GDP in Q2 was weak, risks are increasing
As in much of the country, the weather this summer here in southern Indiana has been hot and dry. It has relentlessly sucked the life out of things that grow, including the corn and bean crops. For different reasons, the same seems to have been happening to the economy. There have not been any dramatic shocks. Rather the pace of activity has just gradually decelerated, to the point that continued expansion is coming into question. This has been reflected in the evolution of our forecast, which has become progressively less optimistic. Three months ago, we anticipated real GDP growth for 2012 would be a mediocre 2.3%. In the current forecast that number is just 1.9%.
Monthly data have been generally consistent with an economy that has little forward momentum. Consumer confidence rose slightly in July, but followed four months of decrease. Auto sales in July were even with June at an annual rate just above 14 million. Except for a modest surge in February, they have been consistently at that level the entire year. As the GDP figures indicate, household consumption has been quite weak, with an actual decline in June. The weakness in spending has been associated with an increase in the saving rate (disposable income has shown adequate growth), another indication of household anxiety.
Both ISM indices moved slightly higher in July, but both remain down significantly from earlier in the year. The manufacturing index remains in negative territory.
After three months of acceptable job creation, the past five months have been very disheartening. During that period the private sector has added a monthly average of just 105 thousand jobs, less than half the 252 thousand rate of the previous three months. Government continues to reduce head count – at a rate of about 15 thousand per month. In July private employment rose by 172 thousand, while unemployment ticked up to 8.3%. The labor market remains a source of concern.
To summarize: The economic expansion slowed to a dangerously low rate in the first half of the year, with little indication of improvement in the most recent data. This raises a real possibility that we could slide back into recession, and renders any return to acceptable growth less probable.
The data reviewed above do nothing to relieve our apprehension about the outlook for the next year. Our estimate of growth in the current quarter is now 1.8%, which is about one-half percent below our prior forecast. We anticipate growth averaging just 2.1% over the next three quarters, and then 2.9% for the rest of the forecast period.
Consumption spending is subpar over the next three quarters, averaging growth of only 1.7%. The strongest part of the economy over the next year (and beyond) is residential construction. However, the shrunken size of this sector means that its contribution to overall growth is not large. The forecast has weak export growth over the rest of this year. This leads to some increase in the trade balance deficit, but in 2013 that trend reverses. Later in the forecast, the trade balance again rises, however. Inflation is below 2% through 2013. Unemployment ends this year above 8%.
There is a dip in the first quarter of next year due to the expiration of the payroll tax cut. This is the only component of the “fiscal cliff” that is included in the forecast. The (upwardly revised) federal deficit remains close to or above the trillion-dollar level through the forecast horizon. At the end of 2015 this represents 6% of GDP.
Our GDP forecast calls for slow improvement over the next few years. GDP dropped 3.1% in 2009 and rebounded 2.4% in 2010. Growth slowed in 2011 to just 1.8%. We expect to see a small improvement in growth to 2.2% in 2012 with further gains of 2.4% in 2013 and 2.8% in 2014. All three years of this forecast are below the historical average for the U.S. economy.
NOTE: Prior GDP data was revised by the BEA this month.
The U.S. economy is paying the price for close to a decade of ineffective, and even counter-productive, policy. Both monetary and fiscal policy bear large portions of blame, and in both cases a central problem has been a focus on recreating pre-recession conditions.
A decade ago, monetary policy remained far too easy due to worry about the slow recovery from the 2001 recession. This provided the fuel for an asset bubble, which (aided by a misguided policy push for universal home-ownership) turned out to be in housing. When that bubble collapsed, the initial crisis response to avert total financial collapse was necessary and arguably effective.
But policy since the crisis has been the opposite. The bubble collapse left the economy with three fundamental problems. First, a housing sector that had grown far larger than was sustainable. Second, a household sector whose balance sheet had been cut to shreds. Third, a government sector (especially at the local level) that had grown to reflect a bubble inflated revenue base that had collapsed.
Policy since the crisis has been aimed at trying to recreate the economic configuration prior to the crash – a strong housing sector, strong consumption, growing (at least not shrinking) government. All to be achieved via short-term stimulus to “jump start” the economy. So we got temporary subsidies for home buyers, Cash-for-Clunkers, temporary tax cuts, temporary assistance for local governments, historically unheard of low interest rates, quantitative easing. And an economy that is unable to even match its long-run potential, let alone stage any meaningful recovery.
The economy needs and wants to shift away from debt and consumption toward saving and investment. Policy is trying to force it to do the opposite – fiscal programs that encourage consumption; monetary policy that punishes savers.
At this point I see little likelihood that this dismal situation will change soon. That means that the current subpar economic performance will continue. If nothing really bad (e.g. Euro collapse, oil crisis, fiscal cliff) happens the economy should avoid sliding back into recession. But for the next year, we are most likely stuck with growth in the 2-2.5% range contained in our baseline forecast. There is some upside potential (hope springs eternal), but in the present context “strong growth” means only something approaching 3%.
The advance release of second quarter National Income and Product Account data was, as expected, depressing. [Along with the second quarter data, the BEA also released benchmark revisions of earlier data.] Growth in total output was estimated to have been only 1.5%, just two-thirds of the 2.2% in last month’s forecast. The prime movers in the poor number were consumption of goods, which came in nearly flat from the first quarter, and government spending, which declined significantly (again). Also troublesome was that inventory accumulation accounted for about 0.3% of the growth (that is, final sales rose only 1.2%). On the positive side, business investment was strong and above our May forecast, while residential investment was strong although a little below our expectation. Exports also held up, in spite of the difficulties in Europe. Still, the bottom line is that the economy was very close to stall speed in the second quarter.
Looking back at the past year is also disheartening, with growth of just 2.2%. Sadly, this too was not unexpected – our forecast of a year ago was for growth of 2.4%, although we expected to see some acceleration as the year progressed. In terms of components, the major surprises were construction (both business and residential), which was far stronger than we anticipated, and government spending, which fell more than we had forecast.
The risks to the downside have certainly increased as of late. Our baseline forecast is that the U.S. economy will continue to muddle through the next year. The downside represents mainly the possibility of a negative shock – there is currently no indication of a specific industry or event that would lead to a better economic outcome.
We assign a probability to the main economic scenarios to highlight where your concerns and efforts should be most concentrated. Once more, our downside potential increased this month at the expense of the base forecast. The possibility of a recession is now a reasonable outcome. We are still confident in our moderate growth outlook for 2012, but the headwinds continue to gather additional steam. Below are our current thoughts. Note that there is now a greater than 1-in-4 chance of seeing slower growth:
• Stronger Growth (GDP better than 3%): 10% probability
• Current Forecast (GDP between 2% – 3%): 50% probability
• No Growth (GDP under 1%): 25% probability
• Recession (GDP under 0%): 15% probability