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U.S.

Economic Forecast: Still Treading Water S&P August 2011
On August 5, Standard & Poor's Ratings Services lowered its long-term sovereign credit rating on the U.S. to 'AA+' from 'AAA' and kept its negative rating outlook, which increased worries that the economic recovery has faltered. The downgrade and concerns that the eurozone sovereign debt crisis was spreading north to France caused markets to go into a tailspin last week. This likely forced the Federal Reserve to take more policy action, which helped calm markets. However, while the market panic subsided, recovery concerns that helped launch it are still very real. After the recession officially ended two years ago, the outlook for growth is worsening and the U.S. economy is still treading water trying to stay afloat. The "temporary shocks" sound less convincing, even to the Fed, as an explanation of paltry growth during the last two quarters. The lack of underlying momentum was highlighted in second-quarter GDP report, where backward revisions showed not only how much worse the recession was, but how anemic the recovery really is. While July data finally showed a slight improvement in the U.S. economy, it's not enough to support expectations that the second half of the year will see a bounce in growth. We now expect to see an even slower recovery than the half-speed we earlier expected. We now expect just 1.9% growth in the third quarter and 1.8% in the fourth, to bring 2011 calendar year growth closer to 1.7% instead of 2.4% we earlier expected. We also downwardly revised growth expectations for 2012 and 2013, as a more drawn-out recovery is factored into our forecast. It is disturbing that policymakers do not seem to have the weapons or the political resolve to fight the economic crisis. Those policy problems are a large reason why we believe the economy is more vulnerable to another recession. Once again the Fed is willing to step in, just like it did in 2008 when Congress refused to pass legislation (including TARP), as markets spiraled out of control. But this time, the Fed is confronting the collapse with a sling shot, not a bazooka, so its measures will have less bite. We are not surprised that in the aftermath of the worst recession since the Great Depression, the recovery would be slow and uneven. As history has shown, financial crises are often followed by prolonged recessions, and after that, a long bout of sub-par growth. Several studies measure just how much damage a financial crisis can cause, and how long it can last. According to these studies, economic growth will be slower than normally expected, which most people won't recognize as a recovery. Just Like Old Times The markets' violent swings in early August resurrected fears of the market meltdown, such as the one in 2008 when Lehman Brothers went under and Reserve Fund broke the buck. Currently, the crisis is considered to be much more severe, with U.S. sovereign debt at risk of default. The low Treasury yields indicated that markets were expecting Congress to come to its senses and reach a deal. However, the wait and the last-minute deal, which left a lot to be desired, only increased worries that the government will do more harm than good.

Continued weak growth after sharply downward GDP revisions has made the "temporary argument" a less plausible explanation for the slew of bad news for the first half of the year. The high unemployment rate. But the revised data also indicate a much weaker outlook than we previously expected. However. and massive storms have certainly contributed to the slowing U. We now expect below- . gas. The jobs market will likely remain weak into 2013.1% from 9. because the former is still working off excess debts and the latter excess supply. Excluding autos. such as the stronger-than-expected July retail sales and recent jobs report. The bad news during the last few months suggests that these fears may not be unfounded.1% gain). it shows just how fragile this recovery is.2% in June. After U. if a couple of one-offs can do so much damage. The results by no means suggest that we are in the clear. they may lose it next week.S. and building materials.1%.000 job gain and the unemployment rate slipped to 9. housing won't contribute to the recovery. More importantly. At least the GDP revisions make the persistently high unemployment rate make more sense. the preponderance of evidence to the contrary explains the sour moods.S. maybe it was retail therapy after all the sour news. the consumers have been squeezed by higher commodity prices which wiped out any benefit of the payroll-tax credit. The recovery comprised a first-half average growth of just 0. The storms that blanketed the U. policymaking has hit new lows. There are some signs that the second half of 2011 won't look as bad as the first. climbing energy prices.4% increase in June (sharply revised up from a 0. this winter kept people away from the mall and Japan's natural disaster supply-chain disruptions can only be partly blamed for lower sales. But at least the economy is inching away from a double-dip recession. As I said in my last monthly forecast report.S.8% average growth rate is not impressive. however. Amid sluggish job market and stagnant wages. But even the Fed admitted that those events alone may not explain the extent of the decline. The supply shock due to the earthquake in Japan.S. show that not all news is bleak. The global stock-market plunge reflected fears that a double-dip recession is coming. As the boosts from rebuilding inventories and fiscal stimulus unwound. but the July retail sales data showed that consumers began to spend more. Ready To Take Another Dip? Does the Great Recession have company? Many think that another crisis will follow the Great Recession. worried that even if they have a job.8%. consumer spending and housing couldn't cover the hole. So without that jobs-related boost. This comes while the government payrolls report posted a better-than-expected 117. and it's not because of a hefty price tag at the pump. not a recession. painful recovery than the half-speed one we earlier expected. the onslaught of dismal news puts even that forecast at risk. consumer confidence hit a 31year low and manufacturing sentiment readings contracted. As the economic data continue to disappoint.Confidence in the recovery and in U. we have become more worried about the strength of the recovery. economy. anything slightly better than a 0. at 9. We expected some improvement in the jobs market to help revive household formation to absorb excess supply. Though we still expect weak growth. sovereign debt lost its triple-A status and financial markets unwound. the data indicate a more drawn-out. sales were up 0.3% in July after a 0.5% over June numbers. While some hard data. so housing will remain soft. the wallets are empty after people fill up their gas tanks. kept people cautious. We have been expecting a half-speed recovery for some time. Total sales jumped an upbeat 0. However.

According to these studies. there are a few things to watch. Since the Second World War. and well above the 25% odds we expected in March.3%. There are a lot of rules of thumb that the investment community uses to signal a recession. 2010) found 45 episodes of deleveraging since the Great Depression. Another plunge in the stock market. But markets still keep trying to predict. On August 5. a deeper contraction in already weak consumer confidence levels. amid the fragile economy. it ended just when NBER declared that it began. to say with more certainty that recession has started. the normal rules may not apply.9% trough in March.? As the recovery is on a precipice. financial crises are often followed by prolonged recessions. which would imply that the economy is falling into recession. where we have a very sluggish recovery. While a market sell-off is also watched. the shock of another stock market drop and resulting loss of wealth could be the tipping point. The McKinsey report (Debt and deleveraging: The global credit bubble and its economic consequences. if unemployment rate climbs by more than 0.1% to 9.S. in order to top the 8. recoveries from financial crises are typically a hard climb. recovery with intermittent declines bringing the growth rate so close to zero. It's Only Just Begun Why are we surprised that in the aftermath of the worst recession since the Great Depression the recovery would also be slow and uneven? As history has shown. which is often revised. a recession follows within a year roughly 70% of the time. could push the recovery back into recession. We would need the three-month average rate to reach 9. backed up by a Fed study. Trying to use various rules of thumb to determine a coming recession can be dangerous. The economic growth will be slower than normally expected and won't be felt as a recovery by most.potential growth through the end of next year.1%. and in case of the 2001 recession. Given the July figure edged down 0. and at a minimum they show an economy with very feeble growth prospects.3%. when does a double dip becomes the most likely outcome for the U. so we have a little more time. And while the numbers are still positive. a recession has always followed. it's hard to identify a recession in real time. and consumer confidence dropping. It takes the National Bureau of Economic Research (NBER) many months to announce the start of a recession. which is followed by a long bout of sub-par growth. Several studies measure just how much damage a financial crisis can cause and how long it can last. With the odds of a double dip at 35% and climbing every time stock market sells off. we increased the chance of a recession in the next year to 35% from 30% in June. though weak. of which . a plunge in stocks during the past three weeks doesn't necessarily mean a new recession (the economy avoided a recession after the stock market crash of 1987). Another shock to the economy. Second-quarter GDP growth was 1.6% over last year. credit spreads widening. The three-month unemployment average rate is another important indicator. even a mild one. We'd watch whether the deterioration in financial conditions persists or if leading economic data worsen. the smaller they get. We may still be in a sustained. Given a lag in the release of economic data. says that when real GDP growth drops below 2% year-over-year. or sub-50 ISM readings for several months would push the recession gauge to the brink. However. One. the greater the risk of dipping into another recession. we still haven't arrived at that point. And in this case. one more spike in initial claims that holds. But the signals are disturbing.

oyment rate will rema above 8.5% nat ed tural rate fo another 10 years. Reinh and Vin r en hart ncent R. which . with the media unemplo e h an oyment rate for the e five adv vanced eco onomies of about 5% h higher. Accor rding to the study." m massive def faults. or "growing out of deb (through strong h o g bt" h econom expansio a war. which is i " w what th U. 2010) put numbers er n to the n news. or 0 What's Left In Th Tool Box s he x? In a sha departu from the usual prot arp ure e tocol. it indicated that econom conditio "are ich he way t mic ons .S unemplo S. al real per capita GD growth rates were " r DP r "significant lower" with the me tly w edian post-f financial crisis G GDP growth declining about 1% in the five ad h a n dvanced eco onomies. they would hat y's ies at y experien six-sev years of deleveragi where th debt-to-G nce ven f ing he GDP ratio f falls by abo 25%. A paper by Carme M. Th study als found he so that in t 10 year following a severe fi the rs g financial cri isis. and inflation low (or deflation f d for some). unempl loyment co onsistently high. The report found that the most common mic on. Re einhart (Afte the Fall.5% throu e ain ugh 2013 and not re each the estimate 5. high inflation. The wrote th "In ten o the fifteen postey hat of crisis ep pisodes." Th hese depres ssing results support ou expectati s ur ions that the U.S. the Federal Open Market C n Committee (FOMC) ( last wee assigned a time fram to its "e ek d me extended per riod" phrase While the statement had the e. The type of delev es veraging the report do e ocumented included i "belt tig ghtening. The Mc cKinsey rep port said th if today economi were to follow tha path. t t c type of deleveragin after a major finan f ng m ncial crisis is the "belt tightening" scenario. du eir during the decade following a sev d vere financia crisis. e that foll lowed now through en nd-2009. whi gives th Fed a w out. GD growth could be sl d DP lower than it would ha been oth i ave herwise. out As the debt is paid down. o . e t usual caveats. is no experien he ow ncing. or a "peace dividend"). unempl loyment rat are significantly tes higher t than in the decade pre eceding the crisis. une employmen has never fallen back to its prent r k -crisis levels not in the decade s. unfortun nately sounds s all too similar r to our cu urrent situation.32 follo owed a financial crisis.

We expect no rate ng t hike fro the Fed before 2014. poss lar sibly later th year. however. it wi likely om he a yed ill attempt another pro t ogram of qu uantitative e easing simil to the last one. e d Given t that the Fed has fewe effective ways to st deflatio but has numerous ways to er top on tighten policy. the Fed will lik project the outlook to remain weak and fi kely k fight deflatio on." Nevertheless. t Commit said s the ttee that dow wnside risk have increased. MC nally indica ated that no all the ot weakne in econo ess omic growth was trans h sitory. They will. Since th Fed has already play its best hand. And to no one's surprise. mic . sugg ks gesting that more easin is likely.   ." The sta atement note that the Committee "now expe a some ed e ects ewhat slowe pace of recovery er r over co oming quart ters" than it did before The FOM also fin t e. th hough they will only m w modestly sup pport the econom growth. ote ere ree ers which c could lead to an interes sting struggl between the doves and hawks f the rema le a for ainder of 2011. and "is prepar to emplo these too as approp d red oy ols priate. prevent the risk of slipping into outright deflation. his Both m measures sho ould boost financial con f nditions.likely t warrant e to exceptional low leve for the federal fun rate at least through midlly els nds 2013. it's important to no that the were thr dissente to that opinion. the FO OMC went on to say tha it "discus o at ssed the range of policy tools avail y lable…" to stren ngthen the re ecovery. In addition to the Fed''s pledge to essentially offer free money to markets fo a few o y e or more ye ears.