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Issue No: 11/52 December 30, 2011
FOR THOSE PERMISSIONED: Goldman Sachs Global ECS Research at https://360.gs.com
5 Questions for 2012
We wish all of our readers a happy, healthy, and prosperous 2012. Today’s focus article discusses what we see as the 5 most important questions facing the US economy in the coming year.
Jan Hatzius firstname.lastname@example.org 212 902 0394 Zach Pandl email@example.com 212 902 3393 Alec Phillips firstname.lastname@example.org 202 637 3746 Sven Jari Stehn email@example.com 212 357 6224 Andrew Tilton firstname.lastname@example.org 212 357 2619 Shuyan Wu email@example.com 212 902 3053 Maria Acosta-Cruz firstname.lastname@example.org 212 902 6709
Alternative Measures Suggest Q4 GDP Tracking May Overstate Growth
Percent change, annual rate 10 Current Activity Indicator* 8 Quarterly GDP Growth Quarterly GDI Growth 6 4 2 0 -2 -4 -6 -8 -10 2006 2007 2008 2009 2010 2011 2012 * First principal component of 25 weekly and monthly US activity indicators. Shaded area denotes recession. Source: Department of Commerce. GS Global ECS Research. Percent change, annual rate 10 11Q4 Tracking = 3.3% 8 6 4 2 0 -2 -4 -6 -8 -10
First, will US growth pick up to an abovetrend pace? We think not. Underlying growth is probably considerably weaker than implied by our 3.3% tracking estimate for Q4 GDP growth; tight oil supplies act as a “speed limit” for global growth; fiscal policy remains a drag on growth; and the spillovers from the European recession are likely to increase. Second, how much will the European crisis— the biggest downside risk—subtract from US growth? Our baseline estimate is 1 percentage point, but the uncertainty is large. On the one hand, we have not seen much impact yet. On the other hand, a failure of peripheral European economies to stabilize due to a “paradox of thrift” situation in both the public and private sectors poses a downside risk for Europe and ultimately also the United States. Third, will the US housing market bottom in 2012? We think yes. With excess supply diminishing gradually and valuations back to “equilibrium,” we expect the house price decline to end in 2012H2, although the recovery is likely to look very U-shaped. Fourth, will inflation be too high or too low by late 2012, relative to the Fed’s target? Too low, in our view. The commodity price impulse is waning and there is still plenty of excess capacity. We expect core inflation to fall back to 1¼% by yearend, clearly below the Fed’s implicit target. Fifth, will Fed officials ease further? We think yes, probably via purchases of agency MBS (and perhaps Treasuries) announced in the first half of the year. We also expect Fed officials to provide a forecast path for the funds rate and adopt an official inflation target at the January 24-25 FOMC meeting.
Core Inflation Likely to Ease
Percent change, year ago 4 Contributions to Core CPI Inf lation: Goods Shelter Services Ex-Shelter Core CPI 3 Fcast 3 Percent change, year ago 4
-1 2002 2004 2006 2008 2010 2012
Source: Department of Labor. GS Global ECS Research.
Important disclosures appear at the back of this document.
2.8 -1. annual rate 10 Current Activity Indicator* 8 Quarterly GDP Growth Quarterly GDI Growth 6 4 2 0 -2 -4 -6 -8 -10 2006 2007 2008 2009 2010 2011 2012 * First principal component of 25 weekly and monthly US activity indicators.8 -0. We expect growth in 2012 to look broadly similar to 2011. Source: GS Global ECS Research.3% in the fourth quarter of 2011.0 Cumulative Impact on Level of US Real GDP f rom Eurozone Financial Stress* Percentage points 0.6 -1. 1. not far from that seen in 2011. However. as shown in Exhibit 2. Will US growth in 2012 pick up to an abovetrend pace? No.0 -0. tight oil supplies are likely to act as a “speed limit” on global growth.4 -0. They believe that this tightening will push up crude oil prices further. Issue No: 11/52 2 December 30. 2011 .3% 8 6 4 2 0 -2 -4 -6 -8 -10 Third. GS Global ECS Research.0 -2. but uncertainty is large. both our current activity indicator and income-side real GDP have been weaker than expenditure-side real GDP recently. expenditure-side GDP is a “noisy signal” of the economy’s growth trend. GS Global ECS Research. as discussed next. but real GDP is likely to increase at a slightly below-trend pace of 2% or so on a Q4/Q4 basis. ** Shaded area represents range of estimates f rom alternative models. First.2 Average Impact** -1.0 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013 *From bank equity shock in Q2 and/or short-term f unding shock in Q3. Second. we tackle what we view as the five most important questions on the economic outlook for 2012. A more substantial fiscal tightening looms in 2013. Source: Department of Commerce. The “healing” from the imbalances built up in the bubble economy of the pre-2007 period continues. perhaps more importantly.2 -1. The utilization of global oil production capacity is already well above normal levels. And fourth. As shown in Exhibit 1.4 -0. Following the agreement to extend the payroll tax cut and emergency unemployment benefits for two months—and assuming that most of these provisions will ultimately be extended for the full year—the fiscal impulse is likely to be around -¾. How much will the European crisis subtract from US growth? About 1 percentage point. As shown in Exhibit 3. fiscal policy continues to be a drag on growth. we expect more spillovers from the European crisis. growth in early 2012 is likely to be well below our current tracking estimate of 3. they see a significant risk of price spikes in response to news of weaker-thanexpected supply or stronger-than-expected demand. Source: IEA. By 2013 the market is likely back to capacity constraints Global Oil Production 90 80 70 60 50 40 30 20 Million barrels per day 100 Exhibit 3: European Spillovers Likely to Grow Percentage points 0.GS Global ECS US Research US Economics Analyst I. Exhibit 1: Alternative Measures Suggest Q4 GDP Tracking May Overstate Growth Percent change. Our commodity strategists believe that utilization will rise further in 2012 as our global GDP growth forecast of 3¼% implies that oil demand will continue to grow a bit faster than oil production capacity. annual rate 10 11Q4 Tracking = 3. Shaded area denotes recession. Percent change. and we suspect the truth is considerably less positive. 5 Questions for 2012 In the last US Economics Analyst of the year. our baseline estimate is that Exhibit 2: Oil Capacity Runs Short Million barrels per day 100 Ef f ective Global Oil Capacity 90 80 70 60 50 40 30 20 65 70 75 80 85 90 95 00 05 10 15 Note: Dashed lines represent f orecasts.6 -2.
even with such a bargain. and a tightening of bank lending worth around ½ point. otherwise. a private sector surplus of 1% of GDP. But it is partly also because the outlook for the European economy itself is highly uncertain. the financial balances need not add up to zero. September 16. Portugal. and the external sector is unlikely to provide enough of an ex ante boost to offset it. And there is a risk that the simultaneous pressure toward retrenchment in the public and private sector in the periphery will prevent such a recovery. Ireland. Italy. Source: OECD. And if all three taken together are “trying” to spend less than they earn—that is. and Spain—is on track for an ex ante fiscal cutbacks of a little over 2% of GDP in 2012. Given the tightening of financial conditions in the European periphery. or on an ex post basis. Italy. the financial balances between income and spending across these three sectors must add up to zero. As a matter of accounting. government spending. or on an ex ante basis. both relative to its own history and relative to other post-crisis economies such as the US. a tightening of financial market conditions worth ¼-½ point. “European Banks—A Drag on US Growth?” US Daily. In any given economy. the UK. 11/37.1 However. 2011. We also expect upward pressure on the private sector balance (dark shaded bars in Exhibit 4). households and businesses may decide to retrench further. the primary budget and trade surpluses necessary to stabilize government and external debt/GDP ratios will be difficult to achieve. a corresponding improvement in external demand (solid line in Exhibit 4) is unlikely. Portugal. US financial conditions. This is partly due to US-specific factors. Ireland. and an external deficit of 4% of GDP. It is still quite low across the periphery. and foreign spending. “Will the European Storm Cross the Atlantic. and Spain. GS Global ECS Research. and Japan. The European periphery currently runs a general government deficit of about 5% of GDP. 1 Exhibit 4: A Simultaneous Public and Private Retrenchment in the Euro Area Percent of GDP 10 European Periphery*: 8 6 4 2 0 -2 -4 -6 -8 -10 90 92 94 96 98 00 02 04 06 08 10 11E 14 12 * Greece. the labor market weakens. Ultimately. Real exchange rates across the European periphery remain overvalued as countries still struggle with the sharp increase in unit labor costs prior to the crisis. the uncertainty around this baseline estimate is large. the risk of economic and financial instability is unlikely to disappear quickly. Our European economists currently estimate that the periphery—Greece. the links between European economic developments. and external demand is neither growing quickly nor likely See Andrew Tilton. Our European economists have argued that a resolution of the crisis will need to involve an implicit bargain between a “mutualization” of excessive debt stocks and commitment to future fiscal responsibility in the periphery. However. fiscal sustainability requires a recovery in economic growth. The prospect of upward pressure on the government balance (light gray bars in Exhibit 4) is obvious. Meanwhile. 2011 . if the ex ante balances add up to a number greater than zero—then the result will be a shortfall of demand relative to production. and Jan Hatzius. 2011. Our concern is that both the government sector and the private domestic sector are likely to be a source of ex ante restraint for the foreseeable future. there are three possible sources of demand: private domestic spending. Fiscal Cutbacks Percent of GDP 10 Government Balance Private Sector Balance Current Account Tight FCI 8 6 4 2 0 -2 -4 -6 -8 -10 Exhibit 4 shows how the three financial balances have evolved over the past 15 years. on top of the ¼½ point impact that we have probably already seen over the past few months. This means that production plans need to be revised downward. and income disappoints. But as a matter of economics. December 13. Our baseline forecast is that such a bargain will emerge in the course of 2012. albeit in more halting fashion than would be desirable for a forceful resolution of the crisis. This consists of three effects—a direct trade effect worth ¼ percentage point or less. and US economic activity are difficult to estimate with precision.” US Economics Analyst.GS Global ECS US Research US Economics Analyst the European crisis will subtract around 1 percentage point from growth over the next year. The result is ongoing cyclical weakness in the economy. This means that households and businesses are still not paying down debt and/or accumulating financial assets at a particularly rapid pace. Issue No: 11/52 3 December 30.
000 demolition rate for existing homes.4 0. 3. Issue No: 11/52 4 December 30.8 2.2 0.8 2. The implication is that the euro area could suffer from a shortage of aggregate demand for a long time to come. 2011.8 0. our European economists’ forecasts imply a further decline in nominal GDP relative to its pre-crisis trend through 2013. with some (such as Detroit and Las Vegas) now well below equilibrium but others (such as Los Angeles and New York) still well above. will continue to support banks and government bond markets. 11/17. while nominal house prices are likely to bottom in the course of 2012.4 2. there are substantial differences between metropolitan areas. That said. The fact that a drop-off in external demand was not part of the problem in triggering the downturn in peripheral economies in 2011—i. This estimate is likely to be conservative because household formation in recent years has been depressed by weakness in the labor market. Although we believe that the European authorities in general. April 29.8%. GS Global ECS Research. GS Global ECS Research. we project a 2%-3% decline in nominal house prices through mid2012. Overall.4 0.0 70 75 80 85 90 95 00 05 10 Housing Starts Demographic Demand f or Homes* Household Formation** Millions 2.” US Economics Analyst. Source: Eurostat.e. that external demand is not particularly depressed—makes it less likely that a normalization in external demand will be part of the solution.6 1. which we calculate as the sum of the 10-year average rate of household formation and an assumed 300. If these cyclical factors diminish or reverse. the risk of renewed bouts of instability in the euro area—and larger spillovers to the rest of the world—therefore remains quite high. and the ECB in particular.0 * Household f ormation plus an assumed demolition rate of 300K per year. Exhibit 7: Home Prices Back at Fair Value Index 200 Case-Shiller Home Price Index: Actual 150 Estimated Equilibrium 150 Index 200 100 Forecast 50 2011Q2 100 50 2 See Zach Pandl. 2011 . population.2 Moreover.0 1. we estimate that this is only about half the underlying demographic rate. we estimate that home prices are now back in line with the underlying fundamentals such as income. followed by stabilization in 2013 and gradual recovery thereafter.GS Global ECS US Research US Economics Analyst to pick up significantly anytime soon.000. As shown in Exhibit 6. break adjusted. **10-year average change in number of households.0 1. Housing starts are running at an annual rate of 600.000-700. Source: Department of Commerce. the user cost of capital. Exhibit 5: Nominal GDP in the Euro Area Far Below the Pre-Crisis Trend Trillions of euros 12 Euro Area Nominal GDP: 11 10 9 8 7 6 5 1995 Actual Trend* GS f orecast 13% 10 9 8 7 6 5 2000 2005 2010 2015 11 Trillions of euros 12 *Estimated as level of nom GDP in 2005Q4 extrapolated backward at historical trend rate of 4% and extrapolated f orward at assumed 3. The slump in nominal GDP is also likely to weigh on countries’ ability to reach their fiscal goals and retain their electorates’ support for unpopular fiscal measures.8 0. As shown in Exhibit 5. “The Longer-Term Outlook for US Homebuilding.6 1. and construction costs (see Exhibit 7).2 0. Will the housing market bottom in 2012? Yes. We believe that housing starts have probably bottomed already. Exhibit 6: Housing Starts Still Far Below the Demographic Demand for Homes Millions 2.. 0 0 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: Moody's Analytics. we should see a significant pickup in household formation. This forecast mainly reflects the fact that there has already been a very large amount of adjustment.4 2.
We view the funds rate forecasts as a sensible step. 4. These moves are somewhat independent of the shift to renewed QE. In addition. we believe Fed officials would be loath to end their securities purchases at the conclusion of “operation twist” in mid-2012. continued high unemployment. -1 2000 -1 2002 2004 2006 2008 2010 2012 Source: Department of Labor. We expect Fed officials to ease anew in the first half of 2012 via purchases of agency mortgage-backed securities. we also expect the FOMC to provide forecasts for the federal funds rate in the Summary of Economic Projections (SEP) published four times per year. Will the Fed ease further? Yes. Although they are unlikely to go as far as to complement the official inflation target with an outright target for the unemployment rate. But one of the lessons of 2011 has been that the standard core inflation indexes can also be quite sensitive to changes in commodity prices. and also that unemployment remains far above their estimate of the structural rate. This forecast is based on our expectation that real GDP growth will slow to a below-trend pace and inflation will fall to a below-target rate in the course of 2012. December 9. “Inflation: From Hill to Valley.” US Daily. This would be below the Fed’s implicit—and probably soon explicit—inflation target of about 2%. From a top-down perspective. the FOMC will also move from its current all-but-official inflation target of “2% or a bit less” to an outright inflation target of 2%. 11/49. Both a top-down and a bottom-up view point to lower inflation ahead. our models suggest that the slowdown in commodity price inflation since the spring. the US economy remains far from full employment. and this is showing up in measures of overall labor costs such as average hourly earnings. 2011. From a bottom-up perspective. GS Global ECS Research. and unit labor costs. year ago 4 2 2 1 1 0 0 5. With the level of output still far below potential. Our own view remains that a move to a nominal GDP level target. 4 See Jan Hatzius. At a minimum.” US Economics Analyst. would provide a greater chance to achieve the Fed’s dual mandate over time. starting at the January 24-25 meeting. year ago 4 Contributions to Core CPI Inf lation: Goods Shelter Services Ex-Shelter Core CPI 3 Fcast 3 Percent change. 2011 Issue No: 11/52 5 . the employment cost index. we believe that this would be a sufficient signal for Fed officials to decide to ease further. Is US inflation likely to look too high or too low? Too low. Fed officials are likely to emphasize that the inflation target is “flexible” and applies to the medium term.GS Global ECS US Research US Economics Analyst Exhibit 8: Core Inflation Likely to Ease Percent change. the decline in spare capacity not only pushes up the central forecast but also raises the risk of a significant price spike. Our baseline forecast is that core CPI and PCE inflation will fall back from around 2% year-onyear now to around 1¼% by the end of 2012. and additional purchases essentially require a balance sheet expansion. they might decide to state even more clearly that they aim for an unemployment rate in line with their estimate of the structural rate over the medium term. 3 Jan Hatzius See Andrew Tilton.4 We are less sure about the inflation target because it might be misinterpreted as a shift away from the employment part of the dual mandate. and an end to the pickup in rent inflation are all likely to push down inflation over the next year (see Exhibit 8). “Why the Fed Should Forecast Its Own Policy. complemented with potentially large amounts of QE. But while we would not rule out such a move if the economy performs significantly worse than our forecast. because they are likely to enhance the communication of the Fed’s reaction function to incoming information. the reversal of the auto price surge following the Japanese earthquake.3 The biggest risk to this view is probably another sharp increase in energy prices. Our commodity strategists’ point estimate that Brent oil prices will climb to $130/barrel would still be consistent with declining inflation pressure because it would imply a slower rate of price increase than over the past year). we do not expect Fed officials to embrace such a seemingly radical option anytime soon. We believe that this weakness will also reassert itself in lower core price inflation over time. either on their own or combined with Treasuries. More likely than not. at least in the short term. October 24. 2011. However. To counteract this impression. Such a spike would primarily lift headline rather than core inflation. December 30.
Second. In particular. Moreover. consumer confidence reported for December by the Conference Board increased more than expected. This deceleration is due to two factors. a larger increase than expected. Issue No: 11/52 6 December 30. First. the four-week moving average dropped to 375. A continued easing bias from the Fed. Initial claims.GS Global ECS US Research US Economics Analyst II.7%. We estimate that real GDP increased by 3. core PCE inflation should fall to 1. Upward pressure on prices earlier this year caused by pass-through from high commodity prices and other temporary factors looks to be receding. but would be more clearly conditional on outcomes for economic activity and inflation. The FOMC is implementing the “twist”. mainly via the financial channels. the Chicago purchasing managers' index held steady in December despite expectations for a notable decline. likely reflecting Fed asset purchases (and expectations of more to come) and a flight to quality resulting from the European financial crisis. This change will probably be accompanied by more guidance of the Fed’s longrun objectives. we expect the Euroarea crisis to weigh somewhat more heavily on growth than it has done so far. Although both major surveys of consumer confidence—Conference Board and the University of Michigan—remain low in an absolute sense. First.1% by the end of 2013. up from 1. We also expect Fed officials to begin publishing their forecasts for the federal funds rate in the quarterly Summary of Economic Projections (SEP) at the January 24-25 meeting.0% by Q4 2012. and plans to continue sales of shorter-maturity Treasuries and purchases of longer-maturity Treasuries through mid-2012. ending 2012 around 9%. and business surveys point to diminishing input cost pressure.3% (annualized) in Q4. We expect the unemployment rate to stay move sideways to higher. A Week of Light Data The (light) dataflow this week was mostly positive. however. increased a bit more than expected (up 15. Like the current forward guidance in the post-meeting statement.000 in the week ended December 24). and that it will begin to decline early next year.3% by the end of 2012 and 1.8% in Q3. We expect that the Fed will ultimately announce a return to balance sheet expansion sometime in the first half of 2012.000 to 381. 4. Core inflation near its peak. both our Current Activity Indicator and income-side real GDP have been weaker than expenditure-side real GDP recently. we expect the unemployment rate to drift back up to 9. We expect a modest drift up in rates throughout the forecast horizon. Moreover. resulting in a 3. the Case-Shiller index of home prices in 20 metro areas fell more than expected in October—down 0. 2. Forecast Highlights 1. this would emphasize that rates are likely to stay low. expenditure-side GDP is a “noisy signal” of the economy’s growth trend. the index of pending home sales—a leading indicator for existing home sales—rose by 7. we still expect growth to slow in the first half of 2012. Nonetheless. Long-term interest rates to rise gradually. and we suspect the truth is considerably less positive. The US 10-year yield is below our strategists’ fair value estimate of about 2.4% year-onyear decline. The last few core inflation readings have been more moderate.6% (month-on-month) on a seasonally adjusted basis. each of them has shown a significant improvement since September/October levels. 2011 . 3. and to remain there throughout 2013. We believe that core PCE inflation is near its peak on a year-over-year basis. Since our forecast entails growth that is slightly below the US economy’s potential. likely including purchases of mortgage-backed securities (MBS). including a formal inflation target. Second.000—the lowest level since mid-2008. 5. Despite this momentum in the recent data. Based on our forecast for activity.3% (month-overmonth) in November.
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Fluctuations in exchange rates could have adverse effects on the value or price of.0 -1.4 4.0 1. yr/yr) Consumer Price Index (CPI) Core CPI Core PCE* Unit Labor Costs LABOR MARKET Unemployment Rate (%) FINANCIAL SECTOR Federal Funds** (%) 3-Month LIBOR (%) Treasury Yield Curve** (%) 2-Year Note 5-Year Note 10-Year Note 30-Year Bond Profits*** (% chg.gs.8 -422 59 5.2 1..45 74 * PCE = Personal consumption expenditures.90 10.1 1. photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group.5 -1. regulated by the Bundesanstalt fur Finanzdienstleistungsaufsicht.0 _ Q4 2. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. and a loss of original capital may occur.0 1.10 0. in Hong Kong by Goldman Sachs (Asia) L.7 2.2 0.3 1.
0 +2. Regional surveys sent mixed signals on the state of manufacturing activity in December.6M 10.3M n.000 3.0 n.1% +1. CT St Louis Fed Pres Bullard spks at Korean American Assoc Estimate GS Consensus Last Report +0.US Calendar Focus for the Week Ahead ■ We forecast that nonfarm payroll employment rose by 175.a.000 381. We expect the ISM manufacturing index to remain broadly unchanged (January 3).7 +2.000 in December (January 6).601.000 375.2 52.a. 53. Time (EST) 10:00 10:00 14:00 10:00 17:00 17:00 8:15 8:30 8:30 10:00 11:00 8:30 8:30 8:30 10:20 18:00 Indicator Construction Spending (Nov) ISM Manufacturing Index (Dec) Minutes of December 13 FOMC Meeting Factory Orders (Nov) Lightweight Motor Vehicle Sales (Dec) Domestic Motor Vehicle Sales (Dec) ADP Employment Change (Dec) Initial Jobless Claims Continuing Claims ISM Nonmanufacturing Index (Dec) GS Retail Index (Dec) Unemployment Rate (Dec) Nonfarm Payrolls (Dec) Average Hourly Earnings (Dec) Boston Fed Pres Rosengren spks at econ summit.9% 13.a.2% -0.3% 13.000 +0.4M 10.000 53.6% +120.0 n. 8.7% +150.000 3. 8.4M +168.7 +0.573.a. The pickup from a gain of 120. n. We anticipate a slight improvement in the non-manufacturing ISM index in December (January 5).a.000 in November reflects mainly the continued decline in initial unemployment claims and an improvement in consumers’ assessment of current conditions in the labor market.000 52.5M +206.000 +0.1% ■ ■ Date Tue Jan 3 Wed Jan 4 Thu Jan 5 Fri Jan 6 Sat Jan 7 Issue No: 11/52 8 December 30.8% 53.0 53. n.7% +175.5% +0.9% 8.000 -0.4% 13. 2011 .5M 10.
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