GS US Economics Analyst: What to Make of the Fed's Upbeat 2010 View

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      The FOMC minutes show that the Fed staff—and to a lesser degree the committee itself—has adopted a rather upbeat growth outlook.  The staff forecast now looks for above-trend growth in 2010, versus the prior expectation of a “moderate” recovery.
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      Our view remains more cautious.  Much of the recent improvement in the data is due to an upturn in the inventory cycle, as we expected.  Meanwhile, final demand remains lackluster, as illustrated by this week’s disappointing retail sales release.
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      Looking ahead, we see five factors that will likely weigh on final demand: (1) higher saving, (2) falling wage growth, (3) the overhang of houses and capacity, (4) state and local budget cutbacks, and (5) fading federal stimulus.
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      Indeed, if we take the observable factors literally, the implication would be a significant risk of a double-dip recession.  This may be too pessimistic given the tendency of forecasters to underestimate cyclical turns as unobservable factors improve systematically.  But the observables are sufficiently weak to expect below-trend growth.
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      Does the Fed’s more upbeat view pose a risk to our monetary policy call of no hikes until at least the end of 2010?  Not necessarily, as most Fed officials themselves seem to expect easy policy for a long time.  Indeed, it is interesting that the Fed staff’s longer-term forecast is based on the assumption that “monetary policy would remain stimulative” in 2011-2012.

What to Make of the Fed’s Upbeat 2010 View

The equity market took a decidedly more upbeat view this week, amidst hopes that the recession has either already ended or will end soon.  This is consistent with both the data and our long-standing forecast of positive growth starting around midyear.



While the near term should look better, the question is what comes next.  Will the economy experience a traditional recovery, with an unemployment rate that peaks by late 2009 or early 2010 and then declines quickly?  Or will we see sluggish growth, with still-rising unemployment and a risk of a double-dip recession?



An Upbeat View from the Fed

The forecast of the Federal Reserve staff—and to a lesser degree the separate “central tendency” forecast of Fed governors and reserve bank presidents—is now fairly clearly in the “traditional recovery” camp.  According to the minutes of the June 23-24 FOMC meeting, the staff expects real GDP to grow “above” trend in 2010, a notable upward revision from the prior forecast of “moderate” growth.  Assuming a staff estimate of trend growth in the 2½% region, we interpret this to mean at least 3% and possibly as much as 3½%.  Moreover, the staff expects real GDP growth “well above” trend in 2011-2012, which we take to mean at least 3½%-4%.



Unfortunately, we still fail to see a compelling rationale for such a sharp upturn, at least in 2010.  The problem is that the current improvement owes much to the turn in the inventory cycle, while final demand remains very lackluster.  Inventory drawdown subtracted 2.2 percentage points (at an annual rate) from real GDP growth in the first quarter and will probably add an average of 1-2 percentage points in the second half of the year.  But when this boost peters out over the course of 2010, we will need to see significant growth in underlying final demand in order to keep the recovery going.  There is little evidence of actual or impending growth in final demand, and there are good reasons to think that it will remain sluggish even in 2010.



Exhibit 1 shows some of the key monthly measures of final demand—retail sales, auto sales, home sales, and capital goods orders—and illustrates that few signs of such a pickup are visible yet.  The weakness in retail and auto sales is particularly disappointing given the fact that the consumer provisions of the fiscal stimulus package should have given the consumer a meaningful boost over the past few months.



Going forward, there are several reasons—we count five important ones—to doubt a forceful upturn in final demand over the next 12-24 months:



1. A rising saving rate.  The saving rate is currently around 5½% if we exclude the one-off checks to Social Security recipients in May.  We expect a further increase to around 8% by 2011, which would presumably weigh heavily on consumer spending.



2. Falling wage growth.  We expect the high and rising unemployment rate to push average hourly earnings growth down further, probably into negative territory in 2010 (see Exhibit 2).  This would be a further drag on consumption.



3. Overhang of houses and capital goods.  Although housing starts have risen in recent months, we expect the pickup to be limited by the still-enormous overhang of unsold homes.  Similarly, the lowest capacity utilization rate on record is likely to weigh on capital spending.



4. State and local budget woes.  We estimate that the combination of falling tax receipts and balanced budget rules will force state and local governments to deliver a negative impulse to the economy of at least 0.6%-0.7% over the next year (see “The State and Local Sector: What a (Fiscal) Drag!” US Economics Analyst, 09/27, July 10, 2009).



5. Fading federal stimulus.  Last but not least, the impact of the federal fiscal stimulus on real GDP growth is probably already close to peaking, if our estimates of the lags are correct.  As shown in Exhibit 3, fiscal policy should add around 3 percentage points to growth in the middle two quarters of 2009, with much smaller positives thereafter.  The basic pattern would hold even if Congress passed another fiscal stimulus package in early 2010 as we tentatively expect.



This laundry list of headwinds might suggest that even our forecast of subdued growth is still too sanguine and a double-dip recession is likely.  This interpretation is probably too pessimistic. After all, it is well known that economic forecasts—whether judgmental or model-driven—tend to underestimate the extent of a cyclical turn, both on the upside and on the downside.  The reason is that some of the improvement (or deterioration) in economic conditions is due to unobservable factors, such as multipliers and/or animal spirits.  This implies that it is optimal to adopt a more upbeat view than justified by observable factors when things are getting incrementally better—as they clearly are at present—and a more downbeat view when things are clearly getting worse.


But we simply think that the gap between the Fed staff forecast and the observable factors—as we perceive them—is too large.  This is particularly true given the absence of notable upside surprises relative to our own expectations for a modest recovery over the past few months.  Yes, the data have improved, but final demand has at best matched our expectations.  So we remain comfortable with our baseline view, although there are clearly risks on both sides.



Implications for Monetary Policy

Does the Fed’s more upbeat view of the economy pose a risk to our monetary policy call of no hikes until at least the end of 2010?  Not necessarily.  Our perception is that most Fed officials themselves do not expect to hike rates until at least the middle—and probably the end—of 2010, despite their more upbeat growth outlook.



Indeed, one of the most interesting passages in the FOMC minutes was the staff’s assumption that “monetary policy would remain stimulative” in 2011-2012.  To be sure, an assumption is not a forecast, the staff is not the committee, and “stimulative” is not necessarily 0%-¼%.  Nevertheless, when combined with the Fed staff’s more upbeat growth forecast, the passage does show that there is a significant margin for error built into our view that short-term interest rates will stay extremely low for a long time to come.


Jan Hatzius

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