Additionally, the rising tide of foreclosures is adding to the glut of homes for sale and exacerbating the downward pressure on prices.

Over the past year, the decline in residential spending has subtracted about 1-¼ percentage points from the economy's growth rate. This drag will not fade anytime soon. It takes six to nine months to complete a home after the groundbreaking process begins. Hence, the depressing influence of the ongoing plunge in starts on construction hiring and expenditures for building materials and supplies will be spread out of the next several quarters. While that may seem like an awfully long time for this housing debacle to come to an end, it falls squarely within the timetable experienced during past major housing corrections. After peaking out in 1978, for example, the homebuilding industry remained in the doldrums for four years before finally recovering in 1982. Similarly, the housing meltdown that began in January 1986 did not hit bottom until January 1991, five years later. This slump began in early 2006, so by the two most recent housing downturns, we are about half way through the process.

But it is not the ongoing housing slump that stands as the major obstacle to a second-half growth rebound, Indeed, thanks to two-plus years of declining homebuilding activity, residential outlays now comprise a much smaller slice of overall economic output than a few years ago - 3.4 percent compared to 5.5 percent in the fourth quarter of 2005, the last quarter of the housing bubble. As a result, housing's direct influence on overall economic activity has diminished correspondingly. (Conversely, the inevitable rebound in housing activity, whenever it does occur, will have less of a positive influence on economic growth than was the case during the most recent housing boom). What is the biggest impediment to an economic recovery now is the debilitating credit crisis that is stifling the flow of funds not only to the housing market but also to a broad swath of household and business borrowers.

Just when it seems that the credit crisis has moved past its most critical juncture, another thunderbolt strike threatens to throw the financial markets into turmoil. This week it was news that a major bank (IndyMac) went belly up due to insurmountable credit losses followed by more disheartening news of deteriorating conditions at the nation's two major mortgage-market supporters -- Fannie Mae and Freddie Mac. The giant government sponsored agencies (GSEs), of course, can not be allowed to fail without creating a depression-like havoc in the markets so both the Federal Reserve and the Treasury stepped in with predictably strong measures of support. But aside from averting a crisis in confidence in the financial system, the woes being experienced by the GSEs highlights the daunting challenge facing the Fed. It simply cannot risk lifting interest rates until the wounds in the financial markets are healed, something that clearly lies well into the future.

But the Fed must dance a delicate tightrope even as it nurses the financial markets back to health. Indeed, were it not for the fragile condition of the banking system, battered by burgeoning loan write-offs and rising loan delinquencies, the policymakers would no doubt be leaning against inflationary pressures that continue to build. In June, the consumer price index jumped by an unsightly 1.1 percent, pushed up by soaring food and energy prices, which lifted the annual increase to 5 percent. That's the highest inflation rate since early 1991, when the first Gulf Crisis sparked higher oil prices. For the most part, the escalating rise in energy prices has not spilled over into the broader price index, but the trend in the so-called core CPI is also above the Fed's comfort level - up 2.4 percent over the past year. The Fed believes, as do we, that the core inflation rate will not gain traction as long as underlying wage-cost pressures remain tame. So far, that catalyst is still under wraps, thanks to a weak labor market that prevents workers from making feisty wage demands. Nonetheless, the headline-grabbing spike in consumer prices is infiltrating inflation expectations, which also have an important influence on wage and price-setting decisions. The Fed will have a tough time forging a policy that simultaneously tames these expectations while nursing the financial system and economy back to a healthier state.