2012 Economic Outlook: The Game Has Changed: Transitioning to a Post-Leveraged World
Despite many challenges, we believe U.S. and global economic growth is poised to continue over the course of next year. However, businesses will need to remain cognizant of the evolving economic and policy landscape that will prove to be a game changer in 2012.
Executive Summary and Outlook
“Happy economic recoveries are all alike;
every unhappy recovery is unhappy in its own way.”
- With thanks - or perhaps apologies - to Leo Tolstoy
Over the past year, we have often been greeted by friends and colleagues with the comment that “your job must be really interesting,” or “you economists are very much in demand.” Indeed, economics does give the appearance to be a countercyclical business where the more problems in the economy, the greater the demand for our views. However, after the polite greetings, the real story is that current economic difficulties call for a re-examination of the business and policy fundamentals that underlie the recovery, and that re-examination has been very uncomfortable to many. Therefore, when in doubt, call in the economists for this economic recovery has truly been an unhappy one, with the outward evidence of disappointing growth, high unemployment and a seemingly unending stagnation in the housing sector.
We continue to view this economy as threading a thin needle between below-historical growth rates associated with the idealized economic recovery and the decline in growth associated with the non-idealized recession. There is no easy economic policy that will quickly resolve problems that have been developing for more than 40 years. So, what are we facing?
Our key theme in the second half of this year was one of moderate, subpar economic growth accompanied by modest inflation pressures, and no change in the Federal Funds target rate. As we transition into 2012, our growth outlook reflects more of the same for the year ahead. We expect the economy to expand 2.0 percent for the year ahead, with small gains from many sectors of the economy as opposed to a major contribution from any one segment (Figure 1).
We build our outlook upon the idea that consumer spending will continue to add to economic growth. However, the slow pace of job gains, marginal improvement in personal income and modest inflation pressures in the first half of the year will keep consumer spending in check. We expect approximately 1.5 million jobs to be added over next year, for an average of 123,000 jobs per month. The pace of job growth will be disappointing as structural challenges in the labor market persist. The disconnect between the skills among the American labor force and the skills in demand by firms remains the biggest challenge to stability in the labor market.
The sluggish pace of job gains should result in only a marginal improvement in personal income. Inflation is likely to remain somewhat elevated in the first half of the year at 2.3 percent but should moderate in the second half of 2012 (Figure 2). The inflation environment in light of only marginal personal income gains will restrain personal consumption to 1.5 percent in the first half of the year before giving way to somewhat stronger growth in the second half of the year.
Reiterating our view of “more of the same” in 2012, business fixed investment will remain a strong support to growth over the next year. The main driver of business investment over the past year - investments in capital equipment - should remain strong, but will not reach the doubledigit gains observed in 2011. The composition of business fixed investment should shift toward structures as stability in the commercial real estate market begins to slowly return. Short-term interest rates should remain low for most of the year, while longer-term borrowing rates should begin to rise in the latter half of 2012. As promised, the Fed should remain on hold for the duration of year.
We expect the government sector to remain a drag on economic growth in the year ahead. State and local governments will continue the process of aligning spending with the slower pace of revenue growth. Local governments will likely continue to aggressively reduce spending over the next 12 months in light of falling property tax collections and fewer resources from the federal and state governments.
At the federal level, the process of reigning in spending will begin as a result of the first $900 billion federal budget cuts from the Budget Control Act passed earlier this year. The first wave of cuts are spread out over the next 10 years, thus the impact will likely be minimal in the year ahead. However, the more aggressive $1.2 trillion in cuts set to begin in 2013 have the potential to weigh heavily on growth the following year. Continued stalemate in Washington will likely do the same. Nonetheless, federal spending will likely remain more restrained than in years past and should detract from economic growth in the second half of the year.
On the trade front, we expect to see the pace of export growth pull back slightly in light of a modest recession in Europe. However, exports to emerging market economies should continue to help support domestic global producers and, in turn, a moderate pace of corporate profit growth. Import growth will likely remain constrained with the slower pace of consumer spending. Imports should begin to pick up in the latter part of 2012 as employment growth and consumer spending continue to improve. In the year ahead, we expect net exports to subtract a modest 0.1 percent from headline GDP growth as the trade balance begins to widen in the second half of the year.
A discussion of our forecast for next year would not be complete without addressing the risks to our outlook, which mostly come in the form of policy risks. On the fiscal policy front, we expect unemployment benefits and the Social Security payroll tax reduction to be continued in 2012. However, the recent failure of the Deficit Reduction Committee in Congress reflects the underlying theme of policymakers' inability to make tough fiscal policy choices. In light of the additional costs of these payroll extensions after the collapse of the deficit reduction talks, there is a moderate risk that these policies will not be extended, which would put slight downward pressure on personal consumption and, in turn, headline GDP growth next year.
On the monetary policy front, discussions of additional quantitative easing (QE) have emerged in recent weeks. Given our inflation forecast for the first half of the year, we believe that another QE program is unlikely. However, if such a program were implemented, our outlook for interest rates would be adjusted downward in the short run, but, depending on the size of the program, another round of QE would not likely affect our outlook for economic growth.
Our outlook also calls for continued global growth in 2012, though at a below-average pace. Growth in Asia will likely remain intact as receding inflation has lowered the probability of excessive central bank tightening in the near term. We look for the expansion in Latin America to also proceed, although growth will likely slow over the next year. Our base-case scenario assumes that the sovereign debt crisis in Europe does not “blow up” and that the Eurozone experiences only a mild recession through early 2012. That said, there is a significant risk that the sovereign debt situation could incite another global financial crisis, which would downgrade our outlook for both U.S. and global growth in 2012.
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