Sunday, January 29, 2012

US GDP: the strong and weak of it...

The US economy posted its strongest quarterly growth of the 2011 year in Q4, contrary to most of the world’s major economies which generally lost momentum as the year progressed. The result printed at a seasonally adjusted annual rate (saar) of 2.8%, up from 1.8% in Q3 but weaker than the average 3.0% market expectation. Annual growth came in at 1.7% for the 2011 calendar year.

Consumption growth came in weaker than expected at 2.0% (saar) for the quarter. This was the primary reason for the weaker than expected overall GDP result. Even then, weak income growth meant the consumption growth was partly funded out of a reduced savings rate, which dropped from 3.9% in Q3 to 3.7% in Q4, the lowest savings rate since Q4 2007.

While it was the strongest overall result of the year, this was largely due to a significant build-up of inventories, which added 2.0 percentage points to the quarterly result. Excluding this component, GDP was only up 0.8%. That’s soft.

Other components were as expected. Residential construction increased 10.9% (saar). We put that down to a “bounce off the bottom” and good weather over the quarter. We don’t expect housing to be a persistent driving force of US growth anytime soon. The Government was a detractor from growth over the quarter, posting a contraction of 4.6% (saar), mostly from a decline in defense spending. We expect the Government sector to be a detractor from growth for the foreseeable future as Federal, State and local government all move to more sustainable budgets.

Here’s the good news: the two sectors we have looked to drive growth since the recovery started, exports and business investment, put in further solid performances. On a saar basis, exports were up 4.7% in the quarter while business equipment and software posted a 5.2% gain. That’s a great export performance given weaker global growth towards the end of the year.

There are some important messages in this GDP result. Firstly, it was not as strong as a cursory glance at the headline number would suggest. We do not expect the improving quarterly trajectory of 2011 to persist into 2012. We are still happy with our 2012 calendar year forecast of 2.0% for 2012.

Secondly, the US economy is in the early stages in an important rebalancing. Over the foreseeable future we expect consumption to remain soft reflecting slow jobs growth and continued household deleveraging, albeit at a slower pace. At the same time we expect the government sector to contract and exports and business investment remain the strongest areas of growth. The problem for the US economy is that exports are only 10% of GDP: we expect that ratio to rise overtime, just as we expect manufacturing to increase its share of sectoral growth. Time to dust off the rust belt!

More generally, the major challenge for the US economy in building higher sustainable growth is to produce goods the world’s consumers (e.g. China and India) want to buy at globally competitive wages. This is a structural recession requiring a structural recovery.

Thursday, January 26, 2012

The Fed, monetary policy and economic growth

The Federal Open Market Committee (FOMC) of the US Federal Reserve is clearly open to the concept of further monetary accommodation. In this mornings announcement the committee extended the period over which they expect to keep the Fed funds rate at “exceptionally low levels” out to late 2014. They are also clearly open to further quantitative easing.

In the accompanying economic projections the committee lowered the forecast range for GDP growth to 2.2-2.7% in 2012, down from a range of 2.5-2.9% in November. That’s still a tad higher than our 2%, but they’re getting closer.

We think they are still too optimistic further out with 2.8-3.2% growth expected in 2013 and 3.3-4.0% in 2014. We are quite happy with the view that trend growth in the US is around 2% per annum, reflecting largely ongoing household and government deleveraging.

Their core PCE inflation forecasts are broadly in line with our expectation of a modest easing in core inflation pressure over the next few months, but not significantly so; they have a forecast range of 1.4-1.8% for 2012.

They also provided target Fed funds rate targets for 2012-14. Some FOMC members expect to see an increase in the Fed funds before 2014, but that’s not surprising given there are some dissenters of the current accommodative stance on the committee.

The surprise for me was the cluster of committee “longer run” Fed funds expectations at around 4.25%. We need to be careful here with terminology. In the notes accompanying the forecasts the Fed talks about these longer term projections being the level the committee member expects the rate to converge to over time, “maybe in 5 or 6 years”.

4.25% seems to me to be far too high to be a neutral cash rate: we would put that closer to 3%. Perhaps our long-term is different to theirs! Our rationale for lower US interest rates over time is that we are going to see a long period of fiscal austerity. A persistent negative fiscal impulse takes the pressure off the amount of work monetary policy has to do to keep inflation in check. Time will tell.

Whether the Fed goes down the path of another round of quantitative easing will be dependent on how the data plays out over the next few weeks and months.

The hurdle for QE3 is higher than it was for the previous two episodes of QE. We expect the Fed to undertake the same rigorous cost benefit analysis they undertook for QE2 (remember Bernanke’s Jackson Hole speech in 2010??). QE1 stacked up on the rationale of restoring financial stability; QE2 was about avoiding deflation as annual core inflation dipped under 1% in mid 2010 and looked to be heading lower.

Here’s where I have a problem with QE3. If QE3 is about building a stronger recovery and restoring full employment, I’m not sure it’s going to pass the cost benefit test. Restoring stronger economic and more robust jobs growth in an environment of significant structural change isn’t just a monetary policy problem: it’s a broader policy challenge. In short, I think the link between QE and stronger GDP and jobs growth is, at best indirect and at worst, weak.

That doesn’t preclude a more targeted QE: perhaps a purchase of Mortgage Backed Securities aimed at helping create greater stability in the housing market. More will be revealed when we see the minutes of the meeting which will be released in about 3 weeks. Watch this space.

Monday, January 16, 2012

France Downgrade and the EFSF

Just as with their downgrade of America last year Standard and Poor’s downgrade of France, Austria and others doesn’t tell us anything we didn’t already know: Europe is suffering under the weight of elevated risk premiums, tight credit conditions and weak growth prospects.

S&P save their toughest criticism for the policymakers who have “...not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems.” We half agree with that: the political process has certainly been arduously slow, but we think some progress has been made.

We are in more fulsome agreement with S&P’s broader assessment, in particular that there is only “partial recognition” of the source of the crisis. On top of financial profligacy at the periphery of the eurozone, they add rising external imbalances and the divergence in competitiveness between the core of Europe and the periphery. Yep.

Like them we have also been concerned that the response to the crisis so far has been ever more stringent fiscal austerity that loses the balance between fiscal consolidation and economic growth. That makes an enduring solution to what will be a long-term problem, more difficult. A focus on economic growth, in particular improving productivity, is an essential part of the equation.

In the near-term the implications of the downgrades of two (France and Austria) of its six AAA-rated guarantors on the AAA-rated European Financial Stability Facility (EFSF) are more interesting. This will reduce the amount of AAA-rated debt it can issue (unless the four remaining AAA-rated guarantors agree to step up the quantum of their guarantees, which is unlikely).

Of course the EFSF issuing AA-rated debt is an option and is not necessarily a bad outcome. Borrowing from the EFSF would still be preferable for countries which rely on the fund (currently Greece, Ireland and Portugal) than raising debt in their own name. The same point holds if the EFSF is itself downgraded. All will be revealed in the next few days.