Largely because of some recently-released economic reports, we have bumped up our real GDP (Gross Domestic Product) forecast significantly for Q4:2009 and much less so for all of 2010.
But we have not changed our fundamental view of the 2010 economic outlook. That view is that the recovery will continue through 2010, but will not be vigorous. Because we expect growth in the first half of 2010 to be slower than it was in the second half of 2009, we would not be surprised to hear the talking heads on CNBC start yapping about a “double dip.” They are likely to be wrong, as usual.
With regard to the Q4:2009 forecast, the data shows that the increase in the forecast for real GDP growth of 1 percentage point from revised third quarter data is due primarily to stronger residential investment expenditures, a much smaller liquidation of inventories and a larger contribution from net exports.
We do, however, acknowledge that the rate of liquidation of real business inventories is slowing, and that is a positive for real GDP. Thus, our forecasts of real GDP growth have been raised in both the Q4:2009 and Q1:2010 because of assumed less liquidation of inventories.
Exports up
Another factor accounting for our upward revision to Q4:2009 real GDP growth is net exports. Real exports grew at an annualized pace of 17 percent in the third quarter, and the October trade data suggest that real exports in the fourth quarter could grow even faster. This is largely due to the economic recoveries underway in the rest of the world.
Almost 43 percent of the October increase in nominal U.S. exports of goods was purchased by Pacific Rim and South/Central American countries. We believe that developing economies will become even larger purchasers of U.S. exports in the coming years.
Housing completions are up, and spending on home improvements went through the roof in October. This is what prompted us to raise our forecast for residential investment expenditures in the fourth quarter of this year.
All else the same, the large upward revision to our Q4:2009 real GDP forecast implies an upward revision to our average annual real GDP growth forecast for 2010 due to arithmetic. This, plus a little less assumed inventory liquidation in Q1:2010 has resulted in our forecast for annual average real GDP growth in 2010 increasing to 2.5 percent from last month’s forecast of 2.3 percent. Despite the upward revision, this is tepid growth for a recovery, especially after such a deep recession.
Tight credit
Why do we not see more robust growth for 2010? Because the private financial system appears to remain incapable of creating much, if any, net new credit for the private sector.
The contraction in commercial bank credit provided to the private sector in the recent recessionary period is unprecedented in the post-war era. Although the rate of contraction slowed in November to 5.6 percent year-over-year, this still represents a decline not seen prior to the recent recession.
To be sure, some of the decline in bank credit is due to weaker borrowing demand by the private sector. With inventories so low, businesses have cut back on their working capital needs. With capacity utilization so low, there is reduced demand for borrowing to fund capital expenditures. But we believe that the primary factor currently driving down bank credit and likely to restrict its growth in 2010 is bank capital.
Although banks and other financial institutions have raised unprecedented amounts of equity capital in the past year, they, of course, experienced an unprecedented “evaporation” of capital in the past two years.
It is widely expected that another wave of capital evaporation is on the way in the form of commercial mortgage defaults. Although the dollar amount of residential mortgages outstanding is over three times as large as the dollar amount of combined commercial and multi-family residential mortgages outstanding, the losses associated with commercial/multi-family mortgages are likely to be significant. Moreover, regulators, national and international, are considering phased-increases in required capital ratios for financial institutions.
Therefore, a currently adequately capitalized financial institution may find itself inadequately capitalized a year from now due to new losses and/or higher required capital ratios.
Stubborn job market
It is generally believed that the U.S. economy needs to grow in the range of 2-3/4 percent to 3 percent annually to maintain the level of the unemployment rate. Given our forecast of 2.5-percent real GDP growth for 2010, we expect the annual average unemployment rate level to be higher in 2010 than it was in 2009.
Although the reported decline in the unemployment rate from 10.2 percent in October to 10.0 percent in November was encouraging, we believe it was just statistical “noise.” Rather, we see the unemployment edging higher in the first half of 2010, peaking at about 10.5 percent, and then slowly falling in the second half of the year, ending up in the fourth quarter of 2010 about where it was in the fourth quarter of 2009.
In addition to relatively slow growth, another impediment to a speedy decline in the unemployment rate is a low average work week. When the unemployment rate hit a cycle low of 4.4 percent back in March 2007, the average work week was 33.9 hours. In this past November, the average work week was only 33.2 hours. Thus, businesses can increase their output to meet rising demand by extending the working hours of their existing staff rather than having to hire additional staff.
Yet another impediment to rapid job growth and a declining unemployment rate is the structural change the U.S. economy is undergoing. Although it is encouraging that motor vehicles sold at an annualized pace of almost 11 million units in November, this still is a far cry from the almost 17 million units sold in 2005. We are told that U.S. producers are anticipating that motor vehicle sales will settle in at about 14 million units annually.
Regrettably, this implies that some currently unemployed auto-sector workers will never find employment in this industry again. They will have to acquire training to qualify for jobs in different industries, which takes time. The same holds true for some currently unemployed real estate brokers, mortgage brokers, bricklayers and financial engineers.
Although commodity prices have risen significantly this past year, largely because of increased demand in the face of the global economic recovery, and these prices could continue to trend higher in 2010, we do not believe that this will push consumer inflation to a particularly “threatening” level. Again, final demand will not be sufficiently strong to enable businesses to pass on higher commodity prices to their customers.
Although we do not put as much emphasis on labor costs be a cause of inflation as others do, to the degree that they might be, they will not be in 2010. If the unemployment rate behaves as we expect, labor will not be in a strong bargaining position to secure large wage and salary increases. Moreover, labor productivity growth will remain relatively high, keeping unit labor cost growth in check.
Inflation not likely
Late last year, the global economy was on the precipice of another Great Depression, which, if we had fallen over, would have ushered in deflation. But we did not fall over the precipice, and we now are experiencing an economic recovery. So, deflation is off the table. But inflation expectations remain below where they were pre-Lehman. In addition to this market-based measure, we have two other gauges of inflation expectations. When a national men’s clothing store chain stops offering three suits for the price of none and when a national upscale steakhouse chain abandons its “value meal” menu, then we will know that inflation is about to move much higher.
In addition to revising our 2010 real GDP forecast marginally, we also have revised our Fed policy forecast marginally. Last month, we expected the Fed to begin tightening policy at its late-June 2010 FOMC meeting. We now have pushed the tightening back to the early-August 2010 FOMC meeting. In preparation for an explicit tightening, we expect the Fed to allow the federal funds rate to drift up to 0.25 percent, the top of its current target range, in the second quarter of 2010. At the Fed’s midyear report to Congress, we think that the Fed chairperson, presumably Ben Bernanke, will prepare the world for the imminent commencement of a tightening cycle.
Although we are forecasting an acceleration in economic growth in the second half of 2010, this growth still is relatively restrained. Therefore, the Fed tightening we foresee in the second half of 2010 also is restrained, with the funds rate ending the year at a level of 1-1/4 percent. It will be in 2011 when Fed tightening gets more aggressive.
