by Calculated Risk on 8/21/2007 12:44:00 PM

From Jeffrey Lacker, President, Richmond Fed: The Economic Outlook. These excerpts are Lacker's view of the impact of the recent financial turmoil on the 'real economy'.

The Committee’s action last week underscores an important point. Financial market volatility, in and of itself, does not require a change in the target federal funds rate, in my view. Interest rate policy needs to be guided by the outlook for real spending and inflation. Financial turbulence has the potential to change the assessment of the appropriate rate if it induces a sufficient revision in growth or inflation prospects.

Even before the recent stint of financial market turbulence, the predominant concern on the real side of the economy was the outlook for housing activity. Residential investment fell rapidly over the last three quarters of 2006, but then the rate of decline slowed in the first half of this year. The question in my mind a couple of months ago concerned whether home-building would bottom out soon or continue declining. Recent data on actual housing market activity have dampened my optimism, however. Housing starts and residential building permits, which earlier this year looked as if they might be stabilizing, have both softened in the last couple of months. Broader measures of sales activity are also showing a pronounced downward trend.emphasis added.

Yes, Lacker has consistently been wrong on housing, but he is finally realizing there is a serious problem.

While the housing market implications of the recent financial market turmoil are quite unclear at this stage, there is a possibility that it will result in further increases in retail mortgage rates for some borrower classes and thus further dampen residential investment. ...

Allow me to translate, Lacker is really saying: "Look out below!"

Business investment spending has been an impressive source of strength over much of this expansion. ... Business investment faltered late last year, with weaker sales of autos and construction materials apparently playing important roles. Most of the fundamentals for business investment are still quite positive, however; profitability is high and the cost of capital is still fairly low, despite recent financial market developments. Thus investment could well maintain momentum this year, I believe, and we have been seeing some favorable signs. For example, manufacturing production increased by 2.2 percent from March through July.

I agree that non-residential investment, especially in structures, is a key going forward, but I'm not as sanguine as Lacker.

It is worth noting here that there is one area in which financial market events could affect business investment spending. One of the market segments in which activity has slowed dramatically in recent weeks is in the financing of leveraged buy-outs used to take companies private. ... Given the other strong fundamentals for business spending, it is not clear that the rising cost of buy-out financing should have significant effects on real investment.

And on consumer spending:

Financial market turmoil has the potential to make households apprehensive and thereby cause a precautionary pullback in consumer spending. We have numerous experiences in the past several decades, however, of declines in household financial net worth, and experience suggests that the effect on household spending tends to be small. Evidently, consumer expectations regarding their future income prospects is a stabilizing influence on their spending plans.
...
On balance, then, I still expect consumer spending to be reasonably healthy, and for business investment to continue to expand. But I expect overall growth to come in somewhat below its long-term trend for the remainder of this year, based on my expectation that the drag from housing will continue for some time. The most plausible downside risk is that financial market developments will lead to higher mortgage rate spreads and will further depress housing activity. Other finance-related risks to economic growth appear to be relatively minor.

There will be an impact of falling house prices (reverse wealth effect) and less MEW (Mortgage equity withdrawal) on consumer spending. The question is how big the impact will be. Once again I'm more pessimistic than Lacker, and I think the impact on (PCE) personal consumption expenditures could be significant.