Goldman's Ten Questions For 2010

One of the great paradoxes of life is that the smarter one is, the better one realizes just how little one knows. The same thing is  true with forecasts: one can hypothesize and conjecture, but if one is unlucky, one is screwed: no matter how thought out, error-proof or logical the narrative - it is the unpredictable events that ultimately shape events, not the "priced in" obvious factors. The Heisenberg Uncertainty Principle applies in a perverse fashion not only to the wave-particle duality in the quantum realm, but to the very underpinning of economics: by predicting the future we implicitly change it. The futility of forecasts is well known to all those, who with the exception of a several few, whose very existence is an economy of scale "strange attractor" (think Warren Buffett and Goldman Sachs), have tried to repeat a winning performance, be it based on fundamentals, technicals, or kangaroo entrails. It is also sufficiently useless to the point where we will spare you a Zero Hedge set of observations of what to expect: if you have been reading this blog, you know what we believe is relevant as we enter 2010. How it will all pan out, however, is a totally different story. It is therefore not too ironic, and somewhat fitting, that Goldman Sachs' chief economists do not leave 2009 with a dogmatic set of forecasts, which, just like every other year would have the success rate of a coin toss, but with 10 key questions addressed exactly one year into the future. Here are Goldman's 10 Questions for December 31, 2010.


Our forecast for 2010 features sluggish GDP growth, employment gains that are too slow to prevent a further modest increase in the unemployment rate, low (and probably falling) core inflation, and a Federal Reserve that “exits” from some unconventional monetary policies but keeps the funds rate at its current near-zero level.  For the last US Economics Analyst of the year, we try to answer what we think are the 10 most important questions for 2010.

1. Have house prices bottomed?

Probably not yet, but we are quite uncertain.  Although US homes are no longer significantly overvalued, we believe that much of the increase in prices over the past six months has been due to three temporary factors: a) the homebuyer tax credit, which has been extended into 2010 but is likely to be less powerful in boosting demand than it was when first introduced in 2009; b) the Fed’s purchases of mortgage-backed securities, which have pushed down mortgage rates but are slated to end in early 2010; and c) the temporary mortgage modifications through the Obama administration’s Home Affordable Mortgage Program (HAMP), only a relatively small portion of which seem to be turning into permanent modifications.  These factors suggest that home prices are at risk of declining anew, and our working assumption is a renewed 5%-10% cumulative drop in the national Case-Shiller index through 2010.

Indeed, there are some early signs that home prices are starting to fall again.  In particular, the Loan Performance home price index fell more than ½% in both September and October.  The S&P/Case-Shiller index, which is based on three-month moving averages, remained positive in these months but the gains were smaller—averaging just over ¼% versus more than ¾% in the preceding three months—suggesting that spot observations are turning negative.

2. Will banks become more willing to lend?

Probably yes, but at a pace that is only consistent with subdued spending growth.  In thinking about banks’ willingness to lend, it is important to distinguish between levels and rates of change.  Conceptually, it is the change in lending standards that should affect the change in consumption, capital spending, or GDP.  Exhibit 1 shows this is what we observe in the data.

The concern in the current recovery is that the very sharp tightening of lending standards during the recession is giving way only very gradually to an easing during the recovery.  As of the fourth quarter of 2009, standards for both consumer and business loans are still being tightened modestly.

The combination of sharp tightening followed by gradual normalization puts the current cycle in a category of its own.  Exhibit 2 illustrates this by plotting the net percentage of banks professing greater willingness to lend to consumers through each business cycle since 1966.   On the one hand, it shows that the recession phase of the current cycle was similar to those of 1969-70, 1973-75, and 1980-82.  Each featured a large cumulative decline in willingness to lend before and/or during the recession (the dark line, like the shaded area, is consistently below the horizontal axis).  On the other hand, the current recovery so far looks much more similar to the recoveries from the 1990-91 and 2001 recessions, in which banks tightened credit standards modestly after not having tightened them much at all during the preceding downturns.  If this persists, it would be one important reason to believe that the frequently noted correlation between deep recessions and vigorous recoveries may break down in the current cycle.

One reason to expect this credit restraint to persist is that there is an important structural difference between the credit crunches of the 1970s and early 1980s and that of 2007-09.  The 1970s/early 1980s crunches were primarily due to very tight Fed policy that was aimed at bringing inflation down from high levels in the late stage of the preceding expansion.  Once inflation had started to come down, the Fed cut interest rates, the pressure on the banking system abated, and banks quickly normalized their lending standards.  In contrast, the 2007-09 crunch was due to large-scale credit losses rather than tight Fed policy.  It takes much longer for banks to recognize and absorb these losses than it takes for the Fed to normalize interest rates.  This is an important reason why the recovery from the deep 2007-09 recession is likely to be substantially weaker than the recoveries from the deep 1973-75 and 1981-82 recessions.

3. Will small business activity pick up?

It should, but so far we are not seeing it.  We have been quite concerned about the implications of the weakness in the small business sector.  Since small firms aren’t as well captured in the economic statistics as larger firms, their weak performance may mean that standard economic indicators currently overestimate growth in economic activity.

Assuming that the relative weakness of small firms reflects the difficulty of obtaining credit from banks compared with capital markets, rising willingness to lend should lead at least to a gradual pickup in small business growth.  But so far, we have seen even less improvement than one would expect based on the declining pace of credit tightening.  This is illustrated in Exhibit 3, which plots the change in banks’ credit standards for small business loans against the small business optimism index compiled by the National Federation of Independent Business (NFIB).  Although standards are now being tightened much more slowly than before, the NFIB is still mired in deeply recessionary territory.

4. Will hiring revive?

Yes, but we expect the rate of job creation to reach only about 100,000 per month by the second quarter, not enough to push the unemployment rate down in a meaningful way.
Some analysts argue that US businesses cut jobs more aggressively during the recession than was warranted by the decline in output out of fear that the downturn would be even more severe.  If this were true, it might suggest that employment would rebound more sharply than suggested by the cumulative growth of real GDP from the business cycle trough.

But the evidence for the “excess layoffs” hypothesis is weak.  The simplest way to see this is to look at Exhibit 4, which plots nonfarm payrolls against real GDP.  (The payroll data are adjusted to incorporate the preliminary benchmark revision of -824,000 for March 2009, announced in October 2009.)  Visually, the relationship looks similar to the prior two cycles, although both series have of course dropped more sharply in the current cycle.  Indeed, a slightly more sophisticated analysis that looks at the relationship between GDP and either the unemployment rate or nonfarm payrolls comes to the same conclusion.

Indeed, it seems more likely that companies will hire fewer workers per dollar of additional GDP than in the average recovery of the postwar period.  This would be in keeping with our Brave New Business Cycle research, which says that greater competitive pressures since the 1980s have made companies more cautious in their hiring, capital spending, and inventory management.  In the two “jobless” recoveries since then, it took significantly more GDP growth to achieve the same amount of payroll growth than in prior recoveries.  Moreover, Exhibit 5 shows that the same is true for the current recovery, at least so far.

5. Does the saving rate have further to rise?

Yes, we think so.  The current saving rate of just over 4% remains below the 6%-10% range that we estimate is needed to stabilize the ratio of household net worth to disposable income in a “normal” environment for capital gains on existing assets.  This is admittedly a very long-term perspective.  But in addition, the current level of household net worth also seems to imply an increase in the saving rate on simple short-term “wealth effect” grounds.  Hence, we project a gradual increase to around 6% by the end of 2011.

 The main reason why we see only a very slow increase is the weakness in household income growth.  Household debt is already contracting sharply, so an increase in saving would need to reflect a pickup in gross saving—i.e. purchases of financial and physical assets—from its current, depressed level.  This will be difficult for households to accomplish if income growth remains anemic.

6. Will inflation fall further?

Very likely yes, at least as far as the “core” indexes are concerned.  As we demonstrated in a comprehensive study recently, “slack” is the best predictor of inflation both at the aggregate level and in individual sectors of the economy.   Moreover, Exhibit 6 shows that slack is pervasive throughout the economy, not just in the well known data on unemployment and industrial capacity utilization.

 One particular area in which slack could put significant further downward pressure on inflation is actual and imputed rents.  There is a clear inverse relationship between the rental vacancy rate and the pace of rent inflation.  With rental vacancies at a record, we expect further significant declines in year-on-year rent inflation into negative territory.

7. Does the dollar pose an inflation risk?

Only to a very limited degree.  For one thing, the dollar just isn’t that weak—and that was even true prior to the most recent round of risk reduction.  It has certainly depreciated substantially over the past nine months, but we view this as the flip side of the normalization that has taken place in global financial markets.  Indeed, according to the Fed’s broad trade-weighted index, the dollar currently is slightly stronger than the average of the past two years.

Moreover, the currency is less important to inflation in the United States than elsewhere given the relatively small size of the trade sector.  Thus, while Fed officials certainly take account of its impact on financial conditions, the impact of currency changes on inflation, in particular, is quite minor.  A common rule of thumb is that a 10% depreciation in the trade-weighted dollar raises the level of the CPI by just ¼%.  So it would take a very large depreciation indeed to start ringing alarm bells about imported inflation.

8. Will Congress pass more fiscal stimulus?

Yes.  Beyond the extension of the homebuyer tax credit (and other tax relief measures) enacted in early November, the Congress has passed and the president has signed a two-month extension of unemployment benefits.  More is coming as the House has passed a much larger bill providing additional unemployment insurance (four more months) as well as more aid to states, and more infrastructure spending.  The Senate is likely to follow suit early next year, and the ultimate legislation may well include provisions such as a hiring tax credit and/or extended bonus depreciation for companies.

But even with these likely measures, the boost from fiscal policy to real GDP growth is likely to decline in the first half and vanish (or even reverse) in the second half of 2010.  This is because it is the change in spending and taxes that governs the impact of fiscal policy on real GDP growth.  Even with the latest round of packages—worth about $200bn altogether—the change will not be nearly as positive as it was in the wake of the $787bn package enacted almost a year ago.  Indeed, Exhibit 7 illustrates that the longer-term perspective is one of gradual fiscal restraint, though this is mostly an issue for 2011 and beyond.

9. How will the Fed “sequence the exit”?

In theory, Fed officials have four choices for “exiting” from their current, highly accommodative stance: (1) terminating the current program of asset purchases, (2) draining excess bank reserves via reverse repos and/or term deposit facilities, (3) hiking short-term rates via parallel increases in the federal funds rate and the interest rate on reserves (IOR), and (4) selling assets outright.

In 2010, the main form of “exit” is likely to be an end to asset purchases.  In addition, Fed officials will probably drain some excess reserves, mainly in order to prove to market participants that they are capable of doing so.   In contrast, we expect neither a hike in the funds rate nor outright sales of assets on the Fed’s balance sheet in 2010 (or for that matter in 2011).

10. Will the end to the asset purchases tighten financial conditions?

Possibly, although the degree is highly uncertain.  Over the past 12 months, the Fed has bought a net $1.3 trillion in Treasury coupon debt, agency debt, and agency mortgage-backed securities, about three-quarters of the total amount of net issuance in these markets.  These purchases are already diminishing and will likely stop by the end of the first quarter, while net issuance is likely to remain at levels similar to the recent pace through 2010.  This means that non-Fed buyers will need to absorb a far greater amount of “flow supply” of securities.

This could put upward pressure on long-term interest rates.  But two points are worth noting.  First, our bond strategists’ models do not find any misvaluation of US Treasury yields at present.  If this means that the asset purchases didn’t have a dramatic impact on the level of yields, it would suggest that end of the purchases might also not have a significant effect. Second, and presumably related to this, the policy shift away from asset purchases has been very well flagged and there are plenty of market participants who have a much darker view of the outlook for federal solvency than we do.  For this reason, a sizable short base in the rates markets has been established in anticipation of the end to the Fed’s purchases.  This means that much of the impact may already be discounted in the current level of interest rates.