Monthly Economic Outlook - July 2010

U.S. Overview

Slower Growth but No Double-Dip

The wave of disappointing economic reports this past month combined with the inability of the Administration to push additional stimulus through an election-wary Congress has reawakened fears about a double-dip. We continue to believe such fears are overblown. We remain concerned that so much stimulus is ending in such a short period of time but expect growth to continue. Real GDP is expected to rise at a 1.6 percent pace in the third quarter and fourth quarter growth should be a little more than 2 percent.

The impact from expiring stimulus programs is most apparent in housing. Sales of new homes plummeted 32.7 percent in May, just one month after the incentives expired.

Retailers are also already missing the boost from stimulus programs. Sales had gotten a huge boost from rebates for energy-efficient appliance purchases and the formerly resurgent stock market, which has been faltering ever since the Fed's quantitative easing ended. The most pressing concern today is state and local governments, which had been counting on a few hundred billion more federal dollars to tide them over this budget season. Without additional assistance, state and local governments are making deep and painful budget cuts.
The prospects of slower growth combined with diminishing inflationary pressures have sent bond yields sharply lower over the past month. We have reduced our interest rate outlook over the forecast horizon and do not expect the Fed to boost the federal fund rate until the latter part of 2011.

Expectations Have Been Scaled Back

Second quarter economic activity ended on a weak note, with nonfarm payrolls falling in June and most other economic reports posting declines or paltry increases for May and June. The recovery feels like it is running out of gas, as much of the impetus from stimulus programs and inventory rebuilding has begun to wane. To add insult to injury, economic conditions earlier this year turned out not to have been as strong as first reported. The first quarter was revised lower and real GDP for the period now shows an increase at just a 2.7 percent annual rate. Our forecast for the just competed second quarter has the economy growing at a 3.2 percent pace.

The economy's performance during its first full year of recovery has been disappointing, particularly given the enormous amount of stimulus thrown at it. The Congressional Budget Office estimates fiscal stimulus provided just more than half of the first quarter's growth. The other half was provided by inventory rebuilding. Now that many stimulus programs have ended or are in the process of winding down, the economy will have to rely on private final demand. Unfortunately, private final demand has been weak, even with billions of dollars of stimulus at its back. As a result, we expect real GDP to rise at just a 1.6 percent pace during the third quarter.

Not only is stimulus spending ending but we are also likely to endure a payback for all the incentives put in place to drive home sales and new home construction over the past year. Tax credits for first-time homebuyers and some trade-up purchasers ended in April and the impact on new home sales was unusually harsh and immediate. New home sales plummeted a record 32.7 percent in May and pending home sales fell 30.0 percent. We now expect residential construction outlays to fall 7.5 percent during the third quarter but then look for a legitimate recovery in home sales and new home construction to finally take hold later this year.

Faltering home sales will also cut into consumer spending during the third quarter, as reduced sales commission and closing fees will hold back services outlays. Fewer home sales also means fewer trips to discount stores and home improvement centers to buy all the things no one knew they ever needed until they moved. Discretionary spending in general is likely to struggle with hiring sputtering and millions of recipients of extended unemployment benefits seeing their benefits end this summer. Our forecast calls for real personal consumption expenditures to rise at just a 1.5 percent pace in the third quarter and then looks for outlays to gradually improve in line with some modest improvement in employment and income gains.

Prospects for state and local governments have diminished recently. The federal government will still likely come to the rescue but state and local budgets are likely to be squeezed first in order to build a political constituency to support additional federal assistance. We have reduced our forecast for state and local government outlays by about half a percentage point over the near term and little less than that in 2011. State and local outlays are expected to fall at a 0.3 percent annual rate during the third quarter and decline on a quarterly basis through most of the forecast period.

Slower economic growth has further reduced the chances that inflation will become an issue for policymakers anytime soon. Bond yields have plummeted over the past month, reflecting both the expectation of slower economic growth and realization inflation will be lower. We have pushed back the Fed's first rate hike to late 2011.

International Overview

Global Double-Dip Does not Seem Likely Either

Some investors are starting to fear that the global economy will slide back into recession over the next few quarters. How realistic is that scenario? Most recessions occur when something in the economy gets out of balance, and the subsequent correction is large enough to turn overall growth negative. In our view, there are two imbalances at present that could potentially lead to global recession.

First, inflation has risen in many developing economies, which could cause central banks in those countries to tighten policy too much. However, we view the probability of an inflation-induced downturn to be rather low. Inflation is hardly raging at present, and central banks in developing economies will likely move cautiously as long as growth in the developed world remains sluggish.

In our view, fiscal retrenchment in advanced economies poses the more credible risk to the global economic outlook. Many European countries, including Greece, Portugal, Spain and the United Kingdom plan major fiscal adjustment programs over the next few years, which will exert powerful headwinds on growth in those economies. The experience of Canada in the 1990s shows that advanced economies can indeed pull off major fiscal adjustment programs. However, Canada spread out its adjustment over a decade rather than just a few years, and it benefitted from strong global growth. Although the global economy should continue to expand, growth could turn out to be more sluggish than many investors had anticipated.

Double Dip Global Recession Not Likely in Store

Financial markets have weakened recently due to the realization that growth in most countries probably will be slower in the second half of the year than in the first half. Indeed, some investors fear that a double-dip global recession could be in the offing. How realistic is this possibility?

Recessions typically happen when something in the economy becomes unbalanced, and the subsequent correction tends to weaken the overall economy. For example, the painful U.S. recession of the early 1980s occurred because growth in aggregate demand outstripped growth in aggregate supply in the late 1970s, which subsequently led to high inflation. The Fed then tightened monetary policy significantly, throwing the economy into recession. Likewise, the Japanese and German recessions of the early 1990s were caused by high inflation (growth in demand outstripping growth in supply again) that led to excessive monetary tightening. More recently, excessive credit growth led to over-investment in residential real estate not only in the United States but in some other major foreign economies as well. The inevitable bursting of the real estate bubbles caused the global economy to tumble into a deep recession.

So are there any signs of imbalance in the global economy at present? The United States still has a current account deficit and China still has a current account surplus, but these imbalances are smaller today than they were a few years ago. Therefore, massive dumping of U.S. assets by foreigners does not seem very likely. U.S. consumers still have fairly hefty debt loads, but the household debt-to-disposable income ratio has come down to less than 115 percent at present from 125 percent in late 2007. We believe that balance-sheet adjustments will constrain growth in American consumer spending over the next year or two, but we do not anticipate panicked deleveraging. Real estate bubbles in the economies that experienced them have already burst, so another sharp downturn in house prices does not seem likely.
In our view, there are two imbalances that could potentially lead to another global recession. First, inflation rates have crept up in some important developing countries. Although sharp increases in food prices have helped to push up the overall CPI inflation rate in China, non-food price inflation has also picked up (see graph on front page). Similarly, CPI inflation in Brazil has risen this year. There is a risk that central banks in important developing countries could tighten too much, leading to recessions in those economies, but we think this risk is rather low. Inflation rates are not generally out of control at present, and expectations of slower growth in most advanced economies will likely prevent central bankers in developing countries from slamming on the brakes.

Fiscal deficits in many advanced economies pose the bigger risk to global prosperity. Greece, Portugal and Spain have announced significant fiscal retrenchment programs, and the United Kingdom plans a fiscal adjustment worth roughly 10 percent of GDP over the next five years. Germany, which is fiscally sound, is also contemplating budget cuts. The experience of Canada, which made a fiscal adjustment equivalent to 9 percent of GDP in the 1990s, shows that significant fiscal adjustment can be done. However, Canada spread it out over a period of almost 10 years rather than just a few years, and it had the benefit of strong global growth to offset the contractionary effects of fiscal retrenchment. Moreover, Canada, which accounts for only 2 percent of global GDP, did not have a debilitating effect on the global economy.

We look for weak growth in Europe over the next year or so, and the risk of another modest downturn in the euro area is not insignificant. Recession in Europe would not necessarily pull other regions under as well, but global growth could turn out to be more sluggish than was expected only a few months ago.