United States –Outlook 2012
Triple dip
The US economy approaches 2012 with considerable momentum. With the oil and Japan shocks fading, GDP growth has picked up from sub-1% at the start of the year to an estimated 3% growth in the current quarter. Enjoy it while it lasts. In many respects, we expect 2012 to play out like 2011, only in reverse:
�� We expect growth to gradually slow as three shocks hit: fiscal tightening, a recession in Europe and a policy uncertainty shock prior to the election.
�� Inflation will likely slow as commodities level off and firms face increasing resistance from cash constrained consumers.
�� The Fed will continue to respond to signs of weakness. In the spring, we expect it to extend the interest rates on hold promise into 2014 and next summer we expect it to start QE3.
�� The risks are primarily to the downside: if the Euro zone crisis spins out of control it will likely push the US economy into a mild recession.
Growth: duelling debt debacles
Despite the recent pick-up in growth, we expect the economy to slow over the course of 2012 (Chart 7). Three things argue for weaker growth.
Fiscal tightening: Fiscal policy is gradually moving from easing to tightening. Spending from the 2009 stimulus plan is steadily fading. The number of workers receiving extended unemployment benefits has already fallen 40% from the March 2010 peak. The payroll tax cut boosted growth in the first half of 2011 and faded in the second half. The good news is that despite this modest policy tightening the economy accelerated over the course of the year. The bad news is that we expect further tightening in 2012. In our view, Republicans are likely to reject all of President Obama’s jobs bill, arguing that the economy needs regulatory reform and permanent tax cuts, not gimmicks. As a result, on top of the ongoing tightening, we expect the payroll tax cut and extended unemployment benefits (roughly $150bn between the two programs) to expire. Extension of the payroll tax cut could add a few tenths of a percent to our first half forecast, but only if it is not “funded” with immediate cuts in other parts of the budget.
Euro flu: Our European team believes a recession in the first half of next year is almost inevitable. Under our baseline forecast, European GDP falls at about a 2% annual rate in the first half of the year and then recovers at a similar pace in the second half. Historically, the US economy has tended to breeze past Euro-centric crises, but as we argue in the global overview, banking and stock market linkages to Europe have grown in recent years.
Policy uncertainty shock: A differentiated aspect of our growth forecast is that we have explicitly incorporated a shock to growth from fiscal policy uncertainty. We expect the economy to slow sharply in the second half of 2012 as businesses and households anticipate three post-election shocks: an across-the-board income tax increase (1 ½% of GDP), across-the-board cuts in discretionary spending (1% of GDP) and another debt ceiling deadline. Keep in mind that two of these potential time bombs are set to go off during a lame duck session of Congress. Even if each of these time bombs is ultimately defused, it will be very hard to be confident about that outcome in advance.
Inflation: It takes two to tango
One of the surprises of 2011 was the rise in core CPI inflation. At the start of the year, we expected inflation to inch lower, from 0.8% yoy in November 2010 to 0.6% by December 2011. Instead, core inflation has accelerated to just over 2%. Despite the pick-up, we expect core and headline inflation to moderate in 2012. To understand why, it is important to understand why inflation picked up in the first place.
As we noted in the Global Overview, by some accounts, the pick-up in inflation is the natural consequence of super expansionary monetary policy. For example, in May 2009, Allan Meltzer warned that, “the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain.” Since then the Fed has expanded its balance sheet even further.
We always disagreed with this view and continue to disagree to this day. The monetary transmission mechanism is broken: despite a tripling of high powered money (reserves and cash), banking lending is barely growing and nominal GDP is up just 3.7% over the last 12 months (Chart 2). Easy policy has also had little impact on inflation expectations: both market and survey expectations of inflation remain low. The reserve expansion story is a red herring.
In our view, three factors caused the acceleration in inflation. Two of these factors are fading, while the other persists:
1. Commodity price pass-through has been stronger than expected. Inflation models using data from the last 25 years show very little impact of commodity prices on the core. However, the pass-through this year seems to have increased, with core goods inflation accelerating from -0.3% at the end of last year to 2.1% in the 12 months through October.
2. In a similar vein, overseas pricing pressures have pushed up consumer import price inflation faster than expected. It took almost a decade of dollar weakness to push import price inflation up to 3.4% in 2008; by contrast, just two years of both a weak dollar and rising foreign wages has boosted import inflation to 3.6%.
3. Despite a surplus of housing, a shortage of rental units has created rent pressure.
Looking ahead, we expect a partial reversal of these pressures. On the one hand, rent inflation will likely continue as foreclosures drive people into the rentals. On the other hand, commodity prices have already started to level off and the growth slowdown should take some of the pressure off of global wages. Stepping back, the deeper reason for lower inflation is that households have a budget constraint. With persistently high unemployment, wage growth continues to slow (Chart 9). Moreover, US workers neither expect, nor are likely to get, cost of living increases. Hence rising inflation puts an ever tighter squeeze on living standards. We expect considerable purchasing power pushback in the years ahead.
Policy: Better go down fighting
As we noted above, fiscal policy is tied up in political knots. In our view, an effective policy would couple modest fiscal stimulus in the near term, with credible deficit reduction in the longer term. Neither seems likely, in our view. In the near term, while there is some chance of an extension of the payroll tax cut, Republicans would prefer to do nothing until after the election. In the longer term, the debt ceiling agreement leaves excessive entitlement spending untouched, keeps all of the revenue side of the budget off-limits, and sharply cuts back discretionary spending. We would not be surprised to see a significant portion of the cuts in discretionary spending rescinded after the election. While fiscal policy is tied in knots, the Fed is likely to remain active in the year ahead. In the face of a disappointing recovery the Fed has had two options: give up trying and admit it is out of ammunition, or keep easing using unconventional methods. As expected, Bernanke has consistently chosen the latter. In 2012, we expect the Fed to repeat the same pattern as the prior two years: if growth slows on a sustained basis, as we expect, the Fed will ease further. So in the spring we expect the Fed to extend its “promise” to hold interest rates near zero into 2014. And after Operation Twist ends in June, we expect the Fed to announce another big asset buying program.
In our view, both the markets and many Fed watchers have made two mistakes in judging Fed policy. First, Bernanke and the majority of the Fed have a different view of what constitutes a recovery in the economy. In the market’s mind, the clock started ticking toward rate hikes the day the economy exited from the recession. In reality, as we saw in the last two business cycles, the Fed does not even think about hiking until there is real healing in the economy (Chart 10). In the current context, that means a steady and sustainable drop in the unemployment rate, and some sign that damaged sectors of the economy, such as housing, are getting back on their feet. This suggests that the Fed is no closer to hiking rates today than it was at the start of the recovery.
The second mistake is that the markets seem to be seduced by the views of the hawks on the FOMC. In the past the hawk commentary was sometimes a good leading indicator of rate hikes. Today, however, the hawks and the doves are in two different worlds. For the hawks, quantitative easing is a dangerous mixture of monetary and fiscal policy and should end as soon as possible. By contrast, Bernanke et al embrace QE as a necessary policy when a central bank runs out of conventional policy ammunition. Our advice to investors: ignore the hawks.
Risks: Stale on arrival?
Year-ahead pieces often have very short shelf lives. This year the risk of our Year Ahead report becoming stale quickly is higher than normal. The crisis in Europe is escalating as this goes to press and as such we are being cautious with our view, assuming three scenarios for European GDP growth: good (Europe grows 1% in 2102), bad (mild recession with -0.6% growth) and ugly (major crisis with -2.5% growth). In our view, only the latter scenario pushes the US itself into a recession. Nonetheless, given the crisis in Europe, fiscal follies in the US and the usual array of other risks, we see a 40% probability that the US slips into recession at some point in 2012.
A common question from clients is whether the US (and Europe) are at risk of a “Japan scenario,” with a long period of essentially zero nominal GDP growth. We think such an outcome is possible, but unlikely. In the post-war period, five countries have gone through major banking and real estate crises. In each case, a very weak recovery followed, with real GDP growth averaging 2 to 3% for several years. Deleveraging recoveries are weak and fragile. The extreme case is Japan: nominal GDP has been flat in Japan for two decades, by contrast in the other four instances nominal GDP was up at least 50% 10 years later (Chart 11).
Source/转贴/Extract/Excerpts: BofA Merrill Lynch Research
Publish date: 01/12/11
