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U.S. ECONOMIC AND
INTEREST-RATE OUTLOOK
Prepared by Merrill Lynch & Co.
International Fixed Income Research
It will take some time before it becomes clear how the disruptions in the Asian economies will affect the U.S. economy. Part of the answer depends upon whether the disruptions spread to Latin America. Our estimate is that the events in Asia will subtract 0.5 percentage points from GDP growth in 1998, putting growth at 2.5%.
The potential disinflationary consequences of the slowing in the Asian economies are one of two reasons why the Fed did not tighten policy at its November 12 meeting, even though present domestic conditions suggested that a move was appropriate. The other reason was the turmoil in world financial markets at the time of the meeting. Even if the markets settle down, the Fed will still be faced with uncertainty about the potential disinflationary repercussions of the Asian situation. The data needed to make a reasonable assessment will not become available until December and January. Therefore, even if domestic activity remains strong, the Fed will probably keep policy steady at the December 16 meeting.
What is raising the most concern at the Fed is the potential inflationary consequences of the tightening in labor markets. The growth in the demand for labor is outstripping the growth in supply, causing the pool of available workers to shrink. For now, though, the Fed is comfortable with the idea that productivity gains, the strong dollar, and the growth- depressing effects of the events in Asia will counteract these influences.
Consumer spending slowed during the third quarter and into October. The slowing appears to have nothing to do with the troubles in the stock market, since measures of consumer confidence remain strong. We suspect that the recent slowing is merely one of the occasional lulls that often occurs. Spending should accelerate as the holiday season approaches. Nevertheless, there appears to be no immediate threat of an acceleration in inflation.
Martin J. Mauro
Fixed Income Trading Strategy
It is quickly approaching the one-month mark since stock prices swooned, credit spreads gapped wider, and investor psychology and confidence levels were challenged. It is our sense that the environment definitely feels better, even though activity has been somewhat sparse. One area that has benefited from the increased level of uncertainty has been the Treasury sector. With the front end anchored over the near term by the lack of Fed movement, we expect the yield curve to remain biased towards flattening. The persistence of the current set of market dynamics should keep pressure on spreads in the mortgage market. Pass-through spreads, which have widened 10-15 basis points over the past month, remain vulnerable to further widening. The risk of wider mortgage spreads may prove beneficial to the corporate market over the weeks ahead. As we approach year-end, wider corporate spreads will probably be purchased early, as investors remind themselves of the corporate market's seasonally strong year-end performance.
Thomas J. Sowanick
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
November 20, 1997Merrill Lynch & Co.
International Fixed Income Research
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