Consumers appear to have turned their rebate checks around even more quickly than expected, maybe even before they received them. Even though auto sales remain extremely soft, consumers are spending on almost everything else, boosting the prospects for real GDP, at least in the short run. The spending is a surprise given how gloomy consumers say they are, but apparently they feel spending money will lift their spirits.

Oil prices are adding to the gloom, with oil at more than $125/barrel and gasoline near $4/gallon. The main impact has been on car sales. So far, at least, the rebate checks have offset any impact on non-auto purchases. The summer will be a challenging period for the consumer. Will they be traveling as much as usual, given the high transportation costs?

Although housing remains soft, the data on starts and sales are doing a bit better than expected. Nonresidential construction remains much stronger than anticipated, despite a dearth of new projects. Upward revisions to the manufacturing data are keeping the outlook for equipment spending in positive territory as well. Overall, capital spending looks like it will support growth a bit more than anticipated.

The outlook for the second and third quarters has improved, primarily because of the consumer. We now expect growth to average 1.5% for the middle two quarters. However, we expect a bad hangover after the rebate party, with consumer spending and the economy sliding downward in the fourth and first quarter of this year and the first quarter of 2009. The recession is thus going to stretch out through early next year, but the start is much milder than anticipated.

Spend That Rebate
Some Americans will initially use some of their rebates to pay down credit card or other debt, but past behavior suggests households will soon run the debt back up. The saving rate popped up to 5.0% in May, despite the 0.8% rise in consumer spending. The saving rate was also boosted by the weakness in car sales; the rebate won’t cover a new ride. We expect some of the rebate checks to be spent on summer vacations. The timing seems appropriate, and $1800 will provide a week’s vacation lodging in many areas.

We expect that the saving rate will stabilize near 2%. The rate will surge in the second and third quarters, reflecting unspent rebates, but then fall back in the fourth. Consumer spending will be supported by the rebates for a few months, but we expect consumers to capitulate in the fourth quarter, slowing consumer spending after the checks are spent.

The drop in wealth that lower home prices has caused seems to have been less of a problem than we thought. Consumers do not seem to have decided to save more just because their house is worth less. However, we do think the lower wealth numbers should be a concern, particularly for the Baby Boomers now approaching retirement.

We do not expect any major retrenchment by the American consumer. The saving rate is expected to hold below 1%, and to be negative for the next few quarters after the temporary surge in the second quarter caused by tax rebates. Tax policy under the next president will also help determine the patterns of saving and investment.

Housing remains weak. Although there is some encouraging evidence that bargain hunters are beginning to get into the market, the large inventory of unsold existing homes suggests the problem has a long while to run. We expect sales and starts to bottom out sometime in the third quarter, but prices are likely to continue to drop through the first half of 2009. Nationally, we expect home prices to drop another 10% by mid-2009. Because the S&P/Case-Shiller price series is already down 18% from its peak, it will have fallen 25% to 30% by the time prices stabilize, but the price declines will be more pronounced in the bubble areas and the auto-producing states.

The various home price indices are giving different readings of the seriousness of the problem, but it seems clear that both regional and home size issues are causing different sectors of the market to behave differently. The Great Lakes region is suffering from a lack of jobs, and with car sales weak, the problem is going to get worse, not better. The “bubble states” of Florida, California, Arizona, and Nevada still have home prices that are too high relative to income, so we expect further declines. In the rest of the country, the problems appear to be comparatively minor, with home prices mostly flat except for the low end of the market, where the lack of subprime lending makes selling tough.

The Fed and Financial Markets
The Federal Reserve is expected to stay on hold for the rest of the year, after holding at its June 24-25 meeting. The Fed will want to see the impact of the tax rebate checks as well as the effect of the 325 basis points (bps) in rate cuts they have already made, because Americans seem to be spending the rebate checks, we expect no more rate cuts.

The Fed remains concerned about the financial markets but apparently believes that the dangers of a total freeze-up have diminished. Quality spreads have widened in the last month after earlier narrowing. Speculative-grade bonds were trading 650 bps above Treasuries a month ago; the spread has now widened to 690 bps. The LIBOR rate has risen to 100 bps above the federal funds rate; the spread was 38 bps a month ago. Markets were calming, but they seem to be getting more nervous again. The Fed remains worried that markets will remain troubled.

We do not expect the Fed to raise rates until it is clear the risk of recession is over. We think the worst of the recession will be early next year, so the second quarter seems the earliest likely rate hike. There is concern that the July 3 tightening by the European Central Bank (ECB) will send the dollar down further, but just because the ECB tightens doesn’t mean the Fed should automatically follow. As your mother always asked, “If all the other kids on the block jumped off the bridge, would you follow them?” The Fed is charged with handling the U.S. economy. The U.S. economy is in recession, and the dollar will help employment growth in the U.S. by helping to close the trade gap. The Fed is concerned about the inflationary aspects of a weak dollar, but those seem controlled so far. In particular, there is no sign of the kind of “wage-price spiral” that caused such disaster in the 1970s. Prices are going up, but wages and unit labor costs aren’t. Unit labor costs are a better series to focus on than overall inflation, because the Fed can do nothing about oil prices.

We expect the dollar to drop slightly with the ECB rate hike, but then to stabilize. European bond yields are now above U.S. yields, so the inflow of capital into fixed-income investments has slowed. The U.S. trade deficit has been reduced, and Europe is sliding into deficit, but the U.S. current-account deficit is still very large relative to GDP (5.0% in the first quarter). The inflow of capital from abroad has slowed down, but the lower dollar should attract capital in to purchase real assets, which will partially offset the reduced inflow of fixed-income funds.

Bond yields remain relatively low, with the 10-year holding at 4%. We expect bond yields to continue to edge higher over the next 18 months, as the world economy recovers. Fed policy has less impact on bond yields than in the past, because financial markets have become more global. U.S. 10-year government bond yields (4.0%) are now significantly below the equivalent European yield (4.7%). That yield differential is putting upward pressure on U.S. yields and downward pressure on the dollar.