Brooklyn's Progress
October/November 2007

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

Real GDP (adjusted for inflation) grew at a 2¼% annual rate the first-half of 2007.  In our view, it will be difficult for the economy to do too much better during the second half. As feared, recent events in the financial markets seem to have encouraged another down leg in the housing market that is likely to stake a claim to other parts of the economy, at least at the periphery.

If left unchecked, even more damage could be done.  Inflation has headed lower and given our projections, may continue to do so over the near term.  We look for 2%-2½% real GDP growth for the next few quarters.

Consumer Spending Helps
We believe consumer spending, the single largest driver of economic activity, remains underpinned by solid household balance sheets, still-healthy income growth and, for the time being, lower gasoline prices. Going into the crunch, auto sales surprised on the upside. The chances of the consumer sliding in unscathed remains small, however.  Housing developments are likely to adversely impact consumer wealth. August’s employment weakness was probably overstated by the data, but a downshift in job growth is clearly underway. 

Investment
The data show capital spending holding in, but the chatter charts a slower, albeit still positive, course.  Core shipments have been a little worse than forecast and weakness in construction machinery and light truck sales have been noted. This is a casualty of housing weakness, in our view.  Nonresidential construction looks healthy to us at the moment, but the availability and cost of financing ultimately may be reflected in slower growth.

Inflation
Inflation readings appear to be stabilizing at a relatively low level – the core PCE index is up just 1.9% over the past year, the smallest increase since April 2004.  Wage and labor costs have not accelerated much.

Wider corporate spreads, lower stock prices and a re-pricing of risk have contributed to more restrictive financial conditions.  Financial conditions are not particularly tight and we don’t see a recession near term, but they are tighter than a few months ago when major U.S. equity indices were setting new highs. This is beginning to impact economic growth and the Fed will have to ease these conditions, in our opinion.  Smoother functioning of the financial markets, particularly the money markets, requires a similar recipe.  Lower short-term rates should result.

The Discount Rate Cut
The Fed last lowered its discount rate, which is based on future cash flow in place of present value, by 50 basis points on Aug. 17 in order to “promote the restoration of orderly conditions in financial markets.” Some markets have improved; others, notably those for asset-backed commercial paper and adjustable rate preferred stock, have worsened. Participants’ fear of counterparty risk has increased, as well-functioning money markets are crucial to policymakers to achieve their desired impact.

Fed Funds Target Rate
We now believe that the Fed will lower the overnight rate, which is what large banks use to borrow from and lend to one another, by 50 basis points soon. Current conditions in the money markets (see above) seem to require a more aggressive policy move than previously thought. Meanwhile, the data continues to suggest that while the economy is progressing forward at a moderate pace, “the downside risks to growth have increased appreciably.” At the moment, tightening in financial conditions, combined with a 5¼% nominal (about a 3% adjusted for inflation) Fed funds rate would place the economy on a much slower growth track than the Fed desires.

A nominal rate closer to 4½% (2%-2¼% adjusted for inflation) provides a less restrictive or more neutral policy edge, which seems more consistent with the Fed’s projected growth path of the economy. A follow-up 25 basis points cut is likely at either the Oct. 30-31 or Dec. 11 Federal Open Market Committee meetings, in our opinion. We believe they’ll cut more aggressively if they have to.

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/.