Slower Growth, Yes; Recession, No

Recent data show the economy is clearly slowing, but not enough to threaten recession. Whereas third quarter growth surged 4.9% from the prior quarter, it looks like the fourth quarter is tracking closer to 2%. That’s ok of course; the Federal Reserve’s long-run annual growth target is 2%. But softer business activity and consumer spending will give bears just enough reason to keep them fearful. Meanwhile, stock and bond markets have been rallying.

I’ll summarize today’s reports. US mortgage applications picked up last week after mortgage rates sagged. According to Bankrate.com, the average 30-year fixed rate is back to 7.73% compared with October’s high of 8.09%. Initial filings for unemployment insurance continue to bump along at low levels. Bloomberg News says, “employers are still holding on to workers in a gradually cooling labor market.” The job market tends to be seasonally choppy around the holidays, but we’re not seeing any trouble in the numbers. Corporate capital spending is clearly softening. Durable goods orders are down 5.4% from year-ago levels on weakness in commercial aircraft, communications gear and motor vehicles. There were some quirks in the data (i.e. UAW strike & dip in aircraft orders following a surge in September), new orders for capital goods are up about 1% from a year ago. That’s not terribly inspiring, but it makes sense given lingering weakness in the manufacturing sector. Finally, the University of Michigan’s consumer sentiment survey deteriorated this month. Respondents were only slightly more optimistic than they were a year ago. Their biggest concern remains inflation, and on average they expect prices to accelerate 4.5% over the next year.

I need to say something about the apparent incongruity of that consumer sentiment survey. The probability of worsening consumer finances along with rising inflation is very low. In other words, it’s difficult for inflation to accelerate while the economy is slowing. Currently, the various measures of retail price inflation (UIG, CPI, PCE) are running between 2.2% and 3.7%, and are trending lower. Reaccelerating inflation toward 4.5% would imply unabated strength in the job market and consumer spending, with the implication that attitudes about consumer finances should be more optimistic.

On the other hand, what we’re actually seeing is some slowing, which is a direct result of the Federal Reserve’s interest rate policies. Citigroup’s Economic Surprise Index shows that over the last three weeks data have been weaker. Most market-based measures of inflation expectations are also lower. TIPS market trading currently implies 2.1% inflation over the next two years. In other words, there are plenty of indications that the Fed is winning its battle against inflation. If that is the case, stock & bond markets can continue to rally into year-end.