Prepared by First Chicago

The First National Bank of Chicago

GDP rose a revised 3.3% in the third quarter, slightly behind initial estimates. A sharp deterioration in the trade balance and weaker commercial construction activity accounted for the bulk of the changes. Inventories were also revised down slightly, but household spending remained extremely robust.

Preliminary data suggest that underlying demand softened in the current quarter. Retail sales declined in October, and November was likely another slack month. A late Thanksgiving pushed much of the Christmas rush into December. Aggressive ordering for Christmas suggests that inventories will remain relatively high, however, and exports are expected to accelerate. Real GDP is expected to rise 3.2% in the fourth quarter.

The remainder of this special report takes a look at the 1998 outlook. Turmoil in Southeast Asia is expected to exacerbate a slowdown at the start of the year and temporarily ease inflationary concerns at the Fed. Persistent tightness in the labor market and a resurgence in growth later in the year, however, could quickly re-ignite the debate on inflation.

Growth Slows

Chart 1 shows the outlook for economic growth in 1998. Real GDP is expected to rise 2.8% in 1998, a full percent behind the robust pace of 1997:

–Household spending is expected to settle into a more reasonable trend (at least temporarily), now that credit accumulation has slowed and personal saving has eroded;

–Business investment is expected to abate, but remain a driver of economic gains;

–Trade is expected to deteriorate, reflecting the on-going strength in domestic investment and problems in Southeast Asia; and

–Inventories are expected to drain. The worst of the losses are likely to occur early in the year, however, as retailers will be pushing hard to liquidate the overhang from Christmas.

The only upside risk is household spending, which could get an unexpected lift from recent increases in wages and wealth. It remains unclear, however, whether wealth will provide the same push on spending that it did this year given the drop in saving.

Inflation Gradually Inches Up

Chart 2 shows the forecast for CPT inflation in 1998, The core rate of inflation is expected to end the year at 2.8%, slightly higher than it started the year:

–A slowdown in growth and continued gains in business investment are expected to keep bottlenecks to a minimum;

–A push to liquidate retail inventories is expected to help keep apparel prices soft; and,

–Lags on the dollar suggest that import prices will remain in check.

The risk is, however, that inflation accelerates more than expected. Labor markets remain extremely tight and there is evidence that wages are beginning to pick up.

The Fed Remains Sidelined

Chart 3 shows the forecast for the federal funds rate in 1998. The federal funds rate is expected to end the year at 5½%;

–A slowdown in growth and continued good news on inflation are expected to temporarily ease inflationary concerns at the Fed;

–Recent problems in Southeast Asia are expected to further the cause for near-term monetary restraint.

–Recent Clinton appointees are likely to argue against tightening.

We are in unchartered territory with regard to Fed policy, however, and a resurgence in growth and a gradual pick up in inflation are expected to re-ignite the debate on inflation as the year progresses.

Long-Term Bond Yields Remain Low

Chart 4 shows the forecast for long-term bond yields in 1999. The 30-year Treasury bond is expected to end the year at 6<$E5/8>%. Two temporary factors should help to hold yields low at the start of the year:

–The slowdown in growth.

–The continued flight to quality by investors.

A resurgence in growth and a pickup in inflation later in the year, however, should reverse earlier market pins.

The Dollar Trades In A Broad Range

Political uncertainties with regard to the Euro, coupled with prospects for a resurgence in growth at home late in the year, will keep the dollar in a narrow trading range vis-a-vis European currencies in 1998. On net, the dollar is expected to end the year at 1.77 DM.

Prospects for dollar movements against the yen are greater. Political pressures to stimulate growth and shore up investor confidence in Japan are expected to bring the dollar back down a bit, ending the year at 128 yen.

The Great Lakes Index (GLI) rose a revised 2% in the third quarter, slightly behind initial estimates. Weaker than initially reported exports accounted for the bulk of the weakness. Light vehicle production surged, and equipment spending remained robust.

Preliminary data suggest a slight uptick in growth for the current quarter. In October and November, light vehicle production held close to the highs of September, equipment orders remained strong, and exports appear to be accelerating again. Rail car shortages at Union Pacific meant that many of the vehicle pins remained in wholesale inventories, however, and could not make it to dealer lots. The only soft spot was household spending, which was curtailed by unseasonably warm fall weather and a late Thanksgiving. On net, the GLI is expected to rise 3.1% in the fourth quarter, slightly slower than the pace of real GDP growth.

The remainder of this report takes a look at what the 1998 outlook means for the core manufacturing industries of this region of the country. Prospects for growth in the heavy manufacturing sector remain good, despite recent setbacks in Southeast Asia. Labor shortages, however, suggest that area gains will come more from productivity than employment growth.

Topping Out On Growth

Chart 5 shows the translation of the forecast. The GLI is expected to rise 2.5% in 1998, slightly behind the pace of real GDP growth. Charts 6 through 8 lay out the prospects for area manufacturers.

–Light vehicle production is expected to hold, but not improve from the highs of 1997.

–Heavy truck production is expected to pick up, supported by the continued strength of Latin America, and the increased demand created by rail car shortages at Union Pacific.

–Equipment spending is expected to remain relatively robust, fueled by recent profit gains and the on-going push to gain efficiencies (especially in the auto sector).

–Exports are expected to slow, with losses in Southeast Asia tempering gains elsewhere.

Trade Risks

Recent turmoil in Southeast Asia and stagnation in Japan have raised the specter of trade risks. Political pressure by Washington to stimulate demand in Japan should help, but will not entirely alleviate those pressures. Japan still has the fallout of banking deregulation to endure, and problems in Southeast Asia are likely to get worse before they get better. Capital equipment and motor vehicle exports are expected to be particularly slow to those regions of the world.

Offsets

Growth in Europe has shown signs of accelerating in recent months and prospects for Canada and Mexico remain good. Latin America is a good bet to pick up at least some of the slack left by Southeast Asia. Look for gains to be uneven, however, as the more fragile Latin American economies struggle with the drop in investor confidence created by the crisis in Southeast Asia.

Larger Issues

Tight labor markets and the limits that they impose on growth are a greater threat to the regional outlook. The unemployment rate dipped to a 26-year low in 1997, and employment growth slowed to a near standstill.

An uptick in in-migration would help alleviate the situation. So far, however, movement to the region has been limited. Retirees continue to flock to the more temperate South, and an improvement in the economies of the coasts has limited moves by younger workers. The movement out of California has actually reversed itself over the last 2 years.

The only true upside is productivity growth, which is expected to remain strong given recent increases in investment. Productivity growth averaged between 4 and 5% in the heavy manufacturing sector in 1997.

A Wage Payoff

Wages should also accelerate in 1998. Most of those gains, however, an expected to remain concentrated at the entry level. The push to squeeze the premium out of wages further up the skills and wage spectrum continues:

–The big-3 auto makers continue to replace retirees with workers earning less pay and fewer benefits.

–Navistar recently won concessions from one of its most militant (and highest paid) plants in Indiana.

–The benefits of higher paid full-time workers have been cut in some cases to finance greater benefits and more attractive pay packages for part-time workers.

On net, much of what the region gets in the way of wage increases in 1998 will be earned, and is not likely to pose a substantial threat to inflation. We are close to a boiling point with regard to inflation, however, and the risk is that wage gains start to put some pressure on prices.

December 9, 1997 First Chicago

The First National Bank of Chicago

One First National Plaza, Chicago, Illinois

Consensus National Futures and Financial On Line Index

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