Following up on Friday's economic forecast reduction, Goldman's economic team provides an extended analysis validating its dramatic cut to 2011 GDP from 2.5% to 1.9%, and its increase to the unemployment rate from 9.7% to 10.0%. It does so not without a decent bit of gloating: "Our forecast for a significant slowing in the second half of 2010, widely seen as implausible three months ago, is now increasingly accepted." Of course, those reading this blog are fully aware that the fake economic sugar high achieved over the entire past 2 year period is what accountants would consider a non-recurring, one-time item achieved in the face of a deflationary tide, interspersed with ever more desperate attempts by the Fed to stimulate (hyper)inflation. And the closer we get to the imminent realization that as tens of trillions of debt need to be eliminated (and guess what that means for a like amount in underwater equity value) before any form of self-sustaining growth can be achieved, the more likely it becomes that the Fed will commit to the nuclear launch codes which will eventually destroy the US currency, in what many have pegged as hyperinflation for the items we need, and hyperdeflation for the items that nobody really cares about: an outcome which will make the Schrodinger Cat nature of our economy apparent in its final wave function collapse, with the only difference that the US economy is dead in both worlds.
Back to Goldman. The firm is now even more pessimistic on the future than before:
- Lower growth in 2011. We continue to expect real GDP growth to average 1½% (annual rate) in the second half of 2010. However, we have scaled back the anticipated reacceleration in 2011, largely due to heightened congressional resistance to extending fiscal stimulus. Thus, whereas we previously forecasted growth to rise from 2½% in the first quarter to 3½% by the second half, we now look for a more gradual pickup?from 1½% in the first quarter to 3% in the fourth quarter.
- Continued disinflation, but at a slower pace than before. We now expect both the price index for personal consumption expenditures excluding food and energy (core PCE index) and the core CPI to slow to a year-to-year rate of ½% by year end 2011; our previous forecasts were ¼% and zero, respectively. Although the growth revision implies a larger output gap over the next 18 months, two other considerations dominate: (a) upward revisions to core PCE inflation announced in the latest annual GDP revisions and (b) signs that disinflation in rents may have ended.
- A return to unconventional monetary easing by late 2010/early 2011. We expect the Federal Open Market Committee (FOMC) to respond to renewed upward pressure on the unemployment rate with another round of unconventional monetary easing. These measures could involve more asset purchases?probably Treasury securities?and/or a more ironclad commitment to keep the federal funds rate low. If the committee decides on more asset purchases, the amount would be at least $1 trillion (trn).
- A ?baby step? to unconventional easing next week. Although it is a fairly close call, we now expect the FOMC to announce that it will reinvest pay-downs of mortgage-backed securities (MBS) in the bond market at next Tuesday?s meeting. While this would be a ?baby step? in the direction of renewed unconventional easing, it would probably be packaged as a decision to prevent gradual tightening of the overall policy stance.
The reason for the pessimism is that Goldman continues to see no let-up in the three main headwinds to private sector growth:
- The overhang of unoccupied housing remains near its record high. Until this supply is worked off, it will siphon off a disproportionate share of the net increase in demand for housing, leaving builders with little reason to start new homes. Thus, housing is not providing the cyclical power that it has in past cycles, as shown in Exhibit 3.
- Employers remain cautious in hiring. Throughout this recovery, we have argued that US firms did not reduce payrolls disproportionately relative to real GDP during the recession, and that they would more likely follow the path of the last two ?jobless? recoveries than the more vigorous patterns of earlier cycles. The deeper downturn now reported for real GDP reinforces the first point; Exhibit 4 illustrates the second.
- Consumers appear unlikely to reduce saving materially. One of the most striking elements of the annual GDP revision was the upward revision to the personal saving rate, shown in Exhibit 5. The household financial balance (not shown) was also revised up by a comparable amount. Although this suggests that US households have made more progress in adjusting to lower net worth positions, they are probably still wary of reversing course. If that is correct, then the constraints on income implied by cautious hiring, coupled with the likelihood of more price weakness in a housing market saddled with excess supply, suggest that real consumer spending will remain on a sluggish growth path.
So with all this negativity a "Double D" is inevitable right? Well, no. Goldman will not go that far yet, for these two reasons, the primary one being the much anticipated QE2, which Goldman expects will be announced next week and amount to at least $1 trillion in Treasury purchases:
The FOMC Will Combat with QE2… A key factor in this judgment is this: when push comes to shove the FOMC is likely to act and to do so aggressively. This may sound surprising at first blush, as the minutes to the June FOMC meeting revealed only a small downgrade to the committee?s growth forecast and provided only a fleeting and highly qualified reference to the possibility that renewed easing might be needed. Moreover, Chairman Bernanke largely stuck to the party line at the policy hearings in July, at least in his prepared testimony.
However, in the question-and-answer sessions the chairman did indicate that more Fed easing would be forthcoming if the slowdown persisted to the point of pushing the jobless rate back up. This makes sense given how reliable small increases in the jobless rate have been in signaling recessions. As we have noted many times over the years, since World War II the US economy has never escaped recession once the jobless rate has posted a cumulative increase of more than 0.3 percentage points on a 3-month moving average basis from a fresh low, as shown in Exhibit 6. Although the applicability of this rule in early recovery is unclear, the FOMC can hardly afford to stand by if the jobless rate rises 0.3 points from the current low of 9.57%.
Chairman Bernanke also outlined three possible tools for further easing: (1) to strengthen the commitment to keep short-term rates ?exceptionally low for an extended period;? (2) to cut the interest rate on excess reserves (IOER) from its current 25-basis-point level; and (3) to resume asset purchases. He also said that the FOMC would review all of its options, including the possibility of reinvesting MBS prepayments and redemptions. Currently, these proceeds are not being reinvested, with the result that the Fed?s balance sheet is set to shrink slowly over time. This amounts to a slight tightening bias in the current policy stance, albeit one that may not have much effect given the enormous volume of excess reserves in the system. With the IOER already close to zero, we see little to be gained from cutting it further, other than to signal a switch in policy orientation. The incentive for banks to make new loans would increase only marginally, while money market funds would have a tougher time eking out positive returns as yields on other short-term assets moved even closer to zero. Besides, the FOMC could send the same signal by taking up the MBS reinvestment option. Although it is a close call, we now expect this to occur at next week?s meeting.
Implementation of the "?bigger?" options? - a stronger commitment to keep the federal funds rate near zero and/or more asset purchases? - will require both more discussion and more evidence of economic weakness. Recall in this regard that most FOMC members are starting from a more robust economic outlook than ours; as recently as late June, the committee?s ?central tendency? range for growth in 2010 was 3% to 3½%. These figures would undoubtedly be lower now, but probably not to the point where most members see a double-dip as sufficiently likely to warrant more than a shot across the bow.
The one member who has publicly spoken on these alternatives is James Bullard, president of the St. Louis Federal Reserve Bank. In a recent paper, he argued that additional stimulus? -if needed- ?should take the form of purchasing Treasury securities rather than beefing up the rate commitment language, which he sees as potentially counterproductive. Elsewhere we have shown that both have had similar effects in reducing long-term interest rates. However, we think that the FOMC is likely to opt for asset purchases as the more effective way to provide additional stimulus.
This is because most members appear uncomfortable with the type of policy rate commitment needed to push real long-term rates down materially? -for example, one that promises to hold rates low until inflation rises to a certain level. That said, one possibility would be for Chairman Bernanke, after consultation with the FOMC, to speak out publicly about research that shows how the FOMC?s past rate-setting behavior would currently imply a federal funds rate well below zero. By suggesting, even indirectly, how long it would take for this desired funds rate to get back to zero, he could have a meaningful impact on market expectations.
Some of this research is ours, but notably it also includes contributions from the San Francisco Fed.
In the end, the FOMC is more likely to embrace a new asset purchase program?climbing aboard QE2 to help avert a double dip, so to speak?though both are certainly possible. The most likely timing of these larger steps would be late 2010 or early 2011, as the jobless rate approaches 10%. The asset purchases would likely be for Treasury securities, and to have a meaningful effect, total at least $1trn.
As we have long anticipated, QE2 is a certainty as the Fed is now out of all bullets, and can only proceed with the nuclear tactical option. This will once again achieve nothing, and no incremental borrowing will occur by Main Street, but will only double excess reserves held at banks, in the process shooting all risk assets into the stratosphere (merely courtesy of the fact that those who now trade the markets, the primary dealiers, have endless access to zero-cost money via the Fed), making the inflation/deflation debate moot: for everyone who has access to the Fed's discount window and zero-cost capital, assets will explode resulting in inflation for commodities of all types (when the downside is zero, the upside-downside analysis is irrelevant), and likely spilling into all risk assets (stocks), now that the 10 Year is approaching a laughable 2.5%. With the permanent guaranteed bid on the curve courtesy of the madmen at the Fed, look for Treasuries to surge even more, making the inflation-deflation disconnect reach ridiculous levels (but will at least allow the US to monetize its own debt indefinitely and fund its isane budget). The outcome will simply be another round of middle class destruction, as prices for critical items surge (especially those not counted in the core CPI), while all other goods that depend on access to bank credit (housing and other big ticket items) will see their price fall, leading to an acceleration in the inflation-deflation disconnect, as it spills into the real world. We have no doubt now that the end result of this continued monetary insanity will not be the avoidance of a double dip, as Goldman hopes, but a social upheaval which finally overturns the corrupt and criminal status quo.
The other factor that Goldman believes will prevent a double dip is an increase in private-sector spending on durable
While the prospect of more monetary stimulus certainly helps the case against a double dip, two private-sector considerations also factor into our thinking on this issue. First, purchases of durable goods have already taken a beating as households and businesses have deferred acquisitions of these largely discretionary items. In many cases, activity has fallen close to or below replacement rates. The most obvious example is home building, where starts have fallen to a 600,000 annual rate. While the case for a near-term increase is not good, this starts rate appears to be a frictional low, and it is only about half the trend rate of household formation. Meanwhile, business spending on capital equipment has fallen to the level needed to replace worn-out equipment, as shown in Exhibit 7. The same is likely true for household purchases of motor vehicles.
Second, at some point the headwinds to growth will peter out. The excess supply of empty housing will eventually disappear, businesses will eventually hire more workers as they run out of ways to squeeze more out of the existing work force, and consumers will eventually tire of efforts to boost saving. These points are obviously hard to predict, and not all of them will be reached in 2011. But as the headwinds diminish, real GDP growth can strengthen, aided by policy stimulus. It is on this basis that we forecast a gradual resumption of trend growth in 2011, though with lingering concern that risks still tilt to the downside.
The problem with uniform deleveraging is that as it reverts to the mean, all recent support levels are irrelevant. Simply consider our thought experiment from last week which demonstrated that an inverse reversion to the mean analysis should put the unemployment rate (U-3) not at 9.5% but at 13%, courtesy of the growing population and a trendlining labor force. But of course economists ignore that which is inconvenient in their attempts to goal seek a preferred outcome.
All in all, we are happy with Goldman's capitulation, but of course it is nowhere near enough. With time, Hatzius' team will realize that not only is the double dip not inevitable, but the sugar high has merely been a blip in a continued Double D, as defined by Zero Hedge - Deflationary Depression, which in the process will be accompanied by episodes of massive inflation as the population loses faith in the form of all fiat currency exchange, post continued attempts by the Fed to subvert it, and forcing real price discovery to occur not in traditional monetary aggregates but in new form (or, as the case may be, very old), forms of wealth exchange. The real reasons for the debt monetization, by the way, is that the world is rapidly running out of money to purchase the $10 trillion or so in debt coming up for issuance by the US Treasury over the next 5-10 years: it simply means the Fed is once again starting to monetize the nation's debt, nothing more, nothing less. Luckily, in the painful but now inevitable end, the population will rid itself of the Federal Reserve and of the false economic religion of Keynesianism, but not before the current wealth for 99% of the population, both rich and poor, is wiped out, as it is discovered to have been nothing more than an endlessly diluted subordinate claim on existing hard assets. As for the timing, we will use cite Dmitry Orlov, in saying that it will likely occur in the next 5 years, with a +/- 5 year buffer (more on this later).