Just as Domestic Demand Picks Up, Foreign Demand Weakens
by Paul Kasriel and Asha Bangalore
The Commerce Departments first estimate of Q3:2011 real GDP growth was 2.5% annualized. Although this headline was better than the 0.8% annualized real GDP growth in the first half of 2011, underneath the headline, the news was even cheerier. Real final sales to domestic purchasers grew at an annualized rate of 3.2% in Q3:2011, the fastest growth of this measure since the 4.9% posted in Q2:2010. So, is it onward and upward for the U.S. economy going forward? Unlikely. Although things may be looking up for domestic demand, foreign demand for U.S. exports is expected to wane because of European sovereign debt issues and slower growth in developing economies. Putting it all together, we forecast continued growth in the U.S. economy, but growth too slow to prevent a mild upward drift in the unemployment rate. With the unemployment rate inching higher and consumer inflation moderating, we believe that there is a high probability of another round of Federal Reserve asset purchases, i.e., quantitative easing, commencing in the first quarter of 2012.
Why did growth in real final sales to domestic purchasers accelerate in the third quarter? We think it had something to do with the Federal Reserves second round of quantitative easing, which commenced in November 2010 and terminated at the end of June 2011. Chart 1 shows the 13-week annualized growth in combined Federal Reserve and commercial bank credit. Despite slow growth or outright contraction in commercial bank credit through June 2011, growth in combined Federal Reserve and commercial bank credit accelerated, reaching almost 10% annualized at the beginning of June 2011. Because both Federal Reserve and commercial bank credit is credit created out of thin air, it theoretically should have a positive impact on domestic demand. Why? Because credit created out of thin air implies that the recipients of this credit can increase their spending while the grantors of this credit need not cut back on their current spending. Thus, an increase in credit created out of thin air carries with it a presumption of a net increase in domestic spending spending on currently-produced goods and services, previously-produced assets and/or financial assets (e.g., equities). We believe that this accelerating growth in combined Federal Reserve and commercial bank credit through the first half of 2011, which was dominated by growth in Federal Reserve credit, played an important role in stimulating domestic demand for currently-produced goods and services in the third quarter of 2011. We also believe that this accelerating growth in combined Federal Reserve and commercial bank credit through the first half of 2011 played an important role in stimulating the demand for risk assets, e.g., equities.
Chart 1 also shows that since the Federal Reserves termination of quantitative easing at the end of June 2011, commercial bank credit growth has picked up. If this growth in commercial bank credit should continue, this would be a positive for U.S. domestic demand growth going forward.
But at the same time that domestic demand growth has a chance of maintaining its Q3:2011 improvement or perhaps even strengthening more, foreign demand for U.S. production has waned in recent quarters (see Chart 2) and is likely to weaken more going forward.
In response to actual or expected higher inflation rates due to excess demand, central banks in some major developing economies began raising their policy interest rates in the second half of 2010. The effects of these higher policy interest rates are now being seen on the growth of production in these economies. For example, Chart 3 shows that industrial production in China and Brazil has slowed significantly in recent quarters. As inflation in developing economies has begun to moderate, central banks in these economies are likely to begin lowering their policy rates. But the positive effects from lower policy interest rates on production in these economies and, therefore, the positive effects on their demand for U.S. exports will not occur until several quarters ahead.
Given that the eurozone purchasing managers' index for manufacturing moved below the 50-level in September and October, there is a high probability that the eurozone economy has entered a recession. Growth in eurozone "thin-air" credit creation, i.e., monetary financial institution (MFI) lending, had been none too robust prior to the latest round of sovereign-debt issues (see Chart 4). With the worsening of the eurozone sovereign-debt challenges, credit creation that could stimulate domestic demand in the eurozone is bound to weaken further. Why? Eurozone banks are going to have to write down the value of the sovereign debt they are carrying on their books. This means that the capital of eurozone banks will fall. Eurozone banks reduced capital will inhibit their ability to put new loans and investments on their books. In addition, the financial market regulators in the eurozone are calling for an increase in required capital ratios for banks. There are two ways eurozone banks can meet the higher required capital ratios and both ways imply weaker growth in domestic spending. One way that eurozone banks could meet higher required capital ratios would be to shrink further their assets, thereby increasing their capital-to-asset ratios by reducing the denominator. This would reduce the quantity of "thin-air" credit in the eurozone economy and would thus have a negative effect on domestic demand. Another way that eurozone banks could meet their higher required capital ratios would be to raise more capital from investors. But this would likely imply a diversion of funds from entities that wanted to obtain funds with the intent of increasing their current spending to banks that would be obtaining funds just to maintain the amount of loans and investments on their books. In this case, there would be a net decline in eurozone domestic demand. Thus, unless the European Central Bank were to engage in securities purchases that would increase the size of its balance sheet, the eurozone economy is likely to remain mired in a mild recession for an extended period of time. This will result in weak eurozone demand for exports, including U.S. exports.
The spike in U.S. consumer prices earlier in 2011 appears to have been due largely to a corresponding spike in commodity prices, the latter of which was caused by strong growth in the developing economies and expected interruptions in the supply of crude oil because of political turmoil in North Africa. But, as shown in Chart 5, the rate of increase in consumer prices has moderated as commodity prices have begun trending lower. In addition to a moderation in actual consumer inflation, market expectations of consumer inflation remain "well-anchored" around the 2% a rate thought to be consistent with the Federal Reserves implicit long-term target rate (see Chart 6)
All of which brings us to our expectations of Federal Reserve policy in the next several quarters. Of late, Fed officials with a "dovish" bent have been talking about the desirability of the U.S. central bank resuming securities purchases such that the Feds balance sheet would begin growing again. The securities most mentioned for Fed purchase are mortgage-related securities. Notwithstanding the protests from Republican presidential candidates and federal legislators that renewed Fed securities purchases would elicit, the Fed will resume securities purchases sometime in the first quarter of 2012 if sluggish real GDP growth, a rising unemployment rate and moderating rate of consumer inflation we foresee over the two quarters were to come to fruition. This would be the catalyst for stronger U.S. economic growth in the second half of 2012.
*Paul Kasriel is the recipient of the Lawrence R. Klein Award for Blue Chip Forecasting Accuracy
THE NORTHERN TRUST COMPANY
ECONOMIC RESEARCH DEPARTMENT
SELECTED BUSINESS INDICATORS