Following up his earlier note laying out expectations (translated as: "you better or else") for the outcome of the FOMC meeting tomorrow, Goldman's chief economist Jan Hatzius produces another 'concerning' research note tonight providing just enough evidence for a growing downside risk to the firm's 2% GDP growth estimate for 2012. We assume the failure of the market to hold onto dramatic losses (easier to justify more easing) or dramatic gains (can't disappoint a Pavlovian public waiting for the FOMC bell to ring) in the last few days prompted the 'nudge' from the policy-makers-elect. It appears weak stocks, a strengthening dollar, and the European crisis were not what the doctor ordered.
From Goldman US Daily : A More Downbeat Message from Our Financial Balances Model (Hatzius/Stehn)
An update of our "financial balances" model, introduced three months ago, points to below-trend growth in 2012. Although the model still suggests that the net impulse from changes in the private and foreign balance will be slightly positive, this is overwhelmed by a negative impulse from fiscal retrenchment. Overall, the results imply some downside risk to our current forecast of slightly below-trend growth next year.
Since the late 1990s, we have repeatedly looked at the US economic outlook via the “financial balances” framework championed by the late Cambridge economist Wynne Godley. It starts from the accounting identity that one person’s spending is always another person’s income. This means that in the economy as a whole, total income must equal total spending, and the financial balances—the gaps between income and spending—of the different sectors of the economy must add up to zero. In turn, this means that the financial balance of the US private sector plus the financial balance of the US public sector must equal the US current account balance (the financial balance of the rest of the world vis-à-vis the US).
But while this identity must always hold ex post in terms of national income accounting, it need not hold ex ante in terms of the spending intentions of the different sectors of the economy. If all sectors taken together try to reduce their financial balance—i.e. increase spending more than income and finance the difference by borrowing more or running down their cash balances—the economy will tend to grow above potential. Conversely, if all sectors taken together try to increase their financial balance—i.e. increase spending less than income and use the difference to accumulate cash or pay down debt—the economy will tend to grow below potential.
This suggests that we may be able to predict the ups and downs of the business cycle if we can predict the ups and downs of the ex ante financial balances of the different sectors. In particular, if there is good reason to expect a tendency toward declines in the aggregate financial balance—i.e., spending growth that runs ahead of income growth in the economy as a whole—we should expect above-trend growth in GDP, and vice versa.
A few months ago, we constructed a model to quantify these linkages (see "Private Boost, Public Restraint," US Economics Analyst, 11/25, June 24, 2011). We explain the different components of the private sector balance—household saving, household investment, and the nonfinancial corporate financing gap—as well as the external balance with economic fundamentals such as household wealth, interest rates, house prices, exchange rates, and lending standards. Using assumptions for the evolution of economic fundamentals, we then project the underlying balances into the future, focusing on the overall impulse to aggregate demand. Finally, we compare this impulse with the likely drag from public sector retrenchment and discuss the implications for overall GDP growth.
Our conclusion at the time was that the overall financial balance was still likely to show an ex ante decline—i.e. a drop in personal saving, a rise in residential investment, a decline in corporate net saving, and a decline in the US trade deficit. Although a retrenchment in the public sector was likely to cut the other way, the implication was still for modestly above-trend growth in 2011-2012, at least excluding the negative impact from the increase in oil prices this year.
Three months on, the picture has deteriorated. This is illustrated in the chart below, which plots the private sector boost, public sector drag, and the net effect of the two taken together. To be sure, we still obtain a positive impulse from a predicted decline in the private sector balance. However, the impulse is now only +0.2 percentage point compared with 1-1.5 percentage point three months ago.
The reasons for the reduced impulse lie in the drop in equity prices, a somewhat weaker outlook for credit standards, and an appreciation of the trade-weighted dollar over the past few months. This minor positive impulse now no longer looks large enough to offset the drag from public sector retrenchment. As a result, our model now implies a net impulse from all sectors taken together of -0.6 percentage point in 2012. (The impulse in 2011 is positive, but note that the chart does not include the impact from the sharp increase in real energy prices, which has probably taken as much as 1 percentage point from growth in the first half of 2011; see "Subpar Growth Brings the Fed Back into Play," US Economics Analyst, 11/31, August 5, 2011.)
Financial Balances Model Now Points to Restraint for 2012
On its own, this seems consistent with our real GDP growth forecast of 2% on an annual-average basis. However, the risks to this forecast are tilted to the downside. First, the financial balances impulse excludes the drag from a tighter commodity constraint, which still looks significant. Although energy prices have eased a bit in recent months, the growth impulse in 2012 is still likely to be somewhat negative in 2012 given the lags in the relationship between energy prices and growth, as well as our commodity strategists' view that prices are likely to resume their upward trend. Second, sub-trend growth has historically been an unstable place to be for the United States; there has never been an increase in the unemployment rate of more than 35 basis points (on a 3-month average basis) that has not resulted in a recession. And third, of course, the risk is that the tightening of financial and lending conditions that has caused the message from our financial balances model to become less friendly continues in the wake of the European crisis.