Friday, March 26, 2010

"The Bipolar Economy," UCLA Anderson Forecast, March 2010

The economy seems to be suffering from a bipolar disorder. For example since 1985 there have been 15 quarters where real GDP expanded by 5% or more including the 5.9% gain in fourth quarter. In every one of them, except for the fourth quarter of 2009, payroll employment typically expanded on the order of a 2-3% annual rate. In contrast employment contracted at an annual rate of 1.3% in the fourth quarter. Unfortunately the closest comparable was during the “jobless” recovery of 2003 where in the third quarter of that year real GDP grew by 6.9% and payroll employment increased at 0.1% crawl. In economics terms “Okun’s Law,” which defines a relationship between GDP growth and unemployment, appears to have broken down as gains in productivity swamped the employment effects of a growing GDP.[i]

Ironically the sluggish growth in payrolls could be an unintended side effect of all of the economic medication coming from fiscal and monetary policy. The stimulus seems to working its effect on GDP and temporary hiring, but make no mistake the follow through to a sustained expansion in employment has been disappointing. After all long term hiring decisions are not generally based on temporary tax and spending programs coupled with a non-sustainable zero interest rate policy. In addition all of the policy uncertainty coming out Washington has made more difficult for businesses to ascertain their long term cost structures. Nevertheless the economy is now on growth path and employment will soon be increasing, albeit modestly.

After a stunning inventory-led 5.9% increase in real GDP in the fourth quarter, we expect the economy to grow at a 3.2% rate in the current quarter and continue to grow at a 2%+ rate for the remainder of the year. (See Figures 1 and 2) Moreover real GDP is forecast to grow at a 2.3% and 3.2% pace in 2011 and 2012, respectively. However, in keeping with our bipolar disorder thesis unemployment will remain high throughout the forecast period. We forecast that the unemployment rate will be 9.6% at the end of 2010, just a tad lower than where it is today and 9.1% at the end of 2011. (See Figure 3) Why? Simply put employment growth will struggle to stay barely ahead of labor force growth. Furthermore, with the modest employment growth we are forecasting, payroll employment will still be two million jobs below its peak in 2007 by the end of 2012! (See Figure 4) Even after creating about 200,000 jobs a month in 2011, the economy will find it very difficult to climb out of the 8.4 million lost job hole it dug for itself.

Figure 1. Real Inventory Change, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 2. Real GDP Growth, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2005Q1- 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4. Payroll Employment, 2005Q1 – 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

The Basis for Recovery

The recovery we envision is based on strength in business equipment and software, exports, and a revival in home construction from its postwar nadir to a more normal level of housing starts. (See Figures 5, 6 and 7) With the exception of housing all of these forces are now in train.

Figure 5. Real Equipment and Software Spending, 2005Q1-2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Exports, 2005Q1 – 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 7. Housing Starts, 2005Q1 – 2012Q4

Source: Bureau of the Census and UCLA Anderson Forecast

Growth will be held back by declines in nonresidential construction and the hitherto resistant state and local government sector. (See Figures 8 and 9) Nonresidential construction is suffering from weak demand and the after effects of the credit crisis. As is typical for most cycles nonresidential construction lags the overall economy. Thus we expect to witness a recovery here starting in the second half of 2011.

In contrast the ongoing restructuring of state and local government represents a fundamental structural adjustment. Something more than the recession is at work. The era of public employment and compensation well exceeding private sector averages is coming to an end. Further exacerbating the situation is the trillion dollar underfunding of state and local pension plans.[ii] A gap that will be closed by a combination of reduced employment, lower pay, lower benefits, higher employee contributions and higher taxes.

Figure 8. Nonresidential Construction, 2005Q1 – 2102Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 9. Real State and Local Government Spending, 2005Q1 -2102Q4

Source: Department of Commerce and UCLA Anderson Forecast

Although the recent data on retail sales have been somewhat better than expected, we continue to believe that balance sheet impaired consumers will reign in their spending. To be sure consumer spending will be growing, but the 2% or so growth that we are forecasting will be far less ebullient than the 2005-7 housing bubble era. (See Figure 10)

Figure 10. Real Consumer Spending, 2005Q1- 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Interest Rates and Inflation: The Big Question Marks

Despite the high unemployment rates we forecast, with the economy on the mend, we anticipate that the Federal Reserve will start moving away from its zero interest rate policy this fall. Simply put, the financial emergency of 2007-2009 is over and we believe that the Fed will soon recognize this reality. To be sure interest rates will remain historically low throughout 2011, but the way will be open to more normal interest rates. Concomitantly the yield on 10 year U.S. Treasury notes will gradually rise above 4% later in the year and rise modestly thereafter. (See Figure 11) Indeed the deficits arising from the financial crisis and its hangover will exert upward pressure on interest rates for a long time to come. (See Figure 12)

Figure 11. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2005Q1 – 2012Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

Figure 12. Federal Deficit, 2005 – 2012F

Source: Office of Management and Budget and UCLA Anderson Forecast

Despite the sluggish growth we are forecasting, we believe that the real risk the economy faces is that of inflation. By way of analogy the Fed’s monetary policy has strewn kindling wood throughout the economy that could ignite into inflation at any time. Presently the kindling is wet and is in no danger of ignition, but in a few years that might not be the case. We believe that the Fed understands this risk and that is why we believe policy will be tightened this year.

Our forecast assumes that inflation will remain under control. Nevertheless core CPI is forecast to be modestly in excess of the Fed’s historic target of 2% in 2012. (See Figure 13) Yes, 2012 is a long way off, but markets have a way of telescoping future events into current market prices with astounding rapidity.

Figure 13. Core CPI, 2005Q1 - 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast


Modest GDP growth will soon translate into job growth, but the unemployment rate will stay above 9% through 2011. After a huge inventory rebound, economic recovery will be led by equipment and software, exports and housing. Offsetting these strong sectors will be weakness in state and local government, nonresidential structures and tepid consumption growth. Although the threat is real, inflation will remain modest throughout the forecast period as the Fed ends its zero interest rate policy and gradually returns interest rates to more normal levels.

[i] See, Daly Mary and Bart Hobijn, “Okun’s Law and the Unemployment Surprise of 2009,” FRBSF Economic Letter, March 8, 2010.
[ii] “The Trillion Dollar Gap,” The Pew Center on the States, February 2010.

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