Goldman's 10 Questions (And Answers) For 2011

It is only fitting that just minutes after we disclosed our skepticism about those who forecast future events in a centrally planned regime, either directly or rhetorically, we ran into Goldman's 10 questions for 2011: the firm to whom none other than Brian Sack is supposed to report. While everything else is mostly Koolaid, the only important thing according to Jan Hatzius, who minutes ago appeared on Tom Keene, is that he may still advise his underlying at the FRBNY Bill Dudley to press go on QE3. Full list below.

From Goldman's 10 Questions for 2011 (pdf)

  • We wish all our readers a happy, healthy, and prosperous 2011.  In the last US Economics Analyst of the year, we tackle what we believe are the 10 most important questions on the economic outlook for the next year.
  • For the first time in five years, our one-year-ahead forecast for real GDP growth is well above the published consensus.  The main reason is a slowdown in the pace of private sector deleveraging, which has become evident in a sharp improvement in the economic data despite the loss of growth support from fiscal policy and the inventory cycle.  The enactment of the fiscal compromise has also helped.
  • One sector that is unlikely to show much improvement yet is housing.  We expect prices to fall further and building activity to pick up only gradually.  We also expect little help, on net, from foreign trade, though the main reason for this is stronger growth in US demand.
    Contrary to consensus expectations, core inflation is unlikely to accelerate from current levels, which are the lowest in at least half a century.  Indeed, our central forecast is for a slight further slowdown in core inflation to just ½%.  Because of the huge amount of excess “slack” in the economy, tail risks remain tilted to deflation rather than inflation.
  • We now think that Fed officials will stop expanding their balance in June 2011, i.e. after the first $600 billion of “QE2.”  However, further purchases are possible if inflation falls further and/or the economy grows more slowly than we now expect.  In any case, we do not expect any funds rate hikes in 2011 (and for that matter in 2012).
  • Longer-term interest rates are likely to drift up modestly, but we do not share the widespread concern about a federal debt crisis.  The state and local crisis will linger, but we do not think it will be severe enough to derail the recovery.

In the last US Economics Analyst of the year, we tackle what we view as the 10 most important questions on the economic outlook for 2011:

1. Will we finally see a “real” economic recovery?

Yes.  For the first time in at least five years, our one-year-ahead GDP growth forecast is well above the published consensus, as shown in Exhibit 1.  It is also well above our estimate of the economy’s potential growth pace of 2¾%.

What has made us so much more optimistic?  Most importantly, a sharp improvement in the economic data.  As shown in Exhibit 2, “organic” GDP growth—that is, the change in real GDP excluding the effects of inventories and fiscal policy—is on track for about a 5% (annualized) pace in the fourth quarter of 2010.  This is the fastest organic growth pace since at least 2006.  It contrasts with the picture of a year ago, when real GDP grew sharply but essentially all of the growth was due to transitory factors.  We believe that
the main reason for the improvement is a slowdown in the pace of private sector deleveraging, via a decline in the private sector financial balance—the gap between the total income and total spending of households and businesses—from the exceptionally high levels reached at the end of the recession.

2. Will the housing market recover meaningfully?

No.  The housing market is the only major sector of the economy where the news over the past few months has failed to improve materially.  Indeed, it has gotten a bit worse, and we now expect house prices to fall another 5% during 2011.  The reason is the still-large excess supply, as we have only unwound about one-third of the pre-bubble increase in the homeowner vacancy rate so far (see Exhibit 3).

In contrast to prices, housing starts should rise in 2011, though not yet at a pace that we would label “meaningful.”  In the most overbuilt parts of the country, activity is so close to zero that further declines are almost mathematically impossible.  In markets without a large supply overhang, in contrast, building activity is likely to recover gradually alongside the labor market and the broader economy.
3. Will the trade deficit shrink substantially?

No.  In the next few months, the deficit is likely to narrow a bit further as inventory accumulation slows and the apparent seasonal adjustment distortions in the petroleum import data abate.  But over the year as a whole, a meaningful improvement is unlikely.  Exhibit 4 shows that strong domestic demand growth almost always widens the trade deficit.  The only exception in recent memory was the late 1980s, when the Fed’s real broad trade-weighted dollar index fell by nearly 30%.  While our foreign exchange strategists expect the dollar to depreciate against most major currencies, their forecast implies a trade-weighted drop of only about 5%, probably not enough to make a significant dent in the deficit when demand is strengthening.
4. Will the unemployment rate fall?

Yes.  We expect a decline to 9% by the end of 2011 and a further drop to 8¼% by the end of 2012.  As shown in Exhibit 5, the relationship between changes in real GDP and changes in the unemployment rate—known by economists as “Okun’s law”—remains as close as it ever was.  The chart suggests that growth in line with our forecast would almost certainly bring down the unemployment rate meaningfully, although the level will remain high for years.
5. Will inflation move back toward 2%?

No.  In contrast to both the Federal Reserve and the consensus of forecasters, we expect core inflation to stay well below 1%, and indeed see a small further drop to ½%.  The main reason is the still-large amount of slack in the economy.  For at least five decades, core inflation has never risen when the unemployment rate was above 8%, as shown in Exhibit 6.  That is obviously not a law of nature but nevertheless a neat illustration of the basic idea that the demand/supply balance matters for prices.  And it illustrates that the risks remain tilted toward deflation rather than higher inflation, although neither is our baseline forecast.

6. Will profit margins rise further?

Yes.  To be sure, margins are already quite high by historical standards.  Exhibit 7 shows that the ratio of after-tax economic profits to nominal GDP currently stands at 5.6%, somewhat above the historical average.  Eventually, a combination of higher labor costs, higher taxes, and slower top-line growth may well push margins back toward the historical norm.
In 2011, however, we expect profits to grow about 15%, more than three times as fast as nominal GDP, as top-line growth accelerates and the high level of unemployment keeps labor costs at bay.  The best macroeconomic predictor of changes in profit margins is the gap between price inflation and unit labor cost inflation.  As shown in Exhibit 8, this measure still points to an exceptionally favorable outlook for corporate profits.  Although the gap is set to shrink, we do not see it closing until well after 2011.
7. Will QE2 end on schedule, i.e., in June 2011 with total holdings of $600bn?

Yes.  Although Fed officials have promised to review the “QE2” purchase program regularly, an early end is unlikely barring a huge upside surprise in growth or inflation.  But what will happen after June?

Not too long ago, we thought that QE2 could total as much as $2 trillion.  But we have beaten a hasty retreat from this forecast.  If real GDP grows at a 3½%-4% pace in the first half of 2011, it is hard to see a sufficiently strong push from Chairman Bernanke and other senior FOMC members to overcome the opposition from several regional Fed bank presidents who never liked QE2 much in the first place.  Our forecast for 2011 looks quite similar to the Fed’s—in hindsight, overly optimistic—view in early 2010, when the committee was nowhere close to considering further monetary easing but instead discussed the timing of the eventual “exit.”

This does not mean that further QE is now out of the question.  If core inflation falls moderately further than we expect—say to 0% rather than ½%—Chairman Bernanke and others may press to keep buying after June to provide extra insurance against deflation.  At a minimum, this means the FOMC is unlikely to “close the door” to further QE next spring.

8. Will Fed officials start to “exit” from their current policy stance by raising the funds rate or shrinking their balance sheet?

No.  Once again, we are puzzled by the consensus among economic forecasters that rate hikes are right around the corner.  The most recent Blue Chip Financial Indicators survey provides a stark illustration.  Out of 40 institutions that supplied forecasts for the first quarter of 2012, only 9 predicted a federal funds rate of 0.2% or less, i.e. more than three-quarters thought that the funds rate would rise from the current level.

In our view, rate hikes by early 2012 are possible but quite unlikely.  This is partly because standard models suggest that the “warranted” funds rate will remain in negative territory for a much longer period.  As shown in Exhibit 9, our forward-looking version of the “Taylor rule” currently suggests that the first rate hike should not occur until the fourth quarter of 201

4.  Admittedly, this is too extreme as a prediction because it does not take into account the impact of unconventional monetary policy measures and/or the unusually loose stance of fiscal policy.  If we include these two factors (crudely) via our measure of the “overall macroeconomic policy stance,” the first rate hike is indicated in early 2013.  We readily admit that these types of calculations are far from precise, but the conclusion that it is difficult to justify hikes by early 2012 is fairly robust.

In any case, there are also more practical reasons to doubt that Fed officials will raise the funds rate (or sell assets) quite so soon.  There are several things that likely need to happen before the first rate hike.  First, Fed officials need to stop expanding their balance sheet.  Second, they need to stop reinvesting MBS paydowns in Treasury securities.  Third, they need to drop the “extended period” commitment from the FOMC statement.   Fourth, they may want to drain some of the excess reserves out of the banking system (although we do not believe that this is necessary).

Could all of these steps occur in time to allow for a rate hike in 2011 or early 2012?  Yes.  If inflationary pressure rose quickly, the financial markets would clamor for tighter policy, and Fed officials would of course move more quickly.  But this would require economic outcomes that we find quite unlikely.

9. Will the 10-year Treasury note yield end 2011 above the current level of 3.4%?

Yes.  We expect a moderate increase to 3¾% by the end of 2011 and 4¼% by the end of 2012.  The “Sudoku” model constructed by our rates strategy team suggests that the turn to above-trend growth in the United States coupled with continued strong momentum in the emerging world will outweigh the slight further decline in core inflation and translate into a gradual updrift in bond yields.  Partly based on the message from Sudoku, our strategists argued back in October that 10-year yields were bottoming.

But given the scale of the recent selloff we are not particularly bearish on bonds.  Although we forecast rising yields, the rise falls short of the forwards and therefore implies that investors would be a bit better off ex post investing in bonds rather than cash.

Why so tame an increase in rates?  Mainly because the inflation and credit fundamentals are likely to remain more benign than many market participants now think.  In particular, we do not expect a meaningful increase in concerns about a federal debt crisis.  The deficit is very large, and a credible plan for longer-term consolidation would be very beneficial for US economic performance.  But there is still a lot of room to maneuver for a government with the power to tax a $15 trillion economy whose debt service payments currently total just 1½% of GDP.

10. Will the state and local budget crisis derail the recovery?

No.  To be sure, the situation is unlikely to get better quickly.  State governments still need to cut spending and raise taxes to offset the loss of federal stimulus funds, and cities are likely to see their property tax base shrink in lagged response to the house price collapse—with property tax rates and other local fees likely to move up in many jurisdictions.  All told, state and local cutbacks are likely to shave around ½ percentage point from growth in the next year, a similar amount as in calendar 2010.
But there is also some good news.  Exhibit 10 shows that real state and local tax receipts are now rising at a solid pace.  If the economy recovers in 2011-2012 as we expect, this increase is likely to gather pace.  And while we cannot rule out a recurrence of high-profile budget crises in some cases, we do not expect them to cause a large tightening of broader US financial conditions or derail the economic recovery.

Jan Hatzius