Just released - apology #3 from Jan Hatzius on his ill-timed "golden age" call. We expect many more. We almost feel sorry for the German strategist and the replacement of FRBNY's Bill Dudley. For our most recent roasting of Hatzius (and there have been several), read here.
From Goldman Sachs: Now What
1. Nice timing on our GDP forecast upgrade! The November employment report was a disappointment, and there weren’t a lot of redeeming features buried underneath the headlines. Private sector payroll growth fell back to +50k, the slowest pace since January 2010. The household survey was also weak, with a rise in the unemployment rate to 9.82% and a drop in the employment/population ratio to 58.18%, just a hair above the cycle low seen in December 2009. The jobs report followed higher initial jobless claims on Thursday and a soft manufacturing ISM survey on Wednesday.
2. So are we nervous about our shift? Not really. For one thing, our new forecast does not say that the US economy is now off to the races. We are not predicting above-trend growth until the second quarter of 2011, so it is hardly a huge surprise that the labor market is still struggling (indeed our own forecast for Friday’s number was somewhat below consensus). More importantly, the report leaves the rationale for our forecast upgrade unaffected, which is that GDP growth is firming modestly at a time when the short-term impact of inventories and fiscal policy has turned from positive to negative. This says to us that the growth rate of underlying final demand—GDP excluding the effects of inventory changes and fiscal policy—is improving. And the news on the demand/service side of the economy has remained fairly encouraging, with auto and same-store retail sales both stronger than expected, an upward revision to core capital goods orders, and a good nonmanufacturing ISM survey (interestingly with a 3-year high in the employment index).
3. What lies behind the demand improvement? In our view, the main reason is an incipient decline in the private sector financial balance—i.e., the gap between the total income and total spending of US households and businesses—and a slowdown in the speed of private sector deleveraging. To a first approximation, the private sector balance is the “flow” equivalent to the “stock” of private sector debt. When the private sector balance is below the long-term average of +1½% of GDP, households and firms are increasing their leverage, relative to the long-term trend; when it is above average, households and firms are reducing their leverage. In late 2006, the private sector balance was -4% of GDP and starting a long trek toward surplus—a terrible combination because it implied that spending was falling relative to income and had a long way to fall before the increase in leverage would be halted. Now, the private sector balance is +6½% of GDP and falling—a good combination because it implies that spending is rising relative to income and has a long way to rise.
4. How fast demand rises depends on how far we are from a sustainable private sector debt/GDP ratio. Unfortunately, nobody knows the answer to that question. We can make educated guesses based on the historical trend of the private sector debt/GDP ratio, the historical average of the household debt service/disposable income ratio, the experience of other countries that have gone through deleveraging cycles, or credit-related indicators such as loan delinquencies, credit standards, and bank lending. But these deliver a wide range of estimates, none of which is obviously superior to the others. While the uncertainty is therefore sizable, we feel like we’re being reasonably cautious with our projection that the private sector balance will still be at +4½% at the end of 2012, which wouldn’t imply a particularly rapid return to the historical average but could still be consistent with decent demand growth.
5. Unfortunately, “decent”—or even somewhat better than decent—demand growth isn’t likely to restore anything resembling full employment anytime soon, and we still expect an unemployment rate of 8½% in late 2012. Indeed, Friday’s report of a 0.2-point increase implies some upside risk to this forecast. Meanwhile, core inflation is already below 1%, and we think it’s likely to stay low or head even lower. There has never been an increase in core inflation over the subsequent 2-3 years when the unemployment rate was above 8%. That’s obviously not a law of nature, but it is a useful observation that neatly encapsulates the idea that idle resources weigh on wages and prices.
6. The monetary policy outlook is both simple and complicated. In terms of conventional policy, it is simple because rate hikes in 2011 or 2012 seem unlikely unless the economy evolves very differently from our forecast. In terms of unconventional policy, it is complicated because the outlook for QE beyond June 2011 is cloudy. If growth at that point is decent but unspectacular, the unemployment rate hasn’t changed much, and inflation remains very low, further QE would still seem very sensible. Our forecast is therefore that Fed officials will keep buying until they reach a QE2 total of $1 trillion. Indeed, Chairman Bernanke confirmed in his “60 Minutes” interview this evening that additional purchases were “certainly possible.” However, it is quite a close call, not just because it depends on the data but also because of the political backlash. Fed officials view the benefit from QE2 as positive but not very large. A decision to buy more therefore requires that the costs not be too large either. If the cost in terms of threats to the Fed’s independence looks low when June 2011 rolls around, further asset purchases would probably still be worthwhile from their perspective. But if that cost looks high, Fed officials may decide to pass, even if they are still missing their mandate by a large margin.