Chart 1 Reserve Bank Credit: Primary Credit to Depository Institutions

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1 August 5 August 9, 8 Northern Trust Global Economic Research 5 South LaSalle Chicago, Illinois 663 Paul northerntrust.com L. Kasriel Hplk1@ntrs.com Asha G. Bangalore Hagb3@ntrs.com Fed Policy: Financial Market Fragility Remains Top of Fed s Worry List The Fed has lowered the federal funds rate aggressively and put in place innovative programs to bring about financial market stability during the past year but financial markets remain fragile. On March 17, 8, the primary credit program was temporarily changed to allow primary credit loans for terms of up to 9 days. Following this announcement, discount window borrowing under the primary credit program has risen sharply (see chart 1). Chart 1 Reserve Bank Credit: Primary Credit to Depository Institutions Avg, Mil.$ Source: Federal Reserve Board /Haver Analytics At the same time, there is a great deal of suspicion and uncertainty in the marketplace which has led to a resumption of a widening of credit market spreads (see charts -4). Chart 3-month Libor Less 3-Month Treasury Bill rate (I) Source: Haver Analytics 8.

2 Chart 3 Spread: -year Swap rate less -year U.S Tresuary note yield percent Source: Haver Analytics 8. Chart 4 Merrill Lynch High Yield Master less 1-year U.S.Treas. Note Yield (I) Source: Haver Analytics 8 These troubling market conditions lower expectations of a higher federal funds rate and reinforce predictions of a steady federal funds rate. In fact we can make a case for the balance tipping slightly in favor of a lower federal funds rate. For now, we hold on to our forecast of an unchanged federal funds rate in the near term

3 Minutes of August 5 FOMC Meeting: Fed on Hold, Arguments in Favor of Policy Supporting Growth Outweigh Inflation Concern The main message from the minutes of August 5 FOMC meeting is that the Fed is on hold for several meetings, barring unexpected developments. That said, the minutes lean toward favoring policy supportive of economic growth in the inflation-growth debate. Inflation did feature extensively, but growth and financial market stability are at the top of the list of concerns. The concern about inflation expectations appears overdone because, for now, the market is less concerned about inflation (see chart 5) than a few weeks ago. Chart 5 Inflation Expectations 1-Year Nominal minus 1-Year TIP Rate % Source: Federal Reserve Board/ Haver Analytics 8. It is also interesting to note the following: Most members did not see the current stance of policy as particularly accommodative, given that many households and businesses were facing elevated borrowing costs and reduced credit availability due to the effects of financial market strains as well as macroeconomic risks. Although members generally anticipated that the next policy move would likely be a tightening, the timing and extent of any change in policy stance would depend on evolving economic and financial developments and the implications for the outlook for economic growth and inflation. 3

4 Inflation vs. Economic Growth A Quick Comparison of remarks in minutes Growth Labor markets had softened Financial marklet remained under considerable stress. Elevated energy prices and the ongoing housing contraction would likely weigh on economic growth. Members saw continuing downside risks to this outlook, particularly relecting possible further deterioration in financial market conditions. Participants pointed to the potential interactions between financial stresses and the housing market contraction as the primary source of continuing downside risk to growth. Many participants noted that the financial system remained fragile, with some expressing concerns about the possibility of adverse feedback loop. Uncertainities about the financial conditions of Fannie Mae ad Freddie Mac added to market worries about the potential consequences of financial strains for the broader economy Inflation Most members anticipate that inflation would moderate. Some viewed the upside risks to inflation as having diminished modestly. Other viewed these risks as having increased. A number of participants worried that core inflation might fail to moderate unless the stance of monetary policy was tightened sooner. However, participants also expressed concerns about the upside risks to inflation, particularly the risk that long-tem inflation expectations could become unmoored. Highlights from U.S. Economic Reports Existing Home Sales, New Home Sales, and Home Prices July 8 Although Sales of Existing Homes Increased, Inventory of Unsold Homes Remains at Cycle High Sales of existing homes rose 3.1% to an annual rate of 5. million units in July, after a.8% decline in June. Sales of all existing homes have hovered around a narrow range of 4.91 million units to 4.47 million units for the ten months ended July. The National Association of Realtors has indicated that 33% to 4% of sales in July were of foreclosed properties. 4

5 75 Chart 6 NAR Total Existing Home Sales, United States SAAR, Thous Existing 1-Family Home Sales: United States SAAR, Thous Source: National Association of Realtors /Haver Analytics The inventory of unsold existing homes rose to an 11.-month mark, a cycle high, matching the level reported for April 8 (see chart 7). Most of the recent growth in inventory is in condos and apartments (15.1 months vs. 1.1 months in June). The inventory-sales ratio for single-family homes fell slightly to a 1.6-month supply from an 11.-month supply. Chart 7 Inventory/Sales Ratio:All Existing Homes month's supply Jan- 4 Jul- 4 Jan- 5 Jul- 5 Jan- 6 Jul-6 Jan-7 Jul-7 Jan-8 July 5

6 This large inventory of existing homes continues to translate into lower prices for homes. The median price of an existing home fell 7.1% on a year-to-year basis in July. On a month-tomonth basis, the median price declined 1.6% to $1,4 in July. The median price of an existing single-family home dropped 7.7% from July 7 to $1,9. In April, the median price of an existing single-family home fell 9.% on a year-to-year basis, marking a record decline. There was a mild moderation in the pace of price declines in the May and June months, with July now showing a sharper drop in price compared with each of the prior two months. Chart 8 NAR Median Sales Price: Existing 1-Family Homes, United States % Change - Year to Year $ Source: National Association of Realtors /Haver Analytics On a regional basis, sales rose in the West (mom: +9.7%; yoy: +.9%) largely due to a sharp drop in prices from a year ago (-.%). According to anecdotal reports and the NAR, foreclosures have led to significant declines in prices which have helped move sales, particularly in the West. Sales of existing homes rose in the Northeast (+5.9%) and Midwest (+.9%) but fell in the South (-.5%) during July. On a year-to-year basis, sales of existing homes have declined in the Northeast (-11.8%), Midwest (-17.%) and South (-18.1%). The housing market adjustment is incomplete and has many months to ago before stabilization. New Home Sales and Home Price Indexes Sales of new single-family homes increased.4% to an annual rate of 515, in July, after a revised sales mark of 53, in June (previously estimated as 53,). Sales of new homes in May were also revised to 514,, down from the earlier count of 533,. Effectively, the sales pace is still lower than the April reading of 54,. The level of new home sales is close to the cycle low of 513, set in March 8. Sales of new single-family homes are down nearly 63% from the peak in July 5. 6

7 Chart 9 New 1-Family Houses Sold: United States SAAR, Thous Source: Census Bureau /Haver Analytics 95 5 On a regional basis, sales of new single-family homes rose sharply in the Northeast (+38.9%) and West (+9.9%) but dropped in the South (-.5%) and Midwest (-8.%). The median price of a single-family home rose to 3,7 from $3,3 in June but fell 6.3% from a year ago. The pace of decline in the median price of a new single-family home has accelerated from a.3% drop in June. Chart 1 New 1-Family Houses: Median Sales Price % Change - Year to Year Dollars Source: Census Bureau /Haver Analytics

8 A large part of the reason for the continued drop in prices is the elevated level of inventories. There was a 1.1-month supply of unsold new homes in the marketplace in July, down from a 1.7-month supply in June but still very bothersome (see chart 11). The median number of months to sell a home was longer in July (8.5 months) compared with June (8.3 months) Chart 11 New 1-Family Houses For Sale: Months Supply SA, Ratio Source: Census Bureau /Haver Analytics 95 5 The good news is that the number of completed homes for sale are down 6.6% from a year ago after a revised steady reading in June (see chart 1). Chart 1 New 1-Family Houses For Sale: Completed Units % Change - Year to Year NSA, Thous Source: Census Bureau /Haver Analytics After several months of declining sales and prices, what is the status of the market for new homes? The inventory situation and the home builders survey point to more gloomy news in the months ahead. 8

9 In other related news, the Case-Shiller and OFHEO Price Indexes were published this morning. The Case-Shiller Home Price Index fell 15.4% on a year-to-year basis in the second quarter compared with a 14.% drop in the first quarter and a 9.% drop in the fourth quarter of 7. These numbers are pointing to a moderation in the pace of decline in home prices (see chart 13). Chart 13 S&P/Case-Shiller Home Price Index: U.S. National % Change - Year to Year NSA, Q1-= Source: S&P, Fiserv, and MacroMarkets LLC /Haver Analytics - The OFHEO Price Index sends a similar message of a slower drop in prices in the second quarter (-4.8% year-to-year change) compared with the first quarter (-3.% and -.6% in 7:Q4). But, as mentioned earlier, the July median price for new and existing homes fell more sharply in July compared with June. Information about the Case-Shiller Home Price Index for July will be published on September 3. Chart 14 OFHEO House Price Index: Purchase Only, United States % Change - Year to Year NSA, Q1-91= Source: Office of Federal Housing Enterprise Oversight /Haver Analytics 9

10 A Perspective on Home Prices There has been a significant decline in home prices for several months as shown in chart 15. Foreclosures and defaults continue to post an advancing trend. Elevated inventories of unsold homes are leading to questions about the extent of the decline in home prices. Chart 15 S&P/Case-Shiller Home Price Index: U.S. National % Change - Year to Year NSA, Q1-= Source: S&P, Fiserv, and MacroMarkets LLC /Haver Analytics - The price-to-rent ratio of homes and median price of existing homes as a percentage of median household income are useful measures to put home price trends in a big picture framework. The price-to-rent ratio (used here) is computed from the national Case-Shiller Home Price Index and Owners Equivalent Rent of the Consumer Price Index. The Case-Shiller Price Index goes back to 1987:Q1. (For the convenience of reading a chart, I set the 1987:Q1 priceto-rent ratio = 1.) Excluding the go-go years when home prices climbed rapidly, the median price-to-rent ratio and mean price-to-rent ratio during 1987:Q1 1:Q4 were and 96.38, respectively. Compared with these numbers, the 15.4 price-to-rent ratio in the second quarter of 8 is still at an elevated level. It appears that home prices appear to have a long march ahead when compared with the mean (19.6) and median (1.5) price-to-rent ratio for the period :Q also. Notice that the variation, as measured by the standard deviation, is larger if the -8:Q period is considered in the computation (see table 1). 1

11 Chart Price-to-rent ratio 1987:Q1-8:Q Mean (1987:Q1-8:Q) + 1 Standard deviation Mean (1987:Q1-1:Q4) + 1 Standard deviation Table 1 Case-Shiller Home Price Index vs. Rent Price-to-rent ratio 1987:Q1-1:Q4 1987:Q1-8:Q Mean Median Standard deviation Another useful gauge for examining home prices is median price of an existing single-family home as a percentage of median house hold income. (Median household income data from the Census Bureau for 8 will be published in 9.) The median price of an existing singlefamily home as a percentage of median disposable income rose to a record high of 469.5% in 5, far above the median value of 337.9% during the history of this series (1968-7) which includes the inflationary period of the later 197s and the sharp increase in home prices seen in the first seven years of the current decade. Excluding the problematic period of the 197s and the current decade, the median was 336.5% (see table ). Irrespective of which of these statistical measures one uses to evaluate the current status of the housing market, the median home price of an existing single-family home as a percentage of median household income was significantly higher than historical trends at the end of 7 (see chart 17). If history is any guide, both gauges -- price-to-rent ratio and the median price as percentage of median household income -- suggest that the bottom of home prices is not here yet. 11

12 48 Chart 17 Median Price of 1-Family Existing Home as a Percent of Median Household Income Mean (1968-7) + 1 Standard deviation Mean (198-1) +1 Standard deviation Table Median Price as % of Median Household Income Median Price as a % of Median Household Income Mean Median Standard deviation Real GDP 8:Q and Personal Consumption & Income (July 8) Q GDP Is History, Focus Should Be on the Future The U.S. economy grew at an annual rate of 3.3% in the second quarter compared with the advance estimate of a 1.9% increase. This large discrepancy in the headline estimate came about due to a significant upward revision of net exports and inventories. Net exports in the second quarter are now estimated as -$376.7 billion vs. -$395. billion in the advance estimate. In addition, firms decreased inventories by $49.4 billion compared with the earlier estimate of a $6. billion reduction. The upward revision of government expenditures (3.9% vs. 3.4%) was another category accounting for the upward revision of GDP growth in second quarter. Other minor upward revisions included a 1.7% gain in consumer spending vs. a 1.5% increase and a 3.% drop in capital spending vs. a 3.4% drop in the advance estimate. Offsetting these upward revisions were downward revisions of expenditures on structures and residential investment expenditures. 1

13 Chart 18 Real Gross Domestic Product % Change - Annual Rate SAAR, Bil.Chn.$ Source: Bureau of Economic Analysis /Haver Analytics This report also included corporate profits for the second quarter. On a year-to-year basis, corporate profits fell 6.98% in the second quarter, marking the sixth consecutive quarterly decline. Chart 19 Corporate Profits with IVA and CCAdj % Change - Year to Year SAAR, Bil.$ Source: Bureau of Economic Analysis /Haver Analytics Corporate profits from domestic industries declined 14.4% from a year ago in the second quarter, which represents an accelerating trend after a 9.4% drop in the first quarter (see chart 19). Within domestic industries the decline in profits in the non-financial sector (-17.7%) was larger than in the financial sector (-8.6%). Corporate profits from the rest of the world (see chart ) grew 6.4% on a year-to-year, offsetting the weakness in domestic industries. 13

14 6 Chart Corporate Profits with IVA & CCAdj: Domestic Industries % Change - Year to Year SAAR, Bil.$ Corporate Profits with IVA & CCAdj: Rest of World % Change - Year to Year SAAR, Bil.$ Source: Bureau of Economic Analysis /Haver Analytics However, corporate profits from the rest of world on a quarter-to-quarter basis have now dropped for two quarters in a row. Moreover, the recent rally of the dollar casts doubts about the ability of corporate profits from the rest of the world to help trim the decline in overall corporate profits. Chart 1 Corporate Profits with IVA & CCAdj: Rest of World % Change - Period to Period SAAR, Bil.$ Source: Bureau of Economic Analysis /Haver Analytics As the headline notes, the future path of the economy is more important than the history. Incoming data suggest that labor market conditions remain weak, with the number of people claiming unemployment insurance the highest in five years. 14

15 Chart Insured Unemployment, State Programs SA, Thous Source: Department of Labor /Haver Analytics Gross Domestic Income - David Rosenberg of Merrill Lynch noted in his comments that the recent behavior of Gross Domestic Income (GDI) -- embedded in the GDP report -- is important. He has also indicated in his comments today that the Greenspan and Bernanke Fed have discussed the behavior of GDI. The bottom line is that according to GDI (see chart 3), the economy has been in a recession, if we adopt the popular understanding of two consecutive quarters of declines. Chart 3 Real Gross Domestic Income % Change - Annual Rate SAAR, Bil.Chn.$ Source: Bureau of Economic Analysis /Haver Analytics Here are the definitions of GDP and GDI according to the BEA: Gross domestic product (GDP) measures output as the sum of final expenditures-consumer spending, private investment, net exports, and government consumption and investment. Gross domestic income (GDI) measures output as the sum of the costs incurred and the incomes earned in the production of GDP. In theory, GDP should equal GDI; in practice, they differ because their components are estimated using largely independent and less-than-perfect source data. In the 15

16 national income and product accounts (NIPA's), the difference between GDP and GDI is called the "statistical discrepancy"; it is recorded in the NIPA's as an "income" component that reconciles GDI with GDP. The BEA considers the GDP as a more accurate measure and list reasons in their website: ( In my humble opinion, even in the absence of an official announcement of a recession, the fact is that the unemployment rate is climbing, the number filing for unemployment insurance is growing, financial markets are fragile, a credit crunch is underway, the housing market is in shambles, and consumer spending has slowed. These are serious issues to grapple with; we don t need an official acknowledgement of a recession to recognize the severity of these problems. It is about time we quit hiding under the shroud of specious phrases. Real Gross Domestic Product 8:Q Preliminary Estimate ( chained dollars) Percent Change (SAAR) 7:4 8:1 8: 8: from prior quarter Final Final Advance Preliminary 7:4 Fin 8:1 Fin 8: Adv 8: Prel. GDP CONSUMPTION DURABLE GOODS NONDURABLE GOODS SERVICES INVESTMENT FIXED INVESTMENT NONRESIDENTIAL STRUCTURES EQUIPM. & SOFTWARE RESIDENTIAL CHG. BUS. INVENT NET EXPORTS EXPORTS IMPORTS GOVERNMENT (C & I) FEDERAL DEFENSE OTHER STATE AND LOCAL DISP. PERS. INC FINAL SALES GROSS DOMESTIC PURCHASES PRICE DEFLATORS: GDP CHAIN TYPE GDP EX. FOOD & ENERGY PCE CHAIN TYPE PCE EX. FOOD & ENERGY

17 Consumer Spending: Strong Likelihood of Decline in Q3 Nominal consumer spending increased.% in July, following a.6% gain in June. However, inflation adjusted consumer spending fell.4% in July after a.1% decline in June. Chart 4 Real Personal Consumption Expenditures % Change - Period to Period SAAR, Bil.Chn.$ AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN 8 JUL -.4 Source: Bureau of Economic Analysis /Haver Analytics Consumer spending will have to advance in leaps and bounds in August and September for a flat reading in the third quarter. In other words, a decline in third quarter consumer spending is nearly certain. Assuming our forecast is accurate, this would be the first quarterly decline in consumer spending since the fourth quarter of 1991 (see chart 5). Chart 5 Real Personal Consumption Expenditures SAAR, %Chg Source: Bureau of Economic Analysis /Haver Analytics 17

18 If consumer spending posts a decline, it should not be surprising to see a minus sign attached to change in GDP during the third quarter. Our forecast earlier in the month was a steady reading for real GDP in the third quarter. We have yet to finish our forecast for September, but there is a good chance that this may change. In July, inflation adjusted purchases of durables (-1.6%) and non-durables (-.9%) dropped and outlays of services held steady. The personal consumption expenditure price index moved up.6% in July and the core personal consumption expenditure price index excluding food and energy rose.3%. On a year-to-year basis, the core personal consumption expenditure price index increased.43% in July, which is higher than the.% comfort level of the Fed. Additional weakening of economic conditions in the months ahead should translate into a moderation of core inflation. Chart 6 PCE less Food & Energy: Chain Price Index % Change - Year to Year SA, = Source: Bureau of Economic Analysis /Haver Analytics The good news is that inflation expectations do not pose a threat, with the spread between nominal 1-year U.S. Treasury note and the 1-year TIP at 17 bps as of August 8, down from 57 bps as of July 3 (see chart 5). Personal income fell.7% in July, after a.1% gain in June. Changes in income during both June and July reflect the impact of tax rebates. Excluding tax rebates personal income grew.5% in July and.3% in June. Excluding rebates real disposable income fell.1% in July and.4% in June (including rebates real disposable income fell 1.7% in July and.6% in June). Personal saving as a percent of disposable income was 1.% in July, after a.5% reading in June (a distortion from tax rebates). 18

19 Durable Goods Orders July 8 Durable Goods Orders: Aircraft Orders Boost Headline Orders of durable goods increased 1.3% in July after a similar increase in June. The noticeable 8% jump in aircraft orders following a 1.4% decline in June was largely expected. However, excluding transportation, bookings of durables increased only.7%, a more muted gain than the headline. The surprising strength in orders of durables is attributed to growing demand of exports. Going forward, the weakness in economic conditions among trading partners of the U.S. points to a less robust growth in exports. Chart 7 Manufacturers' New Orders: Durable Goods % Change - Period to Period SA, Mil.$ Manufacturers' New Orders: Durable Goods Excl Transportation % Change - Period to Period SA, Mil.$ Source: Census Bureau /Haver Analytics 8-6 Orders of defense items fell 19.7% in July, after two months of strong consecutive gains. Primary metals (+.%), machinery (+4.6%), and autos (+1.%) were some of the categories showing an increase in orders of durable goods. DURABLE GOODS ORDERS - % CHANGE M-M NON-DEFENSE CAPITAL NON-DEFENSE CAPITAL COMPUTERS AND DATE TOTAL DEFENSE GOODS GOODS EX-AIRCRAFT ELECTRONIC PRODUCTS Feb Mar Apr May Jun Jul

20 Shipments of durable goods moved up.5% in July. Shipments of non-defense capital goods excluding aircraft, proxy for capital spending in the GDP report, increased.6% in July after a.4% gain in the prior month. This is a big positive for third quarter GDP. Capital spending fell 3.4% in the second quarter. 6 Chart 8 Mfrs' Shipments: Nondefense Capital Goods ex Aircraft % Change - Period to Period SA, Mil.$ Mfrs' New Orders: Nondefense Capital Goods ex Aircraft % Change - Period to Period SA, Mil.$ Source: Census Bureau /Haver Analytics 8-6 DURABLE GOODS SHIPMENTS- % CHANGE M-M NON-DEFENSE CAPITAL NON-DEFENSE CAPITAL COMPUTERS AND DATE TOTAL CAPITAL GOODS GOODS EX-AIRCRAFT ELECTRONIC PRODUCTS Feb Mar Apr May Jun Jul Consumer Confidence Index August 8 Consumer Confidence Improves, But May Be Temporary The Conference Board s Consumer Confidence Index rose to 56.9 in August vs in July. The decline in oil price appears to have helped in improving the outlook of consumers. The Present Situation Index (63. vs in July) fell but the Expectations Index (5.8 vs. 4.7 in July) advanced.

21 Chart 9 Consumer Confidence SA, 1985= Source: The Conference Board /Haver Analytics 5 4 However, the number of respondents viewing jobs as hard to get advanced to 3.% from 3.% in July and those indicating plentiful fell to 13.1% from 13.6% in July. The net of these two indexes rose to 18.9 from 16.6 in July, which suggests a higher unemployment rate in August. Chart 3 Appraisal Pres Sit: Employment, Jobs Hard to Get % Respondents; SA 6 Appraisal Present Sit: Employment, Jobs Plentiful % Respondents; SA Source: The Conference Board /Haver Analytics 5 In related news, the University of Michigan Consumer Sentiment Index moved up in the final survey to 63. from 61. in June and 61.7 in the preliminary estimate. The Current Economic Conditions Index (71. vs in July) and the Expectations Index (57.9 vs in July) rose in August. The small improvement in consumer sentiment is not entirely significant given the weakening of labor market conditions. 1

22 Chart 31 University of Michigan: Consumer Sentiment NSA, Q1-66=1 (I) Source: University of Michigan /Haver Analytics Initial Jobless Claims Weekly Jobless Claims Remain At Elevated Level Initial jobless claims declined 1, to 45, during the week ended August. Initial jobless claims have risen 19, between July 5 and August, with the large jump attributed to the fact that extended unemployment benefits were available under a federal program. In the past three weeks, only a part of this gain has been reversed (-3,). Continuing claims, which lag initial claims by one week, rose 64, to 3.4 million. We should get a better sense of the underlying trend in a few weeks. But, the fact remains that the number of people obtaining benefits under the unemployment insurance program is the highest in nearly five years. Chart 3 Unemployment Insurance: Initial Claims, 4-Week Moving Average SA,Thous 5 Continuing Claims: 4-Week Moving Average SA, Thous Source: Department of Labor /Haver Analytics

23 Victoria Marklew Highlights from Germany and Japan German Data Suggest Euro-zone is Headed For Recession So much for hope that Euro-zone growth will improve in Q3. Data releases from Germany this week underlined the fact that the zone s powerhouse economy is flirting with a technical recession, and the details of those releases pointed to negative developments for the Euro-zone as a whole. Chart 33 Germany: Gross Domestic Product % Change - Period to Period SA/WDA, Bil.Chn..Euros.5 Germany: Ifo Business Climate Index: All Sectors SA, = Sources: Bbk, ifo /Haver 5 8 The Ifo business climate index for August dropped to 94.8 from 97.5 in July, the weakest since June 5. While this is still well above the lows recorded in late, the last time Germany was headed into recession, the speed of the recent fall is disconcerting. Coming hard on the heels of last month s plunge, the August fall brings the two-month decline to 7.5 points, the sharpest since reunification in 199. The gauge of current conditions slipped from 15.6 to 13. while the expectations index dropped from 89.9 to 87., its lowest since February And, the sub-component on manufacturing fell from +. in July to a surprisingly-weak -6.8 in August. There was also confirmation of negative real GDP growth in Q, with a contraction of.5% on the quarter (+3.1% on the year), weighed down by weaker private consumption and investment. Consumer spending was down.4% q-o-q, and although trade actually made a positive contribution to Q GDP this was only because imports fell by more than exports. Gross capital investment was also down.4%, although mostly thanks to the contraction in construction investment, with equipment investment unchanged on the quarter. This at least raises the hope that there is not a massive level of overcapacity that needs to be worked off, and that investment will recover by the end of this year. Finally, GfK s forward-looking consumer sentiment indicator fell to a new five-year low of 1.5 going into September, from a downwardly-revised 1.9 in August. While this is still above 3

24 zero, signaling that private consumption growth should remain positive year-over-year, the trend is downward. With investments weakening and investment stalling, this underscores the risk that Germany will suffer a second consecutive quarter of negative real GDP growth in Q3, i.e., a technical recession. And where does this leave the Euro-zone? The Ifo release stated that German companies see a weaker export outlook. However, as we noted last week, the latest Belgian National Bank business confidence index (a leading indicator for Euro-zone growth about six months out), had pointed to a more hopeful outlook for the zone. Recall that the August reading nudged up to -5.9 from -7.6 in July. While the retail sales sub-component had dropped even further, from -1.5 to -14., the manufacturing sub-component had improved from -8.1 to So, the bad news is that the Euro-zone will almost certainly see a second quarter of contraction in Q3, with Germany, France, and Italy headed that way and Spain almost certain to drop into negative territory too. The good news is that, for now at least, it looks as if the zone will stall rather than fall right off a cliff, implying signs of recovery could crop up by the end of this year. But watch those leading indicators. James A. Pressler Hjap1@ntrs.comH Japan: The Response to the Upcoming Recession Even though GDP has not contracted for the two consecutive quarters required, the world s second-largest economy is showing every sign of recession. A prolonged contraction in industrial production has been the main sign of recent recessions, and that seems to be the case as of today s release. The monthly figure for July production was surprisingly up on the month, but it is very likely that it will show another contraction for Q3 as a whole, and GDP will follow suit. Given this grim scenario, it is no surprise that the government took action. However, it would be hasty to call Tokyo s announced measures a stimulus package. Chart 6 Japan: Gross Domestic Product % Change - Annual Rate SAAR, Bil.Chn..Yen 15. Japan: Industrial Production: Mining and Manufacturing % Change - Annual Rate SA, 5= Sources: CAO, METI /Haver

25 Today, the government announced an 11.7 trillion ($17 billion) set of fiscal measures in response to the weakening economy (and likely to the ruling party s low approval ratings). As opposed to past financial packages, these actions will not aggravate the high government debt burden. Most of the support will be in the form of loan guarantees and other forms of small business assistance, with very little set aside for relief from sharply-rising consumer prices. Some tax cuts were promised as well, but details were thin and they would likely not be introduced until FY9 (April-March). The strategy behind this fiscal package is to balance the need for economic stimulus with the government s goal of balancing the primary budget. In that context, reviews are mixed. After years of stable or declining prices, July inflation rose to a decade-high.3% according to today s release. Real interest rates are now decidedly negative, and consumer sentiment has taken a significant hit. The fiscal stimulus package does nothing to remedy this situation until April 9 at the earliest, and by that time the recession may have really sunk its teeth into the economy and deeper tax cuts would be required. The main beneficiaries of today s announcement will be small businesses struggling to stay open during such trying times. They will not have any additional incentive to expand operations or create jobs, but there will be some short-term financial padding that could prevent another round of bankruptcies and job losses. Chart 7 Japan: Consumer Price Index % Change - Period to Period SA, 5=1 3 Japan: Consumer Price Index % Change - Year to Year NSA, 5= Source: Ministry of Internal Affairs and Communications /Haver Analytics 8-1 5

26 As we said earlier, this is not a stimulus package as much as it is a stabilization package. It is not designed to spur future growth as much as it tries to contain the damage caused by the current economic slowdown. We do not expect a formal stimulus package to be announced until the FY9 budget, and it is too early to speculate at its magnitude. The current government of PM Yasuo Fukuda may be so weak by that time that it is beholden to its junior coalition partner New Komeito, which has been pressing for low-income tax cuts and a number of costly, populist measures. A new administration may not fare much better, but a change of leadership may buy the ruling party a little time to possibly push through more aggressive measures. The one thing that is almost certain is that the Bank of Japan (BoJ) will remain on the sidelines for the near-term. Normally, stagflation is a central banker s nightmare, but the BoJ can rest a little easier than most. As it is reluctant to cut interest rates and stimulate the economy in the face of rising prices, it can allow the government to do the easing through fiscal measures and state that rates will remain steady so the government s measures can take hold. We expect rates to remain steady throughout this year and well into 9, and any surprise change in monetary policy would be a rate cut if the recession deepens significantly over this quarter and next. U.S Highlights for Next Week 1. ISM Manufacturing Survey [Sep. 1] The consensus for the manufacturing ISM composite index is 49.5 vs. 5. in July. If the consensus forecast is accurate, it would be consistent with weakness in other parts of the economy. Consensus: 49.5 vs. 5. in July.. Employment Situation [Sep. 5] Payroll employment in August is expected to have dropped 85,, taking the tally of consecutive monthly declines to eight. The jobless rate is predicted to have held steady at 5.7%.. Consensus: Payrolls: -75, vs. - 51, in July, unemployment rate: 5.8% vs. 5.7% in July Other reports Construction spending, auto sales (Sep. ), factory orders (Sep. 3), ISM non-manufacturing (Sep. 4). 6

27 Key Interest Rates 8/9/8 1-wk. change, bps 4-wk. change, bps 1-yr. change, bps 3-month Libor year U.S. Treasury note yield year U.S. Treasury note yield Global Economic Data Real GDP SAAR, yoy % CPI Unemployment Rate Central Bank Rate NSA, yoy% % year-ago % year-ago United States. Q Jun Jul Jul Euro-Area 1.5 Q Jun Jul Jul-8 4. Japan 1. Q1-8.3 Jun-8 4. Jul Jul-8.5 UK 1.4 Q Jun-8.7 Jul Jul Australia 3.6 Q Q Jul Jul Canada.7 Q Jun Jul Jul China 1.1 Q Jun-8 4. Q Jul-8.1 India 7.9 Q Jun Jul-8 6. New Zealand.7 Q Q Q Jul Norway 3.3 Q Jun-8.5 Q Jul Singapore. Q Jun-8.3 Q Jul-8.37 South Korea 4.7 Q Jul Jul Jul Sweden 1. Q Jun-8 6. Jul Jul Switzerland 3.1 Q Jun-8.5 Jul Jul-8.71 Taiwan 4.1 Q1-8.1 Jul Jul Jul Thailand 5.4 Q Jul Jun Jul * UK - Claimant Count Unemployment Rate * Thailand - GDP Non-Seasonally Adjusted * EA-13, UK, Sweden - Harmonized Unemployment 7

28 Historical US Economic Data Jul-8 Jun-8 May-8 Apr-8 Mar-8 Feb-8 Jan-8 Dec-7 Nov-7 Oct-7 Sep-7 Aug-7 Payroll Employment () % Change, Year Ago * Unemployment Rate (%) Avg. Hourly Earnings (% Chg.) % Change, Year Ago PPI (% Chg.) % Change, Year Ago * CPI (% Chg.) % Change, Year Ago * ISM Diffusion Index (%) Industrial Production (% Chg.) % Change, Year Ago Capacity Utilization (%) Nondefense Cap. Goods ex Aircraft - Orders (% Chg.) % Change, Year Ago * Shipments (% Chg.) % Change, Year Ago * Retail Sales (% Chg.) % Change, Year Ago Real Personal Consumption (% Chg.) % Change, Year Ago Personal Income (% Chg.) % Change, Year Ago New Home Sales (SAAR, mn) % Change, Year Ago * Existing Home Sales (SAAR, mn) % Change, Year Ago * Housing Starts (SAAR, mn) % Change, Year Ago * International Trade (Bils $) Q-8 Q1-8 Q4-7 Q3-7 Q-7 Q1-7 Q4-6 Q3-6 Q-6 Q1-6 Q4-5 Q3-5 Real GDP, Chain Weighted, SAAR % Change, Year Ago Chain-Weighted Price Index, SAAR % Change, Year Ago Nominal GDP, SAAR % Change, Year Ago Employment Cost Index (%) % Change, Year Ago Productivity Nonfarm, SAAR % Change, Year Ago Unit Labor Costs, Nonfarm, SAAR % Change, Year Ago Source: Haver Analytics * NSA 8