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Friday, May 11, 2007

FRB Dallas: Economic Outlook and Quarterly Energy Update

Here are two outlooks from the Dallas Fed, one for the national economy and one for energy prices.

First, the national economic outlook. The first paragraph is interesting - it says that first quarter GDP estimates probably overstate the extent of the slowing in the economy. Chart 3 showing the depth and duration of the current housing downturn compared to past housing downturns is also interesting - it shows that, as of now, the depth and duration of the current cycle is very close to the average over all cycles:

Growth Slows in First Quarter 2007, by Jim Dolmas, FRB Dallas: Real GDP growth slowed to a 1.3 percent annual rate in first quarter 2007 from a 2.5 percent rate in fourth quarter 2006, according to the Bureau of Economic Analysis’s advance estimate. While the pace of economic activity certainly cooled in the first quarter, the 1.2 percentage point drop in the GDP growth rate probably overstates the extent of the underlying slowing. Unusual declines in exports and federal government defense outlays combined to subtract about 0.4 percentage point from first-quarter growth.

Chart 1 breaks out recent GDP growth into contributions from its broad components. Consumption continued to be the main driver of growth in the first quarter. The contribution from nonresidential fixed investment swung from negative in 2006:Q4 to positive in 2007:Q1, but remained somewhat weak compared with its recent average behavior. The change in business inventories continued in negative territory.

Charr 1: component contributions to recent GDP growth

As was the case in 2006:Q4, residential investment continued to be the most significant drag on growth, subtracting a full percentage point from growth in the first quarter.

Chart 2 isolates the contributions from residential investment over the past few years and shows the extent to which residential investment, in recent quarters, has taken a bite out of real GDP growth. Having contributed nearly 0.5 percentage point to quarterly growth rates over 2002:Q1 to 2005:Q3, residential investment has since subtracted an average of 0.7 percentage point each quarter. Note, though, that the drag in 2007:Q1 was somewhat less than in the prior two quarters.

Chart 2: Residential investment taking a bite out of GDP growth

An Average Residential Downturn
In terms of duration and depth, the current downturn in residential investment would be roughly an average downturn for the post-World War II period, provided that it met one unlikely condition—that it ended tomorrow.

Chart 3 shows a scatter plot characterizing 13 prior residential investment downturns in terms of duration (points farther to the right are longer downturns) and depth (points lower on the plot represent deeper downturns, where depth is measured by the percentage decline in real residential investment from peak to trough).[1] The average of the 13 prior episodes is also indicated. The average downturn lasted 6.5 quarters and resulted in a peak-to-trough decline in real residential investment of about 20 percent. This is very close to what we’ve already seen so far in the current episode, also represented on the plot.

Chart 3: Duration and depth of residential investment downturns since 1948

The two points with green markers—the episodes from 1994:Q3 to 1995:Q2 and 1964:Q2 to 1967:Q1—are the only prior residential investment downturns that don’t overlap with economywide recessions.

Business Investment Growth Remains Sluggish
As noted above, nonresidential fixed investment—business investment in structures, equipment and software—picked up slightly in 2007:Q1 after declining in 2006:Q4. At a 2 percent annual rate, however, growth was still quite weak by recent standards. In both 2005 and 2006, real nonresidential fixed investment grew by about 7 percent.

New orders for so-called core capital goods (nondefense capital goods excluding aircraft) did show a strong uptick in March, growing a relatively robust 4.8 percent after having declined in four of the five prior months. Nevertheless, orders are still down 4 percent on a quarter-to-quarter basis and 0.6 percent on a 12-month basis.

The trend in orders points to continued weakness for business fixed investment. Chart 4 plots the two-quarter annualized growth rates of real nonresidential fixed investment and new orders for core capitals goods, with the latter shifted forward one quarter.

Chart 4: Orders for capital point to sluggish investment growth

Core Inflation Slows a Bit
The March data on Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) inflation contained welcome signals that core consumer price inflation may be returning to the decelerating trajectory it had been on prior to January and February.

The indexes for CPI and PCE excluding food and energy both showed scant increases in March (0.7 percent and 0.6 percent, annualized). This follows two months with rates of increase at around 3 percent or better. Though slowing less dramatically, the trimmed mean PCE also showed a substantial deceleration in March, to a 2.1 percent annualized rate, from rates of 2.5 percent and 2.8 percent in the prior two months. Twelve-month inflation rates for CPI excluding food and energy, PCE excluding food and energy, and the trimmed mean PCE are shown in Chart 5.

Chart 5: Core inflation moderates a bit

One factor that has been working in favor of more moderate rates of core inflation is the behavior of Owners’ Equivalent Rent (OER). Over the past four months, OER in the CPI has grown at an average annualized rate of 3.2 percent, after occupying a range of 4–5 percent for much of 2006. The PCE equivalent to OER has decelerated similarly.


  1. Identifying expansions and contractions in economic series always involves some judgment. While a simple rule like “two or more consecutive quarters of negative growth represent a downturn” has some appeal for its simplicity and objectivity, episodes that seem evident to the naked eye as downturns are often interrupted by a single “up” quarter. Hence, the rule I used corresponds roughly to identifying cycles in a four-quarter moving average of real residential investment. This yields 13 downturns (not including the current one) in the real residential investment series since 1947.

Next, Stephen Brown and Raghav Virmani of the Federal Reserve Bank of Dallas with the outlook for energy prices:

Energy Prices Rising as Markets Tighten Further, Quarterly Energy Update, Second Quarter 2007, FRB Dallas:

Oil Prices Strengthen
Since reaching lows of near $50 per barrel in January, oil prices have taken a decidedly upward trajectory—with the benchmark West Texas Intermediate (WTI) breaking through $60 in early March and $65 in late April (Chart 1).

Chart 1: Oil prices rebound from January low

Several factors account for rising oil prices. Overall market tightness has generally increased throughout the year because the growth of world oil consumption has been greater than the growth of oil production outside the Organization of Petroleum Exporting Countries (OPEC). Although the U.S. Energy Information Administration (EIA), the International Energy Agency (IEA), and OPEC have differing opinions about how much tighter the market is likely to be in 2007 than it was in 2006, they all see generally tightening market fundamentals since December 2006 (Chart 2). Geopolitical tensions, including a recently foiled attempt to attack Saudi Arabian oil fields, continue to raise concerns about the security of supply.

Chart 2: Projected call on OPEC oil production

WTI: A Broken Benchmark?
Trading on the New York Mercantile Exchange (NYMEX), WTI has been the world’s premier energy contract for years, with active trading running into tens of billions of dollars daily. Recently, however, some oil market analysts expressed concerns about the pricing of WTI crude oil versus other major benchmark crude oils. Although WTI is traded on the NYMEX, its physical delivery point for contract settlement is midcontinental North America (Cushing, Okla.). Relatively high levels of U.S. crude oil storage, congestion at some delivery points in the United States and an insufficient number of tankers to provide full world arbitrage have depressed the WTI price relative to other oil benchmarks such as Nigerian Bonny Light and UK Brent (Chart 3).

Chart 3: WTI falls behind Bonny and Brent

In a market where physical delivery is required to complete arbitrage, pricing relationships out of the norm can be sustained for relatively lengthy periods. Such pricing need not be indicative of anything other than a temporary lack of deliverability that is impeding arbitrage, and the weakness in WTI relative to other crude oils is likely to disappear as the impediments to the free flow of oil dissipate.

Gasoline Prices Head Upward
Pulling ahead of the gains in oil prices, U.S. retail gasoline prices have surged upward during the past two months—rising by about 70 cents per gallon to a recent high over $3 per gallon for regular unleaded. Higher crude oil prices, rising gasoline consumption in the first quarter (2.5 percent over a year earlier), refinery outages and low levels of gasoline imports have pushed gasoline inventories sharply downward and prices upward (Chart 4).

Chart 4: Gasoline inventories at seasonal low

Nonetheless, both the futures market and the EIA are projecting slightly moderating gasoline prices for the summer. The current differential between gasoline and crude oil prices makes it profitable for refiners to boost gasoline output, and the EIA forecasts summer gasoline consumption running only 1.2 percent above a year earlier. Of course, unexpected refinery outages could result in temporarily higher prices in some regions of the country, as was seen recently in California.

Natural Gas Prices Likely to Slip?
Prolonged winter weather in many parts of the nation helped keep the Henry Hub price of natural gas well above $7 per million Btu. Nonetheless, natural gas inventories are plentiful, which suggests the possibility of price slippage as the heating season comes to an end. The futures market shows natural gas prices rising steadily through December, but a model developed by Dallas Fed economists Stephen P.A. Brown and Mine K. Yücel suggests that current inventories, current crude oil futures prices and normal weather are likely to mean declining natural gas prices by early summer (Chart 5). The futures price for December natural gas would be roughly consistent with crude oil futures and normal weather—if inventory levels are reduced to normal, which implies that market participants may see the possibility of some combination of growing natural gas consumption and slipping natural gas production.

Chart 5: Natural gas price outlook

    Posted by on Friday, May 11, 2007 at 05:40 PM in Economics, Oil | Permalink  TrackBack (0)  Comments (4)


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