Smith Faculty Opinion Article	November 1, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

Personal Income up $47.4 Billion in September
Fed Will Face Pressure to Cut Interest Rates Further, Stocks to Rise

Today, the Commerce Department reported in September personal income increased $47.4 billion or 0.4 percent, disposable personal income increased $40.6 billion or 0.4 percent, and personal consumption expenditures increased $30.1 billion or 0.3 percent.

Consumer spending continued to support economic growth through the third quarter. However, with rising energy prices, a sluggish jobs market, and falling home values dragging on consumer confidence, consumer spending will grow slowly in fourth quarter. This will not be a very merry holiday season for the big department stores, as shoppers will seek out value at the big discounters. Purveyors of big ticket consumer electronics will be in a discount mode.

Consumer spending will moderate until consumers are confident that housing values have bottomed out and stabilized, and employers become more generous with wage increases. In the meantime, with interest rates falling and bonds suspect, household savings should find its way into the stock market. That is good for stock prices.

Third quarter growth was 3.9 percent, and that strong showing was helped a lot by an upswing in government spending, nonresidential construction, and an improving real trade deficit--rapid growth in exports and fewer imports--as the weaker dollar began to bite on consumer choices.

In the fourth quarter, less of the increase in consumer spending will fall to the bottom line for economic growth, as rising prices for imported crude oil and gasoline siphon off money that could be spent on domestic products.

Slumping housing prices and sales are negatively impacting local government budgets, and this will curtail both current spending and construction projects in 2008. Taxes will be increased in some states, and that is never good for the economy when growth is flagging. Governors, mayors and legislatures seem to have less cents than they need in multiple dimensions.

The trade deficit is not likely to improve much further, because petroleum and trade with China account for 80 percent of the deficit. Oil is priced in dollars, and the Chinese yuan has fallen little against the dollar; therefore, a weaker dollar will not much affect 80 percent of the U.S. trade deficit.

Overall the pace of economic growth is likely to be in the range of 1.5 to 2.0 percent in the fourth quarter and first quarter of 2008. The danger of a recession is substantial.

Although inflation remains worrisome, the risk of a recession is substantial. The high risk of recession will likely pressure the Federal Reserve to cut interest rates further.

Inflation and Federal Reserve Policy

The price index for personal consumption expenditures, including food and energy, was up 0.2 percent in September, and was up 2.4 percent from September 2006.

The Federal Reserve closely watches the price index for personal consumption expenditures, less food and energy. This core price index was up 0.2 percent in September, after rising 0.2 and 0.1 percent in July and August. In September, the index was up 1.8 percent from September 2006.

As important to the Federal Reserve, the market-based core inflation index, which excludes food, energy and imputed prices like rent on owner occupied homes, was up 0.2 percent in September, after rising 0.1 and 0.1 percent in July and August. That index has increased 1.6 percent since September 2006.

Oil and other commodity prices continue to surge on international markets, and this is likely to feed U.S. inflation. The Federal Reserve, by constraining U.S. economic activity, can do little to slow rising commodity prices, and will likely continue to focus on stabilizing credit markets and avoiding recession.

With the housing market continuing to deliver discouraging news, and structural problems in the mortgage market and bond rating systems continuing to handicap credit markets, financial and economic stability will remain the Federal Reserves primary objective through the end of 2007.

Pressures will build for the Federal Reserve to cut interest rates further, when the Open Market Committee meets on December 11.

Outlook for Stock Prices Remains Bullish

The stock market came through the subprime crisis reasonably well. The major stock indexes will set new records in the closing months of the year but wide fluctuations will continue, as investors overreact to news, for example, about write downs on mortgage backed securities by Wall Street firms and surging oil prices.

Global economic uncertainty precipitated by the U.S. subprime crisis, rising global oil prices and surging Chinese trade surpluses, are causing foreign investors to seek safe harbor in U.S. real estate and equities but not corporate bonds. And, U.S. multinationals are reaping big profits from growth in China and elsewhere in Asia. Foreign demand and profits from abroad will continue to drive the market.

Skepticism about the quality of U.S. bond ratings will continue, thanks to the denial and stone walling at Standard and Poor, Moodys and other rating agencies. Coupled with lower short-term interest rates, pessimism about the security of U.S. bonds should be good for U.S. equities.

With U.S. companies earning large profits from robust growth in Asia and uncertainty in credit markets driving foreign money into U.S. stocks, steady or falling U.S. interest rates create a great incubator for an end of year stock market rally.

If the economy dodges a recession, the bull market will continue, and the Dow should pierce 15,000 in 2008.

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The Falling Dollar and the Stubborn U.S. Trade Deficit

Since October 2006, the euro has risen about 13 percent against the dollar but dont expect dramatic improvements in the U.S. trade deficit until China and other Asian exporters permit their currencies to rise significantly too.

Large U.S. trade deficits and excessive foreign borrowing are driving down the dollar against the euro, the British pound and several other currencies. American and European businesses compete intensely in global markets, and a cheaper dollar advantages U.S. exporters.

Since October 2006, U.S. monthly exports have jumped $14 billion. Yet, the U.S. trade deficit, though fluctuating month to month, remains about $58 billion, because oil prices are rising, and the Peoples Bank of China and other Asian central banks have stepped up purchases of dollars and other foreign securities to keep their currencies cheap.

Oil, Chinese consumer goods, and automobiles account for about 98 percent of the U.S, trade deficit.

Net imports of petroleum are about $24 billion, up from $5.5 billion in December 2001. Retuning conventional gasoline engines, hybrids, nuclear power, and alternative energy sources could substantially reduce oil consumption. These solutions require national leadership, but both Republican and Democratic Party leaders have failed to champion comprehensive policies to accomplish what is possible.

Meanwhile, a falling dollar drives up the oil import bill, because petroleum is priced in dollars and a cheaper dollar permits foreign consumers, who earn their incomes in other currencies, to aggressively bid up the price. No surprise, oil seems headed for $100 a barrel.

The bilateral trade deficit with China is about $23 billion, up from $5.5 billion in December 2001, in large measure because China keeps the yuan cheap. That makes Chinese products in U.S. stores artificially inexpensive, and U.S. exports to China too costly.

China revalued the yuan from 8.28 to 8.11 in July 2005, and has since permitted the yuan to rise 3.4 percent every twelve months. Modernization raises the true underlying value of the yuan more than 5 percent a year, and it remains 40 to 50 percent undervalued.

Automotive products contribute $10.1 billion to the monthly deficit. Mexico and Canada account for $3.6 billion, reflecting the cross-border supply chains of the Detroit automakers. Those production decisions change only slowly. For example, GM has announced its exports will not be much altered by the decline in the dollar.

German automakers account for $1.7 billion of the trade deficit, but U.S. imports of their products are mostly higher-priced models within their vehicle classes. Total sales will not greatly respond to price changes driven by exchange rate movements.

Korean and Japanese automotive products account for $4.7 billion of the deficit, and a large share face fierce price competition. Having successful assembly facilities in the United States, Asian manufacturers could move more production here, but the won has risen only about 4 percent against the dollar, and the yen has gained much less.

The central banks of Japan and Korea have aggressively stepped up sales of yen and won for U.S. dollars and other securities to keep their currencies cheap against the dollar. This discourages Toyota, Hyundai and others from moving more auto assembly and sourcing to the United States.

The International Monetary Fund publishes Central Bank holdings of dollars and other securities, providing an accurate picture of currency market intervention. China and several other countries have increased intervention to keep their currencies cheap against the dollar. This forces the U.S. dollar lower against the euro, British pound and Canadian dollar, which generally float without central bank intervention.

Annual Currency Market Intervention
(Billions, U.S. Dollars)

2005 2006 2007*
China 207.0 247.0 489.5
Japan 0.4 45.4 63.5
Korea 11.3 28.6 24.5
India 6.3 38.8 92.9
Brazil 0.8 32.0 102.8
Russia 55.1 119.7 159.6
*estimated through September (latest data)

In 2007, these central banks purchases of predominantly U.S. dollar-denominated securities will exceed $900 billion and the U.S. trade deficit.

It is fashionable to tag the U.S. federal budget deficit for these purchases, but this deficit is on track to be only $200 billion in 2007. Currency manipulation is not about funding U.S. federal spending, it is about boosting exports to the United States.

The fall in the dollar against the euro gave U.S. exports a boost, showing exchange adjustments can have their intended effects on the trade deficit. However, until the United States does something about its appetite for oil and China and other mercantilist states stop manipulating their currencies, the United States will continue to have large trade deficits.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.