More tricks than treats from the economy …
On Halloween, the Commerce Department reported that growth of real gross domestic product (GDP) rose to a 3.1% annual rate in the third quarter, up significantly from the second quarter (1.3%) and equal to the average for the first half of the year. While this “advance” report was reasonably good news, third-quarter growth was less than generally anticipated. Furthermore, a variety of monthly indicators show that growth was front-loaded within the third quarter and that the economy weakened as the quarter progressed.

It’s also clear that the fourth quarter is off to a very slow start. October reports on consumer confidence, auto sales, manufacturing activity and employment were decidedly weak, reviving fears of a “double-dip” recession. Some major foreign economies are faltering as well, weakening demands for U.S. exports and raising the specter of an extended global recession following two full years of recessionary conditions abroad.

The Federal Reserve races to the rescue …
Faced with such alarming late-breaking economic news, the U.S. central bank (the Federal Reserve) decided to cut short-term interest rates at the Nov. 6 meeting of the Federal Open Market Committee, the first cut in 2002 following massive monetary easing last year. The FOMC dropped the target federal funds rate by 50 basis points to an historically low 1.25%, a policy rate that has slipped well into the negative “real” (inflation-adjusted) zone. The decision was unanimous, and the FOMC said that the risks now are “balanced” with respect to its twin goals of sustainable economic growth and low inflation. Thus, don’t look for another rate cut at the next FOMC meeting on Dec. 10 unless the economic situation fails to improve.

The Fed’s rate cut on Nov. 6, along with flagging economic indicators abroad, have put heavy pressure on foreign central banks to cut the short-term rates under their control. Rate cuts by the Bank of England, the European Central Bank and Sweden’s Riksbank should occur in the wake of the Fed’s action. The Bank of Japan already has its overnight rate at zero (a positive real rate in Japan’s deflationary environment), but the Japanese central bank is pumping more and more reserves into the banking system in a desperate attempt to keep economic growth from falling back into the red zone. [return to top]

Not all the news is bad …certainly not housing news …
This all sounds quite dismal, but not all the news is bad. Indeed, the Fed’s rate cut (and the imminent cuts abroad) will put downward pressure on the entire interest rate structure since there’s no fear of inflation prowling the bond market. Furthermore, the stock market has staged a meaningful recovery from the cyclical lows in early October, suggesting that the devastating blows to household wealth and consumer sentiment, as well as to corporate confidence and capital investment plans, might be easing off. It’s hard to know where the stock market is headed, but the Fed’s dramatic rate cut can’t hurt!

The housing sector continues to be a relatively bright spot in the economy, despite a slight setback in the third-quarter GDP accounts (slippage that may very well get revised away). The single-family housing market has been a pillar of strength, but the multifamily housing sector also is holding up well, despite relatively high rental vacancy rates and relatively low absorption rates for newly completed apartment units.

Indeed, total housing starts surged to an average annual rate of 1.71 million units in the third quarter, with 1.35 million single-family and 358,000 multifamily units. Furthermore, the September starts figures were huge (1.84 million units), and NAHB’s Housing Market Index was quite upbeat for both September and October. These developments point to renewed positive growth for the housing production component of GDP (residential fixed investment) in the fourth quarter. [return to top]

Onward and upward … after a lull …
Everything considered, it’s reasonable to expect a distinct slowdown in economic growth in the final quarter of 2002 but not slippage back into recession (we’re estimating 1.8% growth). That will leave economic growth for the first year of this recovery at 2.8%, certainly a slow takeoff by historical standards. Things should be better in 2003, particularly in the second half, and economic growth should be strong enough to put the unemployment rate on a downward path after the first quarter.

This kind of economic performance should encourage the Federal Reserve to hold the federal funds rate steady at its 41-year low until the job market shows substantial improvement, and that probably won’t happen until the second half of 2003. Long-term rates are likely to gravitate upward beginning early next year, in anticipation of a stronger economy and higher short-term rates, but cumulative increases for 2003 are not likely to be large (less than a percentage point).

The projected economic and financial market environment should support a healthy housing market in both 2003 and 2004. We’re forecasting total starts of 1.63 million and 1.62 million units for these two years, respectively, following an unsustainably high rate in 2002 (close to 1.7 million units). Single-family starts should continue to account for nearly 80% of the total, and the nation’s homeownership rate should resume an upward trend following a modest setback in the first half of this year (the third quarter showed a partial recovery). [return to top]

The elections and Harvey Pitt …
The financial markets reacted positively to the outcome of the Nov. 5 elections, presumably concluding that Republican majorities in both houses of Congress will provide a better environment for the pro-business/pro-investor tax changes that President Bush has put on the table. The Nov. 5 resignation of controversial SEC Chairman Harvey Pitt also appeared to be a positive for the markets, as President Bush is expected to replace Pitt with a Chairman that will help restore investor confidence in U.S. markets after a year of scandals involving major corporations, accounting firms, and securities houses. [return to top]

Iraq and other shocks …
The financial and petroleum markets are coping reasonably well with uncertainties surrounding the situation with Iraq. Resolving these uncertainties is likely to be a plus for the markets and the economy in 2003 even if the U.S. finds it necessary to go it alone. We’re assuming that any U.S. military action in the Middle East goes well, and that the U.S. economy will not be stunned by severe shocks comparable to 9/11/01 or the “Enron-itis” crisis of confidence that rocked the markets this year. [return to top]

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