Q&A With The Hatzius Who Stole The Hopium: Economic Outlooks Summarized As "Bad" Or"Very Bad"
Jan Hatzius is on a roll these past two days: after first debunking any myths that QE2 will be less than $1.5 trillion in total, thereby confirming the dollar's days as a reserve currency are numbered, now he is out to prove to Obama and his incoming chief economic advisor whichever Mark Zandi that may be, that there is no Santa Claus. To wit: "We see two main scenarios for the economy over the next 6-9 months—a fairly bad one in which the economy grows at a 1½%-2% rate through the middle of next year and the unemployment rate rises moderately to 10%, and a very bad one in which the economy returns to an outright recession. There is not much probability of a significantly better outcome. The reason is that “short-cycle” factors such as the inventory cycle and the impulse from fiscal policy are likely to continue deteriorating through early 2011, keeping GDP growth very sluggish." That pretty much sums up why stocks will continue being completely irrelevant as an indicator of reality for about a year longer.
From Goldman Sachs: More Q&A on the Outlook
Today’s comment extends yesterday’s discussion of monetary policy to the overall economic as well as fiscal outlook. A number of the questions surfaced in a panel discussion at the conference on “America’s Fiscal Choices” in Washington today.
Yesterday’s daily comment considered the monetary policy outlook in Q&A form. Today’s comment applies the same format to other questions about the economic and fiscal outlook that we have encountered recently. A number of these surfaced in a panel discussion at the “America’s Fiscal Choices” conference organized by the Economic Policy Institute, Demos, the Center for Budget and Policy Priorities, and the Century Foundation in Washington on Tuesday (http://demos.org/event_list.cfm?currenteventid=73D0AB98%2D3FF4%2D6C82%2D539AAAAE55A8D617).
Q: What is the short-term outlook for the economy?
A: We see two main scenarios for the economy over the next 6-9 months—a fairly bad one in which the economy grows at a 1½%-2% rate through the middle of next year and the unemployment rate rises moderately to 10%, and a very bad one in which the economy returns to an outright recession. There is not much probability of a significantly better outcome. The reason is that “short-cycle” factors such as the inventory cycle and the impulse from fiscal policy are likely to continue deteriorating through early 2011, keeping GDP growth very sluggish. (See “The Risk of Recession: Concentrated over the Next 6-9 Months,” US Daily Comment, September 23, 2010.)
Between the two scenarios, the fairly bad one—slow growth, rising unemployment, but no outright recession—has significantly higher probability, for three reasons.
First, activity in the cyclical sectors of the economy (which typically account for most or all of the overall decline in GDP during a recession) remains at very low levels. As of the second quarter, the sum of consumers’ durable goods spending, business fixed investment, and inventory investment—the most cyclical parts of GDP—stands at just 20.0%, above the postwar low of 18.1% seen in early 2009 but still far below the historical average of 24.8% and below any pre-2008 point in postwar history. In some of these areas, it is almost mathematically impossible to see another big drop (homebuilding is the best example).
Second, excess supply of houses and capital goods is gradually being worked off via these low levels of activity. As the excess supply declines, the appropriate flow of production will increase gradually, although it will probably take several years before both are back to normal.
Third, monetary policy is gearing up for another dose of stimulus, most likely starting at the November 2-3 FOMC meeting, as we discussed in yesterday’s daily comment. The expectation of this move has already led to a broad easing in financial conditions via lower interest rates, higher stock prices, and a weaker dollar.
However, the recession scenario also has significant probability (we still think about 25%-30%). First, it is still possible that we will see a full expiration of all of the 2001-2003 and 2009 tax cuts if Congress fails to agree on a bipartisan “deal.” Relative to our baseline scenario of extension of the lower- and middle-income tax cuts, we estimate that full expiration would result in a further hit to GDP growth in early 2011 of nearly 2 percentage points (annualized).
Second, house prices over the next year could fall by more than our baseline forecast of about 3%. If we saw, for example, a 10%-15% decline, the risk of recession would rise significantly. The uncertainty about the future path for house prices is particularly large at present because two of the best predictors of house prices are pointing in opposite directions. On the one hand, valuation and affordability are decent, even if we adjust for the still-tight level of lending standards. On the other hand, excess supply remains at very high levels (although it is declining slowly). It is difficult to be certain which of these two factors is more important, and the answer makes a big difference to the house price outlook. However, in 6-9 months we are likely to have a much better idea of whether the current relapse in house prices is just “bumping along the bottom” (our baseline expectation) or a more serious renewed decline.
Third, the current gradual labor market deterioration might turn into more rapid deterioration if the economy proves unable to sustain “stall speed”. In the postwar US economy, we have never seen an increase in the unemployment rate (on a three-month moving average basis) of more than one-third of one percentage point that did not coincide with or foreshadow a recession. There are some decent reasons to believe that this pattern may not apply under current circumstances—particularly the fact that the level of activity is already so depressed following the Great Recession—but the consistency of the pattern is so striking that it should be viewed as a serious warning sign given our forecast that joblessness will rise back too 10% by early 2011.
Q: What about the longer-term outlook, i.e. beyond mid-2011?
A: The answer depends on whether we are talking about the level of economic activity or the rate of change. The levels of output and employment are likely to remain depressed relative to potential for many years. This means that there will be many people who are out of work but would be working in an economy with an adequate level of demand. It also means that we should worry about the possibility that a greater share of the—currently mainly cyclical—unemployment turns structural in coming years. And it finally means that the risks will remain on the side of deflation, or at least undesirably low inflation for a long time to come.
However, the rates of change of GDP and employment are likely to improve as we move past early/mid-2011 and into 2012, provided the economy doesn’t return to recession in the near term. Beyond early 2011, the impulse of short-cycle factors such as inventories and fiscal policy to GDP growth is no longer likely to deteriorate (i.e. it will not get worse in a second-derivative sense, although it will likely remain negative). Meanwhile, the slow-motion improvement in areas such as excess housing supply and bank credit quality is likely to continue. This should add up to a gradual acceleration in growth to a trend or slightly above-trend pace by late 2011 and going into 2012.
Q: What should policymakers do about it?
A: On the monetary side, we believe that substantial further stimulus is needed. It does appear that Fed officials are moving in that direction. The latest policymaker to add his voice to the chorus was Chicago Fed President Charles Evans today. In an interview with the Wall Street Journal, Evans made the following comments, which are notably aggressive for an official who has generally been viewed as a centrist: “I knew it was going to be bad. And it is not improving. We’re pushing out the growth prospects. I just think it calls for much more than we’ve put in place. My view on accommodation at the moment is not data dependent. I think we’re there.”
On the fiscal side—the main theme of today’s conference—the prospects are in any case bleaker. Under our baseline assumption that most of the tax cuts are extended but emergency unemployment benefits expire in November, we will see fiscal restraint of about 1¾ percentage points in 2011. Even under the most optimistic assumptions from the perspective of the overall stance of policy—full extension of all tax cuts as well as another extension of the emergency unemployment benefits which are currently slated to expire in two months—we are still likely to see fiscal restraint of around 1 percentage point (mainly because of weakness on the state and local side). And under the most pessimistic assumption—i.e. that all tax cuts and benefit programs expire as scheduled over the next few months—the restraint rises to about 3 percentage points in early 2011.
Q: Are policymakers at least moving in the right direction?
A: Fortunately yes, although the progress is slow when measured against the scale of the challenges. On the monetary side, we have been encouraged by comments such as those of Presidents Evans and Dudley which not only recognize the need for additional asset purchases but are also willing to explore more aggressive options such as price level targeting. And on the fiscal side, the likelihood of a full expiration of all of the tax cuts does seem to have declined somewhat further. While the overall policy stance will still be far from what is needed, at least the debate is moving in the right direction.