According to participants in the Chicago Fed's annual Automotive Outlook Symposium, the outlook for 2006 is for the U.S. economy to expand at a rate slightly above its trend, with unemployment edging lower. Since energy prices are expected to moderate, inflation is forecasted to fall this year. Light vehicle sales are predicted to remain steady.Gross domestic product ; Economic forecasting

Emily Engel

William A. Strauss

English

Research Papers in Economics

Chicago Fed Letter
Economy on cruise control through 2007
by William A. Strauss, senior economist and economic advisor, and Emily A. Engel, associate economist
According to participants in the Chicago Fed's annual Automotive Outlook Symposium,
the outlook for 2006 is for the U.S. economy to expand at a rate slightly above its trend,
with unemployment edging lower. Since energy prices are expected to moderate, inflation
is forecasted to fall this year. Light vehicle sales are predicted to remain steady.
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK AUGUST 2006
OF CHICAGO NUMBER 229a
2005 2006 2007
(Actual) (Forecast) (Forecast)
Real gross domestic producta 3.5 3.5 3.0
Real personal consumption expendituresa 3.5 3.5 2.9
Real business fixed investmenta 8.6 8.9 5.9
Real residential investmenta 7.1 –1.7 –0.9
Change in private inventoriesb 20.3 31.0 31.2
Net exports of goods and servicesb –633.1 –682.3 –681.7
Real government consumption
expenditures and gross investmenta 1.8 2.4 1.7
Industrial productiona 3.2 3.6 3.3
Car & light truck sales (millions of units)c 16.9 16.7 16.8
Housing starts (millions of units)c 2.07 1.97 1.83
Unemployment rated 5.1 4.8 4.9
Consumer Price Indexa 3.4 2.6 2.4
1-year Treasury rate (constant maturity)d 3.62 5.14 5.05
10-year Treasury rate (constant maturity)d 4.29 5.29 5.44
JPMorgan trade weighted dollar indexa –2.4 –1.2 –0.5
Oil price (dollars per barrel of
West Texas Intermediate) 56.47 65.51 66.00
aFourth quarter over fourth quarter percent change.
bBillions of chained (2000) dollars.
cFourth quarter average.
dPercent.
SOURCES: Actual data from Haver Analytics; median forecast from Automotive Outlook
Symposium participants.
1. Median forecast of GDP and related items
In 2005, the economy expanded by 3.5%,
a rate slightly above potential growth for
the U.S. economy, leading to a decline
in the unemployment rate from 5.4%
in the fourth quarter of 2004 to 4.9%
in the final quarter of
2005. The economy
added nearly two mil-
lion jobs in 2005, av-
eraging 165,000 jobs
per month.
Yet the economy expe-
rienced a substantial
swing in economic ac-
tivity beginning in the
third quarter of last
year. Real gross domes-
tic product (GDP) ex-
panded by 4.1% in the
third quarter, slowed
to 1.7% in the fourth
quarter, and then
bounced back up to
5.6% in the first quar-
ter of 2006. There
were a number of fac-
tors that contributed
to this pattern.
Faced with mounting inventories of light
trucks in the early part of 2005, domes-
tic nameplate manufacturers began to
offer “employee pricing” to their custom-
ers. This pulled sales up substantially
in the middle of last year. While light
vehicle sales totaled 16.9 million units
in 2005, the third quarter selling rate
soared to 17.9 million units at a season-
ally adjusted annual rate (SAAR), with
July recording the second strongest sell-
ing month in history at 20.7 million
units (SAAR). These attractive discount
programs pulled forward purchases
into the third quarter, and light vehi-
cle sales in the fourth quarter slipped
to 15.9 million units (SAAR). October
sales declined to 14.7 million units
(SAAR), the first monthly reading
below 15 million in over seven years.
This pattern in vehicle sales contributed
to personal consumption expenditures
growth rising to 4.1% in the third quar-
ter and then falling to 0.9% in the fourth
quarter. However, if we remove motor
vehicles from personal consumption ex-
penditures, spending in the fourth quar-
ter actually increased 4.3%, faster than
the 3.5% recorded in the third quarter.
Accentuating this pattern were Hurri-
canes Katrina and Rita, which hit Gulf
Coast states in August and September.
The disruption to oil and gas extrac-
tion, as well as oil refining, was quite
severe, with nearly a third of refining
capacity closed at one point. Energy
materials production fell 14.3% in the
fourth quarter.
As we entered 2006, vehicle sales re-
turned to more stable selling rates, with
sales averaging 16.9 million units (SAAR)in the first quarter, in line with last year’s
sales. Energy materials output rose 11.9%
in the opening quarter as a good part of
the disrupted Gulf production came
back on line. Because the severe shocks
were not repeated in the first quarter,
real GDP growth rebounded to 5.6%.
Also, the unemployment rate fell to
4.7% in the opening quarter of 2006.
One challenge the economy continues
to face is the effect of rising energy
prices. Oil prices rose from around
$47 per barrel at the beginning of
2005 to slightly above $60 by the end
of the year. It has continued to move
higher in the early part of 2006, rising
to over $70 per barrel in May.
Higher energy prices have contributed to
the rising inflation rate. Running around
3.0% in early 2005, inflation rose to av-
erage 3.7% in the first quarter of 2006.
The Federal Reserve continued raising
short-term interest rates throughout
While light vehicle sales remained rela-
tively stable, the Big Three’s market share
continued to deteriorate. Compared
with last year’s market share through
May, the Big Three’s year-to-date market
share fell an additional 2.6 percentage
points, averaging 54.9% in the first five
months of 2006. This translates into a
sales loss of over 400,000 units over this
period. This amount represents a loss
that is equivalent to the annual output
of roughly two assembly plants.
Against this backdrop, the Federal Re-
serve Bank of Chicago held its thirteenth
annual Automotive Outlook Symposium
on June 1 and 2, 2006, at its Detroit
Branch. More than 80 economists and
analysts from business, academia, and
government attended the conference.
This Chicago Fed Letter reviews last year’s
forecasts for 2005; analyzes the fore-
casts for 2006 and 2007 (see figure 1);
and summarizes the presentations at
this year’s conference.
While housing starts were expected to
rise to 2.00 million units in 2005, they
actually increased to 2.07 million units.
The forecasts for 2006 and 2007 are for
economic growth, outside of the hous-
ing sector, to remain solid this year and
then to moderate in the following year
but still expand at a rate that would be
regarded as close to trend. The housing
sector is forecasted to fall at a controlled
pace both this year and next. Real GDP
is anticipated to rise by 3.5% this year
and by 3.0% in 2007. With economic
growth being slightly above trend this
year, the unemployment rate is expected
to fall to average 4.8% in the fourth
quarter of this year and then edge high-
er to average 4.9% in the final quarter
of 2007. Inflation in 2006 is expected
to decline to 2.6% and then ease a bit
more next year to 2.4%. Oil prices are
predicted to fall to average $65.51 per
barrel in the final quarter of this year
and then remain at that level, averag-
ing $66.00 at the end of 2007. Personal
consumption expenditures are forecast-
ed to expand by a solid 3.5% rate in 2006
and then rise by 2.9% in 2007. Light
vehicle sales are expected to remain
steady, with sales edging down to 16.7
million units this year and then edging
back up to 16.8 million units next year.
Business fixed investment is expected to
increase a strong 8.9% in 2006 and 5.9%
in 2007. Industrial production is fore-
casted to increase at a slightly faster rate
than GDP growth, rising 3.6% this year
and 3.3% next year. With this increased
pace, business inventory increases are
expected to rise to a level that is slight-
ly higher than in the past several years.
One sector that takes a step back over
the next year and a half is housing. With
long-term interest rates forecasted to
increase by 100 basis points in 2006 and
by an additional 15 basis point in 2007,
housing starts are predicted to fall in
2006 to a level of 1.97 million units and
then to 1.83 million units in 2007. After
rising by 7.1% in 2005, residential invest-
ment is expected fall 1.7% this year and
then decline 0.9% in 2007.
The dollar’s value has been declining
over the past four years. The dollar is
predicted to decline in 2006 and 2007 by
Oil prices are predicted to fall to average $65.51 per barrel
in the final quarter of this year and then remain at that level,
averaging $66.00 at the end of 2007.
2005 and early 2006, with the federal
funds rate rising from 2.25% at the be-
ginning of last year to 5.00% by May of
this year. Yet mortgage interest rates
stayed low through most of 2005, aver-
aging around 5.75% for the first three
quarters of 2005; they began to rise, av-
eraging 6.22% in the fourth quarter of
2005, and eventually reached 6.60% in
May 2006.
This increase in mortgage rates appears
to be gradually slowing the housing mar-
ket. Year-to-date housing starts through
May of this year were 2.04 million units,
down 1.3% from a comparable period
a year earlier.
Manufacturing output expanded at a
solid pace in 2005, increasing 4.3%.
Manufacturing output growth expand-
ed at a faster pace in the first quarter of
2006, rising by 5.9% compared with
the previous quarter.
At the 2005 Automotive Outlook Sym-
posium, participants were anticipating
that the economy in 2005 would expand
at a 3.2% rate, just a bit below the 3.5%
growth that did occur. With an accurate
economic growth forecast, they also were
quite close in their forecast for the un-
employment rate. They expected that
the unemployment rate would fall to
average 5.2% in the fourth quarter of
2005, virtually in line with the actual
5.1% rate that unemployment averaged.
Inflation was predicted to average 2.7%,
lower than the 3.4% actual rise in in-
flation. This higher actual result was in
part due to a tamer outlook for oil prices
in 2005. Last year, forecasters expected
oil prices to average $49 per barrel in
the fourth quarter of 2005, but oil prices
wound up averaging over $56. Light
vehicle sales were predicted to come in
at 16.7 million units, slightly below the
16.9 million units sold during 2005.Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; Jonas Fisher,
Economic Advisor and Team Leader, macroeconomic
policy research; Richard Porter, Vice President, payment
studies; Daniel Sullivan, Vice President, microeconomic
policy research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Kathryn Moran, and Han Y. Choi, Editors; Rita
Molloy and Julia Baker, Production Editors.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2006 Federal Reserve Bank of Chicago
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Prior written permission must be obtained for
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ISSN 0895-0164
1.2% and 0.5%, respectively. The trade
deficit is predicted to worsen in 2006
and then remain unchanged next year.
Auto sector outlook
Paul Ballew, the executive director of
global market and industry analysis for
General Motors Corporation (GM), de-
livered the 2006–07 vehicle sales outlook
for the Big Three automakers. In his
presentation, Ballew discussed markets
that underperform due to various pres-
sures, including the dual problem of
rising oil costs and interest rates. Global
economic expansion is expected to con-
tinue in the near future, leading to high-
er oil prices and interest rates. Due to
these factors and an expected softening
in the housing market, automotive sales
are only expected to increase approxi-
mately 1.5 million units in 2006.
According to Ballew, the automotive in-
dustry is increasingly facing more chal-
lenges. Currently, the industry must
restructure itself by creating a new and
improved business model that accom-
modates price pressures. Unfortunately,
outside factors, such as higher oil prices
and interest rates, are hindering the auto
companies’ plans to launch a new busi-
ness model. In addition, legacy costs
(e.g., health care costs for retired work-
ers) provide another obstacle to industry
restructuring. On a positive note, how-
ever, product costs, marketing costs, and
operational costs are competitively
priced for this industry. Even though
2006 is forecasted to be a stronger year
than 2005 for the automotive industry,
Ballew noted that the Big Three’s mar-
ket share has been steadily decreasing
since 1965. Still, a positive note for GM
in particular is the fact that its attrition
program is much stronger than expected.
The next speaker, Ken Vieth, the co-
principal for Americas Commercial
Transportation Research Company, pre-
sented the heavy equipment outlook.
He stated that with the Environmental
Protection Agency’s new mandates to
reduce emissions in 2007, Class 8 trucks
(trucks that haul everyday products)
are predicted to continue to have strong
sales through the end of 2006. Retail
sales of Class 8 trucks reached record
levels in April 2006, Vieth noted, and
build rates for these trucks continue to
stay at high levels. Even though truck
sales remain strong, the major problem
with trucking seems to be the lack of
available drivers. This truck driver short-
age is a global problem and allows truck-
ers to retain their pricing power and
to pass along their increased costs, such
as higher fuel prices, to their suppliers.
There is a great demand for hauling
freight, but the lack of truck drivers
requires the trucking industry to look
at other means of transporting goods.
Transporting goods by rail has the po-
tential to help (trucking companies
have been known to place trailers onto
rail cars due to lack of drivers). Still,
railroad transport cannot reduce all
the backlogs in trucking transport be-
cause there simply aren’t enough rail
cars, nor is there enough storage capac-
ity on trains. Should the demand for
trucking/railroad shipments follow the
current expansive trend, some relief
may come with a new 2009 highway bill
that contains a provision allowing trucks
to carry more freight. If that bill pass-
es, the new longer and heavier trucks
that would follow might form part of
the solution to the lack of drivers.
David Andrea, vice president of the Orig-
inal Equipment Suppliers Association,
presented the auto suppliers’ perspective
on the auto industry outlook. Andrea
pointed out that U.S. domestic motor
vehicle sales are strong, but flat. The Big
Three’s sales have been rapidly declin-
ing for years, while international auto-
makers have increased their sales over
the same time period. This is causing
manufacturing, especially in the Midwest,
to reduce a significant number of jobs.
Thus, direct supplier jobs were down
20% from 1990 to 2005. Over that same
period, Michigan, Ohio, and Indiana
lost 28%, 17%, and 21% of their direct
supplier jobs, respectively. Because there
must be a restructuring of operations
and strategies for this very competitive in-
dustry, both the auto manufacturers and
their suppliers have much work to do.
David Cole, the chairman for the Center
for Automotive Research, talked about
the future for the U.S. automotive in-
dustry. “The automotive industry has a
problem,” Cole explained. But this is
both good and bad news for the indus-
try. Since there is a crisis, it is uncom-
fortable for the auto companies and
their workers; however, this crisis creates
an urgency among domestic producers
to change. Doing nothing is no longer
an option: Change is mandatory in order
to survive. Increased sales volume will
not heal the industry anymore. Domestic
auto companies must shrink in size in
order to obtain a profitable base. Accord-
ing to Cole, to complete this reduction,
the Big Three must follow one of the
foundations for business excellence:
discipline. Starting with the most effi-
cient process and then adding in creativity
and innovation, the domestic auto man-
ufacturers should become leaner and
more agile. With plants being able to
integrate new products quickly through
flexible, lean manufacturing, more profit
is the predicted outcome. This new
business model requires a 60%–80%
reduction in the number of physical
prototypes previously required by man-
ufacturers. If this target is met, stated
Cole, the next wave of manufacturing
should be dramatically improved.
Paul Taylor, the chief economist at the
National Automobile Dealers Associa-
tion, talked about the sales outlookfrom the dealers’ perspective. Even with
gas prices being quite high, large cars
and crossover utility vehicles (CUVs)—
utility vehicles built on passenger car
platforms—are doing well. However,
sales of truck-based sports utility vehi-
cles (SUVs) have decreased over the past
two years, and those sales are projected
to fall further in the future. With that
being said, Taylor noted that hybrid
vehicle sales could be the wave of the
future. Ford, Honda, and Toyota have
been selling more and more hybrid units
over the past two years. While hybrids
are useful to consumers in that they re-
quire less fuel and are environmentally
friendly, they are only a short-term so-
lution. The problem for hybrid cars
arises with their resale value: Hybrids’
battery packs are anticipated to need
replacement every eight to 11 years,
and their costs should run between
$8,000 and $10,000 per vehicle. Thus,
the owner of a used hybrid car has to
spend close to a new car’s price just to
replace its battery pack. This costly fea-
ture is an obvious deterrent for some
consumers to buy used hybrids. Last
year, Taylor said that dealers seemed to
be optimistic about the future, espe-
cially for their precertified used cars.
This statement has held true, since used
cars have been shown to be the most
profitable market for dealers.
Conclusion
The outlook for 2006 is for the economy
to expand at a rate slightly above trend
for the economy, leading to a slight fall
in the unemployment rate. With an an-
ticipated moderation in energy prices,
inflation is expected to fall this year.
Growth in 2007 is predicted to slow, with
GDP growth a bit below trend, the un-
employment rate edging higher, and
inflation easing further. Light vehicle
sales are forecasted to remain relatively
flat in 2006 and 2007.

Economy on cruise control through 2007

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Economy on cruise control through 2007

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