July 2011

Even before the Federal Reserve has taken its foot off the monetary accelerator, Northern Trust's Chief Economist Paul Kasriel thinks slowing U.S. economic activity — due partly to still-tight bank lending — may warrant more quantitative easing.

"We have made the transition to a significantly weaker outlook, not only because of the current behavior of bank credit but also because of the current behavior of the overall economy," said Kasriel. As a result, he revised downward his forecasts for gross domestic product (GDP) and job market growth even though the Fed had not yet completed its second round of quantitative easing, which began in November 2010.

Kasriel lowered his forecast for GDP to 2.2% for the second half of 2011 and edged up the jobless rate prediction to 9.4% by the end of this year. He also looks for the consumer price index during the fourth quarter to slow to a 1.8% annualized rate, down from the first quarter's 5.2% rate peak.

"Unless commercial banks miraculously crank up credit creation starting in July, combined Fed and bank credit will dry up, which all else the same, will adversely affect already-weak growth in the aggregate demand for goods and services," he noted.

"If we are close to the mark on our second-half GDP, consumer price index and unemployment rate forecasts, we could envision another round of Fed quantitative easing commencing early in 2012, with no Fed policy interest rate hikes occurring until early 2013," Kasriel added. "In fact, we could envision the Fed making a decision sometime this year to lower the interest rate it pays on bank reserves in an effort to encourage banks to increase lending to entities other than the Fed itself."

So what prompted Kasriel to dissent with many other economists and look for weaker growth? He cited a number of indicators, including the new orders component of the ISM-Manufacturing report, which in May fell 10.7 points — its largest monthly decline since October 2001.

Slowing in the growth of nominal retail sales (sales unadjusted for inflation), a braking in May light motor vehicles, failure of May initial weekly jobless claims to return to the sub-400,000 level, and continued recession-level housing sales and starts all paint a portrait of an economy still struggling to move forward.

So where does that leave the outlook for long-term interest rates? Likely with a slight downward bias, Kasriel surmised. "Unless the prospects for an outright new recession in the next six months should become more prominent, we believe that the 10-year yield will oscillate around the 3% level," he said. "We see a greater risk of the 10-year yield moving down to its early-October 2010 level of about 2.4% than moving back up to its early-February 2011 level of about 3.75%."