The U.S. Economy How Serious A Downturn? Nigel Gault Group Managing Director North American Macroeconomic Services

The U.S. Economy How Serious A Downturn? Nigel Gault Group Managing Director North American Macroeconomic Services

Growth Is Cooling; But a Soft Landing Is Likely (Real GDP, annualized rate of growth) 8 7 6 5 4 3 2 1 0 2003 2004 2005 2006 2007 2008 Real GDP ex. Residential Fixed Investment contribution

U.S. Economic Growth by Sector (Percent change unless otherwise noted) 2005 2006 2007 2008 Real GDP 3.2 3.3 2.4 3.3 Consumption 3.5 3.2 2.8 3.0 Light Vehicle Sales (Millions) 16.9 16.5 16.3 16.5 Residential Investment 8.6-4.4-13.1 0.3 Housing Starts (Millions) 2.07 1.83 1.59 1.67 Business Fixed Investment 6.8 8.2 6.3 4.9 Government 0.9 2.1 1.5 1.6 Exports 6.8 8.8 8.5 8.9 Imports 6.1 6.2 3.6 4.6

Other Key Indicators (Percent unless otherwise noted) 2005 2006 2007 2008 Employment (Percent growth) 1.5 1.4 1.1 1.4 Unemployment Rate 5.1 4.7 5.0 4.9 CPI Inflation 3.4 3.3 2.2 2.0 Oil Prices (WTI, US$/bbl) 56.56 67.01 65.62 64.75 Core CPI Inflation 2.2 2.6 2.5 2.1 Federal Funds Rate 3.21 4.96 4.83 4.50 10-year Government Bond Yield 4.29 4.80 4.59 4.92 Dollar Index (Major Currencies, 2000=1) 0.83 0.81 0.75 0.72

The Housing Slowdown

Residential Construction Has Overshot 6.5 (Residential fixed investment, percent of GDP) 6.0 5.5 5.0 4.5 4.0 3.5 3.0 1970 1975 1980 1985 1990 1995 2000 2005

Housing Starts Tell a Similar Story 3.0 (Million units) 2.5 2.0 1.5 1.0 0.5 1970 1975 1980 1985 1990 1995 2000 2005

Housing Affordability Has Deteriorated 1.6 A higher index means homes are more affordable. 1.4 1.2 1.0 0.8 0.6 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 Affordability Index for Existing Single-Family Homes Source: National Association of Realtors

Notably in the West and North East A higher index means homes are more affordable. 2.0 1.8 Mid West 1.6 1.4 1.2 1.0 0.8 West 0.6 1989 1991 1993 1995 1997 1999 2001 2003 2005 South North East Source: National Association of Realtors

House Price Over/Under Valuation (Percent) Santa Barbara, CA Miami, FL Los Angeles, CA Portland, OR Washington, DC San Diego, CA Seattle, WA New York, NY Boston/Quincy, MA Dallas, TX 2006-Q2 2002-Q2 Source: Global Insight/ National City Bank -20 0 20 40 60 80

Dimensions of the Housing Downturn (Percent change from a year ago) New Home Sales (Aug) Down 17% Existing Home Sales (Aug) Down 13% Housing Starts (Aug) Down 20% Builder Confidence (Sep) Median Existing Home Prices (Aug) Down 35 points Down 2%

Home Inventory Is Rising Sharply (Months supply at current selling rate, single-family homes) 11 10 9 8 7 6 5 4 3 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 New Homes Existing Homes

The Outlook: Home Sales To Fall Further (Million units) (Million Units) 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 7.5 7 6.5 6 5.5 5 4.5 4 New Home Sales (left scale) Existing Home Sales (right scale)

The Outlook: Starts Down Further, Prices Falling in 2007 (Million units) (Year/year percent change) 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 12 10 8 6 4 2 0-2 -4 Housing Starts (Left) Avg. Existing Single-Family Home Price (Right)

A Stretched Consumer

The Personal Saving Rate Has Fallen Below Zero (Personal savings rate, percent of disposable income) 6 5 9/11 Microsoft Dividend 4 3 2 1 0-1 Post 9/11 vehicle incentives -2 Katrina -3 1998 1999 2000 2001 2002 2003 2004 2005 2006

Spending On Home Furnishings Will Be Hurt By The Housing Downturn 20 15 10 5 0-5 -10-15 -20 (Percent change, year-over-year, real dollars) 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Consumer Durables - Furniture etc, ex. Computers and Software Residential Fixed Investment

Housing Wealth Has Supported Consumer Spending 250% (Percent of household disposable income) 200% 150% 100% 50% 0% 1980 1985 1990 1995 2000 2005 Housing Wealth Housing Equity Mortgage Debt

Mortgage Equity Withdrawal Has Begun To Ease 8 7 6 5 4 3 2 1 0 (Percent of disposable income) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 H1 Net Equity Extraction Source: Federal Reserve - Kennedy/Greenspan data updated as of September 2006

Some Evidence on Use of Funds in Refinancings Federal Reserve Survey of Use of Funds in 2001/2002 Refinancings Share of Dollars Home Improvements Repayment of other debts Consumer Expenditures Stock market or other financial investment Real estate or business investment Taxes 35% 26% 16% 11% 10% 2%

Job Creation Is Still Supporting the Consumer But By How Much? 4 3 2 1 (Millions of jobs created) Preliminary estimate of payroll revision 0-1 Mar02 Mar03 Mar03 Mar04 Mar04 Mar05 Mar05 Mar06 6 months at annual rate Mar06 Sep06 Payroll Employment Household Employment

Lower Gasoline Prices Are Giving Relief To Consumers 360 340 320 300 280 (Billions of dollars, annual rate) Every 10 cents off the pump price saves consumers $12 billion per year (0.12% of disposable income). (Dollars per gallon) 3.0 2.8 2.6 2.4 260 2.2 240 06Q1 06Q2 06Q3 06Q4 07Q1 07Q2 07Q3 07Q4 08Q1 08Q2 08Q3 08Q4 Consumer Spending on Gasoline and Motor Oil (Left) Pump Price of Gasoline, all grades (Right) 2.0

Some Rebuilding of Savings Likely But No Consumer Crash 5 (Percent growth, real) 4 3 2 1 0 2003 2004 2005 2006 2007 2008 Real Consumption Real Disposable Income

Business Investment Is Supportive

Equipment Spending Should Bounce Back 18 16 14 12 10 8 6 4 2 0-2 -4 (Percent change annual rate, real spending) 2004 2005 2006 2007 2008 Equipment and Software

Architecture Billings Have Signaled Higher Nonres. Construction 60.0 57.5 55.0 52.5 50.0 47.5 45.0 42.5 40.0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 15 10 5 0-5 -10-15 -20-25 Architecture Billings Index* (Left scale) Real Nonresidential Construction, ex. utilities (Right scale, % change y/y) * Source: American Institute of Architects

Business Capital Spending: Construction Taking The Lead 20 (Percent change from a year earlier, real spending) 10 0-10 -20-30 2001 2002 2003 2004 2005 2006 2007 2008 Equipment and Software Buildings

Foreign Trade: Stabilizing?

Current Account Deficit: Peaking At Last? 200 (Billions of dollars) (Percent of GDP) 1.5 0 0.0-200 -1.5-400 -3.0-600 -4.5-800 -6.0-1,000 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010-7.5 Current Account Deficit Deficit as % of GDP

U.S. Export Growth Is Catching World Trade Growth 16 (Percent change, real) 12 8 4 0-4 -8 1991 1993 1995 1997 1999 2001 2003 2005 2007 U.S. Export Growth World Import Growth (Excluding U.S.)

Inflation and Interest Rates

Headline Inflation Is Being Driven by Oil Prices 4.0 (Percent change from a year earlier) 3.5 3.0 2.5 2.0 1.5 1.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CPI

Core Consumer Inflation Should Peak Soon 3.0 (Ex-food and energy, percent change from a year earlier) 2.5 2.0 1.5 1.0 2001 2002 2003 2004 2005 2006 2007 2008 Core CPI Core Consumption (PCE) Price Index

Housing Has Driven The Rise in Core PCE Inflation 6 (3-month moving average; annualized rate of inflation) 5 4 3 2 1 0 2004 2005 2006 Core PCE Housing Services Other

Don t Exaggerate Labor Cost Pressures 6 5 4 3 2 1 0-1 -2 (Percent change, year-on-year) 2002 2003 2004 2005 2006 2007 2008 Official Unit Labor Costs Alternative Using the Employment Cost Index

We Expect the Fed To Cut Rates in 2007 7 6 5 4 (Percent) 3 2 1 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Federal Funds 10-Year Treasury Yield

Federal Fiscal Outlook

The Federal Deficit Has Beaten Expectations (Percent of GDP) 3 2 1 0-1 -2-3 -4 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Global Insight President's FY2007 Budget

Federal Spending Paths (Percent of GDP) 23 22 21 20 19 18 17 16 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Global Insight President's FY2007 Budget

Federal Revenue Paths (Percent of GDP) 23 22 21 20 19 18 17 16 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Global Insight President's FY2007 Budget

Where Did The Revenues Come From? Fiscal Year 2006 Federal Revenue Gains Individual Income Tax Withheld Non-Withheld Corporate Income Tax Social Insurance Other Total Revenues $ Billions $117 $62 $54 $76 $31 $30 $253 % Increase 13 8 39 27 5 8 12

Warning: The Profits Boom Is Nearing Its End 40 (Percent change in pre-tax profits) 30 20 10 0-10 -20 1991 1993 1995 1997 1999 2001 2003 2005 2007

Bottom Line Below-trend growth in prospect Housing plunging; consumption growth to ease modestly Business investment and exports remain supportive Headline inflation will fall sharply now that oil prices are lower Core inflation is too high for the Fed s liking but is peaking The Fed will be cutting rates in 2007 U.S. dollar to fall further Risks (1): Housing downturn may turn into a rout Risks (2): Vulnerability to another energy shock remains high

Thank You! Nigel Gault Group Managing Director North American Macroeconomic Services