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Economic Update

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Written by Jane Caron, CFA, Chief Economic Strategist

Our long-held forecast that real GDP will reach a trough this summer remains on track. After plunging at annualized rates of 6.3% in the final quarter of 2008 and 5.5% in the initial quarter of 2009, the economy's pace of contraction slowed significantly last quarter. We estimate that real GDP fell at an annualized rate of 1.5% in the second quarter, which should mark the last quarter of contraction in this recession. During the second half of the year, we look for the economy to expand at roughly a 2–2.5% pace.

While we are heartened by the expectation of an expansion in real GDP, we are not feeling particularly cheerful about the economy. We expect a significant portion of second-half GDP growth to reflect government stimulus and a rebalancing of inventory levels following an excessively rapid pace of destocking during the first half of the year. In our minds, this kind of activity does not reflect sustained strength. Not until mid-2010 do we envision a more fundamentally supported pickup in business and consumer activity.

The danger is that some sort of a shock could derail the recovery before we get to that point. We are not forecasting a double-dip, but we are not ruling one out either because, in its fragile state, the economy is vulnerable to a negative shock. We are currently forecasting real GDP growth of roughly 2% next year, but the risks associated with this forecast are significant. If a positive feedback loop can develop or if there is another stimulus package, then growth could be stronger, but if the economy continues to trend sideways or experiences a negative shock, it will likely be slower.

The outlook for inflation is clearer. Over the next year, core consumer inflation is expected to trend down from its current annual growth rate of 1.8% to around zero. The risk, however, is that we enter a period of deflation. Importantly, this risk prevails even if GDP comes in above our 2% forecast next year. That is because there is so much excess capacity in the system that it will take years of very strong growth to remove it.

With unemployment headed to 10.5% next year, downward pressure on wage and salary income is quite substantial. We are hesitant to forecast contracting nominal wages because employees tend to be very resistant to pay cuts, but there is a high probability that this will occur in the current environment of low inflation and high unemployment.

Nominal wage growth has slowed substantially in recent months and is still on a downward track. The Bureau of Labor Statistics reported in the June employment report that average hourly earnings were flat for the month and up just 0.7% (annualized) over the last three months. That is the slowest pace in the 45-year history of this series. The federal minimum wage hike scheduled for July (from $6.55/hour to $7.25/hour) should ensure a positive gain this month, but that event will soon be behind us. In 2010, we believe nominal wages could decline by as much as 1%.

This, of course, will make it harder for households to service their debt, and it could result in a debt-deflation spiral if consumer inflation expectations collapse in line with wages. That would be an exceedingly bad outcome because Washington and the Federal Reserve are not well positioned to fight another battle, and consumers and business managers are already beleaguered from the eighteen-month (and counting) recession experience. This is a key reason why we believe the Federal Reserve will remain highly accommodative through 2010. While it is possible that the Fed may start to slowly adjust the funds rate up from its 0–25 basis point range during the second half of 2010, we would not be surprised if they keep this range in place until 2011.

It is important to point out that we are not forecasting a debt-deflation spiral. We view it as a risk. It is a very serious risk not because it has a high probability of occurring—it is not more than a tail risk—but because it would have very serious consequences for the economy if it were to occur. We believe policymakers recognize this risk, and will err on the side of being overly accommodative rather than under accommodative. Indeed, we expect the Fed to keep the 0–25 basis point range for the federal funds rate in place until mid-2010 and possibly longer. If the Fed begins to move this rate higher in the second half of 2010, they will do so at a very gradual pace. In this environment, investors will continue to worry about inflation in the out years because very high government debt loads and a potentially boxed-in Fed point to significant inflation uncertainty. We sincerely doubt, however, that inflation will be allowed to rear its ugly head because investors will be quick to tighten financial conditions if they deem the Fed is being too lax.

For now, we are willing to give the Fed the benefit of the doubt that they can and will tighten policy as soon as there are convincing signs that core consumer inflation is headed appreciably above 2%. The Fed's actions, however, are unlikely to be well-received by Congress because of the rapidly growing fiscal debt load. Washington is running a federal budget deficit of roughly 11% of GDP this year and 10% of GDP next year. The market's tolerance for such deficits will wane quickly once the private sector comes back on line and is steadily issuing debt again. Thus, Washington needs to soon develop a strategy to control the rate of increase in public debt. Otherwise, Washington will be facing a rapidly growing interest rate bill, and economic growth will be impaired by high interest rates and tax burdens.

Higher Treasury rates during the second quarter sapped some of the economy's strength, but financial market conditions were still loose. Looking forward, we expect economic growth to remain limited by the household sector's need to deleverage. We believe we are entering the recovery phase of this cycle, but we expect it to be a drawn out experience of subpar growth. We retain a high level of confidence in the Fed's ability to control inflation, but we worry about the tail risk of deflation. We also worry about the fiscal outlook, and believe it too will be a restraining force on economic growth. Fiscal prudence, should it occur, implies higher taxes and reduced spending, while fiscal folly will lead to significantly higher interest rates. Similarly, should the Fed overly relax its inflation guard, we have no doubt that investors will tighten monetary conditions for them. There is no free lunch.