There will be no Weekly Commentary for the week of XXXXXX. Scott’s most recent commentary is available below.
The advance figure for fourth quarter growth surprised to the upside, although the story was largely as anticipated. The GDP data will be revised at the end of February and again in late March (and in perpetuity, in annual benchmark revisions). Don’t get too wedded to the numbers. However, the story is unlikely to change much in revision. The fourth quarter data tell us little about what to expect for the current quarter and beyond. Still, the monthly figures suggest an unevenness and lackluster momentum heading into the new year. That doesn’t mean that the recovery is in doubt. Rather, improvement is likely to be gradual in the face of so many headwinds, building over the course of the year. That’s good news relative to where the economy was a year ago, but it’s bad news for those hoping for greater and more immediate improvement in the labor market.
Real GDP rose at a 5.7% annual rate in the advance estimate for 4Q09. More than half of that was due to a slower rate of inventory reduction. Consumer spending growth was moderate. Business fixed investment was mixed, but mostly positive.
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The one major surprise in the data was net exports. Exports continued to improve, as anticipated. That’s good news for the U.S. economy. However, imports rose more slowly than anticipated. The result was that net exports added 0.5 percentage point to the headline GDP figure rather than subtracting a moderate amount. The Bureau of Labor Statistics had to make assumptions about December trade, so these figures are almost sure to be revised. The trade deficit still widened significantly in nominal (current-dollar) terms, but it’s the real (inflation-adjusted) figure that matters for GDP growth.
The government also had to make assumptions about December inventories. However, revisions should not change the story much at all. Inventories fell sharply in 2Q09, subtracting significantly from overall GDP growth, and the pace of inventory decline was somewhat slower in 3Q09. The monthly figures have suggested that the inventory completion is nearing an end. Inventories fell much more slowly in 4Q09. The level of inventories is now more in line with the pace of final sales – and should begin rising more or less with the pace of final sales over the next few quarters (adding moderately to overall GDP growth). The end of the inventory correction is good news, but it’s not enough to fuel stronger GDP growth going forward. That will depend on improvement in underlying demand. A strengthening in job growth will be critical to that.
Last week, President Obama proposed a new stimulus package. Congress, reflecting the will of the American public is dead set against further stimulus. However, this is an election year and it will be very difficult to vote against a “jobs” bill. The jobs bill will create new incentives for firms to hire new workers and the bill is expected to include some efforts to improve the flow of credit to small businesses, which typically account for a third of net job creation during economic expansions. The sticking point will be how to pay for it.
The package will add to the budget deficit, but that should not be a worry in the near term. The bigger concern is the long-term budget outlook. There will be plenty of time to put the country on a course toward a more balanced budget (which will entail some very tough choices in terms of taxes and spending) once the recovery becomes well entrenched.
In the near term, the economy will continue to face a number of headwinds: a continued hangover in the housing sector (with a possible fading in government support), troubles in commercial real estate, great strains on state and local government budgets, and legislative uncertainty (which may be restraining business investment). The recovery will remain susceptible to a major shock, such as a natural disaster or a sharp rise in oil prices. However, despite the current headwinds, the outlook for a gradual economic recovery, building over time, remains in place.
Federal Reserve policymakers meet this week to set monetary policy. While nobody expects the Fed to raise short-term interest rates anytime soon, the Fed will have a variety of new tools available to tighten policy in this cycle. In the months ahead, we’re likely to hear more details about which tools the Fed will use and in what order (sequentially or in combination). The Fed has time to gauge the expected strength of the recovery, but will also have to incorporate uncertainties.
Recessions are not merely the economy slowing down and then speeding back up. There is substantial structural change going on. Most jobs that are lost are unlikely to return. Consumer spending habits and inventory management are also changing. Figures on retail sales suggest a shift to a lower consumption path, which corresponds to an increase in the personal savings rate. Surveys indicate that households have cut back on discretionary spending, increasing savings or paying down debt. The adjustment to the new spending path is transitory. The new path appears slower than before, but that’s partly a consequence of a weak labor market.
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Inventories tend to grow in line with sales over time. Improvements in inventory management and a push toward holding inventories overseas has dampened the inventory cycle in the U.S. Inventories have been a smaller factor in recent recessions. However, in the recent recession, the inventory cycle has been much more apparent. As sales slow, inventories rise, then fall to be more inline with the pace of sales. This inventory cycle appears to have come full circle. Inventory to sales ratios are nearing their pre-crisis levels.
On Friday, the government will report its initial estimate of fourth quarter growth. The advance estimate will be based on assumptions regarding December foreign trade, inventories, and other components. A slower rate of inventory reduction will make a large contribution to 4Q09 GDP growth. Remember, it’s the change in inventories that contributes to the level of GDP. The change in the change in inventories contributes to GDP growth. Inventories don’t have to rise to add to GDP growth, they simply have to fall at a slower rate. There’s some chance that we could see a small inventory build in the inflation-adjusted numbers, in which case the GDP estimate will be even higher (some estimates on the Street are more than 5%). However, excluding inventories, fourth quarter GDP growth is likely to be relatively lackluster. So don’t get too excited about the headline figure. Domestic Final Sales (GDP less inventories and net exports) are a better measure of underlying demand.
The fourth quarter GDP figures tell us little about growth in the current quarter and beyond. The recovery should continue to build over time, but there are still a number of significant headwinds in the near term. Fed officials realize this, which will keep them from raising short-term interest rates anytime soon.
There are a number of uncertainties in the outlook, which makes it difficult to set monetary policy. Inflation should not be a problem. There’s no pressure coming through the labor market, the widest channel for inflation. High government budget deficits do not cause inflation (see: the Reagan years).
Importantly, the Fed will have a number of new tools at its disposal as it tightens. Officials have already begun to unwind the special liquidity and lending facilities. The Fed now pays interest on bank deposits held at the Fed and can discourage bank lending by raising that rate (but why would they do that in the foreseeable future?). If inflation were to become a more immediate concern, the Fed could sell its holdings of Treasuries and mortgage-backed securities, but that would likely be disruptive to the financial markets. It would be easier to do reverse repos (something that the Fed has already tested). An increase in the Fed funds rate is likely to come later. The Fed’s decision to tighten will be driven by job growth, and the trend in core inflation (which has remained low).
Market participants got ahead of themselves last week. There were a number of calls for a positive gain in nonfarm payrolls, which failed to materialize. The economy is in recovery mode, to be sure. However, that doesn’t mean that we’re off to the races. The labor market was expected to lag in the recovery process. This is not going to be a V-shaped recovery, but growth should improve gradually over time. There are a number of headwinds and the list of second half worries is long.
The December Employment report was disappointing, but hardly a disaster. Nonfarm payrolls fell by 85,000 instead of rising as many anticipated. The broad range of evidence suggests that the pace of job losses slowed dramatically toward the end of last year. Initial claims for unemployment benefits have trended lower, nearing a level (about 400,000) that would be consistent with net job growth. Announced corporate layoff intentions for the last three months were the lowest fourth quarter total since 1999. However, new hiring has yet to pick up. That should happen soon. Hiring for the 2010 census should lead to gains in nonfarm payrolls in 1Q10 and 2Q10.
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The unemployment rate held steady at 10.0% in December. However, it would have risen to 10.3% if not for a decrease in labor force participation (which fell from 64.9% to 64.6%). That could reflect people exhausting their unemployment insurance benefits. Annual benchmark revisions showed little change from previous estimates of the unemployment rate. The government’s broadest measure of unemployment, which includes discouraged workers (those that have given up looking for a job and are no longer officially counted as “unemployment”) and those working part time but preferring full-time employment, rose to 17.3%, vs. 17.2% in November and 13.7% a year ago. The unemployment rate for teenagers remained elevated (27.1%) and the rate for young adults (those aged 20-24) edged somewhat lower (15.6%).
In the recession, negative feedback loops took over. Fearful of recession, firms curtailed capital expenditures and trimmed payrolls – which was a self-fulfilling prophesy. Bad news fed on itself. These negative feedback loops appear to have been broken and we seem to be on the brink of some positive feedback loops. If consumers spend a little more, if business invest a little more, if banks lend a little more, that will create a snowball effect. That’s how recoveries progress. Yet, there are still serious headwinds. Problems in the residential and commercial real estate markets will continue for some time. We need to see job growth to ensure a recovery in the housing sector. That should come, but it will take some time.
There is still room for more policy efforts – this time more specifically directed at increasing the flow of credit to small businesses and to increasing new hiring.
Support for the housing market is less certain. The Fed is scheduled to end its purchases of mortgage-backed securities in March. While the Fed cannot support the mortgage market indefinitely, its efforts have reduced mortgage rates significantly. Mortgage rates are expected to pop higher as the Fed stops buying, and long-term interest rates could be higher in general, putting a damper on the traditional spring selling season. Additionally, homebuyer incentives will end in April (the initial transaction must occur by the end of April, closing by the end of June). Will this program be extended? Most likely.
Last week’s reports showed a further increase in inventories through November. These figures are not inflation adjusted and were boosted partly by higher oil prices. Remember, inventories don’t have to rise to add to GDP growth in the fourth quarter. They only have to fall at a slower rate. Depending on what the Bureau of Economic Analysis assumes for December, the estimate of real GDP growth for 4Q09 could be as high as a 5% or 6% annual rate. Don’t get excited. Ex-inventories, growth appears to have been relatively lackluster (1% to 2%) – positive, but aided by fiscal stimulus. Real GDP growth is likely to be in the 3.0% to 3.5% range in 2010 (4Q-over-4Q), but inventories are likely to be choppy, generating relatively large swings in GDP growth quarter-to-quarter.
The economic outlook is cautiously optimistic, not ecstatic. The bigger concerns arrive toward the end of the year. The fiscal stimulus begins to ramp down in the second half of the year and into 2011, effectively acting like a drag on GDP growth. More importantly, the Bush tax cuts are scheduled to sunset at the end of this year. Most likely, there will be some sort of compromise, either extending the tax cuts or phasing them out over time. However, there is a groundswell of public opinion wanting to reduce the budget deficit. The uncertainty may work against consumer and business sentiment later this year.
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