US Economics April 07

The Employment Conundrum

What's New: The mix of growth and inflation has again turned less favorable. And the dichotomy between weak output and firm labor markets raises critical questions about the outlook: Will job and income gains sustain consumer outlays? Has potential output growth declined? If so, will it prolong the whiff of stagflation? And will slowing growth and rising unit costs squeeze profit margins?

Conclusions: Consumer retrenchment is unlikely
although the housing recession is far from over; strong global growth likely will sustain both output and employment. Amid uncertainty about productivity’s trend, we still think inflation has peaked, but inflation risks are rising again. Margin compression implies that profit growth likely will stall in 2007.

Market Implications: This mix likely will reinforce the Fed’s conviction that they must wait patiently for inflation to decline. Rising uncertainty about the outlook and reduced forward-looking guidance from the Fed imply that term and other risk premiums will rise
further, the yield curve will steepen irregularly, and TIPs may outperform.

Risks: The risks for investors are rising with
crosscurrents swirling around the outlook for growth, inflation, profits, and monetary policy. That markets have defied these uncertainties lately does not give us
comfort because we see neither a rapid improvement in growth, a quick decline in inflation, nor relief from the Fed.