Goldman Lowers 2011 GDP Forecast
Once again Goldman confirms that shooting for the moon, when it comes to an artificial, self-sustainable "virtuous growth" cycle in a centally planned economy is an exercise in futility. As long expected, the gradual roll down in growth forecasts begins, and all of Wall Street's lemmings will rush next week to undercut each other, all the while blaming cold weather, hot weather, and any weather for not being able to see this. Fore one previous example (and there are dozens) of Zero Hedge indicating Goldman's overoptimistic forecast read here.
From Goldman: "Spring Cleaning for Our Forecasts"
Forecast change summary:
1. We now forecast that real GDP will increase by 3.5% in Q2 2011 and 3¼% in the second half of this year. The rise in oil prices —although now partly reversing—is likely to prove a meaningful drag on consumer spending and business investment. Besides this sizable shock [what shocks: , however, we continue to see a broad-based normalization in the economy. Bank lending, the labor market, and business confidence have all improved. We therefore expect GDP growth to remain abovetrend, and to accelerate in late 2012 as the effects of the rise in oil prices begin to fade.
2. A gradual drop in the jobless rate, to 8.5% by year-end 2011 and 8¼% by year-end 2012. The persistence of above-potential growth over the next two years should help reduce the rate of unemployment visibly during this period. However, we expect the pace of improvement to slow sharply as the rapid drop in labor force participation gives way to a modest increase.
3. A moderate rise in core inflation. We raised our inflation forecasts, and now expect the core PCE price index to accelerate modestly to 1.3% from 0.9% now. Despite significant excess capacity, stable inflation expectations should draw underlying inflation closer to the Fed’s target. In addition, rising rent inflation—caused in part by a decline in homeownership and surge in demand for apartments—may put upward pressure on the major price indexes. In our forecast, year-to-year headline inflation as measured by the all-items CPI rises to 4% by the third quarter of 2011 before ebbing to just 1½ % at year-end 2012.
4. No Fed rate hikes before 2013. We have a high degree of confidence in this view for 2011, but see it as a much closer call for 2012. However, with the jobless rate far above the Federal Open Market Committee’s “mandate-consistent” 5%-6% central tendency range and core inflation well below the comparable “2% or a bit less” standard, we think most FOMC members will think it premature to start raising interest rates.
5. Yields on 10-year Treasury notes reach 3¾% by year-end 2011 and 4¼% by year-end 2012. As the jitters about global growth in the wake of the Middle East turmoil and the Japanese earthquake subside, we believe that many participants in the financial markets will turn their attention back to higher inflation and the potential for Fed rate hikes. This is especially likely if the dollar also depreciates, as we expect it will, or if bank loans start to grow. While we do not forecast that rate hikes will begin until 2013, we believe that many investors may expect them sooner. Increases in Treasury yields will likely be tilted toward the short end of the curve, where changes in market expectations of monetary policy matter more.
Next up: more growth cuts, and Hatzius casually floating the idea of another quantitiv easing episode "if further broad-based deterioration is observed."
1. Sustainable above-trend growth. After several years with a below-consensus view on US growth, we adopted a significantly more constructive outlook in late 2010. The reasons for this shift were progress in private sector deleveraging, better signs in the labor and credit markets, a pickup in underlying private demand growth, and another helping of monetary and fiscal policy stimulus.
2. Low core inflation. Our view has long been that inflation depends more on the levels of output and employment relative to potential than on their growth rates. With GDP 5%-6% below its potential level and unemployment 3-4 percentage points above its sustainable rate, we predicted that core inflation would stay well below the Fed’s target in 2011 and 2012.
3. A near-zero funds rate. Our version of the so-called Taylor rule showed that the “warranted” federal funds rate—based on inflation and unemployment relative to the Fed’s dual mandate—was likely to stay at or below zero until after 2012. Our forecasts have reflected this, with no rate hikes predicted until 2013.
GDP Growth—Still Above Trend, But the Trend Itself Looks a Bit Lower
These basic themes remain unchanged. However, we are marking our specific forecasts to the recent information flow. On the growth side, our prediction that real GDP would grow at a sequential pace of 3½%-4% through 2011-2012 now looks too aggressive, and we are reducing it to the 3%-3½% range as shown in Exhibit 1. However, we still think that the 1.8% GDP growth rate reported for the first quarter understates the “true” pace of activity in the first quarter and will be followed by significantly stronger figures in the remainder of 2011. Our forecasts for annual-average GDP growth go to 2.7% from 2.9% in 2011 and to 3.2% from 3.8% in 2012.
There are three reasons for our downgrade:
1. Less momentum. The most obvious reason to downgrade our forecast is that the broad momentum of the economic activity indicators—which somewhat ironically was quite strong in the first quarter despite the disappointing 1.8% GDP growth figure—has shown some signs of flagging recently. As shown in Exhibit 2, our Current Activity Indicator (CAI) is on track for growth of only 2.3% (annualized) in April following Friday’s employment report, down from an average of 3.7% in the first quarter. This slowdown mainly reflects the weaker Philly Fed and nonmanufacturing ISM surveys, higher jobless claims, and slower household employment growth; in contrast, both nonfarm payrolls and the manufacturing ISM still look firm. Moreover, the chart also shows a 22-business day (i.e. one-month) moving average of our US-MAP scoring system of economic indicators versus the consensus forecast; this illustrates that the recent data have not only been weaker in absolute terms but also relative to economists’ expectations.
2. Energy prices. Although energy prices plunged this week, our analysis shows that the surge seen over the last few months is still likely to weigh on growth. Exhibit 3 plots the estimated effect of a transitory 20% shock to retail gasoline prices, which is roughly the
“surprise” relative to the path discounted in our forecast five months ago.1 Assuming that the shock dies out over the next quarter—in line with the predictions of our commodity strategists—the impact is to lower real GDP growth by about ¾ percentage
point for three quarters. Subsequently, growth rises above the “baseline” as real income rebounds in the wake of lower oil prices. This could be a reason for growth to reaccelerate in 2012, although it is important to keep in mind that this “shock” and its reversal need to be evaluated relative to a rising path for the underlying oil price trend in our commodity strategists’ forecast.
3. Fiscal tightening. We have long expected fiscal policy to subtract from growth in 2011-2012, but the recent developments suggest that this tightening might be a little more aggressive than we thought earlier. This is not because of the $38 billion cut in budget authority agreed by the two parties to avert a shutdown of the federal government in early April; after all, the Congressional Budget Office (CBO) scored this agreement as an actual spending cut in the 2011 fiscal year of only $300 million. Moreover, our current assumption is that the temporary payroll tax cut passed in December 2010—which is currently scheduled to expire at the end of 2011—is extended for another year as the presidential election approaches. However, we expect the emergency unemployment benefit legislation to expire on schedule in late 2011 and see additional restraint in 2012 from federal discretionary spending cuts, expiring provisions from the stimulus package, and some degree of restraint in the state and local sector.
Slower growth is likely to keep the unemployment rate somewhat higher than we previously thought. The historical relationship between real GDP growth and changes in the unemployment—dubbed “Okun’s law” by economists after President Nixon’s chief economic adviser—suggests that the unemployment rate falls by about half the gap between GDP growth and its long-term trend over a year’s time. In our updated forecast, growth through the end of 2012 averages 3.3%, or ½-¾ percentage point above our estimate of US potential growth. Taken literally, this would imply a drop in the unemployment rate from the 9.0% reported for April 2011 to 8¼%-8½% at the end of 2012. We choose the lower end of this range because we are concerned that the weakness in labor force participation over the past couple of years might indicate that potential growth is a little weaker than we had thought.
Core Inflation—Higher Because of Rents, But Still Well Below the Fed’s Target
Despite the slightly higher unemployment rate and the lower level of GDP in our new forecast, we are also making an upward adjustment to our core inflation forecast. As shown in Exhibit 5, we now expect the core PCE price index—the Fed’s favorite measure of inflation—to accelerate to 1.3% year-on-year in late 2011 and 2012, from 1.0% in our previous forecast.
The main reason is that rent and owners’ equivalent rent (OER) inflation is likely to pick up somewhat further. The private research group PPR is reporting rents that point to higher rent and OER inflation over the next year, as shown in Exhibit 6. This is important because rent and OER together account for a whopping 40% of the core CPI and a still-large 17% of the core PCE index.
That said, it is hard to take at least the acceleration in OER—whose weight is much larger than that of rent—seriously as a sign of higher US inflation. In our view, it is basically a statistical artifact that is closely related to the drop in homeownership discussed on these pages last week.2 This drop is increasing the excess supply of homes in the owneroccupied sector and therefore putting downward pressure on home prices; meanwhile, the drop is reducing the excess supply in the renter-occupied sector and therefore putting upward pressure on rents. Because the CPI imputes the cost of owner occupation from rents, this shift perversely results in upward pressure on measured homeowner costs even though it puts downward pressure on actual house prices and mortgage payments.
More fundamentally, output and employment remain far below the US economy’s potential, inflation expectations remain well-anchored, and both wages and unit labor costs are consistent with inflation well below the Fed’s target in 2011 and 2012. We can show this using our estimated top-down inflation model illustrated in Exhibit 7.3 It explains core CPI inflation by the unemployment gap—the difference between the unemployment rate and the estimated natural rate—as well as long-term inflation expectations.
If we measure inflation expectations by the “forward” inflation rate expected by consumers over the next 5- 10 years, our model implies a pickup in core CPI inflation to 1.4%, right in line with our forecast. However, the message from our top-down model is that the risks to this forecast are if anything on the downside; if we use the 10-year inflation expected by economists, the projection drops to 0.5%. We think it is sensible to “lean” to the higher side of the range projected in our top-down model mainly because of the upward pressure on rents and OER. But fundamentally we still see a very low inflation environment.
Fed Policy—Still on Hold Through 2011-2012
The net effect of these forecast changes on our forecast for Fed policy is approximately zero. In other words, we still think that the first hike in the federal funds rate will occur in early 2013, although the uncertainty is substantial.
The starting point for the Fed policy outlook is our estimated forward-looking Taylor rule model. The latest version is shown in Exhibit 8.4 It uses data over the period from 1988 to 2008 to estimate the funds rate as a function of the Fed’s forecasts for inflation and unemployment relative to its targets for both variables. The model then projects the funds rate forward, under the assumption that the Fed’s forecasts ultimately converge to our own; that is the solid line in the chart. Finally, we adjust the solid line using our estimates of the impact of unconventional monetary policy on financial conditions; that is the dotted line in the chart.
Relative to the prior version Exhibit 7, there are three offsetting changes:
1. Slightly higher unemployment. The ¼-point upward revision to the unemployment rate at the end of 2012 lowers the “warranted” federal funds rate by about 30 basis points (bp).
2. Slightly higher inflation. The 0.3-point upward revision to core PCE inflation raises the warranted funds rate by about 40bp.
3. Reduced commitment. We were struck by Chairman Bernanke’s answer to the question in the April 27 press conference about the meaning of the “extended period” language. Our interpretation had been that this meant no rate hikes for six months or longer. However, the chairman only indicated that it meant no hikes for “a couple of meetings,” and qualified even that statement by a “probably.” This is relevant for our Taylor rule because we have found that this type of commitment language has historically kept long-term interest rates lower and financial conditions easier, and we have therefore treated it as a substitute for cuts in the federal funds rate along lines that are similar to large-scale asset purchases. However, our latest version of Exhibit 7 assumes that the current commitment language is worth only about 20bp, down from 40bp previously.
Similarly, we are making no changes to our long-term interest rate forecasts. We still expect 10-year note yields to drift up gradually to 3¾% at the end of 2011 and 4¼% at the end of 2012; the reason is that the unemployment rate declines, core inflation drifts up, and the date of the first Fed rate hike comes closer. These figures are moderately above the forwards following the recent rally. However, they still imply that long-term interest rates will remain in the low range that has prevailed for the past several years.
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