Signs of economic weakness have continued, suggesting barely positive GDP growth in 1H2008.

The Fed’s aggressive easing and alternative policy measures aim to calm financial markets, whose wider spreads look to slow growth for a more extended period.

Economic growth remains weak, although financial market volatility has drawn attention from the weakness. The recent financial market volatility and wider credit spreads suggest a more extended period of weakness. We expect GDP growth below 1% in 1H 2008 and growth to remain below trend until the 2H 2009, leading the unemployment rate to peak at 5.8% in the middle of 2008.

Payroll employment continued to decline in February. However, jobless claims remain well below recessionary levels and the unemployment rate remains at a still-low 4.8%. The ISM Manufacturing and Non-Manufacturing Index were both below 50 in February, the first time since 2003. Consumer spending is proceeding at a slower pace, with February retail sales -0.8% below their November level. Part of the weakness has been due to auto sales, which averaged 15.3mn in January and February, the slowest start to the year since 1997.

Financial market volatility remains elevated. Equity markets have declined, credit spreads have widened and the Fed has stepped in to limit the damage. The Fed has introduced an alphabet soup of programs to provide liquidity and help stabilize markets. Over the past month, the Fed has announced additional funding through the Term Auction Facility (TAF), added term repos, introduced the Term Securities Lending Facility (TSLF) to provide liquidity to primary dealers, opened the Primary Dealer Credit Facility (PDCF) to provide discount window loans to dealers, and cut the margin between the discount rate and the Fed funds target to 25bp. In addition, the Fed helped arranged a bailout of a primary dealer, trying to prevent contagion with the US financial markets.

Indeed the increased financial volatility has raised Fed concern about the possibility of an adverse feedback loop as explained by Fed Governor Mishkin: “Because economic downturns typically result in even greater uncertainty about asset values, such episodes may trigger an adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline, which, in turn, causes economic activity to contract. Such a contraction then increases uncertainty about the value of assets, and, as a result, the financial disruption worsens. This development then causes economic activity to contract further in a perverse cycle.”

Monetary Policy

The FOMC continued to ease aggressively at its March 18 meeting, lowering the Fed funds target 75bp to 2.25%. As discussed earlier the Fed also cut the margin between the funds target and the discount rate to 25bp the weekend before as part of its extension of a discount window-type facility to primary dealers.

It is estimated that there are at least two more modest Fed funds rate cuts to 1.5% in the coming months, with risks weighted toward even more easing. While we foresee modest economic improvement in 2H 2008, weak financial conditions will delay the impact of monetary easing on dollar spending growth. Additional creative policy measures remain possible as the Fed deals with the credit crunch.