The very near-term economic outlook is unclear and will remain so until the political impasse in Washington over the government shutdown and debt ceiling is settled. If differences are resolved in a day or two, the damage could be about 0.2 percentage points to fourth quarter real gross domestic product (GDP). A failure to raise the debt ceiling would more of a calamity, which we hope not to encounter.
The forecast that we offer below assumes the more benign of these two outcomes. But the downside risk of a bad outcome in Washington must be respected. Market reaction in that event would be negative and could be quite substantial, creating a negative wealth effect. An extended government shutdown would idle workers in both the public and private sectors. And the willingness of businesses to expand might be seriously compromised in this instance.
Key Economic Indicators
In the absence of economic information from the federal government, private sector reports, economic publications of the Federal Reserve and data from state governments offer useful insights.
Although the September retail sales report has not been published, auto sales data from the private sector are available and show a small monthly decline. Putting together auto sales for the entire quarter, the picture is different. Auto sales rose at an annualized rate of 5.4% in the third quarter, which should give a boost to overall consumer spending. The non-auto retail sales component has a strong positive correlation with the ICSC Goldman Sachs Retail Chain Store Index. The September tally shows a slightly better performance compared with August.
The preliminary October University of Michigan Consumer Sentiment Index declined to 75.2 from 77.5 in the previous month. The good news is that the level is significantly higher than the 55.8 reading posted for August 2011, when the debt ceiling issue was looming large over markets.
Initial jobless claims rose 66,000 in the latest weekly report, but the Labor Department noted that about half the increase reflects backlogs following a computer system upgrade in California. Excluding the impact from California, the government shutdown led to a 30,000 gain in initial jobless claims. If the fiscal stand-off is unresolved, we can expect further additions to the unemployment rolls.
The third quarter Purchasing Managers Index of the factory sector stands at 55.8, up from 50.2 in the second quarter, and the highest since the second quarter of 2011. This index has a strong positive correlation with year-to-year change in real GDP, implying that the latest quarterly average bodes positively for the third quarter growth.
The Chicago Board Options Exchanges Volatility Index at 15.7 as of October 11 is noticeably lower than the high (48) seen in August 2011. For the most part, markets have taken the political crisis in stride.
In the interim, our latest forecast includes marginal changes from the previous months projections. Real GDP is predicted to have risen at an annual rate of 1.8% in the third quarter, with a steady jobless rate and a muted trend of inflation. Long-term rates have erased a large part of the rise that occurred in anticipation of the Fed reducing asset purchases.
The Feds decision to stand pat was in response to less-sanguine labor market data, the backup in long-term yields and its likely impact on housing demand, and the projected setback in economic activity given the unresolved fiscal situation in Washington. The nature of the resolution of the contentious fiscal stand-off will determine if the Fed will, indeed, announce a reduction of asset purchases in December.
The likelihood of action at that time has clearly diminished. The Feds hands are tied until Congress gets its act together. In the meanwhile, the Fed can work on improving communications to help the market differentiate between tapering and tightening.
Headwinds from Europe, although less severe, are nonetheless important. The pickups in overall GDP and factory surveys of the eurozone are encouraging, but the lack of a meaningful cleanup of the banking system and the resulting credit crunch will continue to be a major impediment to growth.
Overall, we remain constructive on the near-term performance of the American economy. But our confidence in this outlook declines a bit each day that the U.S. fiscal drama remains unresolved.