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U.S. Economic and Interest Rate Outlook

Happy Days Are Here Again?
August 2003

Yes, for now. Second quarter GDP growth came in stronger than expected. All right, defense spending had a lot to do with it. But private domestic final demand had a lot to do with it, too. Nonresidential fixed investment expenditures, adjusted for prices, grew at almost 7% annualized - the fastest growth in three years. Residential investment expenditures, a.k.a. housing, grew an annualized 6%, thanks to real estate broker commissions. In the current quarter, residential investment expenditures are likely to be boosted by the actions of the folks who actually build new houses, rather than the ones who merely sell the ones already built. And, of course, second quarter GDP growth got a boost from old reliable - increasingly indebted household consumers. Meanwhile, back at the factory, not much was going on except pulling goods off the shelves with which to fill the new orders coming in. But the fact that the warehouse shelves are bare implies increased manufacturing activity in the second half. We now estimate that real GDP will grow at an annualized rate of a little more than 3-1/2% in the second half of this year. This should be enough to, at the least, stabilize the unemployment rate, and perhaps bring it down a smidgen. Will the Fed react to this acceleration in economic growth as it has in the past - by pushing up the funds rate? Nope. The Fed is firmly committed to allowing this economy to grow as rapidly as it is capable over the next year. We don't see the Fed tapping the monetary brakes until August 2004, at the earliest.

We have to admit to being chagrined by the sharp runup in interest rates since the June 25th FOMC meeting - not just the jump in bond yields, but the rise in shorter-maturity rates as well. In fact, it is the increase in shorter-maturity interest rates that is most puzzling to us. The Fed has gone out of its way to tell investors that it has no intention of raising rates anytime soon. Now, we can understand why bondholders would find this a little disconcerting. But unless you firmly expect a massive run on the dollar and/or sharply higher inflation between now and mid 2005, then why fight the Fed? So, we believe that the 2-year Treasury yield will work its way lower over the next several months, and not start to rise again in earnest until the spring of 2004 - unless, of course, there is a run on the dollar.

We believe that movements in the 10-year Treasury note yield get exaggerated these days by the hedging actions of mortgage-backed securities portfolio managers. As we wrote on August 1, there appeared to us to be a legitimate reason why bond yields would rise in the face of the Fed’s desire to produce more inflation. Higher inflation has been the hallmark of the Fed ever since it opened for business back in 1914. So, if the Fed now is actually trying to bring about higher inflation, then we have no doubt that it will be successful over the next 10 years. (By the way, we are a little ticked off at journalists who receive our materials and then write articles essentially using our ideas without attribution. But, as someone said, plagiarism is the sincerest form of flattery.) Moreover, the Treasury is going to be selling massive amounts of 10-year securities over the next 10 years. This, too, could be expected to put upward pressure on 10-year Treasury yields. But, as alluded to in a few sentences earlier, we believe that the actions of mortgage-backed securities portfolio managers have amplified the rise in Treasury bond yields. As Treasury bond yields started to rise, so did longer-maturity mortgage rates. This caused the duration of mortgage-backed securities to rise, as prepayment risk diminished. So as to keep the duration of mortgage-backed securities portfolios from rising beyond their target, portfolio managers unloaded 10-year Treasury securities and/or cutback on their purchases of them. This activity should have run its course by now. As a result, we look for some retracement down in bond yields before they rise again in the spring of 2004.

Why did we qualify our answer to the question: Are happy days here again? Because we still are not sure that the economic "alternator" we referred to in last month’s forecast has been fixed. We continue to wonder if the Fed’s low interest policy has prevented the necessary liquidations and consolidations in the business sector to lead to sustained profit growth. Sustained profit growth is a necessary condition for sustained employment growth. And sustained employment growth is a necessary condition for the rate of personal bankruptcies to start declining. Because of our doubts about all of this, we have incorporated a second-half 2004 slowdown in real GDP growth to about 3% in our forecast. The effects of the latest federal tax cut start to decay rapidly in the third quarter of 2004 and we have the Fed starting to raise the funds rate in August of 2004. Both of these factors reinforce our view of this slowdown. If this scenario were to play out, the Fed would not continue to raise the funds rate into 2005 and bond yield might back down, too.

But there is yet another unhappy ending that haunts us - a run on the dollar. It is beyond us why the rest of the world willing advances the U.S. $1-1/2 billion a day to buy bigger cars, bigger houses, and cruise missiles, especially in light of the Federal Reserve pledging that these foreign investors will be paid back with U.S. dollars that will be worth less in the future. A run on the dollar would cause our inflation rate to rise faster than otherwise and would put the Fed in the position of having to raise the funds rate more aggressively than otherwise. Again, U.S. economic growth would tail off, though exports would strengthen. But interest rates would rise much higher and faster than what we have in this "base case" forecast.

Paul L. Kasriel
Director of Economic Research

Asha Bangalore
Economist

THE NORTHERN TRUST COMPANY
ECONOMIC RESEARCH DEPARTMENT

August 2003
Selected Business Indicators

Table 1

Table 2

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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