Growth Is Stronger Than Expected,
but Temporarily So

The government's barometer of second quarter 2003 economic growth surprised nearly everyone when it registered a stronger-than-expected 2.4%. This triggered the mid-summer rise in long term interest rates (including mortgage rates) as bond market traders interpreted the news as a precursor of Fed tightening of the money supply to choke off inflation. Not to worry, says economic forecaster Ed McKelvey. Writing in the July-August 2003 issue of "The Pocket Chartroom" (Goldman Sachs Economic Research), McKelvey argues that the surge in growth is temporary, the bond markets have over-reacted to the inflationary threat, and the Fed is many months away from adopting a tighter monetary policy.

The Goldman Sachs research unit concedes that it has underestimated (along with most other forecasters) the power of low interest rates and tax cuts to sustain consumer spending. In particular, consumers have taken full advantage of low mortgage rates and rapid home price inflation to refinance and pull equity out of their homes. McKelvey writes "Mortgage equity withdrawal—the difference between net borrowing in the mortgage market and investment in owner-occupied real estate—was nearly $300 billion in the four quarters through March 2003, an amount worth almost 4% of disposable income." He continues, "Ultimately, the cash-out refinancing game must end, although repeated reductions in long-term interest rates and continued home price inflation have kept it going far beyond our expectation. When this process does wind down, consumers will have to reckon with the fact that their current saving is far too low to keep net worth rising in line with disposable income."

How low is the saving rate? Personal saving fell to 3.3% of disposable income in May and June of this year, well below the 40-year average of 7.8%. The Goldman Sachs research team has been warning for at least two years that such an imbalance won't be sustained. Now that mortgage interest rates have turned upward again, the urge to save rather than spend may start to dominate household behavior.

The Federal Reserve Board has signaled its awareness of underlying softness, and some FRB officials said repeatedly over the summer that tightening is not in the cards in the near future. The bond markets didn't seem to hear it. Sustained higher interest rates will certainly impose a drag on U.S. economic activity, shaving a percentage point or more off consumer spending over the next year. So, if elevated rates continue, we can be assured that the Fed will continue an "easy money" policy. For these reasons, the Goldman Sachs forecast for the next 18 months calls for growth of 3-4% over the next 12 months, slowing to 2-3% thereafter; persistently high unemployment over the next 18 months; no FRB tightening of monetary policy until mid-2005; single-digit corporate profit growth in 2003 and 2004.