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Monday, December 17, 2012
Friday, December 7, 2012
As of this writing, the U.S. economy is hurtling towards the fiscal cliff. In short hand, the fiscal cliff is a colloquial expression describing the expiration of previously enacted tax cuts combined with some automatic spending cuts totaling about $600 billion (about 4% of the economy) that are scheduled to take effect in January 2013. Congress and President Obama will resolve it one way or another. Its resolution will be characterized as good, bad or ugly largely depending on the world view of the observer.
Just to remind you, the major elements of the fiscal cliff include automatic spending cuts next year of $78 billion, the elimination of $40 billion in emergency unemployment compensation benefits, and tax increases totaling more than $400 billion from an end to the:
• 2. 2001/2003 Tax Cut (Upper Income) – $56 billion
• 3. 2001/2003 Tax Cut (Middle/Low Income) - $136 billion
• 4. Alternative Minimum Tax Fix - $103 billion
Because we don’t know what the final resolution will be we are assuming for forecasting purposes, despite the current furor, a "benign" compromise where spending is reduced and taxes are increased in a phased in manner over the next few years. From the point of view of the near-term economic environment modest growth continues, but an agreement on the cliff will be far from a solution to the long-term fiscal deficits facing the U.S. economy.
If Congress and the President fail to compromise, then, according to the Congressional Budget Office, the economy will fall back into recession with unemployment rate returning to 9% late next year. In general we agree with that assessment. In this report we look beyond the cliff.
Even assuming a benign resolution to the fiscal cliff and after taking into account the recent upward revision to the third quarter GDP data, the near-term outlook for the U.S. economy continues to be characterized by modest growth. Specifically, we are forecasting that real GDP will increase at an annual rate of only 0.7% in the current quarter and sub-2% growth in 2013s first half. (See Figure 1)
Thereafter, we can visualize growth accelerating to a run rate in excess of 3% in 2014. In this environment the unemployment rate will remain close to 8% in 2013, but decline to 7.2% by the end of 2014. (See Figure 2) Although this reduction in unemployment appears modest, we are forecasting job growth onthe order of 160,000 a month in 2013 and 200,000 a month in 2014. (See Figure 3) Not great, but a small improvement from recent years.
Why will growth be so tepid even after a fiscal cliff deal?
Deal or no deal the U.S. economy is being buffeted by economic weakness abroad. Europe and Japan are in recession and Brazil, China, and India are slowing. Simply put, the export growth engine is stalling; more on that later.
Furthermore, Hurricane Sandy has severely disrupted the economy of the Mid-Atlantic States thereby reducing output over the near-term. To be sure, measured GDP next year will be boosted later
Figure 1 Real GDP Growth, 2005Q1 -2014Q4F
by rebuilding efforts, but make no mistake, wealth destruction is hardly an economic positive. Finally, the tax increases and spending cuts coming out of any fiscal deal will weigh on economic activity. It remains to be seen that a deal will engender sufficient euphoria to boost the economic outlook as so many commentators are currently arguing.
Fiscal Imbalances Remain
The most important thing to understand about the fiscal cliff and the long-term deficit negotiations accompanying it is that both parties have much higher priorities than deficit reduction. If President Obama really cared about the deficit he would never have created the new healthcare entitlement or alternatively he would delay its implementation a few years and use the revenue to reduce the deficit. Similarly, there was nary a tax increase in the Ryan Budget passed by the House Republicans. To emphasize the point neither President Obama nor Speaker John Boehner endorsed the bipartisan Simpson-Bowles Commission recommendations. Any serious attempt to reign in the deficit requires both tax increases on more than just the high income earners and more than modest entitlement reductions, especially in Medicare and Medicaid programs. As a result, we continue to forecast high deficits over the next decade. (See Figure 4)
The current impasse involving the fiscal cliff and the on-going structural deficit of the United States has not gone unnoticed by the global credit markets. Forget the Standard & Poor’s down grade last year, look at the credit default swap market. In early November, it was cheaper to insure against default corporate credits such as Chevron, Google, Johnson & Johnson and Wal-Mart than the United States of America.1 Simply put, high-quality corporates have become the new sovereigns.
Furthermore, the current deficit is understated as result of the extraordinary aggressive monetary policies of the Federal Reserve. A zero interest rate policy does wonders for the interest expense line on the federal budget. In essence, the Federal Reserve has enabled the high deficit policies implicitly endorsed by both political parties. In defense, the Fed has argued were it not for their policies the deficit would be much higher because the economy would have been much weaker.
FY 2000 - FY 2022
Figure 5 Federal Funds Rate vs. Yield on 10-Year U.S. Treasury Bonds, 2005Q1 - 2012Q4F
Nevertheless, we anticipate that the current zero interest rate policy will continue until late 2014. (See Figure 5) In contrast, we note that the Fed has signaled that the current policy will continue until mid-2015. We base our view on the premise that the bond market will begin to sense more inflationary pressures in the economy in 2014 than the Fed now contemplates.
Front End Strength Offset by Back End Weakness
In contrast to the typical business cycle, the recent recovery has been characterized by strength in the back end of the economy, business investment and exports, and weakness in the front end, consumer spending and housing. Now with the recovery more than three years old, the business side of the economy and exports are weakening and housing is gaining strength. In fact ,the late arrival of the traditionally early pickup in the housing market has become the leading source of strength.
Led by gains in multi-family construction housing starts are expected to increase from 612,000 units in 2011 to 768,000 units this year. Further increases to 991,000 units and 1.34 million units are anticipated in 2013 and 2014, respectively. (See Figure 6) Indeed, by the end of 2014 housing starts are expected to run at an annual rate of 1.45 million units. We do not believe our forecast for housing starts to be aggressive because from 1990 – 2007 housing starts averaged about 1.5 million units a year.
After expanding at an 11% clip, the growth rate in real investment in equipment and software will decline to 6.8% this year and is projected to slow again to 5.6% in 2013. (See Figure 7) Essentially, the early cycle rebound in equipment and software spending represented a rebound from the freezing up of capital spending by businesses in response to the credit crisis of 2008. Similarly, business investment in structures, which never really recovered from the recession, appears to be stalling out with essentially zero growth expected for 2013. (See Figure 8) What’s happening here is a temporary reduction in natural gas drilling
Figure 7 Real Investment in Equipment and Software, 2005 – 2014F, Annual Data
in response to falling prices and the completion of several major utility projects. By 2014 this sector will be growing briskly as the construction of office buildings and shopping centers rebounds and natural gas drilling responds to an improved pricing environment.
Over the longer run, energy development has the potential to transform the U.S. economy. For example, the International Energy Agency believes that the U.S. will become the world’s largest oil producer, surpassing Saudi Arabia, by 2020.2 Furthermore natural gas production is surging as the U.S. is forecast to surpass Russia as the world’s leading producer by 2015. So much so that natural gas boilers now account for 31% of U.S. electricity production compared to 24% a year ago.
Much of the increased production is the result of hydraulic fracturing, a process involving the use of a mixture of highly pressurized water with sand and chemicals that has the ability to unlock hydrocarbon reserves in hitherto inaccessible shale formations. This new technology has triggered an energy boom in Pennsylvania and Ohio and it has transformed North Dakota into a leading energy producing state. In fact, the Bakkan Shale in North Dakota appears to have the equivalent oil reserves of two Prudhoe Bays (Alaska’s largest field).
The oil and gas boom is fueling an industrial revival in the Midwest and the Gulf Coast as low cost feed stocks have made the U.S. the low cost producer in a host of petro-chemicals and fertilizer. New plants have been announced in Pennsylvania, Louisiana and Texas. Moreover, the once nearly dead steel town of Youngstown, Ohio is being revived with the manufacture of steel pipe and drilling equipment.
To be sure the boom is not without its critics. Hydraulic fracturing is water intensive and there are several pollution-related questions involving the chemicals used in the process. A major test will come in California where the vast Monterey/Santos Shale (Kern and Los Angeles Counties) is just beginning to be opened for development. A critical question will be the attitude of the state and federal regulators towards this activity. Although much of the energy-related spending will occur beyond our forecast horizon, it
Figure 8 Real Investment in Business Structures, 2005 – 2014F, Annual Data
does offer the prospect of a better economic environment later in the decade. It is ironic that the Obama Administration came to power in 2009 on a platform of alternative energy and that it is now presiding over a major boom in conventional hydrocarbon production.
Meantime, while we await the energy boom that is to come, real exports are decidedly slowing. After increasing at an 11.1% annual rate in 2010, growth slowed to 6.7% in 2011 and will only be 3.3% this year. (See Figure 9) Simply put, it is very hard to grow exports with Europe and Japan in recession and much of the rest of the world in a slowdown. Recall that for several years we have believed that the U.S. growth engine would be exports. That engine is now sputtering, but with rising domestic energy production, at least import growth is slowing even faster than exports.
Inflation: Cold Now, Simmering Later
Although inflation certainly is not a problem today, with gradual but accelerating economic growth and the lagged effect of the extraordinary monetary ease of the Fed, it could very well become an issue in late 2014. Put bluntly, the Fed wants a temporary increase in inflation to lower real interest rates. It believes such a policy will speed up the recovery. With the Federal Funds rate set at zero the only way it can lower real interest rates is by increasing the inflation rate. Because capacity utilization remains low and unemployment and under-employment remains high, it is likely that inflation will stay low in 2013, but we surmise that inflationary pressures will build far quicker than the Fed now thinks and that inflation will be running above their target 2% rate in 2014. (See Figure 10) One source of the inflation will come from rising apartment rents (already happening) and the interaction of higher rents and housing prices on the owners’ equivalent rent calculation in the various price indices.
Looking beyond the fiscal cliff debate, we forecast that the economy will be growing at less than a 2% annual rate through mid-year 2013. Thereafter we expect growth to pick up and to exceed 3% for most of 2014 with housing activity leading the way. In this environment unemployment will stay close to the current 7.9% rate in 2013, but gradually decline to 7.2% by the end of 2014. Towards the end of the forecast period we expect that inflation will be running above the Fed’s 2% target that will bring to an end the zero interest rate policy that has been with us since late 2008.
2. See Faucon, Benoit and Keith Johnson, "U.S. Redraws World Oil Map," The Wall Street Journal, November 13, 2012, p.1