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Market sentiment may have improved marginally in August, but articles abound in the media about the paltry recovery that is expected in coming months. Some economists are so concerned about anemic activity that they are predicting the Federal Reserve will reduce the federal funds target further from the current 1.75 percent level. Yet more than one official at the Federal Reserve are indicating that current policy is stimulative and that GDP is likely to accelerate from the second quarter pace. The Philadelphia Federal Reserve conducts a quarterly forecast survey of 35 economists who expect a mild recovery. The August results are below.

Economists have revised down their estimates for real GDP growth in the second half of the year by roughly 0.8 percent and are now predicting that real GDP will grow at a 2.5 percent rate. Quarterly growth rates for 2003 were also revised lower, but by a smaller amount. Economists are looking for a 3.4 percent rate of growth in the first three quarters of 2003. While the 2002 pace is slow, it is only slightly less than what Fed officials were expecting in mid-July when they made their monetary report to Congress. The 2003 growth forecasts are in line with Fed expectations.

Anemic growth leads to stagnant jobless rate
Historically, a GDP growth rate in access of 3 percent is needed to push down the unemployment rate. Sub-par GDP growth means that the jobless rate will be stagnant in the second half of 2002. But as GDP growth accelerates in 2003, employment should grow - and the civilian unemployment rate should decline marginally. In any case, economists aren't looking for the jobless rate to improve by a large magnitude. Nevertheless, these forecasts are also in line with Fed expectations at mid-July.

Consumers a steady source of activity
A good chunk of the economic activity stemmed from housing construction and home sales. Housing starts are not predicted to surpass the recent peak reached in first-quarter 2002, but the overall level should remain higher than 2000 and 2001. If housing starts remain near 1.6 million units over the next six quarters, they won't add much to growth -- but they won't be a drag on growth either.

On the whole, personal consumption expenditures are looking more moderate in 2002 and 2003 than they were in the two previous years. Nevertheless, consumption growth near 3 percent is typically considered healthy. Ordinarily consumer spending is robust during an economic recovery as pent-up demand is unleashed. This time, however, pent-up demand may be missing since consumer spending held up unusually well during the recession.

Interest rates steady but on the verge of rising
Economists weren't asked for their federal funds rate forecast on this survey, but typically the 3-month Treasury bill moves in line with the federal funds rate. The survey suggests that the 3-month bill will remain unchanged in the second half of 2002 and only inch up marginally in the first quarter of 2003. That implies a Federal Reserve rate hike in March of next year. Rate hikes should be modest in the second and third quarters of next year.

The 10-year Treasury note guides mortgage rates. Interest rates have come down in the third quarter and don't look like they're ready to rise much in the fourth. But economists are looking for gains in 2003. This means that higher mortgage rates could curtail not only the housing boom, but also the refinancing boom. Recent refinancing activity has given consumers more discretionary income. This source of income may diminish in months ahead. It is well to keep these levels in perspective, as the predicted increases in interest rates are mild by historical comparison. If the 10-year note forecasts are realized, mortgage rates will run around 7 - 7 ¼ percent, still pretty good.

BOTTOM LINE
Even though economists expect the Fed to start raising the federal funds target eventually, forecasts show that interest rate levels will likely remain low. This is because growth is not expected to accelerate rapidly and because inflation should remain subdued over the forecast horizon. (The Philadelphia Fed Forecast survey shows CPI at 2 percent in 2002 and 2.5 percent in 2003.)

Despite the slow pace of economic activity, the outlook points to a rebound in corporate profits this year and next. Though the chart above shows an upward trend in after tax corporate profits, the trend still falls short of 2000 levels. It's no wonder that equity market players have been so discouraged! The stock market may not return to the lofty levels seen in early 2000, but an upward trend in profits should mean an upward trend in stock prices too.

Evelina M. Tainer, Chief Economist, Econoday