Here comes the kitchen sink: just in case there was a chance the Fed's historic disclosure had a chance of pushing the market lower, almost to the dot at noon Goldman has completely sold out and has released a surprising (in its own words) report, changing its outlook on the US economy from bearish to bullish. Goldman's take on the dramatic nature of its perception shift: "This outlook represents a fundamental shift in the thinking that has governed our forecast for at least the last five years... Five years ago, we became very pessimistic about the US economic outlook. This was because we expected downturns in the housing and mortgage markets to trigger a substantial increase in the private sector financial balance—the gap between the total income and total spending of US households and businesses. In turn, we thought this weakening in private-sector demand would cause an economic slowdown as the government and foreign sectors failed to take up the slack. So why do we now expect growth to pick up? In a nutshell, it is because underlying demand has strengthened significantly, as shown in Exhibit 3. This chart plots the growth rate of real GDP (dark line) alongside the growth rate of underlying demand (light line). After a deep downturn from 2007 to mid-2009 and near-stagnation from mid-2009 to mid-2010, underlying demand is now accelerating sharply. Currently, it is on track for a 5% (annualized) growth rate in the fourth quarter." Much more hopium inside. This is unfortunate. Jan Hatzius used to have credibility.
From the just distributed email to clients:
- The US growth outlook has brightened significantly in recent weeks. As a result, we have raised our sights for 2011, calling for real GDP growth to average 2.7% for the year versus 2.0% previously. We expect growth to pick up further in 2012—to 3.6% on average for the year—though judgments that far out are clearly tentative.
- The main reason: recent data reveal a firmer trend in domestic final demand and suggest that it will be sustained via improvements in net hiring and credit availability. Meanwhile, the downside risk of a material tightening in federal fiscal policy—i.e., failure to extend expiring tax cuts—has diminished significantly.
- Although our revised outlook implies a meaningful drop in the jobless rate, it will remain high by historical standards, ending 2012 at about 8½%. With other measures of utilization also likely to show significant excess capacity, we expect core inflation to remain at the ½% year-to-year rate in 2012 that we have been forecasting for year-end 2011.
- In turn, this means that the Federal Open Market Committee (FOMC) is unlikely to increase the federal funds rate in 2011 and will probably stay on hold in 2012 as well. The future of unconventional easing is a much closer call. On balance, we think that Fed officials will buy more assets after the $600bn already committed. But we have scaled back our cumulative expectation for QE2 to $1trn from $2trn, and it is also possible that the program will end at $600bn.
- Risks exist on both sides. On the downside, we worry most that renewed home price declines—now expected to fall 5% or a bit more over the next year—will cause another round of consumer retrenchment; risks of a financial spillover from European debt woes and of significant fiscal tightening at home also lurk. On the upside: cash-rich companies may be more willing to spend on capital equipment or to expand payrolls than we now anticipate.
The US growth outlook has brightened significantly in recent weeks. As a
result, in conjunction with revisions and extensions of our global
outlook into 2012 being published today, we have upgraded our US view,
as detailed in Exhibit 1 below. In particular:
1. We have raised our sights for US growth in 2011 and expect further acceleration in real GDP in 2012. Specifically, our revised view calls for growth to remain at last quarter’s 2.5% annual rate through early 2011 and then increase over the next year to a 4% annual rate. On an annual average basis, we now expect real GDP to increase 2.7% (annual average basis) in 2011, versus 2.0% previously, and to increase 3.6% in 2012. These changes put us slightly above the latest Blue Chip median for 2011 (2.5% in early November) and—we suspect—above the median for 2012, to be published in January.
2. As a result, we now expect the jobless rate to fall to about 8½% by year-end 2012. This is implied by Okun’s law on the assumption that potential growth is currently about 2½%. (Okun’s law—which is really a rule of thumb that fits the data quite well—states that the unemployment rate will fall by half the difference between actual and potential growth over a one-year period.). Most of this decline occurs in 2012; over the four quarters of 2011 we expect only a marginal reduction from the current 9.6% rate, to about 9¼%.
3. Core inflation should remain low, at about ½% (year-to-year), through 2012. At 0.6% as of October, the CPI core inflation rate has nearly reached this point already, well ahead of schedule. The core price index for personal consumption expenditures (core PCE index) has a bit more to go, but is also clearly decelerating. Although we expect growth to rise materially above its potential rate over the next two years, the US economy will still be operating with considerable slack throughout the period—in the labor market and in other productive resources. This should keep core inflation from rising, while stable expectations of inflation keep it from falling below zero.
4. Monetary policy will remain highly accommodative. With the unemployment and core inflation rates continuing to run much weaker than their “mandate-consistent” levels (5%-6% for the jobless rate; just under 2% for inflation) throughout the forecast period, increases in interest rates are highly unlikely in 2011 and, we think, also in 2012. The outlook for LSAPs is less clear, as strong growth will stiffen the resistance from some members of the FOMC to extend this policy while large shortfalls vis-à-vis the committee’s employment and inflation objectives prompt others to press for more. On balance, we expect more LSAPs, but cumulating only to $1trn (versus $2trn previously), and we are not very confident of this call.
This outlook represents a fundamental shift in the thinking that has governed our forecast for at least the last five years. Accordingly, a short review of the evolution of that thinking will help set the stage for what has now changed:
Five years ago, we became very pessimistic about the US economic outlook. This was because we expected downturns in the housing and mortgage markets to trigger a substantial increase in the private sector financial balance—the gap between the total income and total spending of US households and businesses. In turn, we thought this weakening in private-sector demand would cause an economic slowdown as the government and foreign sectors failed to take up the slack.
(As a matter of accounting, the financial balances of the private, public, and foreign sectors must sum to zero, as all spending generates an equivalent amount of income. However, as a matter of intention this identity need not hold. In the short run, differences between intentions and actual outcomes are resolved by unintended movements in inventory investment, one component of private-sector spending. Over time, the differences are resolved by shifts in production—up if intended spending exceeds income, thereby causing inventory investment to fall short of the desired rate, and down in the opposite situation.)
Over the following three years, the private-sector balance rose sharply, as shown in Exhibit 2. The 12.5-point move from -3.9% of GDP in mid-2006 to +8.6% in mid-2009 triggered the deepest recession in post World War II US history.
In 2009, the private-sector surplus began to shrink. However, we maintained a below-consensus view, predicting that real GDP growth would slow to a below-trend pace during 2010. We reasoned that the incipient reversal in the private-sector balance and the upswing in GDP it produced were due to temporary factors—namely, the fiscal stimulus enacted in February 2009 and the positive inventory cycle, which probably would not have kicked in without the strong growth support from fiscal (and monetary) stimulus. With underlying final demand—i.e., the growth in GDP less the fiscal and inventory effects—still stagnant, we thought the US economy would slow during 2010, as indeed it did.
So why do we now expect growth to pick up? In a nutshell, it is because underlying demand has strengthened significantly, as shown in Exhibit 3. This chart plots the growth rate of real GDP (dark line) alongside the growth rate of underlying demand (light line). After a deep downturn from 2007 to mid-2009 and near-stagnation from mid-2009 to mid-2010, underlying demand is now accelerating sharply. Currently, it is on track for a 5% (annualized) growth rate in the fourth quarter.
Why such a sharp acceleration? Our explanation is that the pace of private-sector deleveraging is slowing in an environment of somewhat lower debt/income ratios, improving credit quality, and moderating lending standards. In turn, the rise in spending relative to income is starting to generate positive multiplier effects via a stronger labor market, and this is feeding back into stronger income growth. Thus, we have also seen a notable improvement in jobless claims and (at least through October) in nonfarm payrolls.
At the same time, one downside risk has diminished significantly. Although Congress has yet to enact a formal extension of the tax cuts scheduled to expire at the end of this month, both parties seem anxious to avoid the renewed downturn in economic activity that would likely occur if most of these cuts were not extended. Meanwhile, state income and sales tax revenues are now on the rise; this may reduce the fiscal restraint imposed by this sector as it begins its next budget round in the spring.
In short, the improved tone of the US economic data has convinced us that the partial reversal of the 2006-2009 private-sector retrenchment that began in 2009 has evolved into a more durable trend. To borrow Chairman Bernanke’s metaphor, the hand-off from policy stimulus to private demand—which seemed elusive just a couple of months ago—now appears to be developing. Over the next two years we now expect the private-sector balance to fall from +6.5% in the third quarter of 2010 to 4.5% in the fourth quarter of 2012.
As we adopt a more constructive view of US growth prospects, it is important to emphasize what we are not saying:
1. We are not saying the US economy is about to embark on a V-shaped recovery. For one thing, it’s a bit late for that, given that recovery is more than a year old. More importantly, we believe that the drags from reduced inventory investment and fiscal tightening will keep real GDP growth at a moderate pace of 2½% in the next couple of quarters. And even the 4% growth pace that we expect for much of 2012 is quite moderate relative to typical postwar recoveries.
2. We are not saying that deleveraging is over. We still expect private-sector debt/income ratios to decline further. But it is the pace of deleveraging—which corresponds to the level of the private sector balance—that matters for GDP. As the pace of deleveraging slows, the private sector balance falls, and this implies a positive impulse to GDP growth.
3. We are not saying that US housing prospects have improved materially. The residential real estate market still sits under an enormous overhang of unoccupied units. As a result, home prices have weakened after the temporary lift provided by the homebuyer tax credit, and sales of new units remain depressed. Under these circumstances, builders are apt to see only tepid growth in activity.
4. We are not saying that the economy will feel good from a “Main Street” perspective. As already noted, we only expect a gradual decline in unemployment as growth moves above trend, to 9¼% by the end of 2011 and 8½% by the end of 2012. This is still very high by any absolute standard and far above our 5½% estimate of the structural unemployment rate.
With so much slack in the system, inflation is likely to stay well below the Fed’s “mandate-consistent” level of just under 2%, as noted above. This implies that Fed officials will continue to miss both parts of their dual mandate by large margins, and are apt to keep monetary policy very accommodative as a result. Even with our new forecasts, and even if we take into account the quantitative and fiscal policy easing that has already occurred, our analysis of the Fed’s reaction function implies that rate hikes are very unlikely in 2011 and—based on our economic forecasts—will probably not occur in 2012 either.
The future of LSAPs is a much closer call. Barring very large surprises in the economic data, we are convinced that Fed officials will complete their $600bn purchase program. But the pickup in growth and the backlash against this program, both at home and abroad have made us more uncertain about further purchases beyond June. On balance, we think that Fed officials will still buy more, pushing the total amount up to perhaps $1 trillion. But it is also possible that LSAPs will end at $600bn.
Like any forecast, this one has risks on both sides. On the downside, the risk that worries us most is the potential for a significant renewed drop in home prices to trigger another round of consumer retrenchment. We have been estimating that prices would drop only 2½%-3½% over the next couple of years, but as the passage of time allows us to pin down the effects of the homebuyer tax credit more precisely, we now estimate that prices could drop 5% or a bit more over the next year. This still looks manageable, but sharper declines could change the picture fairly quickly.
The risk that currently worries markets the most is the potential for contagion from the European debt crisis. We agree that the US economy is vulnerable to these events, but probably only if it affects financial conditions via a materially stronger dollar, lower equity prices, and/or renewed stress in the interbank lending market. Finally, although prospects of a fiscal accident at home have diminished significantly, they have not disappeared altogether. Stalemate in Washington would pose an obvious, and large, risk to the near-term growth outlook.
On the upside, the main risk is that we have misjudged companies’ willingness to spend, either on physical capital or to expand their workforces. In terms of capital spending, outlays for equipment and software have risen much more over the past year than we had anticipated. Much of this appears to be a short replacement cycle for high-tech equipment, and we therefore expect some slowing in the near term as the replacement cycle winds down and utilization rates for other equipment and for structures remain low. But with private demand now picking up steam, cash-rich companies may surprise us by expanding or modernizing productive capacity more aggressively. They could also hire more permanent workers than we now expect.
It is also conceivable that the fiscal negotiations currently underway between the Obama administration and the Republican congressional leadership produce unexpected growth-positive outcomes. A payroll tax holiday is one commonly mentioned measure, and unemployment benefits could also be extended for longer than the three months we now anticipate.