GDP forecast is modest

The U.S. economy ended 2011 on an ambiguous uptick. The headline GDP number for the fourth quarter, although at the low end of expectations, was still the best since the second quarter of 2010. But below the top line the picture was less positive. The labor market situation, on the other hand, continued to look positive from virtually any perspective. Overall, the data have been consistent with our view that this year will see continuing growth, but at a rate that is only in line with potential.

Neither the fourth quarter GDP data nor the recent labor market results are cause to pop the champagne (although the latter is getting closer). They are basically consistent with the “in line with potential” trajectory that the economy has been on since the recession hit bottom during 2009. Given that we were then in a huge hole, one might hope for better. On the other hand, as Europe is demonstrating, things could be worse. Looking ahead, we basically expect more of the same.

Summary
We are finally becoming more optimistic about the state of the economy during 2012; however, our forecast has remained relatively unchanged over the last few months. While we are feeling more optimistic about the upside possibilities, until we see it coming through more clearly in the monthly economic data our conservative approach to this recovery will remain intact. One issue to take note of is that since manufacturing has led this recovery (and construction remains in the pits) the upside potential lies with the service and retail sectors. The impact on freight by stronger growth in these areas is much more muted unless it gets strong enough to lead to a momentum surge in the whole economy – a possibility but one that we don’t see occurring yet.

Outlook
The data that we track has not significantly changed our view of the most likely path for the economy over the next year. We continue to expect fluctuations around a modest growth pattern – not enough to create euphoric conditions but also staying out of the stagnant growth that was an increasing possibility last summer. The small dip in the first quarter of 2013 is due to the expiration of the payroll tax cut (which we expect will be extended through the end of this year).

The forecast for real GDP growth in the current quarter is now 2.5%, which is 0.3% down from the fourth quarter. However, final sales (GDP excluding inventory swings) are forecast to grow by 2.3%, nearly triple the fourth quarter. Growth for all of 2012 is 2.3%, up 0.6% from 2011. Growth in 2013 is 2.6%, followed by 3.2% in 2014.

The strongest growth comes from business investment in equipment, from exports, and from housing. The first two are expected to rebound from the fourth quarter, while housing is off some from its very strong last quarter performance. Consumer spending will see more of the growth coming in services and less in goods.

Inflation stays below 2% through 2014. Our forecast assumes that the Fed maintains its current (almost zero) target for the Federal funds rate through 2013. This is there stated goal, but we have trouble believing it. The recent string of good employment data has improved our forecast for the labor market. We now expect that unemployment will be below 8% by the end of the year.

Notable Changes
There is very little change from last month – especially when looking at the topline GDP figure. Our residential figures are moving slightly higher starting in 2012 as housing is looking to begin its slow climb from the trenches. Conversely, our business investment outlook edged lower in 2012. The biggest positive is probably in the quicker pace of reductions in unemployment. We now expect to see the unemployment rate get below 8% before the end of 2012. Another segment that continues to show a strong rebound is auto sales. Our Q1 forecast moved higher and helps push the 2012 forecast higher by 0.5 million to 14.4 million sales for the year. That would be the best year since 2007.

Risks
The list of potential problems has three repeat elements, and one new entry. The repeats are (1) European debt, (2) U.S. political deadlock, and (3) potential Chinese slowdown. The new component is the possibility of a conflict with Iran.

As far as we can tell, the situation in Europe has changed very little over the past few months. In a way, this is positive, since it means that things haven’t gone downhill. But it also means that not much progress has been made in dealing with the very real problems that must be confronted for the continent to return to anything approaching economic health. Our baseline is predicated on a continuation of the status quo – no fundamental solutions, but also no collapse.

In the U.S. everything policy-wise is probably on hold until the election. As already mentioned, we think that the payroll tax cut will be extended through year-end, but beyond that there will be nothing but posturing.

Similarly, our baseline assumes that Chinese growth continues to be quite strong, although perhaps down a little from the extraordinary results of the past two decades.

Finally, the situation in the Middle East looks to us increasingly worrisome. The Iranian situation seems to be headed toward a crisis point. Given increased instability in Iraq and Syria to the west, and Afghanistan to the east the whole region is primed for trouble. If it occurs, all bets are off.

We assign a probability to the main economic scenarios to highlight where your concerns and efforts should be most concentrated. Our upside potential is now greater than the downside risks for the first time in nearly a year. We are becoming more confident in the outlook for 2012 but the headwinds still persist. Below are our current thoughts:

• Strong Growth (GDP better than 3%): 25% probability
• Current Forecast (GDP between 2% – 3%): 60% probability
• Weak Growth (GDP less than 2% or recession): 15% probability

Monthly data
The labor market data were nearly all positive. In the January household survey, the string of decreases in the unemployment rate extended to five months. Over that span the rate has dropped from 9.1% to a January level of 8.3%. Moreover, the January decline was not due to shrinkage in the labor force.

Private sector employment rose 257 thousand in January, continuing an acceleration in the rate of job creation that began in October. The average monthly increase in total employment during this period (201 thousand) is well above the 125 thousand that is needed to keep up with growth in the labor force. Manufacturing added 50 thousand and even construction was up by 21 thousand.

Other monthly data have been generally consistent with an economy that has halted its first half slide, but with growth that is inadequate to do much more than maintain the status quo.

Real disposable income growth continues to be disappointing, suggesting that the cautiousness exhibited by households in their spending is likely to continue in the near term. Consistent with this, consumer sentiment, while up from late summer, remains quite low. Auto sales, however, were strong in January. Both ISM indices rose in January – manufacturing to 54.1 and non-manufacturing to 56.8 – although both are below their level a year ago.

Finally, inflation remains relatively well contained. Partly in response the Federal Reserve announced that it intends to keep short-term interest rates at their current low levels until at least 2014. That will mean nominal rates close to zero (and real rates that are negative) for a total of six years. Although we have reservations about the actual implementation of this policy, we have incorporated it into our forecast.