Friday, September 23, 2011

Stalled, UCLA Anderson Forecast, September 2011

“Developments this summer have indicated we are on a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed.”1

Christine Lagarde, Managing Director, International Monetary Fund

The economy has stalled. To be sure, it has not
gone backward into recession, but there is certainly
no forward momentum and our outlook is far worse
than just three months ago. In fact, given the surprisingly
weak revised data for the first half of the year,
we expect that in the five quarter period ending in the
first quarter of 2012, economic growth will average
a decidedly weak 0.9%. (See Figure 1) If there ever
were an economy operating at “stall speed”, this one
is it.

We first introduced the concept of “stall speed”
in September 2007 and again discussed it in September
2008. In fact, we used the same “Stalled” title in
September 2008. What is it about September? The
concept of “stall speed” involves an economy growing
so slowly that any modest shock can trigger a
full-blown recession, just as when an airplane’s velocity
slows to such an extent where it can no longer

Figure 1 Real GDP Growth, 2005Q1 – 2013Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

We are not, however, forecasting a new recession.
Why? Simply put, the three sectors that would
normally put the economy into recession are already
depressed; those being housing, consumer durables
and inventories. Even if housing starts drop to new
lows, this sector of the economy has shriveled so
much that it would only have a modest impact on
economic activity. For example, it is one thing for
housing starts to decline from an annual pace of two
million units to one million units and quite another
for starts to decline from 600,000 units to 300,000

Thus, if we are to have a new recession it
would have to come from a collapse in exports, a generalized
decline in consumer spending with a resultant
decline in business investment. All plausible, but
we are not forecasting that eventuality.
Instead, we forecast economic growth to gradually
rebound in mid-2012 with the economy growing
at a modest 2.5% - 3% clip The factors driving the
return to growth include modest gains in exports,
consumption and equipment and software investment.
In that environment, employment growth will become
more meaningful with gains averaging about 150,000
jobs a month and the unemployment rate falling to a
still very high 8.6% by the end of 2013.

Nevertheless, recession or not, the employment
situation remains horrible. Job growth has stalled and
we forecast that the unemployment rate will soon
rise to 9.5%, above August’s elevated rate of 9.1%.
(See Figures 2 and 3) Thus, even by the end of 2013
we will not be back to the employment levels of late
2007. Indeed, the unemployment rate is being masked
by an unprecedented decline in the employment/
population ratio which is back to where it was in the
early 1980s. (See Figure 4) Simply put, while many
workers have left the labor force by going back to
school, retiring, or staying home to raise children --
all too many have left the labor force and have simply
given up.

Figure 2 Payroll Employment, 2005Q1 – 2013Q4

Source:Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3 Unemployment Rate, 2005Q1 -2013Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Therefore, in terms of the labor market,
we are not in an economic recovery, but rather
we remain mired in one long slump. This view is
consistent with the consumer confidence surveys and
the very low esteem the public has for the elected
branches of government.

Government Policy Response

From the beginning of the financial crisis in
August 2007, the Federal Reserve has thrown all but
the kitchen sink at the economy to forestall what they
thought to be the start of a new great depression. We
have witnessed a raft of special programs and two
major attempts at quantitative easing. Policy rates
have been set at zero since 2009 and the Fed has told
us that they will remain at zero through mid-2013,
truly an unprecedented step. (See Figure 5) With
the Fed anchoring the short end of the yield curve,
long-term interest rates have come in as well, with the

Figure 4 Employment/Population Ratio, 1948 –August 2013, Monthly Data

Sources: Federal Reserve Bank of St. Louis

Figure 5 Federal Funds vs. 10 Year U.S. Treasury
Yields, 2005Q1 – 2013Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

10-year U.S. Treasury bond actually breaching 2%.
Make no mistake, the last time we have seen government
yields this low was during the Great Depression.
To be sure, the Fed can do more, such as embarking
on another bond buying spree in the form of
a third quantitative easing program, but to us, it looks
like they are just about out of policy bullets. Furthermore,
it is not clear that the second round of quantitative
easing even worked.

To be sure, it elevated stock
prices for a while, but it also seems to have ignited
a commodity price surge that lowered real incomes
and sapped consumer confidence with gasoline prices
temporarily breaking through the psychologically
important $4 a gallon price barrier. Nevertheless,
because of the Fed’s dual mandate, they will have to
act. Our best guess is that the Fed will engage in an
“Operation Twist” where they will emphasize the purchase
of long maturities, to bring down already low,
longer-term interest rates.

Fiscal policy is caught in a trap. The July downgrade
of U.S. credit by Standard & Poor’s signaled
what we already knew. The plain fact is that the
federal government will be in an extended period of
fiscal consolidation, a fancy way of saying that longterm
budget deficits will be significantly reigned in.
(See Figure 6) Thus, it is highly unlikely that we will
see a fiscal stimulus program anywhere near the $800
billion appropriated in 2009. Nevertheless, assuming
a credible long-term fiscal consolidation program
can be put in place, admittedly a big assumption, the
federal government could step up near-term spending
on infrastructure and selectively cut payroll taxes.
However, given the lack of comity in Washington,
D.C., we are assuming only modest policy
adjustments. Specifically, for modeling purposes
we are assuming a continuation into 2012 of the 2%
payroll tax cut and the extension of emergency unemployment
benefits, reauthorization of the Surface
Transportation Act, and regulatory changes to make it
easier for homeowners with “under-water” mortgages
to refinance.

Why the Downward Revision to the Outlook?

Our case for recovery rested on the belief that
strong growth in exports coupled with continued
strength in business investment along with a modest
recovery in consumption and housing would generate
a subpar recovery on the order of 3% growth rate in
real GDP. It hasn’t quite turned out that way. To be
sure, exports are still growing, but not as fast as we
thought. (See Figure 7) Weakness in Europe, where
about one-third of our exports go, is casting a pall
over the sector. Furthermore, both Canada and Japan
suffered a decline in real GDP in the second quarter.
As a result, real exports are now expected to run $50-
$60 billion a year below what we previously thought
in 2012 and 2013. Business investment is remaining
strong, but the boost we expected from high-technology
capital goods is not as strong as we thought.

Figure 6 Federal Surplus/Deficit,
FY 2000 – FY2021F

Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 7 Real Exports, 2005Q1 -2013Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 8 S&P 500, Sep 2010- 2 Sep 2011, Daily Data


The situation in Europe is especially ominous.
The PIIGS (Portugal, Ireland, Italy, Greece and
Spain) are facing huge budgetary cutbacks to generate
the cash needed to service their debts. The European
banking system remains weighed down with not
only weak sovereign credits, but private credits that
have yet to be marked to market. As a result, a new
round of bank recapitalizations will be required. The
European bank stress tests were not quite as stressful
as they should have been. In the meantime, U.S.
money funds withdraw assets from European banks
conjuring up the nightmare of September 2008 when
Lehman Brothers failed. We are not there yet, but the
German stock market highlighted the nervousness by
dropping 20% in August. Thus, until Europe sorts itself
out, the global economy and U.S. exports remain
at risk.

We knew that consumer spending would remain
weak, but the recent 18% decline in stock prices from
the 2011 high to the August low has made us very
nervous about the high-end consumer. (See Figure
8) Remember that 5% of the households account for
40% of all household income and that has been the
force driving consumer spending on up-scale goods.
Before getting too carried away with the decline in
stock prices, we should recall Paul Samuelson’s famous
quip that “the stock market forecast nine out of
the past five recessions.”

Nevertheless, with the deleveraging process
far from complete, volatility in equity prices are
especially worrisome. Yes, consumer debt remains
$136 billion off its 2008 high, but that decline can be
accounted for by roughly the same amount of bank
loan charge-offs. (See Figure 9) That means that until
the debt is settled, the consumer still believes he/she
owes the full amount to the financial institution. The
loan is “dead” on the bank’s books, but could very
well be alive on consumer’s personal books. It’s no
fun being hounded by collection agencies.

We were right early on in the middle 2000s that
housing was in a bubble. However, for the past three
years we have been forecasting a recovery in housing
starts. It has yet to come. Thus, once again we are
ratcheting down our view. We now forecast housing
starts of 612,000, 709,000 and 967,000 units in 2011,
2012 and 2013, respectively. (See Figure 10) Last
quarter, for example, we were at 1,311,000 units for
2013. Quite a comedown. Furthermore, the reduction
in conforming loan limits from $729,750 to $625,500
on October 1st, though well justified on public policy
grounds, probably will exacerbate housing activity in
high cost areas over the near-term.

Figure 9 Total Consumer Credit Outstanding, 2000 – June 2011, In $ Billions, Monthly Data

Sources: Federal Reserve Bank of St. Louis

State and Local Governments in Fiscal
Consolidation Phase

Of necessity, rather than virtue, state and local
governments have been operating in a fiscal consolidation
phase since 2008. The tax receipts aren’t there
and unlike the federal government, the states find it
extremely difficult to run sustained deficits. To be
sure, there are exceptions, notably California, Illinois
and New Jersey, but even these three states have
taken the knife to their spending budgets. As a result,
by 2013, real state and local government spending
will have declined for six straight years. (Figure 11)
As we have noted before, the process of fiscal
consolidation is ongoing and it will be worsened
by changes in the healthcare law that will mandate
higher Medicaid spending. Because Medicaid gener-
ally accounts for between 15-30% of a state’s spending,
increases here are certainly non-trivial.

When combined with unfunded public employee pension
and post-retirement healthcare benefits, it is not hard
to see why state and local governments will find
themselves cash strapped for many years to come.
Indeed, the very low interest rates fostered by
the Fed will exacerbate the stress on pension plans.
Put bluntly, there isn’t a pension planner alive today
who thought the benchmark 10-year U.S. Treasury
bond would be yielding close to 2%. With actuarial
yield requirements at 7.5%-9%, the normal pension
arithmetic does not compute. Another way of looking
at the problem is that it represents the mirror image of
the Federal government’s obligations to fund Medicare
and social security.

Figure 10 Housing Starts, 2005 – 2013F

Sources: Bureau of the Census and UCLA Anderson Forecast

Figure 11 Real State & Local Government
Expenditures, 2000- 2013F

Sources: Department of Commerce and UCLA Anderson Forecast


As we noted at the outset, the economy is
stalled. Growth will be minimal over the next few
quarters and thereafter there will be enough strength
in exports and business investment along with modest
increases in consumption to propel the economy
forward at a 2.5%-3% pace. Fed policy will be as
accommodative as it can get, but fiscal policy is hampered
by the realities of the budget deficit and political
gridlock. In this environment, job growth will be
sluggish and unemployment will remain at recession
levels. The big risk is that fiscal and monetary problems
in Europe spill over into a generalized credit
crisis thereby triggering a global recession.

1. Lagarde, Christine, “Global Risks are Rising, But There is a Path to Recovery,” Remarks at Jackson Hole, August 27, 2011.
2. See Shulman, David, “A Near Recession Experience,” UCLA Anderson Forecast, September 2007 and “Stalled,” UCLA Anderson
Forecast, September 2008. For a technical discussion see, Nalewaik, Jeremy J., ,”Forecasting Recessions Using Stall Speeds,” Finance
and Economics Discussion Series 2011-24, Board of Governors of the Federal Reserve System.

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