U.S. Economy: The Big Questions for 2010Michael Englund
Are U.S. consumers growing confident over growth prospects, or just more terrified over federal fiscal imprudence? Are businesses coiled for a cyclical spending surge, or just "recoiled" in the face of an ongoing commercial real estate collapse and one-sided risk for tax, regulatory, and health-care changes? Will movement in net exports and energy costs help or hinder U.S. growth? Will a rapidly changing political dynamic translate to a voter tsunami in 2010? And will the Fed get caught in the undertow? It's likely that all these questions will be answered in 2010. A major problem for the stimulus legislation of 2009, which was intended to provide a feel-good boost to household spending, is that the effort may have instead exacerbated household fear. It emphasized just how soft economic conditions were and it raised expectations that savings needed to be accumulated in the face of likely sizable future tax-rate hikes and other residual damage from an increasingly insolvent federal government. Although various consumer confidence measures have already risen above their deep recession lows, they remain at extremely depressed levels relative to the rebound that is underway in gross domestic product growth. One gauge of consumer caution is the sustained pullback in both new vehicle purchases and vehicle usage, as measured by gasoline consumption. The share of consumption dedicated to auto purchases plummeted through the end of the last cycle as gasoline prices soared. But since last year's commodity price drop, consumers have seemingly restrained both auto purchases and vehicle usage as they attempt to preserve cash flow. Corporate profits outpace spendingWe continue to see last year's spectacular spending dropoff from September to December, and the associated savings rate surge, as a response to last year's TARP legislation and associated fears of a collapsing financial system that would translate to an eventual collapse in government finance. Will the consumer's sustained caution of 2009 reverse course in 2010, or will the consumer pull back further? This will determine whether the consumer sector—which accounts for two-thirds of U.S. spending—will boost or restrain the emerging cyclical rebound. For now, we assume a flat savings rate trend that will leave the consumer contribution in "neutral," with spending simply rising to keep pace with the recovery in GDP growth. As we frequently note, it is the sustained pullback in risk-taking by U.S. businesses that is proving the most unusual part of this year's emerging expansion, as businesses have yet to shift from a "cash preservation" strategy to a growth strategy in line with the economy's change in course. Indeed, accelerating growth in corporate profits has yet to translate to a comparable bounce in business investment spending. Meanwhile, borrowing from the banking sector has exhibited a powerful retrenchment as the economy has bounced. Either improved cash flow is leading companies to accelerate loan pay-downs, or banks are reining in growth in loans via restrictive terms and conditions. In either case, credit data does not display the customary sign of a sharp rebound in the trajectory for business investment. A rebound in lending activity early in an expansion is often associated with a shift toward inventory restocking, as companies often use commercial and industrial (C&I) loans to fund inventory positions. We and most other economists expect the record-pace of inventory liquidation through the middle of this year to give way to inventory accumulation by the second quarter of next year and a rebuild into the end of 2010. Will this occur? At question is to what degree the powerful collapse in inventory holdings in 2009 was intended or unintended, and to what extent businesses will continue to use diminishing inventory levels to preserve cash flow, with restrained "bets" on impending economic success. Corporate pessimism might be fueled in some sectors by the collapsing commercial real estate market, which shows little indication of any reversal over the near term. We continue to expect hefty declines in nonresidential construction through 2010 as companies race to reduce exposure to the commercial market. This should leave a net contraction in 2010 construction overall, despite a recovering housing market. trade-sector improvement should slowWe did see some signs of life in equipment and software spending figures through the third quarter, with a return to positive real growth for the first time since the recession began. But we see the bounce as reflecting some reversal of excessive declines in the first half of the year as GM and Chrysler entered bankruptcy court. Unfortunately, we expect the resumption of negative real growth rates for this component into 2010. One segment of the economy that is likely to fuel U.S. growth in 2010 is the trade sector, given a faster recovery abroad for many of the major trading partners of the U.S., plus a falling dollar, which makes U.S. exports more competitive in world markets. Yet we expect the rate of trade improvement to slow in 2010 as imports fuel the assumed 2010 inventory rebuilding. We are assuming an optimistic path for U.S. export growth. Yet the hefty third-quarter export surge almost entirely reflected the emergence of the U.S. auto sector from bankruptcy court and we have yet to see just how strong the U.S. export rebound beyond the auto sector will be into the fourth quarter and 2010. World GDP is clearly recovering and this is particularly true of the other industrialized countries, where we generally saw a much bigger GDP contraction through the 2008 fourth quarter and 2009 first quarter than we saw in the U.S. The Chinese and Indian economies revealed less of a contraction than widely feared through the turn of last year and hence face less room for a rebound. For U.S. trade, we see greater uncertainty in imports, which will depend on the trajectory for both U.S. GDP growth and its inventory component, which is often fueled by imported goods on the margin. Beyond the third-quarter bounce led by the auto sector, we expect sustained gains in U.S. imports. "big, Bright spot:" U.S. HousingUnfortunately for the U.S., the trajectory for nominal (unadjusted for inflation) imports is heavily dependent on the price of oil, and the recovery in world growth that will fuel U.S. exports will also likely to firm up global oil prices. Oil prices tend to move in tandem with world growth and the trajectory for energy prices into 2010 is upward. The one big, bright spot for the U.S. economy in 2010 was its Achilles heel over the last three years: the housing market. The sharp rebound in pending and existing home sales in 2009 has placed a floor under U.S. housing starts and other early indicators of U.S. home building activity and has allowed some recovery in new home sales. We assume that this improved trajectory will continue into 2010, though we have yet to see to what degree the existing home sales recovery was fueled by a one-off boost from the tax credit for first-time home buyers. Year-over-year declines in home prices by virtually every measure are now moving back toward "zero," and we expect most measures of home pricing to move back into positive territory, in comparison with prior-year prices, in next Spring's home buying season, which could fuel renewed speculative interest in this beleaguered market. We have yet to see to what degree homebuilders will be fast or slow to join in any emerging optimism, however. Our assumption is that 10% to 20% growth will reemerge for real residential construction expenditures through 2010. It is interesting to note that prospects for this usually volatile and fickle sector are probably less uncertain than for most of the remainder of the economy. federal deficits drain creditIt is also noteworthy that prospects for any boost to growth from the government sector are notably limited, despite the spectacular increases in government spending that have been put in place over the past year and that may be legislated over the quarters ahead. As we frequently note, there was remarkably little "stimulus" in the stimulus legislation, which was dominated by transfer payments. Heightened federal government outlays are occurring alongside massive cutbacks in state and local government spending, largely nullifying any net positive effect from the government sector. We appear on track for growth in government spending in 2010 that will merely keep pace with GDP. Despite this limited-growth contribution from government, we have federal deficits as a percent of GDP that are locked in the 7% to 10% range for the foreseeable future, which will increasingly challenge the Treasury's ability to finance government deficits at attractive rates. This powerful drain on credit will crowd out private borrowing and will weigh on growth. The trajectory for yields in 2010 may help to gauge just how long this juggling act can continue without a restructuring of the federal government budget to incorporate some combination of massive tax hikes and spending reductions. This process may prove dicey as we approach 2010 mid-term elections that could prove unusually cantankerous. Polls have documented a sizable shift in voter preferences toward fiscal prudence just as many incumbents have hitched their reelection prospects on the follow-through benefits of government largess. Interestingly, and unfortunately for the markets, this conflict may have more impact on monetary than fiscal policy, as there is considerably more room for change in Congress's relationship with the Fed than in the federal budget balance sheet. The Fed will enter 2010 at what may prove to be the crescendo in its quantitative easing strategy as the central bank's balance sheet hits what we expect will be its maximum size around the start of the year. The Fed's provision of borrowed reserves is continuing to decline, although it will take the start of the Fed's program of large-scale reverse repo operations to "take back" any meaningful amount of the slack now evident in excess reserves. Could paralyzed Fed fuel new crisis?These operations will likely not prove popular with next year's Congress, and Bernanke may face a 2010 fight that will dwarf his 2008 struggles with the financial market crisis. At issue is whether the "exit strategy" will prompt challenges to Fed independence that will boost rather than diminish market fears over long-term inflation prospects as the Fed tightens, possibly leaving the central bank with no "good" options for the withdrawal of reserve credit. As the Fed faces these political risks in 2010, it enters the year with remarkably low interest rate levels relative to what is evident in the other advanced economies, alongside a falling currency. Without a substantial corrective hike in rates over the coming years, the Fed will face the obvious risk of fueling a new financial crisis just as political pressures potentially delay action. In total, the 2010 economic data will likely resolve many diverging views on developments in 2009. We have yet to see whether consumers will be a positive or negative force for GDP growth in 2010 on net, as gauged by the trajectory for the savings rate, which we currently assume will move sideways. Business investment should post a cyclical rebound. Yet available data show little evidence that an investment renaissance is unfolding and the collapsing commercial real estate market may dominate the trajectory. The path for net exports and oil prices remains uncertain and here, most economists assume a sideways path as well. Ultimately, the question of whether the stimulus package boosted confidence, or just raised tax-hike fears, will be gauged to some degree by how incumbent members of Congress position themselves for the 2010 mid-term elections, and how those elections turn out. Perhaps the greatest question of all for the year to come is whether this political debate will leave the Fed as an unfortunate victim—or will, at the least, delay the deployment of the Fed's exit strategy.