Is Europe contagious?

The focus will be on inflation (CPI), housing (sales and prices), and manufacturing (Markit PMI and KC Fed surveys). We expect the growth-related data to show home sales trending higher but some moderation in the manufacturing sector, with only modest consumer inflation. A drop in gasoline prices likely weighed on the overall CPI. We forecast a 0.2% rise in the core CPI after no change in August.

Q3 real GDP appears on track for about 3 1⁄2% growth at an annual rate, a bit above our 3.2% estimate. Early indicators of Q4 activity have suggested continued momentum in purchasing power and consumer confidence.

However, the financial market turmoil of the past week probably gives pause to the Fed. Fed policies have to take market weakness and volatility into account. We anticipate that rather than completing the taper at this month’s FOMC meeting, the Fed will instead reduce its purchases by another $10bn, making the final $5bn cut at the following meeting. The Fed may also cite volatile market conditions and economic weakness abroad as risk factors, but it is unlikely to otherwise change its broader policy stance. We also lowered our estimate for year-end 2014 10-year Treasury yields to 2.5% from 2.8%, reflecting the possibility of that tardy taper.

For merchandise exports (estimated from 1981-2012), US exports to the EU fall 3 times as much in percentage terms as EU growth slows. (A 1 pct pt slowing in EU growth implies a 3 pct pt slowing in US goods exports to the EU.) That sounds large, but with goods exports to the EU only 1.58% of GDP, US real GDP growth would be slowed by only 0.05 pct pt.

For services exports, data are more limited but the elasticities appear smaller— closer to 21⁄2 than 3. (We assume that a 1 pct pt slowing in EU growth implies a 21⁄2 pt slowing in US services exports to the EU.) With services exports to the EU 1.23% of GDP, the 1 pct pt slowing in EU growth would take 0.03 off US growth.
In total, the direct effect of softer EU demand would be a 0.08 pct pt drag on US growth for each 1 pct pt of slowing in growth.

What About Indirect Effects of Weaker EU?

EU weakness would also weigh on the incomes of US trading partners, suggesting a second-round drag on US GDP. But our major trading partners (Canada, Mexico, China) send small shares of their exports to the EU. And countries with high exposures to EU growth (eg, Switzerland and Russia) buy only a very small share of US exports.

We find that, as small as the direct effects are, these indirect effects are only about 17% as large. In turn, that hypothetical 1 pct pt slowing in EU growth, which had a direct drag on US GDP of 0.08 pct pt, would subtract only 0.01-0.02 pct pt via the indirect effects of weaker demand by other US trading partners.

In total, the 1 pct pt slowing in EU growth would take 0.09 pct pt off US growth. That is probably a “maximum” impact, as elasticities appear to be diminishing over time (and, conservatively, we assumed a higher sensitivity for services than the limited recent data would suggest). Estimated from 1981 on, goods elasticity was 3.0, but estimated from 1999 on, it was closer to 2.4.

If that lower, recent sensitivity is a better estimate, it would trim the US drag to 0.07—and one might assume that elasticities have fallen further since then. (Our global economic analysts point to a combination of structural and cyclical factors that have slowed trade volumes.)