Most economists who cover the US forecast very good business conditions next year. Surveys of business attitudes are consistent with this assessment. Consumer sentiment has edged back a bit lately but is holding at a satisfactory level. But implicitly the US bond market disagrees. As reflected in the strong bond price rally since mid-June, bond market participants have embraced the contrarian view that the US economy will weaken sharply over the next year, so much so that inflationary pressures will be quelled and the Federal Reserve will drop its bias toward further tightening of monetary policy.
In the past few days, new information has come out that tends to support a position somewhere in-between: that US economic growth will be reasonably good for the time being but will progressively slow down, especially in 2005. Here is what the latest consumer and business surveys are saying.
Business conditions and outlook
Consumer assessments of current conditions have been mixed. The Conference Board index fell quite sharply in August to 98.2 from 105.7. Those saying business conditions are good declined to 23.2% from 25.2%. Those claiming conditions are bad rose to 20.1% from 19.1%. By comparison, the University of Michigan survey current conditions index eased only slightly in August to 95.9, from 96.7 in July, and is higher than in June.
The respected Hart/McInturff political polling service, used by NBC-TV and the Wall Street Journal, regularly asks voters whether the economy has improved in the past twelve months. In December 2003, 45% of the respondents said the economy had gotten better while only 27% felt it had gotten worse. The rest reported no change. But in August 2004, only 29% felt that the economy had gotten better in the past twelve months, while 33% say it had gotten worse. This does not correspond at all to the official economic data, which show considerable improvement.
Whether it is concern about job conditions or about gasoline prices, this survey discloses a significant weakening in consumer perceptions. And its message is actually consistent with the responses both the Conference Board and University of Michigan are getting when they ask about consumer expectations of near-term prospects. The Conference Boards expectations index dropped to 96.6 in August from 105.3 the month before. Similarly the Michigan expectations index declined to 88.2 in August, from 91.2 in July.
What are businesses saying? They are somewhat more optimistic. The ISM index declined to 59.0 in August from a robust 62.0 in July. All of its components were consistent with a scenario of strong but slowing growth.
Job market prospects
Ten-year bond yields topped out at about 4.8% in the week of June 11. The initial impetus for the subsequent rally were two months of sharply lower increases in non-farm payrolls. What do the latest surveys have to say about perceptions about job prospects? Each month, the Conference Board asks about job market circumstances. In the August survey, consumers saying jobs are plentiful decreased to 18.1% from 19.7%, which was the highest reading since 2002. Those claiming jobs are hard to get was virtually unchanged at 25.8%. However, the employment outlook for the next six months was less favorable. Consumers expecting fewer jobs increased to 15.4% from 13.5%. Those anticipating more jobs to become available fell to 16.2% from 19.5%.
The employment component of the ISM manufacturing report showed a moderate retrenchment in business hiring plans. The employment index had been indicating a relatively robust pick-up in factory jobs during the spring and early summer, which in fact did not happen. The current reading is less upbeat but is still well above 50, with 24% of respondents reporting they are increasing jobs and 15% saying they are reducing jobs.
Overall consumer prices have slowed in the past couple months, with gasoline prices having the largest impact on monthly fluctuations. A gallon of regular gasoline cost an average of $1.48 per gallon at the beginning of the year. The average price reached a peak of $2.06 in May. It has subsequently receded about 20 cents a gallon. But at an average price of $1.86 a gallon, it is still 27% higher for the year to date. Gasoline is a necessity, so price increases act like an excise tax hike. Its effects are regressive, so low income people are disproportionately harmed. Wal-Mart has publicized that there is a direct correlation between increases in gasoline prices and a reduction in customer visits and blames mediocre sales this summer in part on high gasoline prices. Auto companies have statistical models showing an adverse effect on car-buying plans when gasoline prices move up and stay higher. Ford and GM just announced poor sales for August, after a horrible June and a good July. High gasoline prices are playing a role in the troubled motor vehicle sector, which subtracted almost a full percentage from second quarter real GDP growth.
The ISM survey asks about input prices in general and the latest survey brought some bad news. The prices paid sub-index stood at 81.5 in August, reversing the one-month decline in July as oil prices shot up.
The consensus of private sector economists is for real GDP growth of just under 4 ½% this year, followed by a 3 ¾% rate of growth next year. We go along with this years estimate after all, almost three-fourths of the year is already over. But we believe the consensus forecast for 2005 is too high. Instead, we predict real GDP growth of only slightly over 3% for calendar year 2005, more than half a percent below the consensus. The bond market may be registering too much pessimism about growth prospects but we agree that there is little or no evidence at the moment to support an optimistic view that the economy will reaccelerate powerfully in the period ahead.
Where we part company with the implicit bond market view is that we think milder growth will accompanied by higher inflation. There are cost pressures -- from commodity prices, a likely decline in the value of the dollar and associated import price increases, and labor compensation -- that will be percolating through the US economy for a considerable period of time. Consumer irritation with high gasoline prices and business survey results that point to continued price pressures are largely disregarded by the bond market these days, but wont be as price pressures work their way into the official price indexes.
In short, the bond market rally may soon be confronted with some inconvenient developments: a moderate (though ultimately temporary) increase in the rate of growth of real GDP in the third quarter and a renewed acceleration in the rate of inflation. Neither are incorporated in todays structure of interest rates.