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The U.S. outlook for 2012.

When it comes to forecasting, can economists ever get it right? First, many failed to fully comprehend the consequences of the housing boom and bust. Then, most economists (and forecasters) were surprised by the depth and duration of the 2007-2009 recession and financial crisis. Many forecasters then over-predicted the strength of the recovery, believing that the historical tendency of strong economic recoveries to follow deep recessions would occur this time as well. Finally, following passage of the 2008 and 2009 economic stimulus packages, some economists then mistakenly predicted that temporary tax cuts and increases in federal government outlays would lead to a much faster growth of economic activity and employment. Perhaps God really did invent economists to make weatherman look good!

And yet, while the average economists' crystal ball may be as cloudy as ever, investors, businesses, and policymakers still turn to economists to help them sort through key economic developments and what they might foretell about the U.S. outlook for inflation, employment, and interest rates. Some might rightly call this economic cognitive dissonance. However, we must recognize that the decisions of households and businesses depend importantly (though not solely) upon expectations of the future. But, the goal of this article is not to lament on the sorry state of forecasting over the past few years, nor is it to describe in painstaking detail why some forecasting models give certain conclusions and others give something different. Rather, the goal of this article is to try and identify key developments in the U.S. economy over the past few years, and where the economy might end up a year from now based upon what we know today.

Strong Headwinds in 2011

The U.S. economy has been buffeted by many developments that have jolted the economy over the past couple of years. Among the most notable was the sharp rise in energy and commodity prices in 2010 that began to fuel larger increases in CPI inflation. This development reduced the purchasing power (real incomes) of households and helped to markedly slow the growth of personal consumption expenditures. A second development was the Great East Japan earthquake in March 2011, which rattled the U.S. and global automotive supply chain network. Although the just-in-time inventory system has greatly increased the efficiency of the global manufacturing sector, shocks that disrupt the delivery of key inputs can temporarily cut production.

A third headwind has been the European sovereign debt crisis, which was initially triggered by fears that Greece might default on its debt without outside financial assistance. In April 2010, as these concerns spread to other sovereigns, investors began to worry that the actions of several countries to reduce their massive budget deficits might plunge Europe into a recession. Given their close economic and financial linkages, investors also worried about the risk of weaker growth in the United States. In response, stock prices began to fall sharply and the pace of economic activity in the United States began to slow. In addition, U.S. monetary policymakers began to worry that core inflation was at risk of drifting too low. To help stabilize the economy and minimize the threat of deflation, the Federal Open Market Committee (FOMC) announced a second round of large-scale asset purchases ("quantitative easing") on Nov. 3, 2010. This action, combined with some policy actions taken by European officials and the International Monetary Fund, provided some much-needed stability to financial markets.

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Fast forward to July 2011, when lingering concerns about Greece and newfound concerns about the health of several large European banks began to weigh on financial markets. Markets were then throttled by the second-quarter GDP that was released in late July. This report showed that the economy was much weaker than expected over the first half of the year. In response, credit risk spreads and market volatility measures began to rise sharply. Compounding these developments was the drawn-out debate over the extension of the debt ceiling and the decision by Standard & Poor's (S&P) on Friday, August 5, 2011, to reduce its rating on U.S. sovereign debt from AAA to AA+. These actions triggered a further erosion in business and consumer confidence, and financial market turmoil increased further. By early October 2011, stock prices were down a little more than 20.0 percent since early July. Financial markets and some economists began to brace for another recession. (1)

Peering into 2012

But a funny thing happened on the way to the next recession: the data refused to cooperate. In early October 2011, the closely-watched Purchasing Managers' reports for the manufacturing and non manufacturing sectors showed continued modest growth in September. Then, the Bureau of Labor Statistics reported that private payroll employment rose by a little less than 150,000--well above expectations and revisions indicated larger gains had occurred in the previous two months. (2) Subsequent data on weekly initial claims for state unemployment insurance suggested no discernible deterioration in job growth heading into the fourth quarter of 2011. The good news continued in mid-October 2011 when the Census Bureau reported that retail sales were much stronger than expected in September 2011--further evidence of the resiliency of the American consumer.

To many economists, business capital spending (fixed investment) is one of the key signals of a healthy economy since it signals rising business confidence about the future. If businesses are uncertain about the future, then they are usually less willing to commit to long-lived capital projects that are costly to reverse. And, with non-financial firms holding more than $1 trillion in cash, it seems that economic uncertainty has caused them to be cautious about expanding capacity and adding to their payrolls. Nevertheless, employment is on the rise, and new orders and shipments for business capital goods through August have exhibited a strongly positive upward trend. It is not yet clear, though, whether this is the initial stage of a return to much faster growth, or whether much of this investment spending is simply to replace worn out capital rather than net, new additions to the capital stock.

Thus, while much of the data are improving, there are areas that pose some risk to the economy over the near term. First, with the global economy experiencing a modest slowdown, there has been some moderation in the growth of U.S. exports. Over the past two years, exports have been a source of strength for the economy. This slowing, should it persist, will likely cause manufacturers to become more cautious as they plan for 2012. Another risk stems from the budgetary difficulties facing the federal government and many state and local governments. State and local governments have aggressively trimmed expenditures, some have raised taxes, and most have reduced employment.

The most pressing difficulty remains at the federal level. During fiscal years 2009 to 2011, the federal budget deficit average roughly $1.3 trillion. As a share of GDP, these deficits, which were last seen during World War II, are roughly the same as those recently experience by Greece and a few other European countries. Some economists are thus worried that the United States may face its own "Greek moment." If that were to occur, investors may begin to aggressively sell U.S. Treasury securities, causing interest rates to rise sharply. Policymakers may then be forced to reduce the extraordinarily large U.S. budget deficit on a timeline not of their choosing.

On balance, the headwinds that tempered U.S. economic growth over the first half of 2011 seem to be waning. Of note, oil prices have fallen noticeably. Still, forecasters expect below-average growth of real GDP for 2011 and 2012. As seen in Figure 1, developments in July and August caused most forecasters and policymakers to sharply lower their projections. In this regard, the July GDP report was crucial. Before July, forecasters expected that the U.S. economy would grow by about 2.5 percent in 2011 and by 3.0 percent in 2012. Currently (through October), forecasters expect the economy to grow by about 1.5 percent in 2011 and by about 2.25 percent in 2012. With the ratcheting downward of expectations for real GDP growth over the next year or so, the unemployment rate is now expected to remain at around 9.0 percent, or slightly less, through the end of 2012. The recession and financial crisis have been especially damaging to the labor markets. Figure 2 shows that in August 2011 there were about five people for each job opening. Although this is down significantly from its peak, it is well above its pre-recession norms.

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Going forward, the outlook for the real economy could improve measurably if there is a relatively quick resolution to the European crisis and credible action is taken to reduce the federal budget deficit. However, these benefits may be offset to some extent if other impediments that have reportedly elevated the uncertainty felt by businesses and investors remain in place.

The Outlook for Inflation

Despite the aggressive efforts of fiscal and monetary policymakers, the economy has struggled to reach the level of economic activity that occurred before the recession. For example, real per capita GDP in the second quarter of 201l was about 12.0 percent below its long-run trend. Another way to characterize this development is to say that the unemployment rate remains well above its estimated natural rate of unemployment. (3) There are many reasons for this development, including the fact that economic recoveries tend to be appreciably weaker than normal following financial crises.

Economists who use a Phillips curve framework to forecast inflation continue to see little likelihood of acceleration in inflation as long as the economy has so much "slack." As seen in Figure 3, though, both the CPI-all items (headline) and the CPI excluding food and energy (core) have increased noticeably in 2011. The rise in headline inflation, as noted earlier, stemmed from the sharp increase in crude oil and commodity prices from September 2010 to April 2011. Notably, though, prices of crude oil and commodities have drifted lower, but headline and core inflation continued to increase. One reason for this development has been the sharp slowing in labor productivity growth since mid-2010. All else equal, slowing productivity growth increases a firm's per unit costs. And indeed, growth of unit labor costs have turned positive in 2011 after declining over the previous year and a half. To maintain profit margins, firms may begin to increase their sales prices. To the extent they are successful adds to economy-wide inflation pressures. Although inflation is ultimately a monetary phenomenon, economists will be carefully monitoring the evolving trend in productivity growth.

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Two other factors may weigh on the inflation outlook. First, the monetary base (what Milton Friedman termed "high-powered money") was at a record-high level in the third quarter of 2011 ($2.7 trillion). Economic theory suggests that a permanent increase in the monetary base will increase the price level by an equivalent amount eventually. (4) The FOMC has announced a set of policies (the so-called exit strategy) that are designed to prevent this surge in the monetary base from becoming inflationary. A second challenge stems from the FOMC's use of its forward guidance for monetary policy. After its meeting on Aug. 9, 2011, the FOMC indicated that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through 2013."

Although Chairman Bernanke and the FOMC are strongly committed to maintaining price stability, the likelihood of a super-easy monetary policy for the next year and half poses some risk to the inflation outlook if the unemployment rate remains stubbornly high. For example, if the financial markets come to believe that the FOMC has decided to place more weight on the unemployment rate than on the inflation rate, then this might cause inflation expectations to begin drifting higher. Thus far, as seen in Figure 4, both short- and long-term inflation expectations appear well anchored. Moreover, forecasters see only a small probability of inflation exceeding 3.0 percent in 2012. By all indications, it appears that the Fed's promise to maintain price stability is viewed credibly by forecasters and financial markets.

In short, monetary policy remains extremely accommodative and should help bolster economic conditions go ing forward. But, if the headwinds that have slowed the economy over the past couple of years continue to diminish, as expected, then monetary policymakers will need to be especially vigilant should inflation pressures continue to build.

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(1) See "The Uncertainty Shock from the Debt Disaster will Cause a Double-Dip Recession," by Stanford Professor of Economics Nicholas Bloom. The article can be accessed at http://www.voxeu.org/index.php?q=node/6846.

(2) This September 2011 estimate was biased upwards by the end of a worker strike against Verizon that temporarily subtracted 45,000 jobs from the August estimate of private payroll employment growth.

(3) According to the Survey of Professional Forecasts report released on Aug. 12, 2011, the median estimate of the natural rate of unemployment was 6.0 percent. The estimates ranged from a low of almost 4.8 percent to a high of 7.0 percent.

(4) In the second quarter of 2011, the monetary base was about 17.5 percent of nominal GOP, its highest level during the post-WW II period. This percentage was about 6.0 percent in the second quarter of 2008 (prior to the onset of the financial crisis).

by Kevin L. Kliesen, Business Economist, Supervisory Policy and Risk Analysis Unit, Research Division, Federal Reserve Bank of St. Louis

Kevin L. Kliesen is a business economist in the Supervisory Policy and Risk Analysis Unit at the Federal Reserve Bank of St. Louis, which is located in the Bank Supervision and Regulation Division. He came to the Bank in 1988 after graduating from Colorado State University with an MA in Economics. As a business economist, the bulk of his duties comprise reporting on and analyzing current U.S. macroeconomic developments and trends. Previously, he was part of the Research Division.

In his capacity as a business economist, he writes the Bank's monthly Report on Economic Activity, an internal report on general economic conditions that is prepared prior to each Board of Directors meeting. He also briefs the Bank president and staff economists on U.S. economic conditions prior to each Federal Open Market Committee meeting. He also prepares internal reports on macroeconomic conditions and their implication for monetary policy and bank supervisory policy for internal Bank officers and employees. Another important aspect of this position involves speaking to the general public and other interested groups about U.S. economic and monetary policy developments. Besides writing for the Regional Economist, a quarterly publication written for a nontechnical audience, he also writes for the Review, which is the Bank's peer-reviewed economic journal. He has also written for professional economics journals, and he has authored several book reviews. In addition to his responsibilities at the Federal Reserve Bank of St. Louis, he has taught economics part time at Washington University in St. Louis since 2007.

Professionally, Kliesen is a member of the American Economic Association and the National Association for Business Economics (NABE). He was President of the St. Louis Gateway Chapter of NABE from 1999 to 2000. From 2002 to 2005, he served on the Board of the Directors of the national NABE organization. In addition to his interests in business economics and monetary policy, he is also interested in the long-term fiscal problems facing the United States.

See http://research.stlouisfed.org/econ/kliesen/ for more on Kliesen's work.
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Author:Kliesen, Kevin L.
Publication:Business Perspectives
Date:Jan 1, 2012
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