Goldman Apologizes For Its Horrendous December "US Economic Renaissance" Call, Begins QE3 Discussion

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Back on December 1, 2010 Goldman announced it was "fundamentally" shifting its "bearish" outlook on the economy, when Jan Hatzius said "This outlook represents a fundamental shift in the thinking that has governed our forecast for at least the last five years" we accused the Goldman economics team, which we had previously respected, of "jumping the shark" and in describing the piece of fluff said it was nothing but "Hopium", concluding that "Jan Hatzius used to have credibility." Ten minutes ago, Hatzius just threw in the towel and apologized for this horrendous call. "Six months ago, we adopted the view that the economy was
transitioning to a more self-sustaining recovery and predicted
sequential real GDP growth of 3½%-4% (annualized) in 2011-2012.
There
were three reasons for our shift: a) a pickup in “organic” growth—GDP
excluding the estimated impact of fiscal policy and inventories—to more
than 4% in late 2010; b) visible signs of progress in private sector
deleveraging, and c) another round of fiscal and monetary stimulus....It hasn’t happened." Needless to say, this apology has made us regain some confidence in Hatzius. Of course, we fully expect that he and his entire team will relinquish their 2011 bonus (and possibly a 2010 bonus clawback) following this massively wrong call, which only Zero Hedge had the guts to call out. Anyway, we can now move on... to QE3. Just as we predicted in January (but were late by a month, expecting this preliminary discussion would occur in May at the latest), Hatzius has just launched the first shot across Bill Dudley's bow. "So what is the hurdle for QE3?" Hatzius asks... And a very dovish Bill "You can't eat iPads" Dudley will answer very shortly. Next up: QE 3.

Just out from Goldman Sachs

1. Six months ago, we adopted the view that the economy was
transitioning to a more self-sustaining recovery and predicted
sequential real GDP growth of 3½%-4% (annualized) in 2011-2012. There
were three reasons for our shift: a) a pickup in “organic” growth—GDP
excluding the estimated impact of fiscal policy and inventories—to more
than 4% in late 2010; b) visible signs of progress in private sector
deleveraging, and c) another round of fiscal and monetary stimulus.

2. It hasn’t happened. In fact,
organic growth seems to have slowed anew to a below-trend pace in the
first half of 2011. Moreover, our Current Activity Indicator (CAI)—a
statistical summary of 24 weekly and monthly indicators of economic
activity—has slowed from an average of 3.7% in the first quarter to 1.6%
in April and a preliminary 1.1% in May. If we take the CAI at face
value—and it comports quite well with our judgmental sense of how the
data have rolled in—that implies a growth slowdown of about 2½
percentage points in recent months.

3. What accounts for this weakness?
The Japanese supply chain disruptions are clearly responsible for some
of it, but we think that they explain only about 1 percentage point of
the deceleration. (This sounds bigger than the 0.6-point drag on Q2 GDP
growth that we have estimated previously, but note that a 1-point
deceleration in sequential growth in April and May would be consistent
with about a 0.6-percentage point deceleration in Q2 as a whole.) The
oil price shock is also clearly important but at least by our estimates
does not explain the size of the remaining slowdown. The implication is
that we are looking at either a weaker underlying growth pace or a
greater vulnerability to shocks than we had been assuming.

4. We are still reluctant to take the
deceleration entirely at face value, partly because many of the signs
of “healing” in the private sector that encouraged us in late 2010 are
still visible. The household debt service burden has come down sharply,
household credit quality continues to improve, bank lending standards
are easing, and financial conditions remain accommodative. Also, we
disagree somewhat with the negative tone of much of the recent housing
market coverage in the media, including two front-page articles in the
New York Times and the Wall Street Journal last week on the renewed
slide in home prices. It’s true that overall home prices have slipped
to fresh lows. But that wasn’t really a surprise; in fact, we and many
other housing market observers had expected renewed downward pressure on
prices in 2011 given the still-high levels of excess supply. Moreover,
according to the CoreLogic house price index, all of the renewed
weakness has come in distressed transactions, while prices of
non-distressed homes are actually up slightly in 2011 to date on a
seasonally adjusted basis. So it is possible that the recent house
price weakness simply reflects a greater effort by banks and GSEs to
clear out distressed inventory. That would be a sign that the
adjustment process has advanced, and not necessarily a cause for alarm.

5. What would be the policy response
to a sustained slowdown? We do not expect much. On the fiscal side, we
currently assume fiscal restraint of about 1% of GDP in 2012. This is
based on the notion that Congress will implement modest discretionary
spending cuts, and that the remaining provisions of the 2009 stimulus
package as well as part of the late-2010 bipartisan fiscal deal are left
to expire. The most stimulative outcome we can imagine is that all of
the 2010 provisions—the payroll tax cut, the unemployment benefits, and
the depreciation bonus—are extended, but even that assumption would
leave some restraint. And it is also possible that the restraint will
be larger than our baseline assumption, via deeper discretionary
spending cuts and/or a full expiration of the 2010 provisions. Like it
or not, fiscal stimulus no longer has strong advocates in Washington, so
its time has very likely passed at this point.

6. This puts the onus on monetary
policy. And sure enough, markets that not long ago were predicting rate
hikes are now starting to debate QE3. But we believe that the Fed’s
“zone of inactivity” is much wider than these wild swings might suggest.
The hurdle for rate hikes is high, and we feel good about our
long-standing view that the funds rate will remain at its current
near-zero level until 2013. But the hurdle for QE3 is also high, and
indeed much higher than it was for QE2.
First, the perceived cost of
QE3 is higher because inflation has accelerated. This reflects the fact
that at least some of the weakness in growth this year is due to higher
commodity prices, i.e. akin to a supply shock. Second, the perceived
benefit from QE3 is lower
. Fed officials viewed QE1—defined as the
overall balance sheet extension that started in late 2008 and ended in
early 2010—as a resounding success, and that was probably one reason why
they were fairly quick to climb aboard QE2. But they are much less
confident that QE2 made a big difference; while it probably did help
financial conditions ease and the economy grow a bit more quickly than
it otherwise would have done, it’s hard to argue that the effect was
large. That has to color their expectations for what QE3 might deliver.
And third, the backlash against QE2 both domestically and abroad was
greater than Fed officials had anticipated, and they are not keen to
subject themselves to another round of similar criticism.

7. So what is the hurdle for QE3? It
probably requires either a meaningful rise in the unemployment rate or
flat unemployment coupled with a sharp fall in core inflation and
inflation expectations. In contrast, if we just trudge along at a trend
or slightly below-trend growth rate and inflation stays near its
current pace, neither fiscal nor monetary policy are likely to provide
fresh support. Such an outcome might not be so bad from the perspective
of the equity market, which already seems to be discounting a fairly
weak growth pace. But it would be quite bad for the real economy, not
least because it would raise the risk that a significant portion of the
increase in unemployment—which still looks cyclical rather than
structural at this point—will ultimately become “ingrained” via a loss
of skills among the long-term unemployed.