Saturday, September 22, 2012

"The Muddle Through Economy". UCLA Anderson Forecast, September 2012


The economy continues to muddle through at a very sluggish pace as it has since the nadir of the Great Recession in mid-2009. In general real GDP growth has been in a 1-3% channel and it is now operating at the lower end of the range. Specifically, we are forecasting real GDP growth of 1.3% in the current quarter and 1.5% in the fourth quarter. (See Figure 1) Nevertheless, as we get into 2013, growth will ratchet up to above 2% and 2014 could very well put the run rate of GDP growth in excess of 3% as economic activity is buoyed by strength in residential and nonresidential construction and a rebound in export growth.

Tepid GDP growth, combined with a structural adjustment in the economy, has caused employment gains to be modest. (See Figure 2) As a result, the unemployment rate has stayed above 8% for three and a half years. (See Figure 3) With several quarters of 1-2% growth ahead of us we do not expect the unemployment rate to dip below 8% on a quarterly basis until the first quarter of 2014. Simply put, job growth on the order of 160,000 a month in 2013 will not be sufficient to make any real dent in the unemployment rate. However, as job growth accelerates to 200,000 a month in 2014 the unemployment rate will begin to meaningfully improve.
Figure 2 Unemployment Rate, 2005Q1 – 2014Q4F
Figure 1 Real GDP Growth, 2005Q1 -2014Q4F


The economy is being held back by a still over-leveraged consumer and that is working to dampen consumption, a slowdown in corporate investment spending, a softer export environment and a pall of policy uncertainty with respect to fiscal policy and regulation.

Aside from working off the hangover caused by the debt binge of 2003-07, consumers are being plagued by a decline in real household income. Although the economy can and did grow in the face of stagnant median income in the 2000s, weakness in median income is certainly no help. According to Sentier Research, a new economics consultancy founded by two former Bureau of the Census senior staffers, real median household income has declined by 5% since early 2008 and is still 2% below where it was when the economy bottomed in June 2009. (See Figures 4 and 5)
Figure 3 Payroll Employment, 2005Q1 -2012Q4

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast
Figure 4 Real Median Household Income Indexed (thin line) and Unemployment Rate (thin line), 2000 – June 2012
Source: Sentier Research

Business Investment Slowdown

After rising at a very robust 11% rate in 2011, we project that investment in equipment and software growth will slow to 8.1% and 6.4% in 2012 and 2013 respectively. (See Figure 6) To a great degree, the strong growth in investment represented a catch up from the 16.4% collapse in 2009. Similarly, we expect minimal growth next year for investment in business structures as factory, mining (gas drilling) and utility construction started in 2011 is completed later this year and early in 2013. A rebound in these sectors, as well as a ramp up in commercial construction, will cause investment in structures as a whole to grow by 7% in 2014. (See Figure 7) Furthermore, the rapid growth in exports witnessed in 2010 and 2011 is ebbing as Europe is mired in recession and growth in China, Brazil and India slows. (See Figure 8)
Figure 5 Real Consumer Spending,
2005 – 2014F, Annual Data
Figure 6 Real Investment in Equipment Software, 2005 – 2014F, Annual Data


Sources: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 7 Real Investment in Business Structures, 2005 – 2014F, Annual Data

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


Housing Rebound

As we noted last quarter, the one bright spot in the economy is the long-awaited rebound in housing construction. Led by multi-family construction, housing starts are ramping up from 612,000 units in 2011 to 763,000 units this year and just under one million units in 2013. By 2014, we anticipate that housing starts will be in excess of 1.3 million units. (See Figure 9) The growth in housing will account for about a full percentage point in GDP growth by 2014. The strength in housing is being underpinned by gradually rising home prices, record low mortgage rates, improved household formations and modest employment growth.

All Out Monetary and Fiscal Policy

The sluggish growth of the past few years has occurred against a backdrop of extremely stimulative monetary and fiscal policies. Since 2008 the Federal Reserve has had its "pedal to the metal" by engendering an unprecedented explosion in its balance sheet which has more than tripled in size. (See Figure 10) Initially the Fed engaged in a largely conventional monetary policy by lowering its target for the Federal Funds rate from 5 ¼% to essentially zero where it has stood since late 2008. (See Figure 11)

With the policy rate stuck at the "zero bound," the Fed engaged in a large scale asset purchase program known as quantitative easing and made a commitment to maintain its zero interest rate policy through 2014. Fed Chairman Ben Bernanke noted in his recent Jackson Hole remarks that there is academic support for the notion that the Fed’s non-traditional policies lowered the yield on 10-year U.S. Treasury bonds by 80-120 basis points; hardly trivial.


Thus far, the extraordinary monetary policy has not ignited inflation nor an increase in inflationary expectations. Put simply, despite a commodity scare that has accompanied the second round of quantitative easing in late 2010, inflation has been quiescent. (See Figure 12) Nevertheless, if we are correct about acceleration in economic growth in 2014, we won’t be surprised to see inflation rising above their 2% inflation target.
Figure 8 Real Exports, 2005 – 2014F,
Annual Data, Percent Change

Sources: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 9 Housing Starts, 2005 – 2014F, Annual Data

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

Figure 10 Federal Reserve Bank Credit, 1991 – Aug 2012, Weekly Data, In $ Billions.
Source: Federal Reserve Bank of St. Louis
Figure 12 Price Deflator for Personal Consumption Expenditures, 2005Q1-2014Q4F
Figure 11 Federal Funds Rate vs. 10-year U.S. Treasury Bonds, 2005Q1 -2014Q4

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

Sources: Federal Reserve Board and UCLA Anderson Forecast

Similarly, fiscal policy has been highly stimulative with the cumulative federal deficit of the past four years amounting to $5.1 trillion. (See Figure 13) As a result, U.S. debt held by the public has risen from 36% of GDP in 2007 to 73% of GDP in 2012. However, with that level of deficit spending now being viewed as unsustainable, federal government purchases are actually contracting. (See Figure 14)

Remember, in the GDP accounts the bulk of Federal spending is accounted for as transfer payments, which mostly enter into the GDP stream as consumer and state and local government spending. This is important, because as sluggish as it has been, consumer spending has been supported by increases in unemployment compensation, disability payments and other income support programs.

Nevertheless if you spoke to most economists in late 2008 and you told them that the Fed would embark on a four year zero interest rate policy and more than triple the size of its balance sheet and that the federal government would run $5 trillion of deficits over the next four years; they would have predicted a major boom with inflationary consequences. Donald Kohn, the former Vice-Chairman of the Fed and long-time Fed staffer asked the question at Jackson Hole, "Why is it that we’ve had such incredibly accommodative monetary policy for so long and we’ve had so little growth?"


Strong growth has obviously not occurred and two constrasting hypotheses would argue that we were truly headed for Great Depression 2.0 and the policy prevented a disaster or that economic policy as we know it is not as effective as we thought. Perhaps more likely the truth involves a combination of the two alternative hypotheses. We have no answers to this question here and now, but this will be the topic of more than a few Ph.D. dissertations over the next few years. Counter-factual history is hard to do.

Falling Off the Fiscal Cliff?

At midnight December 31, 2012 the tax cuts enacted in 2001, 2003 and 2009 expire, and that includes not only the tax rate schedule, but also the
Figure 14 Real Federal Purchases, 2005 – 2014

Sources: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 13 Federal Surplus/Deficit,
FY 2000 – FY 2022

Sources: Office of Management and Budget and UCLA Anderson Forecast


so-called alternative minimum tax patch and the two percentage point reduction in social security taxes.
5 In addition, about $55 billion of spending will be sequestered and emergency unemployment benefits will expire. All told, about $600 billion in tax hikes and spending cuts are scheduled to take effect. The Congressional Budget Office predicts that if all these eventualities occur, the deficit would be cut almost in half, but the United States would be pushed into recession with real GDP declining by 0.3% in 2013 and the unemployment rate rising to 9%.

The astute reader would have noticed that in Figure 13 above we have the federal deficit gradually coming down. There is no cliff. Why? In the triumph of hope over experience we are assuming that there will be a post-election compromise that will allow for a phase-in of tax increases and spending reductions. This will be especially difficult to do after what will likely be the most vitriolic election in years.

Furthermore, private sector activity is bound to be influenced as individuals and businesses handicap the likely outcome to all of the tax and spending changes on the table. Remember in the fourth quarter of 1992 activity was pulled forward to avoid the likely tax increases that were to come in the new Clinton Administration with a concomitant slowdown in the first half of 1993.

Nevertheless, fiscal discipline is sorely needed. Despite all of the campaign rhetoric that we have already heard and soon will hear, entitlement programs are going to be cut and taxes are going to be raised. A policy of spending roughly $3 for every $2 taken in is hardly sustainable. Indeed with the current debt load equal to GDP and with the debt held by the public equal to 73% of GDP we are rapidly approaching the danger zone identified by Rogoff and Reinhart in their cross country comparisons of historical debt crises.

The economy continues to muddle through in a 1-3% growth environment that will keep the unemployment rate painfully high. Although not contracting, consumer spending, exports and business investment will remain sluggish. In addition, federal purchases weighed down by a high debt load are contracting. The one bright spot is the beginning of the long awaited rebound in housing. The big near-term risk comes in the form of the fiscal cliff where a too rapid fiscal consolidation could very well trigger a recession in early 2013.
Endnotes 1. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.
2. See Shulman, David, "Rebuilding the Housing Economy," UCLA Anderson Forecast, March 2012
3. See Bernanke, Ben S., "Monetary Policy since the Onset of the Crisis," Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31, 2012
4. See Hilsenrath, Jon, "Bernanke Faces Skepticism Over Policy," The Wall Street Journal Online, September 2, 2012
5. See, "An Update to the Budget and Economic Outlook: Fiscal Years 2012-2022," Congressional Budget Office, August 2012

6. For an updated version of Rogoff and Reinhart see, Reinhart, Carmen. M., Reinhart, Vincent R., and Rogoff, Kenneth S., "Public Debt Overhangs: Advanced Economy Episodes since 1800," Journal of Economic Perspectives, Summer 2012, pp. 69-86.

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