January 2010

The U.S. economy in 2010 should continue its sluggish recovery, with muted jobs growth, contained inflation, a nudge upward in interest rates and an improved housing market. But challenges are likely in the financial sector from a wobbly commercial real estate market dogged by high vacancy rates and limited credit availability.

“It’s not going to be all smooth sailing. There are some significant headwinds we have to face,” said Paul Kasriel, Northern Trust’s chief economist.

Although Kasriel has raised his 2010 growth projection to 2.5% from 2.25% for annualized gross domestic product (GDP), that growth is not strong enough to clamp a lid on the jobless rate. There is general consensus that the U.S. economy needs to grow in the neighborhood of 3.0% annually to maintain the level of unemployment.

Kasriel thinks the unemployment rate could drift up to 10.5% during the first half of 2010 as businesses remain reluctant to increase payrolls. Instead, they may ask current employees, who currently are working, on average, only about 33.2 hours per week, to log longer workweeks. The jobless rate is predicted to edge back down to 10% by the end of 2010.

Inflation will most likely stay tame in 2010 because demand conditions are not strong enough for businesses to pass on cost increases arising from higher commodity prices, while labor costs are contained and seem unlikely to be problematic. “The unemployment rate staying high and productivity growing rapidly mean that unit labor cost growth should remain subdued in 2010,” Kasriel added.

In two of the sectors that typically lead the economy — housing and consumer spending — Kasriel sees a muted performance. Low mortgage rates and a sharp decline in home prices have made houses more affordable. In addition, the homebuyer tax credit program has helped to boost home sales.

But consumer spending, which is the largest component of GDP, is expected to grow only modestly in 2010. It will likely remain constrained by continued high joblessness and household balance sheet repair, with tax cuts from the fiscal stimulus package and unemployment insurance providing support to stabilize consumer spending.

Business capital spending is expected to show lackluster growth in 2010, reflecting the impact of large unused capacity and sluggish demand conditions. The pace of inventory liquidation is projected to be significantly slower in 2010 compared with 2009. The ongoing global recovery translates into growth of U.S. exports, which is projected to provide a lift to economic activity through 2010.

The one sector Kasriel believes will not recover in 2010, however, will be commercial real estate. The financial sector has stabilized after its tremendous losses, and the system on the whole is adequately capitalized today. But it could face another wave of losses if the commercial real estate market defaults and some financial institutions holding these loans finally buckle.

“Although these losses are likely to be less than those incurred with regard to residential mortgage defaults, they still could be significant,” Kasriel said. “This concern, along with uncertainty regarding regulatory capital requirements, appears to be constraining creation of new credit by the private financial sector” and could limit the strength of the economic recovery during 2010.