Goldilocks May Soon Go Home

The economy is slowing. The fundamentals forces that have boosted GDP are waning. This should lead to declining growth as the year progresses. I expect that weakness to continue into 2008.

A good barometer of economic health is the relative level of interest rates. This includes rates relative to inflation, and relative to differing types and durations of debt.

Short term rates are particularly significant in their impact. The Federal Funds Target Rate and the Prime Rate are good measures of the short-term rate environment. Both were cheap until 2005, and both have been expensive since the beginning of 2006.

The Fed Funds rate is normally at equilibrium when it is about 150 bps below the ten year treasury rate. Today it is about 50 bps above it. This indicates that the Fed Funds rate is about 200 bps above the natural equilibrium level for current economic conditions. Clearly this is a significant negative factor for economic growth.

We are beginning to see the effects of this expensive level of real short-term rates. The housing market, which was boosted by cheap rates and buyer euphoria, is now being slowed by expensive rates and buyer hesitation. The excess supply of homes for sale is causing a slowdown in construction. Construction employment and other housing related employment is declining and will become a growing drag on the economy.

Soon the risk spreads will widen, causing credit to become more expensive for business and investors. This will exacerbate the slowdown.

Consumer spending should also soften a little as these factors work through the economy. This will also lead to softening of employment and further slowing of spending.

The Fed will respond by lowering the Federal Funds Target Rate. After a while this will begin to have a positive effect. But it will be too late (it may already be too late).

The net result is a slowing economy that could stagnate for a while, or even go into recession. The usual lag periods from the causal factors suggest that the worst or slowest period will be late 2007 through early 2008.