U.S. Economic and Interest Rate Outlook - October 2012
by Carl Tannenbaum and Asha Bangalore
- Budget negotiations in the US and Europe are attempting to balance austerity, prosperity, and posterity.
- US exports and imports are showing the strains of sluggish conditions overseas.
- Our updated economic forecast reflects some "cliff" effects, but not a renewed recession.
Austerity means different things to different people. My mother and father both lived through the Depression, when austerity was forced upon them. Years later, I can still remember their reluctance to throw out leftovers, no matter how meager or moldy they were. For my children, austerity means waiting a few months to upgrade to the newest smart phone. How times have changed.
When the generations are together in my house, we have some interesting discussions about the relative merits of parsimony and profligacy. On a larger scale, the balance between these two is driving budget discussions in the United States and in Europe.
For the past ten years, the United States has been running Federal budget deficits. As you might expect, the depth of these shortfalls has exploded since the recession; revenue shortfalls have combined with stimulus programs to produce this result.
The borrowing needed to support these deficits has required eight increases to our debt ceiling since 2001. Our cumulative Federal debt to GDP now exceeds 90%, bringing us closer to a neighborhood inhabited by some deeply troubled nations.
Fortunately, the consequences of our indebtedness have been very limited to date. The United States Treasury has little trouble borrowing, despite last summers rating downgrade. And the rates on this borrowing remain at very low levels.
This standing is not something that we should take for granted, though. At some point, investors may lose hope that well regain our budget discipline, and allocate their funds elsewhere. The associated increase in borrowing costs will only serve to make deficits worse.
Hence the present urgency to put the Federal budget on a track toward balance. There is a temptation to take a close look at the expense side of the ledger, which is never a bad thing to do. But enhanced rates of economic growth would be a great tonic as well, and the steps we take towards fiscal rectitude might have a tendency to harm the rate of expansion.
Conversations around the US fiscal cliff reflect this tradeoff. The Tax Policy Center estimates that current policy, if not altered, will raise additional revenue of more than $500 billion in 2013. But the associated decline in consumer spending could carve more than 3% off the rate of GDP growth, throwing us back into recession. Automatic cuts in defense spending could cost thousands of jobs. We therefore expect Congress to eventually step in and smooth out some of the sudden changes slated to take hold early next year.
In Europe, the concepts are the same, but the calculus is a bit different. At present, most members of the euro are in violation of the fiscal limits set forth in the Stability and Growth Pact signed shortly before the common currency came into being.
Unfortunately for several member states, their budget problems have had a deeply adverse impact on their debt ratings and borrowing costs. To secure much-needed support, nations are being asked to reach an accord with either the International Monetary Fund or the European Stabilization Mechanism (ESM). These agreements typically require fairly strict austerity measures, which can be harmful to economic growth.
In Europes case, a good deal of attention has been focused the levels and costs of government employment. (The IMF estimates that 10.5% of Europes population is employed in the public sector, as opposed to about 4% in the United States.) To some, reducing government payrolls would have a damaging effect in the near term, but provide opportunity for private sector activity to rise in compensation. The question is whether societies in Europe are ready for that kind of transition.
In both regions, fiscal discussions have both short-run and long-run aspects to them. Escalating costs of retirement and medical care loom on the horizon, and strategy must address the need to remain internationally competitive. Next years budget inevitably occupies much of our attention, but the decisions made in the coming few months on both sides of the Atlantic will have a lasting impact on future generations.
Speaking of future generations, recent grade reports from my own children suggest that they will not be significant contributors to our economic advancement in the decades ahead. My plan for reform includes repossessing that smart phone; Ill deal with their protests in the short-term if it gets us on a better long-term track.
Restraint of Trade
The latest trade report for the US clearly illustrates the real impact of the headwinds from Europe and China. Both exports and imports show a distinct decelerating trend that has been in place since mid-2011. Exports of goods grew a paltry 1.6% from a year ago in August; for context, this number stood at a nearly 17% increase in August 2011.
Regionally speaking, exports to the eurozone fell 3.5% in August from a year ago, after posting a double digit gain in 2011. Exports to China slowed to only a 2.2% increase in August, down from a 13% jump in 2011. The weakness in exports to China stands out because it is a reflection of weak demand in China, a player with a gargantuan bearing on global economic growth.
The sharp drop in exports has held back growth of US GDP and translated to a deceleration of US imports. Imports of goods fell 0.7% in August from a year ago, the first decline since November 2009; this is a telling detail that points to the ramifications on output and employment of economies dependent on US purchases. In a global economy, the eye-popping weakness in trade suggests soft economic conditions for many countries in the quarters ahead.
US Forecast: Still Sub-Par, But No Recession
The Feds monetary stimulus package, forward momentum in the housing sector, and growth in auto sales are positive developments supportive of economic growth. Nonetheless, currently available economic data point to only modest growth in the third quarter followed by a slightly stronger performance in the final three months of 2012. All in, the projected growth of real GDP in all of 2012 should be around 1.6% vs. 2.0% in 2011.
The uncertainty stemming from the fiscal cliff presents challenges in predicting the course of the economy in 2013. Based on recent missives from Washington, negotiations are underway to address the fiscal cliff in segments through modifications and/or delays to temper the blow to the economy. Our sense is that compromise will be reached on enough issues to avoid the full impact of the cliff, but that bigger issues (like tax and entitlement reform) will be deferred.
Our baseline forecast includes a supposition that Congress will let the 2% payroll tax relief expire as of December 2012. This would set back household income by $85 billion in 2013 and would filter through the economy as a reduction in consumer spending. In addition, unemployment insurance payments under the emergency program amounting to $34 billion are expected to be phased out gradually in 2013 and will also serve to trim consumer spending. The impact of these events is that the pattern of economic growth in 2013 will be marked with a relatively slower pace in the first quarter, compared with the rest of the year.
US Economic Outlook
Not to overlook the other sectors of the economy, there is little to derail the modest turnaround in the housing sector; the advancing trend of residential investment expenditures will be a small but noteworthy contribution to real GDP growth. But the pace of business spending is expected to remain tepid. Recent readings on capital goods orders and surveys of spending plans show that firms are hesitant to commit themselves amid uncertainty coming from Washington, Europe, and China.
The contained pace of business activity and significant slack in the labor markets point to inflation hovering below the Feds target of 2.0%. And as the Fed has promised, interest rates will remain at very low levels throughout the coming year.
Risks to the central tendency are, for the moment, massed on the downside. Among the issues were watching most closely:
- A protracted US fiscal impassewould risk the confidence of businesses, investors, and ratings agencies. A poorly-designed compromise could damage economic and market performance.
- A disorderly outcome in Europecould initiate financial and economic contagion, and spur a renewed round of investor risk aversion.
- A hard landing in China(which would be associated with economic growth of less than 5% or so) could impact trade and capital flows and potentially kindle social instability.
- Regional stress in the Middle East could see regional conflicts broaden, impacting the price of oil and challenging the resources of would-be peacekeepers.
Of course, favorable resolution of these matters could clear the way for better outcomes. That is what we will be hoping for.