Brooklyn's Progress
October/November 2006

BY MITCHELL J. HELD, MANAGING DIRECTOR, ECONOMIC
AND MARKET ANALYSIS, CITIGROUP

After a two-year run, during which the FOMC (Federal Open Market Committee) raised overnight lending rates by ¼-percentage point per meeting for 17 consecutive meetings (from 1% to 5¼%), there’s been a break in the action.  At its last two meetings, on Aug. 8 and Sep. 20, the Committee decided to leave short-term rates unchanged.  Where do they go from here?  Maybe they don’t go anywhere for a while.

The economy is slowing as a result of the Fed’s actions.  Real GDP (gross domestic product) growth slipped just below 3% (annualized) in the second quarter, down from 5.6% in the first.  A tumble in housing and a drop in automobile production could drive the current quarter’s growth rate closer to 2%, with a modest bounce likely in the fourth quarter. 

While the economy has slowed, it has not stopped.  Spending has picked up, as consumers appear to have derived some comfort from lower energy prices, while recent data suggest that income growth is improving.  The consumer balance sheet looks good.  The biggest downside risk remains savings (or lack of savings).  Will consumers consciously try to raise savings rates, particularly if housing prices begin to fall?

Weak housing will weigh on the economy for some time but the declines should ease into next year.  The manufacturing sector is offering mixed readings; the further a field from the auto industry, the better.  The capital-spending picture is okay for now although small business may be signaling a slight pullback.  Inventories seem well aligned with sales.  Improving overseas economies have raised U.S. exports, but such growth must significantly exceed import growth before the trade deficit shrinks.

What’s more, inflation generally lags economic growth and may have begun to top out.  Softer demand should damp the desire and ability to raise prices.  This is a critical point in our thesis that the Fed will hold the line on rates.  While our CPI (consumer price index) forecast shows a rise of roughly 3 to 3½% this year, the more important core component should rise 2¼% or so. This is very close, albeit still above, the upper end of the Fed’s comfort band.

Bottom line:  The economy seems to be doing just what the doctor ordered.  Since spring, the U.S. economy has slowed but not stopped, and seems set to grow on a glide path of 2% to 3% or so on average over the next few quarters.  This should keep inflation concerns at bay.  And it should keep short-term rates from rising – or falling – for now.

Mitchell J. Held is a managing director in the Economic and Market Analysis Department of Citigroup Global Markets.  Mr. Held, with more than 29 years of experience in the economics and investment field, focuses on delivering the economic message to Smith Barney’s Private Client Group.  In addition to Smith Barney, Citigroup, a leading global financial services company, includes under its umbrella Citibank, CitiFinancial, Primerica and Banamex.  Additional information may be found at http://www.citigroup.com/.