Download Deutsche Bank`s View of the US Economy and the Fed

Outlook for US Economy and the Fed
Subprime stress vs. inflation risk
Prepared for XXV Meeting of the Latin American
Network of Central Banks and Finance Ministries
May 18, 2007
Peter Hooper
Chief Economist
Deutsche Bank Securities
DISCLAIMER AND ANALYST CERTIFICATION ARE LOCATED ON THE LAST PAGE
Overview
 Fed’s central expectation: Goldilocks.
 Downside risks to growth have risen:
 Housing sector and subprime stresses still to come.
 Capital spending.
 Upside risks to inflation still present, but softening:
 Tight labor market.
 Energy prices.
 Inflation expectations.
 Rent inflation.
 Fed outlook:
 On hold for now, but rate cut before year quite plausible.
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I. Growth Risks
3
US GDP Growth Outlook
Contributions
Consumer spending (PCE)
Res investment
Net exports
Q/Q% AR
Nonres investment
Change in inventories
Government
Q/Q%AR
Forecast
7
7
6
6
5
5
Real GDP growth
4
Potential
4
3
3
2
2
1
1
0
0
-1
-1
Q2 Q3 Q4
-2
-3 2003-05 y/y
average
-2
2008 y/y forecast
2006
2007
-3
2008
Source: BEA, DB Global Markets Research
4
Home construction still in decline
% of real GDP
Thousands
5.6
Real residential investment (ls)
2200
Housing permits (rs)
5.2
2000
1800
4.8
1600
4.4
1400
Demographically driven demand
Plus demolitions
1200
4.0
1000
3.6
1992
1994
1996
1998
2000
2002
2004
2006
800
2008
Source: Census, BEA, DB Global Markets Research
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Excess supply of homes has risen sharply
%
14.0
# Months
13.5
8.0
9.0
Housing vacancies as % of all homes (LS)
13.0
7.0
12.5
6.0
12.0
Months supply
of new homes
for sale (RS)
11.5
5.0
4.0
11.0
3.0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Census, NBER, DB Global Markets Research
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Housing affordability has begun to improve
Index
150
140
Index
200
Housing affordability (ls)
turning up
130
190
180
170
160
120
150
110
140
130
100
120
90
Current conditions for buying houses
improving too (rs)
80
1990 1992 1994 1996 1998 2000 2002 2004 2006
110
100
Source: UM ICH, NAR, DB Global Markets Research
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But lending standards tightening (Subprime fallout I)
%
60
%
60
% of banks tightening standards
50
50
Subprime
40
40
30
30
20
20
All mortgages
10
10
0
0
-10
-10
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: Federal Reserve Senior Loan Officer Survey, DB Global Markets Research
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How important is the subprime market?
Subprime
adjustable 10%
Subprime
adjustable 20%
Subprime
fixed 4%
Alt-A
adj 7%
Subprime
fixed 4%
Alt-A
fixed 4%
Prime fixed
43%
Prime
adjustable
18%
Prime fixed
59%
Alt-A
adj 10%
Prime
adjustabl
e 16%
Alt-A fixed 4%
Mortgage originations 2005-06
($2.6 trillion per year)
Mortgage debt outstanding end 2006
($10.0 trillion)
Source:MBA,DB Global Markets Research
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Home foreclosures will soar (Subprime fallout II)
% of loans
4.5
% of loans
4.5
Foreclosures Started
?
4.0
4.0
3.5
3.5
3.0
3.0
2.5
2.5
Subprime
2.0
2.0
1.5
1.5
1.0
1.0
Total
0.5
0.0
1998
Prime
0.5
0.0
2000
2002
2004
2006
Source: MBA,DB Global Markets Research
2008
10
Home price inflation dropping sharply
yoy%
16
yoy%
16
OFHEO House price index
Median existing single-family
Case-Shiller national index
OFHEO purchase only
12
12
8
8
4
4
0
0
-4
1975
-4
1980
1985
1990
1995
Source:OFHEO,NAR,DB Global Markets Research
2000
2005
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Impact of lower home prices on consumers
Composition of household assets 2006
Other
equities
(Non-corp
business),
6.0%
Income
Consumer
spending
Financial
wealth
Other
assets
(largely
financial)
37.5%
Housing
wealth
Corporate
equities
directly
held, Corporate
equities
8.0%
indirectly
held
15.6%
Housing
assets
32.9%
Interest
rates
Source: FRB, DB Global Markets Research
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Stock market offsetting home price drop, so far…
Index (2003 Q4=100)
120
Index (2003 Q4=100 )
120
House price/income
(OFHEO)
115
115
110
110
105
105
Stock market/income
(Wilshire 5000)
100
95
Dec-03
100
95
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
Source: OFHEO,WSJ,BEA, DB Global Markets Research
Dec-06
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Saving rate should rise as wealth/income falls
%
Personal saving rate (ls)
14
Wealth-to-income ratio (rs)
ratio
Forecast
6.5
12
6.0
10
8
5.5
6
4
5.0
2
0
4.5
-2
-4
4.0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: BEA, FRB, DB Global Markets Research
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Capital spending trend has weakened.
25
yoy%
20
yoy%
Nondefense capital goods orders (ls)
Real equipment and software investment (rs)
25
20
15
15
10
10
5
5
0
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
2000
-25
2001
2002
2003
2004
2005
2006
2007
Source: BEA, Census, DB Global Markets Research
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II. Inflation Risks
16
Core inflation still “somewhat elevated”
yoy%
3.0
2.5
yoy%
3.0
Consumer prices ex food and energy
(Core PCE)
2.5
2.0
2.0
Fed’s
Comfort
zone
1.5
1.5
1.0
1.0
0.5
1996
0.5
1998
2000
2003
2005
Source: BEA,DB Global Markets Research
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Inflation outlook and risks
Core consumer price inflation expected to decline,
due to:
 1. Easing of labor cost pressures


but will employment growth decline?
and will compensation growth ease?
 2. Decline in energy price pass through


but and gasoline prices rising sharply
dollar falling and non-oil import prices accelerating
 3. Gravitational pull from well anchored inflation
expectations

but are they low enough, and are they really anchored?
 4. Decline in rental inflation as vacancy rates rise

but subprime stress may slow that process
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1. Labor market looks tight but should ease ahead
%
%
Unemployment rate
11
11
10
10
9
9
Estimated NAIRU range
8
8
7
7
6
6
5
5
4
4
3
1970
3
1980
1990
2000
Source: BLS,CBO,DB Global Markets Research
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Employment typically lags construction activity
12-qtr % change AR
15
12-qtr % change AR
Total real res and nonres construction investment
15
Total employment in construction (2-qtr lag)
10
10
5
5
0
0
-5
-5
-10
1972
-10
1977
1982
1987
1992
1997
Source: BEA,,BLS DB Global Markets Research
2002
2007
20
Labor cost inflation running high for comfort
%
6
Core PCE price index
Unit labor cost (4q% change)
%
6
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
1990 1992 1994 1996 1998 2000 2002 2004 2006
-2
Source: BLS, DB Global Markets Research
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2. Oil has leveled off but gasoline prices surging
Dollars/Barrel
Cents/Gallon
320
Retail Gasoline (LS)
80
75
300
70
280
65
260
240
60
West Texas Crude (RS)
55
220
50
200
45
40
180
35
160
30
140
25
120
2004
20
2005
2006
2007
Source: BLS, DB Global Markets Research
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3. How much gravitational pull from expectations?
5Y5Y breakeven inflation expectations
%
%
%
UMich 5-10 year inflation expectations
3.5
3.5
Philly Fed (SPF) inflation expectations
3.0
3
2.5
2.5
2.0
2
Top of Fed’s comfort
zone for core CPI
1.5
1.5
1.0
1
0.5
Jan-00
0.5
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Source: U.Mich,Bloomberg,Phil Fed, DB Global Markets Research
Jan-07
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4. Rent has elevated core inflation
Y/Y%
3.0
Y/Y%
3.0
Core PCE
Core PCE excluding rents
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: BLS,BEA, DB US Economics Research
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What will get the Fed to ease
Fed currently has a bias toward tightening.
 To move to neutral, Fed will need to see core inflation
move into the comfort zone and labor market pressure
ease (unemployment rate move up higher or labor cost
inflation moderate).
 To cut rates, Fed will need to see core inflation move
further into comfort zone and unemployment rate rise
significantly.

Source: FRB, DB Global Markets Research
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Risks: How Things Could Turn Out Differently
 Recession scenario
 Subprime stress spreads, residential investment and home prices
plunge.
 Consumer confidence/spending and labor markets weaken
substantially.
 Fed cuts rates aggressively, setting stage for stronger growth in
2008 and beyond.
 Inflation pressures build further
 Housing bottoms, consumer spending remains buoyant.
 Labor cost and consumer prices accelerate.
 Fed raises rates, setting stage for slowdown in 2008.
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Inflation risk in the longer term: the political
dimension
yoy%
yoy%
12
12
Barney
Wright
Consumer prices (PCE)
11
11
Frank
Patman
less food and energy
10
10
Era
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: BEA, DB Global Markets Research
27
Social Security spending nearing take-off
% of GDP
% of GDP
7
7
Projected Social Security spending
6
6
5
5
4
4
3
3
2
2
1
1
0
0
1962 1970 1978 1986 1994 2002 2010 2018 2026 2034 2042 2050
Source: CBO, DB Global Markets Research
28
Medical spending likely to soar
% of GDP
25
20
Medicare and Medicaid
Medicare/Medicaid spending
% of GDP
Assumes medical inflation premium of:
25
20
2-1/2%
15
1%
10
5
15
10
Social Security
5
0
0
1962 1970 1978 1986 1994 2002 2010 2018 2026 2034 2042 2050
Source: CBO, DB Global Markets Research
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Conclusions

Downside risks to growth have increased,
centered on housing sector and potential
spillovers.

Upside risks to inflation remain but may be
starting to ease.

Slow growth and receding inflation risks
should eventually elicit rate cut, by late 2007.

Longer-term risks to US rates lie to the upside.
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Peter Hooper
Managing Director, Chief Economist
Deutsche Bank Securities, Inc.
Peter Hooper oversees a team of economists that analyze and forecast
developments in the US economy and financial markets. Dr. Hooper joined
Deutsche Bank Securities in the fall of 1999 as Chief US Economist, and was
appointed Chief Economist in 2006. Dr. Hooper frequently comments on US
economic and financial developments in the news media.
Prior to joining the firm, Dr. Hooper enjoyed a distinguished 26-year career at the
Federal Reserve Board in Washington, D.C. He held numerous positions at the Fed,
including as an economist on the FOMC and as Deputy Director of the Division of
International Finance. In doing so, he developed an informed view of the Fed's
policy making process.
Dr. Hooper earned a BA in Economics (cum laude) from Princeton University and an
MA and Ph.D. in Economics from University of Michigan. He has published
numerous books, journal articles, and reviews on economics and policy analysis.
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The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s)
has not and will not receive any compensation for providing a specific recommendation or view in this report. Peter Hooper
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