Prepared by First Chicago

The First National Bank of Chicago

Real GDP rose a revised 3.3% in the second quarter, slightly behind previous estimates. A larger than initially reported trade deficit and somewhat slower consumer spending accounted for the bulk of the revision. Much of the rise in imports ended up in inventories, however, which sets the stage for later trade improvement.

Preliminary data suggest that growth remained relatively strong this summer, which will be unwelcome news for financial markets. Consumer spending picked up after an anemic second quarter and equipment spending remained extremely robust. Inventories were drained, but the bulk of those losses showed up as a slowdown in imports, and strikes continued to postpone a rebound in light vehicle production. Real GDP is forecast, to rise 3.0% in the third quarter.

Prospects for the fourth quarter are about the same. Equipment spending is expected to moderate only slightly from the robust pace of the last six months, light vehicle production is scheduled to post a comeback, and the trade situation is expected to improve. A seasonal adjustment problem suggests that exports will accelerate substantially. The only soft spot is household spending, which is expected to moderate with the recent drop in home sales, Aggressive ordering for the Christmas season, however, suggests that inventories will remain relatively high. Real GDP is forecast to rise 2.9% in the fourth quarter.

The remainder of this report takes a closer look at the slowdown, and whether it will be enough to keep the Fed on hold during the balance of the year. Growth that remains in the 3% range is likely to re-ignite the debate regarding inflation within the FOMC and contribute to financial market volatility in the months ahead. Signs of persistently benign inflation should ultimately prevail however, keeping the Fed on the sidelines and financial markets from posting significant losses.

A Buoyant Landing

The good news is that the economy has slowed since the start of the year. Real GDP slowed to a 3.3% rate in the second quarter, well below the near 5% pace of the first quarter. The bad news is that the slowdown appears to have stopped at the second quarter. Real GDP growth is expected to remain in the 3% range in the third and fourth quarters, still well above the Fed's 2% to 2½% comfort zone on inflation.

Recent gains in consumer spending were particularly disturbing from a policy standpoint. Preliminary data suggest that consumer spending accelerated at a 5% pace in the third quarter, close to the 5.3% pace of the first quarter. This time around, however, the Fed resisted the urge to tighten. Policy was left unchanged at the September FOMC meeting.

“What's Changed?”– We have now seen several quarters of stronger growth, with little or no consequences for inflation. Capacity continues to be added faster than it is absorbed, and bottlenecks have been held at bay. Equipment spending alone surged more than 20% in the second quarter, and recent shipments data suggest investment in infrastructure held close to those growth rates in the third quarter.

The key to policy going forward, however, is whether recent gains in consumer spending will persist. Skeptics within the FOMC will argue aggressively to move preemptively against inflation if recent gains in consumer spending do not abate. Luckily for us, there are signs that consumer spending is moderating. The housing market showed signs of slackening over the summer and anecdotal reports suggest that spending at large retailers moderated in September. A repeat of the third quarter is unlikely.

Moreover, changes within the FOMC am likely to shift the balance of power from more conservative to more experimental FOMC members in the months ahead. Both Gramlich and Ferguson will vote in November and are expected to argue aggressively against a preemptive move.

Rough Waters for Financial Markets

On net, the Fed is expected to remain on hold during the balance of the year, but anxiety regarding near-term Fed moves will be high. The upside on equities is slightly better than that for bonds, given the good prospects for profits in a stronger economy. It will probably be rough waters for financial markets, however, until growth settles into a more “manageable” path and uncertainty regarding Fed actions subsides at the start of 1998.

The Great Lakes Index (GLI) rose a revised 2.3% in the second quarter, 0.4% behind last month's estimates. Strikes in the auto industry and weather related delays in construction accounted for the bulk of the weakness. Light vehicle inventories were particularly tight by the end of the period. Equipment spending and exports remained extremely strong.

Preliminary data suggest that growth remained somewhat slack over the summer. Additional strikes in July held light vehicle production down for the period, while exports slowed. Recent shipments data confirm our view that equipment spending remained strong, however, and consumer spending picked up a bit. The back-to-school rush in August was particularly good. The GLI is expected to rise 7.7% in the third quarter, slightly behind the pace of real GDP growth.

Prospects for the fourth quarter are significantly better. Light vehicle production is scheduled to pick up, now that UAW negotiations are coming to a close, and exports are expected to accelerate. Equipment spending is also expected to remain relatively robust, but should moderate slightly from the phenomenal pace of the last two quarters. Finally, household spending is expected to slow with the recent slowdown in home buying. Regional housing markets appear to have hit some sort of a plateau over the last six months. On net, the GLI is expected to rise 3.3% in the fourth quarter, 0.4% ahead of growth for the nation.

The remainder of this report takes a closer took at scheduled gains in the auto sector, whether they can be believed, and what they mean for real GDP growth. In a sharp reversal of the last three quarters, current schedules are likely to be met, and the auto industry is expected to resume its status as a major driver of real GDP growth in the fourth quarter. Price competition in the industry continues to intensity, however, and it seems unlikely that those gains will contribute much to inflationary pressures. The Midwest is expected to remain a model of virtuous growth in the fourth quarter.

Scheduled Gains

Light vehicle production is scheduled at a seasonal adjusted 12.0 million unit rate in the fourth quarter, up an annualized 14.5% from the third quarter. The question, however, is whether current schedules can be believed. UAW strikes at GM, Chrysler, and a vital Ford supplier caused a series of production shortfalls in the first, second, and third quarters.

Justify Gains–A rebound in sales over the summer and the current state of inventories suggest that aggressive schedules arc justified (and desperately needed). Light vehicle inventories dipped below the critical 60-day level over the summer, and are likely to remain constrained if current schedules are not met.

Separately, exposes are expected to remain robust, which will provide some offset should domestic sales soften. Demand in Canada and Latin America remains strong, and demand in Europe has surprised on the upside.

The bottom line, however, will be labor relations. The auto makers will not be able to meet current schedules if the UAW does not cooperate. The good news is that the worst in labor disputes appears to be behind us. Most local contracts have now been settled, and the potential for additional strikes is limited. Moreover, GM managed to avert another round of strikes in early August, which suggests that hostilities may be easing. (They couldn't have gotten much worse!)

The Translation For Real GDP Growth

The auto industry alone is expected to contribute almost $10 billion (annualized) to growth in the fourth quarter, and account for almost one-third of the 2.9% in real GDP gains expected for the period. This marks a sharp reversal from the first three quarters of the year, wheat production consistently fell short of its scheduled level, and the auto industry placed a drag on overall growth in the U.S. economy,

A Hard Spot For The Fed

Persistently strong gains in real GDP growth will give the Fed pause in the fourth quarter. The debate regarding inflation at the November meeting is expected to be particularly heated. Auto-related gains, however, should give policymakers little reason to worry. Bottlenecks remain few and far between in the capacity-laden auto sector, and price competition continues to intensity. In August, light vehicle prices remained almost unchanged from a year ago, and many now model year prices are slated to be rolled back from 1997 levels. Inflationary pressures will not be coming from the industries of the Midwest in the fourth quarter.

October 7, 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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