The U.S. economic data are coming in much stronger than expected. Real GDP rose 4.9% (annual rate) in the third quarter, and payrolls jumped 166,000 in October. Does this mean the economy is ignoring the housing problems and energy prices, or does it just mean that the eventual decline will be even worse?

The Federal Reserve’s quarter-point interest rate cut on Oct. 31 suggests that they believe the worst is yet to come. We agree that the softest stretch is likely to be over the next three quarters. Whether it remains a slowdown, as we expect, or turns into a recession depends on three factors:

• Can consumers continue to ignore energy and home prices?
• Will the current problems in financial markets extend the downturn beyond housing into other sectors, especially commercial construction?
• Will overseas economies continue to grow and buy more U.S. goods?

The third-quarter GDP data show the balancing act between housing and the trade account. The continued slide in residential construction subtracted 1.1 percentage points from GDP growth, but the improvement in the trade deficit added back 0.9 percentage points. The positive contribution from trade is likely to continue, though perhaps not at the third-quarter pace. The negative contribution from housing is also likely to continue, but at a diminished rate as well. The consumer is likely to be the determining factor. The higher oil prices raise our estimated probability of recession to 40% from the 33% we estimated last month. Three consecutive quarters of growth near or less than 1.5% mean that a negative quarter is very likely, but with luck there won’t be two in a row.

Consumer Squeeze
The ability of the American consumer to keep on spending continues to surprise economists. Consumer spending rose at a 3.0% annual rate in the third quarter, rebounding from a slow 1.4% in the second quarter. We have been expecting consumers to slow down because of higher mortgage payments and higher energy costs. In addition, the decline in home prices has hurt household wealth. Our expectation is that consumer spending will slow but not stop. Our expectations are for real spending to slow to 2% next year from 3% this year and for the savings rate to edge up to 1.5%. But this is the most critical sector for the economic outlook.

Selling Abroad
The major area of strength for the U.S. economy is foreign trade. The widening trade gap had been a drag on GDP over the last several years, but it has been improving since last January. U.S. growth has slowed, slowing imports, while growth overseas has remained stronger. The falling dollar has also helped boost exports. For all of 2008, we expect to see exports rise 10%, on top of the 7.8% forecasted gain in 2007.

Asian growth appears solid. We expect that Chinese real GDP will climb 11.5% this year, with Indian real GDP growing 9.5%. Some slowdown in both is likely next year, but China’s should remain in the double digits. Note that these currencies are moving much less against the dollar than the euro is, which means the exchange rate affect their exports less.

The developed countries are doing less well. Europe is slowing, in part because the strength of the euro hurts exports and U.S. growth is slower. Japan’s real GDP fell in the second quarter but should rebound in the third. Growth for the year will likely be near 2%. Right now, it appears that the U.S., Japan, and the eurozone are all converging on a 2%-2.5% growth pattern for 2007 and 2008.

What Does The Fed Do?
The Federal Reserve cut the Fed funds rate in September and October by a total of 75 bps. We expect the weakness in the economy to force another rate cut, likely in both December and January. The Fed is right to be concerned about inflation, especially given the falling dollar and its impact on consumer prices. But in the short run, recession is the bigger risk. Even if there were no election in 2008, the Fed would have to focus on real growth—at least for a few quarters.