Outlook for the U.S. Economy: Moderate Growth and a Bull Market

By Prof. Peter Morici

Each month, I respond to the Bloomberg and Reuters surveys of Wall Street and corporate economists for the medium-term economic outlook. Here is my latest forecast.

In a nutshell, the economy should stabilize in the fourth quarter and gradually rebound in 2007, if energy prices do not rise significantly and adjustments in housing prices do not cause a large, abrupt increase in consumer savings. Overall the economy should grow at a 2.1 percent annual rate in the fourth quarter and average 2.6 percent in 2007.

The national median price for existing homes fell from $230,000 in July to $220,000 in September, or 4.3 percent. Overall, prices should fall about 10 percent before the adjustment is complete.

Housing starts averaged 2.068 million in 2005, and fell from 2.265 million in January 2006 to 1.486 in October, on a seasonally adjusted basis. My forecast assumes housing starts bottom out in the fourth quarter or early next year and average 1.6 million in 2007.

Growth accelerating from 2.1 percent in the fourth quarter to 3.1 percent the second half of 2006 will not be enough to keep unemployment from rising. The unemployment rate should increase from about 4.5 percent in the fourth quarter to about 4.8 percent by the end of next year.

Productivity growth will be decent but down from the strong performance of recent years. Large trade deficits have shifted workers from export and import-competing goods and services, where productivity and investments in R&D are substantially above average, to lower value-added sectors of the economy.

The long-term corrosive consequences of an overvalued dollar and national trade policies, which result in export growth significantly lagging import growth and large foreign borrowing to finance the difference, are taking a toll on productivity and the growth potential of the U.S. economy.

More than 85 percent of the foreign capital flowing into the United States has been to finance consumption, as opposed to direct investment in new productive assets. Slower productivity growth is the inevitable outcome. A debtor’s life always leaves a trail of tears.

The third quarter may well prove the low point of the current economic cycle. Second quarter growth was 2.6 percent, and third quarter growth will likely be adjusted from the1.6 percent preliminary estimate to 1.8 percent when the final data is tallied.

In the third quarter, higher prices for imported petroleum took a big bite out of demand for domestic goods and services. In the fourth quarter, the housing slowdown has affected consumer expectations, but retail sales, ex the automobile sector, have remained resilient; the big drop in gasoline prices has helped a lot.

Housing values are still up nearly 50 percent from early 2001. Even with a moderate housing market adjustment, Americans are much wealthier than they were three and five years ago.

The key question remains: Will Americans focus on the modest decline in home prices and save more, or will they focus on the long-term gains they have enjoyed and are likely to sustain? My forecast bets homeowners will save more but not enough to keep consumer spending from advancing at a moderate pace.

Elsewhere, commercial construction has been showing more bounce and industrial capacity is close enough to peak utilization to require new investments in equipment and technology.

The combination of moderating, but not declining, consumer spending and more robust investment in commercial construction, equipment and technology should be enough to keep the economy growing at a moderate, but not robust, pace.

The picture could be dramatically improved by better exchange rates and trade policies. Reducing the trade deficit would lift to aggregate demand for U.S. made goods and services. Shifting employment from nontradable goods and services to export and import-competing industries would give productivity growth and the potential supply of goods and services a needed boost. Cutting the trade deficit in half could lift potential GDP growth to about 4 percent a year.

In 2007, the adjustment in the housing market should further benefit the stock market. In recent years, Americans have been pouring more and more of their disposable income into house payments to purchase ever more expensive houses, and saving less as a byproduct. When housing prices pull back, Americans tend to shift from investing in housing to investing in paper assets, and that includes stocks. The simple calculus of supply and demand would indicate that stock prices should rise.

Also, many large American corporations earn significant shares of their profits abroad. Growth abroad is expected to exceed U.S. performance in part because of the demand created by large U.S. trade deficits. That will be good for big cap stocks, and the benefits should spread to the rest of the market.

Overall, in 2007, expect moderate growth and a bull market.

Peter Morici is a professor at the Smith School of Business, University of
Maryland School, and former Chief Economist at the U.S. International Trade
Commission.