Fed President Lockhart On the Economy

Yesterday, Atlanta Fed President Lockhart gave a speech on the economy. His main observations are below. Before reading too much into this, let me add this important cautionary note. Before the last Fed meeting there were three Fed speeches that were fairly dovish. This is one of the reasons the market was expecting a 50 basis point cut in interest rates. However, the Fed only cut by 25 BP. In other words, it appears the Fed is still trying to tune their message to market expectations. So, it's important to know the salient points for the speech, but remain flexible in your analysis and expectations.

Throughout 2007, forecasts of housing activity were repeatedly revised downward. Despite the intensifying housing "correction," the economy grew smartly last spring and summer. U.S. gross domestic product (GDP) grew at annual rates of 3.8 percent in the second quarter and then a very strong 4.9 percent in the third quarter of 2007.

But I believe those strong numbers contain anomalous factors that probably won't be repeated soon. Taking out an inventory buildup and exports, third quarter growth was moderate—about half the GDP headline number. Fourth quarter data aren't available, but I expect growth during the final three months of 2007 to come in quite sluggish.

Evidence of slowing economic activity has been mounting. Beyond last year's sharp drop in residential investment, industrial production growth remained well below its rate of the previous year. The data in 2007 showed moderate growth of investment in equipment and software. Anecdotal reports suggest that many firms have begun—especially in the year's second half—to assume a wait-and-see posture because of rising economic uncertainty.

Also, over the past 20 or so months, year-over-year employment growth has slowed considerably. Readings on December employment released last Friday showed a small monthly increase of 18,000 jobs, with the unemployment rate moving up from 4.7 to 5 percent.

Consumer spending is watched closely because of the role of consumption in our economy, and the news here also reflects slowing. Through November, last year's growth in personal consumption expenditures fell off the pace of 2006, which in turn was below its pace of two years ago. Also in 2007, growth of real disposable personal income slowed a bit. Household spending has likely been weighed down by higher energy costs and declining house prices. Although weakening, consumer spending has not plunged.

From September 2006 through August 2007, readings on inflation were generally favorable, with consumer price inflation averaging around 2.3 percent on a year-over-year basis. But later in the year energy costs surged, increasing pressure to pass through higher prices for goods and services. The consumer price index for November increased at a year-over-year rate of 4.3 percent, driven largely by a 21 percent jump in the energy cost component.

Lockhart outlines what we're all seeing: a slowing economy and increasing inflationary pressure. The good news is the Fed sees what we see. However, we have no idea what the Fed will be able to do about it.