Outlook 2007, Part II

So the economy has begun to slow, and there's some talk of a recession in the offing. The current expansion, now in its sixth year, is getting a bit long in the tooth as expansions go.

Is it time to batten down and wait for the storm? Not so fast. Consumers, financial markets, and even policymakers aren't acting act as though the end is near.

Consumers Keep Spending

Despite several interest rate hikes dating back to 2004, there hasn't been a single quarter in which consumer spending declined compared with the previous quarter.¹ And despite the relatively anemic growth in real gross domestic product (GDP) during the first quarter of 2007, advance figures indicated that consumer spending grew nearly three times as fast as GDP.² Even the Bureau of Economic Analysis, which reports GDP, primarily credits the first-quarter growth to an increase in personal consumption expenditures, the technical term for what consumers do with their disposable income.³

Low Inflation, Low Interest Rates

There is some evidence that the Fed's favorite inflation-fighting tool, interest-rate policy, is losing its edge. During the first 15 years following World War II, the Fed was able to reduce consumer spending by about 2% for every 1% increase in short-term interest rates. From 1990 to 2004, however, the average decrease in consumer spending was essentially zero for every 1% increase in short-term rates.⁴ Thus, it seems that the Fed is no longer able to slow the economy simply by raising interest rates. This may be due to a growing resiliency in the private-sector economy. We live in a world that is much different than it was during the postwar era. Globalization, the growing reach of the financial markets, and the increasing ability of businesses to cope with interest-rate uncertainty have conspired to blunt the Fed's efforts.⁵

Nonetheless, inflation has remained in check. It was growing at a tepid 2.6% annual rate at the April reading.⁶ The Fed has stated that it believes inflation, not slow growth, remains the primary risk to the economy — another indication that there is little danger of a recession anytime soon.⁷

Dow Not Dour

You would have to be living on a deserted island to miss the news about the Dow Jones Industrial Average. First it plunged a dramatic 416 points on February 27, putting the rest of the market in a dour mood and encouraging talk of a bear market. Then it broke through the 13,000 mark and began a steady climb, posting record after record — 46 record closings in less than eight months.⁸ The S&P 500 is finally in the neighborhood of its all-time high set in 2000 on the eve of the most recent bear market. However the Nasdaq still struggles and could be years away from a return to its record high set in 2000.

When a recession is imminent, the stock market is often the first to recognize it and react. A weak stock market can exist in a good economy, but a strong stock market is exceedingly rare in a weak economy.

Despite the encouraging signs — and there are many more than are mentioned in this article — there are never any guarantees that the economy will continue to grow. Although you probably needn't worry too much about a recession, neither should you ignore the possibility of one. After all, if history is any guide, a recession will eventually occur. Only the depth and length of it remain to be seen. That's why it's important for us to make sure that you are positioned to take advantage of whatever changes lie ahead.

1) Haver Analytics, 2007
2, 3) Bureau of Economic Analysis, 2007
4, 5) The Wall Street Journal, May 25, 2007
6) Bureau of Labor Statistics, 2007
7) Federal Reserve, 2007
8) Yahoo! Finance, 2007. Dow Jones Industrial Average for the period 10/1/2006 to 5/25/2007. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.