Written by Jeff Thredgold, President, Thredgold Economic Associates
Economic Consultant to Zions Bank

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The U.S. Economy
…how slow is slow?
Recession in 2008? Depends who you talk to. As before, we suggest about a 40% chance of recession sometime during the next 12 months. More likely is a sluggish growth scenario, with a 0.5%-2.0% real (inflation adjusted) annual growth pace during the next six months. We expect better performance in 2008’s second half.

Housing weakness and credit market anxiety, combined with a constantly negative view from the national media, will make it “feel” like a recession. In contrast, surging American exports to a strong global economy led U.S. real growth to slightly exceed a 3.0% annual rate in 2007’s first three quarters.

The Federal Budget
…strong growth in revenues
A budget deficit of $162 billion (the smallest in five years) was recorded in fiscal year (FY) 2007, which ended on September 30. Record gains in individual tax revenue, tied to income and investment tax cuts of recent years, led the deficit lower. The deficit will likely rise modestly in FY2008, with major long-term challenges as Baby Boomers retire.

Employment
…a major long-term issue
U.S. economic weakness could see the nation’s jobless rate average 5.0% in coming months. In contrast, the unemployment rate averaged 4.6% during 2006 and 2007, below the averages of the ’70s, the ’80s, and the ’90s. The longer-term issue of tighter labor availability—especially for skilled workers—will challenge American businesses, both large and small.

Inflation
…high oil isn’t helping
Consumer prices during 2007 will register a rise of roughly 3.8%-4.1%, aggravated by higher energy and food prices. Inflation pressures near 2.5% are likely in 2008. By comparison, the Consumer Price Index rose 2.5% in 2006, 3.4% in 2005, and 3.3% in 2004. Powerful competition in nearly all industries helps keep inflation under control.

The Federal Reserve
…more ease to come?
The Federal Reserve cut its important federal funds rate by a total of 1.00% on September 18, October 31, and December 11, with the rate falling to 4.25%. Another cut is expected at the Fed’s next Open Market Committee meeting on January 30.

If the economy stabilizes, the Fed will move to the sidelines. If the recession forecasters are correct, a federal funds rate approaching 3.00% could be on tap by next summer.

Long-Term Interest Rates
…wider spreads aren’t helping
Nervous investors typically seek the highest quality and greatest liquidity, a process known as “flight to quality.” Global credit market anxiety had pushed U.S. Treasury Security yields to their lowest level in 2-3 years before recent modest increases.

A 10-year U.S. Treasury Note yield near 4.00% would typically lead conforming 30-year fixed-rate mortgages to the “mid-to-high 5s” rather than around 6.00%. However, spreads have risen as lenders remain very cautious.

Home Prices
…too far, too fast
Excessive home price gains on both coasts and in the Southwest during 2002 to 2006 gave way to a buyers’ market during 2007. The simple reason? The average American home value rose 46.92% between September 30, 2002 and September 30, 2007. Florida?…up 85.92%. Arizona?…up 85.27%. Nevada?…up 84.28%. California?…up 80.38%. These outsized gains result even after average price declines in these states during the past 12 months (source: OFHEO). These four states account for more than half of the national rise in foreclosures of the past year. National housing news may not get better until later in ’08.

The Global Economy
…a strong global marketplace
Strong global economic growth continues, although most forecasts have been revised lower in recent months, tied to heightened credit market anxiety. Still, global growth exceeding a 4.0% real annual rate in 2008 would be the sixth year in a row of strong performance.

Japan has returned to modest economic growth in recent years following “the lost decade” of economic nothingness. The Japanese anxiously look over their collective shoulders as China gains in Asian and global influence. Strong Indian economic growth remains on track, led by solid domestic demand for goods and services. The disparity between the “haves” and “have nots” seems to be widening.

Powerful Chinese economic growth has led to further steps by political leaders to slow the economy. The highly emotional issue regarding the quality and safety of goods “Made in China” will be center stage in the U.S. for years to come, with many American consumers simply refusing to buy. China suffers from serious environmental damage, with polluted air in major cities and poisoned rivers the norm. The 2008 focus will be all about the Summer Olympics in Beijing during August.

Euro currency strength of recent years was great for Europeans doing their Holiday shopping on America’s East Coast. However, it is scaring European exporters to death. Necessary labor reforms bode well for greater European competitiveness in coming years, particularly in Germany. The French are even becoming more competitive, with new political leadership taking on powerful unions.

Russian President Putin enjoys widespread support as enormous oil revenues have boosted the standard of living of millions of citizens. Putin continues to strengthen his control and punish his enemies. Even as he is required to step down as President in 2008, he will continue to run the show.

Various South American countries struggle with high taxes and stifling regulatory burdens. Brazilian economic growth is solid, while Venezuela remains a political powder keg. Oil field negligence, combined with recent voter rejection of Chavez-proposed reforms, suggests this “leader” will shrink in influence in coming years.

Canadian job creation remains solid, with the latest 5.8% jobless rate at a 33-year low. A strong Canadian dollar is hurting U.S. visitation and Canadian exports to the U.S. The Mexican economy is growing at a reasonable pace, with the immigration issue highly charged on both sides of the Rio Grande.

The Bottom Line in 2008?
U.S. economic performance will slow in coming months, with mild recession a possibility. In addition, we expect: a slightly larger budget deficit…tight long-term labor availability…lesser inflation pressures…declining short-term interest rates…soft coastal housing markets, with U.S. housing weakness the norm during much of the year…and an anxious but impressive global economy.

And So It Begins!

The Baby Boomers are now retiring, raising the issue of Social Security funding for the future. The following discussion is taken, in part, from our latest book, econAmerica (Wiley & Sons, July 2007).

First of 78 Million
About 3.2 million Baby Boomers, 10,000 a day, turn 62 in 2008, rendering them eligible to draw Social Security benefits. An estimated 51% of these Boomers will elect to draw benefits at age 62, allowing them to receive 75% of the benefits they would draw at their full-benefit age of 66.

An estimated 84 million people will draw Social Security in 2030, up from 50 million today. At that time, two workers will be paying into the system for each retiree. That ratio today is three to one, and was 42 to one in 1945.

The Social Security program is not broken. Pay-as-you-go funding will keep it in surplus for the next 10 to 15 years. The program can then tap into the “mythical” Social Security Trust Fund for the next 20 to 30 years. These projections are based on conservative assumptions about future U.S. economic growth and job creation. Economic growth is likely to be stronger.

Tinkering Around the Edges
What the Social Security program requires is some “tinkering around the edges” to make the program financially viable for future generations when funding pressures are more painful. These changes will require bipartisan cooperation.

My parents both draw Social Security. I tell them they have nothing to worry about relative to Social Security viability in their lifetimes. As a Boomer, I will not draw full benefits until age 66. I tell my married kids that Social Security will be there for them, but not to plan on drawing it until they are 68 or 69 years of age.

I favor proposals that stretch out the retirement age for younger people. This change reflects the reality that younger people will be able to work longer if they wish, will live longer, and will therefore draw Social Security payments longer.

A minor change in the inflation calculation used to determine initial benefit payments for higher income earners is desirable. Such higher income workers would have their future payments inflation-adjusted by the change in consumer prices. Lower income workers could continue to have initial payment levels inflation-adjusted by the average annual growth in wages, resulting in their getting a slightly better deal.

I would suggest a slightly faster boost in wages subject to current taxation. For example, the annual adjustment to the wage cap might be the change in average wages plus an additional 1 percent each year during the next decade.

Giving people greater incentives to save for retirement is advisable. Expanded programs like the 401(k) would minimize the role played by Social Security for millions of future retirees.

econAmerica discusses four key factors, or Silver Bullets, that will combine to drive the American economy in coming years. Learn more at www.econAmerica.com.

Silver Bullet #2: NAP Time is Coming
This nation will reach a point in coming years when politicians are simply forced by the pressure of powerful financial markets and by constant media attention to set aside political rancor and work together to solve the entitlement funding and benefit issue. We refer to this as NAP (No Alternative Politics) time.

Neither party will be willing then or able to make such changes alone. Strong political leadership will see a bipartisan commission created, with required program changes debated in a civil environment. The full Congress will likely be asked to approve changes as proposed by the study group, with no ability to make modifications. Members of both major political parties will agree to avoid finger-pointing and accusations, recognizing that a cooperative effort is mandatory.

We have been at this point before and responded. We will do so again. We simply have no alternative.

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