Sustainable Expansion, High Energy Prices and Fed Rate Hikes

1

• Sustainable Expansion, High Energy Prices and Fed
  Rate Hikes
• Peter E. Kretzmer
• Senior Economist
• Bank of America
• October 2004

2
(No Transcript)
3
Global Expansion

• Sustained but unsteady expansion in U.S.
• Core Eurozone early progress on structural
  issues
• China restrains its rapid expansion
• Japan recovery moderates but continues
• Canada and Mexico on cyclical upswing South
  America improves

4
Healthy Global Performance

• Share of Yr/Yr
• Region Global Output Growth Comment
• U.S. 30.6 4.8 moderating
• EU-15 29.2 2.2 stabilizing
• Mexico 1.7 3.9 picking up
• Canada 2.4 3.0 picking up
• Japan 11.8 4.3 moderating
• China 3.9 9.6 robust
• Other Asia 6.9 4.3 strong

5
Interest Rate Trends
10-Year Treasury Note Yield at Constant Maturity
Federal Funds effective Rate
p.a.
20
20
16
16
12
12
8
8
4
4
0
0
00
95
90
85
80
75
70
65
60
Source Federal Reserve Board /Haver Analytics
09/08/04
6
Nominal Spending Growth
Gross Domestic Product
Change - Year to Year SAAR, Bil.
15.0
15.0
12.5
12.5
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
00
95
90
85
80
75
70
65
60
Source Bureau of Economic Analysis /Haver
Analytics
09/08/04
7
U.S. Economic Background

• Expansion sustainable as business caution fades
• Repeated energy cost surges buffet consumer
  demand
• Inflation tilts upward but risks remain muted
• Profit gains cool slower productivity, rising
  costs
• Fed hikes rates gradually
• Tightening path increasingly data dependent
• Increasing momentum abroad

8
GDP Outlook

• Estimate 4 to 4.5 real GDP growth in 2H04
• Consumer spending rebounds from 2Q soft patch
• -- But more energy cost impacts ahead
• Solid, broadening capital spending provides
  support
• Businesses well into inventory recovery period
• Improving world economy and lower dollar boost
  exports

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Solid Economic Expansion(Percent Change, Q4/Q4)

• 2002, act.
  2003, act. 2004, est 2005, est
• Real GDP 2.3
  4.4 4.1 3.5
• Consumption 2.5
  3.8 3.2 3.2
• Residential investment 6.9 12.0
  7.9 -0.5
• Business fixed investment -6.0
  9.4 9.5 6.9
• Equipment and software -2.2 12.1
  11.0 7.7
• Structures -16.1
  1.5 3.0 4.2
• Pre-tax profits 15.4
  23.3 6.5 8.0
• Unemployment Rate (Q4) 5.9
  5.9 5.4 5.3

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Real GDP Around Recession Troughs
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Real Economic Growth
Gross Domestic Product
Change - Year to Year SAAR,
Bil.Chn.2000
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
-2.5
-2.5
-5.0
-5.0
00
95
90
85
80
75
70
65
60
Source Bureau of Economic Analysis /Haver
Analytics
09/08/04
12
Consumer Rebounds from Softness

• Higher energy costs forced adjustment
• Renewed softening likely by 1Q 2005
• Household net worth providing support
• Rising real disposable personal income
• Low interest rates
• Moderate gains in interest-sensitive spending

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Real Household Net Worth
(trillions of chained 2000)
45.0
45.0
37.5
37.5
30.0
30.0
22.5
22.5
15.0
15.0
7.5
7.5
00
95
90
85
80
75
70
65
60
09/29/04
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Personal Consumption Expenditures
Change - Year to Year SAAR,
Bil.Chn.2000
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
-2.5
-2.5
00
95
90
85
80
75
70
65
60
Source Bureau of Economic Analysis /Haver
Analytics
09/08/04
15
Relative Price of Energy in Consumption
Index 100 in 2000
140
140
120
120
100
100
80
80
60
60
00
95
90
85
80
75
70
65
60
09/08/04
16
Energy Consumption per Dollar of GDP(Thousand
Btu per Chained (1996) Dollar)
17
Business Responds to Stronger Demand and Profits

• Recovery in sustainable phase
• Orders production strengthen inventories build
• Businesses gradually shed cautiousness
• Capital spending gains broaden
• Employment gains surge, then slow but persist

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Business Investment Selective Rebound (average
annualized change)

• 
  1Q96-2Q00 2Q00-4Q01 4Q01-2Q03 2Q03-2Q04
• Bus Fixed Inv (100)
  10.9 -6.5 -0.9 10.8
• Structures (21.0)
  5.2 -6.9 -10.2 1.3
• Equip. Software (79.0)
  13.0 -6.3 2.5 13.9
• Info. Proc.software (46.2) 21.3 -3.5 9.6 18.9
• Industrial equipment (11.6) 3.5 -11.1 -1.4 1.7
• Transportation etc. (10.3) 8.7
  -9.4 -13.8 7.9
• Other (10.9) 6.3
  -6.0 1.2 17.0

Share of business fixed investmentIncludes
furniture and fixtures tractors, agricultural
and construction machinery mining oilfield
machinery service industry machinery and
electrical equipment.
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Change in Private Inventories
SAAR, Bil.Chn.2000
120
120
80
80
40
40
0
0
-40
-40
-80
-80
-120
-120
00
95
90
Source Bureau of Economic Analysis /Haver
Analytics
09/29/04
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Moderate Employment Gains

• Labor markets turn corner but gains moderate
• Acceleration of real GDP above 4 year-over-year
• Recent softening in spending leads to weaker
  payrolls
• Still significant gap between employment surveys
• Household survey shows larger cumulative gains
• But job growth rates have converged in recent
  months
• Shifting supply and demand for labor
• Temp workers future payroll growth, residual
  caution
• Outsourcing real, but not primary source of
  weakness
• Businesses remain sensitive to demand variation
• Why boost payrolls if business pickup is
  temporary?

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Nonfarm Payrolls Around Recession Troughs
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Household Employment Around Recession Troughs
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GDP and Payroll Growth
Real Gross Domestic Product
Change - Year to Year SAAR,
Bil.Chn.2000
All Employees Total Nonfarm
Change - Year to Year SA, Thous
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
-2.5
-2.5
-5.0
-5.0
00
95
90
85
80
75
70
65
Sources BEA, BLS /Haver
09/08/04
24
Profits Flatten Following Surge

• Operating profits reach peak levels in 1Q04
• Productivity efficiency gains
• Modest top-line growth
• In recent months, revenue growth expands but
  profit growth slows
• Productivity slows as hiring picks up
• Costs of energy and raw materials spike
• Implications
• Stock market flattens following sharp 2003 rise
• Corporate bond spreads stabilize following
  narrowing

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Productivity Nonfarm Business Sector
SA,Chg.Yr.Ago -- line
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Real Operating Profits
(trillions of chained 2000)
1.2
1.2
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
00
95
90
85
80
75
70
65
60
07/27/04
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Perspectives on Construction

• Residential market exceptional run as
• declining mortgage rates have enhanced
  affordability
• flexible liquid mortgage markets have spurred
  refinancing
• Robust new homebuilding resilient but flattening
• Remains a buffer against energy-induced weakness
• Private nonresidential construction lags cycle
• Decline severe and prolonged in current
  expansion,
• but structures spending gradually picking up
• Public construction
• Strong growth of the 1990s replaced by flat real
  spending
• Surged in 2Q04 state and local finances improving

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Residential Market Signs of Flattening
New 1-Family Houses Sold United States
Housing Starts
SAAR, Thous.Units
2400
2400
2000
2000
1600
1600
1200
1200
800
800
400
400
00
95
90
Source Census Bureau /Haver Analytics
09/29/04
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Inflation, Interest Rates and Fed Policy

• Issue facing Fed maintaining virtual price
  stability
• Sustainable expansion now in place
• Inflation risks balanced (August FOMC statement)
• Deflation concerns have dissipated
• FOMC recent price spike was in part transitory
• Very accommodative policy no longer appropriate
• Household wealth back on trendline
• Better economic growth and payroll gains
• Rise in core inflation
• Determining the rate hike path
• Fed moves at measured pace tightening becoming
  data-dependent
• Energy prices a significant complicating factor
• Inflation path remains critical focus on
  inflation expectations

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Measures of Consumer Inflation
CPI-U All Items Less Food and Energy
PCE less Food Energy Chain Price Index
Change - Year to Year SA, 1982-84100
2000100
15.0
15.0
12.5
12.5
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
00
95
90
85
80
75
70
65
60
Sources BLS, BEA /Haver
09/08/04
31
Core CPI Inflation
CPI-U All Items Less Food and Energy
Change - Year to Year 3-month Change-ann
SA, 1982-84100
8
8
6
6
4
4
2
2
0
0
00
95
90
Source Bureau of Labor Statistics /Haver
Analytics
10/08/04
32
Core PCE Chain Price Inflation
PCE less Food Energy Chain Price Index
Change - Year to Year 3-month Change-ann
SA, 2000100
8
8
6
6
4
4
2
2
0
0
-2
-2
00
95
90
Source Bureau of Economic Analysis /Haver
Analytics
10/08/04
33
Feds Central Tendency Forecasts (Q4/Q4 Percent
Change)
34
Inflation and Interest Rates
10-Year Treasury Note Yield at Constant Maturity
p.a.
CPI-U All Items Less Food and Energy
Change - Year to Year SA, 1982-84100
16
16
12
12
8
8
4
4
0
0
00
95
90
85
80
75
70
65
60
Sources FRB, BLS /Haver
09/13/04
35
Corporate Bond Spread
Moodys Baa corporate yield minus 20-year
constant maturity yield
2.8
2.8
2.4
2.4
2.0
2.0
1.6
1.6
1.2
1.2
0.8
0.8
00
95
90
09/13/04
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Mortgage Bond Spread
30-year fixed rate mortgage commitment minus
30-year constant maturity yield
2.4
2.4
2.0
2.0
1.6
1.6
1.2
1.2
0.8
0.8
0.4
0.4
00
95
90
09/13/04
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Election, economy the Fed

• Fed raising rates despite election
• Funds rate has risen in about half of recent Pres
  election years
• Economy and inflation dominate Fed policy
• Fed less political than generally perceived
• Only glaring election year exception was 1972
• Economy typically an important election influence
• World affairs to also play key election role this
  year
• Politics of energy costs an important factor

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Economic Policy Implications of Election

• Bush economic agenda if reelected
• Make most first-term tax cuts permanent tax
  reform (?)
• Social security reform, including private
  accounts
• Tort reform
• Kerry economic agenda
• Reverse higher-bracket income tax rate cuts
• Raise capital gains taxes, perhaps reverse
  dividend tax cut
• Possibly raise FICA tax threshold
• Major new healthcare spending
• Raise minimum wage
• Outsourcing (job protection) legislation
• Congressional outcome crucial

39
Federal Budget 1989 Total Spending 1.14
Trillion
Defense (304 Bil, 26.6)

• Other (143 Bil, 12.5)

Social Security (230 Bil, 20.2)
Interest (169 Bil, 14.8)
Medicaid (35 Bil, 3.0)
Medicare (94 Bil, 8.3)
Discretionary (168 Bil, 14.7)
40
Federal Budget 2003 Total Spending 2.16
Trillion
Defense (377 Bil, 17.5)
Social Security (474 Bil, 22.0)

• Other (343 Bil, 15.9)

Interest (153 Bil, 7.1)
Medicaid (157 Bil, 7.3)
Discretionary (385 Bil, 17.8)
Medicare (269 Bil, 12.5)