The economic mood at 200 West has officially downshifted. In a report by Jan Hatzius, the Goldman chief economist warns that "the second half slowdown has begun." Hatzius says: "This is consistent with our long-standing forecast of materially slower growth of just 1½% (annualized) in the second half of 2010." And while the contraction has been obvious to all those without a metric ton of wool in front of their eyes, the two indicators that have broken Goldman's will were this week's NFP and ISM reports. And not only that, but Hatzius is now firmly in the Krugman camp, blaring an even louder warning that should the government cut off the fiscal subsidy spigot "there is some downside risk to our forecast of a gradual reacceleration in 2011 (to about 3% on a Q4/Q4 basis)." In other words, not only will H2 GDP officially suck, but since Goldman has now officially jumped on the Keynesian gravy train, and as Goldman has rapidly become the best contrarian indicator in the world (we can't wait for David Kostin to realize that endless economic stimulus, GDP and corporate profits are, gasp, related), it likely means that Obama will not allow for even $1 dollar of extra unemployment subsidies or state bailouts just to spite Goldman.
The economic data have weakened noticeably over the past few weeks. This is consistent with our longstanding forecast of materially slower growth of just 1½% (annualized) in the second half of 2010. This forecast is based on a very simple idea, namely that final demand growth has remained at just 1½% since the middle of 2009. There is little reason to expect a significant acceleration, and the inventory cycle is ending. All this is illustrated in Exhibit 1, which shows the growth rate of real GDP, the growth rate of real final demand, and the contribution of inventories to growth (the difference between the two).
Manufacturing Starts to Slow…
One implication of our story as illustrated in Exhibit 1 is that the slowdown should be concentrated in the goods-producing sector, which previously enjoyed a disproportionate boost from the inventory cycle. This implies a significant decline in measures of factory growth such as the ISM manufacturing index. Historical experience would point to a drop to around 50 by early 2011.1 The drop in the index from 59.7 in May to 56.2 in June-?much of which was due to a sharp decline in the new orders index from 65.7 to 58.5?is the first significant step on this path.
The June employment report also points to a meaningful factory slowdown. While manufacturing payrolls logged another (small) gain, the manufacturing workweek fell by ½ hour, as shown in Exhibit 2. This is a very big drop by historical standards?in the 4th percentile of month-to-month changes using data that go back to 1936. This may be a sign that the manufacturing sector may be losing steam even more quickly than suggested by the June ISM report.
…and the Labor Market Softened in June
Even beyond manufacturing, the June employment report was weak. This was most obvious in the household survey, where the drop in the unemployment rate from 9.7% to 9.5% was entirely due to a big decline in the labor force. A more accurate gauge is the decline in the employment/population ratio from 58.8% in April to 58.7% in May and then to 58.5% in June, shown in Exhibit 3. (We note the April number in order to illustrate that the weakness cannot just be explained by Census-related ups and downs?after all, the level of Census employment was higher in June than in April.)
But the establishment survey was also soft, despite a near-consensus increase of 83,000 in private sector employment. This number not only falls short of the pace ultimately needed to stabilize the unemployment rate, but it probably overstates the true increase in private labor demand because it probably benefited from the switch of Census workers whose contract has ended into similar private-sector work such as leisure and hospitality or temporary help services. This illustrates that the labor market is still far from ?escape velocity??gains in employment that feed into an income growth pace sufficient to overcome the headwinds from the withdrawal of the temporary inventory and fiscal boosts.
And here is the part that comes straight out of the fundamentalist Keynesian textbook:
The Risk of Fiscal Restraint
For the most part, we view the recent data as signaling that the economy is indeed slowing significantly as we enter the second half of the year, in line with our forecast. While there are risks of a sharper slowdown, the distribution of these risks still seems broadly balanced. In other words, a weaker outcome is clearly possible, but there is also some chance that the recent weakness in the numbers reflects partly noise and the slowdown ends up somewhat less serious than our forecast.
However, the distribution of risks around our forecast of a gradual reacceleration in 2011 to a Q4/Q4 pace of around 3% is tilted to the downside. The main reason for this is not so much the data, but the shift in the fiscal policy risks. As shown in Exhibit 4, we already estimate the impact of fiscal policy on the growth rate of final demand (and GDP) to turn gradually negative in 2011. But even these forecasts are based on the expectation that Congress will ultimately extend all of the Bush tax cuts except for the top two brackets, provide more funds for extended unemployment insurance, and make additional transfers to state governments. While we still believe that most of these provisions should ultimately pass, the risk that some of them?most likely the aid to state government?will fail to materialize have clearly increased in recent months.
For now, we are not making any changes to our growth forecasts. However, we will evaluate developments both in Congress and in the US economic data closely over the next few weeks to see whether any adjustments are warranted.
For all those who are keeping their fingers crossed for a few extra trillion in fiscal stimulus to kick the can down the street with no actual changes ever occurring (which is exactly what happened the last time there was a massive fiscal stimulus, and the time before, etc), we would like to quote Lieutenant Ripley: "happy to disappoint you." Of course, monetary stimuli are a different matter altogether, and we are confident that in the absence of the fiscal piggybank, the Fed will have no choice but to further destabilize trust in the currency via QE 2-X. And remember - hyperinflation is ultimately not a pricing phenomenon, it is one driven by faith in the currency. Or lack thereof.