Biggest Risk: Housing-Inspired Slowdown or Inflation?
The International Monetary Fund (IMF) recently released its semi-annual outlook on the world economy. The report projected that, for the first time in almost 40 years, the U.S. economy will be lagging behind the economies of much of the rest of the world, and it called for a fifth year of continued expansion at a healthy pace of 4.9% for the balance of 2007.

The IMF’s projection underscores the current position of the U.S. economy, which due to a stronger-than-expected deterioration in the housing market, has a projected growth rate of only 2.2%. That is below the 3.3% rate of growth achieved in 2006, and 0.7% below the level that was forecast six months ago. The IMF’s forecast is slightly below that of the Seattle Bank’s monthly tabulation of select economists’ forecast of GDP growth, which is now 2.5% and 2.6% for the second and third quarters respectively.

The IMF further characterized February’s queasy equity markets as being “more of a modest correction.” On the subject of sub-prime mortgage malaise, the forecast sees the future effect upon other financial markets as “likely to be contained.” Why the seemingly relaxed posture of the IMF?

Downturns in certain market sectors, such as the housing market, are currently overshadowed by overwhelmingly strong growth in the global economy, particularly in Europe and Asia. With the U.S. dollar continuing to post near-record lows against such currencies as the Euro and Australian dollar, the IMF also forecasted an improvement in the nation’s current account deficit - thanks to surging exports.

The final calibration of fourth-quarter 2006 U.S. GDP came in at 2.5%–a far cry from the original reported level of 3.5%. The weaker figures were ascribed to sharp declines in home building and business spending.

Inflation: The Real Enemy
It’s becoming increasingly clear that the Fed sees inflationary pressures as the overriding variable in conducting monetary policy. In the release from the Federal Open Market Committee’s March 20 meeting, the Fed noted that “further policy firming might prove necessary to foster lower inflation,” and that tighter monetary policy could “prove necessary.” As long as the unemployment rate remains low, the Fed appears to believe that this should effectively counter the corrosive effects of home price declines upon consumer confidence. Further, on March 28, Chairman Bernancke went out of his way to state that monetary policy had not shifted to a “neutral” position. It’s not difficult to see the rationale: The Fed’s preferred inflation gauge, the personal consumption expenditures index, came in at 2.4% during March (a five-month high), well above the upper threshold of 2.0%. Producer prices also rose by the unexpectedly high amount of 1.0% during the month of February. Labor costs are viewed by the Fed as a particularly large concern.

Tight Labor Market: Good for Consumer Confidence, Bad for Lower Rate Prospects
The March unemployment rate was at a five-year low of 4.4%. This is indicative of strong underlying economic fundamentals outside of manufacturing and housing. The statistic was reinforced by the monthly increase in non-farm payroll of 180,000, which followed on the heels of a 113,000 increase during the previous month. The strongest gains were in the retail and service sectors, with a continued decline in manufacturing payroll. Construction employment increased by 56,000, likely due to recovery from February’s severe weather.

Other positive indicators included stronger-than-expected increases in hourly earnings, and in the average work week of manufacturing employees. According to the Conference Board, the percentage of workers who characterize job availability as plentiful is at its highest level in almost six years. Statistics are supporting the argument that strong employment indicators are countering the ill effects of the housing sector. We’ll see if employment can continue to grow at a healthy clip in the face of the slowing pulse of business spending and waning housing prices.

Road to a Steeper Yield Curve?
As recently as a month ago, the implied forward yield curve was strongly hinting at lower short-term rates, with projections of a rate decline during the summer. This is no longer the case, as the forward yield curve has flattened. Also, the yield curve has signaled an urge to steepen, or at least mend the inverted state it’s been in over the past 10 months. The spread between two-year and 10-year Treasuries is now (barely) positive. What could account for long-term yields once again outpacing short-term yields?

• Increased interest rate volatility (which we pointed out last month, remains at historical lows).
• Growing perceptions that inflation will become more problematic to contain, in the face of expanding labor markets and global growth.

Deposit Growth: Is it on the mend?
As Figure 1 demonstrates, 2006 FDIC statistics for all FDIC-insured institutions showed an increase in deposits of 9.6%. Does this mean that the sluggish era of deposit growth has come to an end? Not necessarily. Deposits grew at a sluggish rate of only 2.6% for insured institutions with less than $1 billion in assets. The top-line number may have been bolstered by the deposit growth that has taken place within broker/dealer-sponsored insured financial institutions. This is effectively due to the conversion of a large amount of retail balances from money market funds to insured deposit accounts.

Figure 1. Historical Annualized Deposit Growth Rates

Additionally, while liquidity constraints, as measured by loans-to-deposits, appear to have peaked in 2005, much of this improvement appears to have come from declining securities and Fed funds sold positions.

Figure 2. Historical Trends of Loans/Deposits and Marketable Securities and Fed Funds Sold, Relative to Assets

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

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