GDP forecast modest for 2012

The economic data during the past month have contained virtually no real surprises, with the small deviations from what was anticipated generally continuing to be positive. At the same time, there has been no meaningful break-through on any of the major downside risks facing the economy, although these may be situations of “No news is good news.” The upshot is that our view of the rest of this year is slightly more sanguine, but basically little changed.

Summary
Our optimism from last month has been renewed and slightly strengthened. We continue to feel that the upside risks are outweighing the downside risks. 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. In the short-term the main risk to the economy lies in the oil sector. See below in the risks section for more on that.

One issue to take note of is that since manufacturing has led this recovery (and construction remains very weak) 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
There is nothing in this new data that leads to significant changes in our baseline forecast. We expect that growth during 2012 will be 2.5%. This is slightly better than in our prior forecast, but still not really strong.

Our estimate of GDP growth in the current quarter is now at 2.7%, slightly above our estimate last month of 2.6%. Our model then forecasts a slight deceleration over the rest of 2012. The current forecast is also somewhat more optimistic than February with regard to employment and unemployment. We think our baseline forecast is relatively balanced in terms of upside versus downside risk.

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.

Our GDP forecast calls for slow improvement for the next few years. GDP dropped 3.5% in 2009 and rebounded 3.0% in 2010. Growth slowed in 2011 to just 1.7%. We expect to see improved growth of 2.5% in 2012 with further gains of 2.7% in 2013 and 3.1% in 2014.

Notable Changes
The second release of fourth quarter NIPA data falls clearly into the nearly unchanged, but slightly positive category. The headline real GDP growth number was raised from 2.8% to 3.0%. There were small positive changes in consumption of services and in construction, and a negative change in consumer spending on goods.

Risks
Recent data certainly provide some case for optimism. Balancing that, the economy over the past several years has consistently shown an ability to disappoint. And, in the background, both Europe and the Middle East remain very capable of producing a significant negative shock.

The list of potential problems remains nearly the same as last month. There is European debt, Chinese slowdown, and 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. We believe that the possibility of a global crisis has been lowered and the impact of a deep European recession would likely only slow our growth by about 1%.

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. They have lowered their GDP outlook but we think that there is a strong concern until we are past 2013.

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. We think that the main concern is in a short-term oil price spike. This would slow growth considerably but not send us into a recession – perhaps similar to what we had after the Japanese tsunami in 2011.

We have stated that our optimism in the economy is improving – what would lead to better economic outcomes? Here’s a short list of possibilities: oil price recedes, strengthening construction markets, global growth leads to increased exports. While the downside risks could lead to a significant reduction, we are more reluctant on saying that the upside possibilities lead to dramatically improved growth. We believe that the constraints in the market (consumers, banks, government) limit the upside potential.

We assign a probability to the main economic scenarios to highlight where your concerns and efforts should be most concentrated. Our upside potential remains greater than the downside risks. 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 Indicators
There has been, in the past several months, a variety of good data that provide talking points for the optimists, but also just enough not-so-good data to keep the conversation interesting. Consumer sentiment has been improving since October and auto sales since June (but higher gas prices might change that). Housing seems to have hit bottom (but prices in many markets are still falling). Both ISM indices are well above 50, with services approaching 60 (but manufacturing was down slightly in February). Interest rates remain very low, with the 10-year Treasury note holding at just 2% (but inflation may be a little above the Fed’s comfort zone).

Finally, the good news from the labor market continued in February. Payroll employment rose by 227 thousand, below the upward revised January increase, but still very solid. As in January, there were job gains in most sectors of the private economy. Moreover, the decline in government employment – a steady drag since June of 2010 – seems to be diminishing. The household survey was also mostly good news. Even though the labor force rose by 476 thousand, the unemployment rate held steady at 8.3%. This implies that the household measure of employment rose a lot (by 428 thousand), far outpacing the establishment measure. This has been consistently the situation over the past six months. Optimists suggest that this might reflect an increase in hiring by start-up businesses that the payroll survey is missing.