GDP forecast relatively unchanged

The U.S. economy started 2012 in the same mode as the previous six quarters – it is plodding ahead, but at a rate that is disappointing. Headline GDP growth for the first quarter was below expectations. Moreover, the labor market situation, which seemed to have taken a positive turn at year-end, again looks suspect. Overall, the data have been consistent with our view that this year will see continuing growth, but at a rate that is at in line with or a little below potential.

To summarize: The first quarter results fell short of our rather unambitious expectations. Recent monthly indicators provide little reason to believe that this underperformance of the economy is likely to improve much in the near-term future. At the same time, there is enough forward momentum to preclude a total collapse.

First quarter data
The advance release of first quarter National Income and Product Account data had overall output growth at just 2.2% (see Figure 1). This was below our expectation, and well below the 3.0% rate in the fourth quarter.

Moreover, as in the fourth quarter, a significant part of the increase came from a rise in inventory accumulation. Final sales in the first quarter grew by only 1.6%. While this is an improvement on the 1.1% in the fourth quarter, it is far from a healthy number. As can be seen in the middle set of columns in Figure 2, the first quarter weakness was most pronounced in business investment (both equipment and structures) and in government purchases (both federal and state & local). In each case the result was far below our February forecast. The fall off in equipment investment may have been due in part to business pulling spending forward to the fourth quarter to take advantage of a tax provision that expired at the end of last year. As in the fourth quarter, the decline in federal government spending (down at a 5.6% rate) was concentrated in defense.

Monthly indicators
After several good reports, the last two reports of labor market data have been very disappointing. After increasing by an average of 252 thousand per month from December to February, March and April came in at 154 thousand and 115 thousand, respectively. In the household survey the unemployment rate did continue to decline – it has been lower each month since last August – but in both March and April the decrease was due in large part to people leaving the labor force. In both months the household measure of employment was down. In fact, the employment rate, which is defined as the ratio of household survey employment to the over 16 population, has experienced an unprecedented decline during the past four years. From above 63% prior to the recession, it was down to just 58.5% in April. This represents its lowest level in almost three decades.

Consumer spending, perhaps squeezed by gas prices, was relatively weak in March. Even so, it nearly matched income growth, with the saving rate (consumption spending relative to after-tax income) below 4% for the second consecutive month. Over the past 6 months consumption growth has been more than double the rate of income growth. Other measures of households’ behavior also suggest caution. Consumer confidence has been steady for three months, while expectations have eroded slightly.

Auto sales have been averaging a little above a 14 million rate so far this year. Housing starts declined in February and March, but building permits were up in both months. The ISM indices are going in opposite directions – manufacturing was up and non-manufacturing was down in both March and April – although both indices continue to signal expansion.

Finally, interest rates remain very low. The Federal Reserve at the most recent meeting of the Open Market Committee (in late April) reiterated its position that “economic conditions . . . are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Meanwhile, the 10-year Treasury rate, which had ticked upward in mid-March dropped back below 2% – to just 1.83% early this week.

Outlook
The data reviewed above do not significantly change our view of the most likely path for the economy over the next year. We continue to expect fluctuations around a path that approximates the long-run growth potential of the economy. The small dip in the first quarter of 2013 is due to the expiration of the payroll tax cut, but does not incorporate other elements of the “fiscal cliff” (for instance, expiration of the Bush tax cuts, drastic cuts in government spending) that are being discussed in the media.

Our estimate of GDP growth in the current quarter stands at 2.2%, just slightly above our estimate last month, but no better than the weaker than expected Q1 data. Our outlook then calls for a very slight acceleration over the rest of 2012. Growth will vary from quarter to quarter but we believe that it is likely to stay just under the 2.5% mark for most of 2012.

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 2.3% in 2012 with further gains of 2.4% in 2013 and 2.9% in 2014.

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.

Analysis
Our forecast for Q2 is for real GDP growth of 2.3%, just a slight bit better than the first quarter. We expect a modest deceleration in consumption (concentrated in spending on durable goods), but improvement in business investment. Housing construction weakens from its 19% first quarter pace, but still registers double-digit growth. The trade deficit increases a little (a negative for GDP), while the government sector is slightly positive.

Our expectation for the rest of 2012 is similar to that for the second quarter. For all of 2012 (4th quarter to 4th quarter) growth is 2.3%, followed by slow acceleration over the next three years.

The continuing decline in the unemployment rate has improved our outlook for that variable, but only very slightly, and partly due to slower labor force growth. We now expect that unemployment will be about 7.7% by the end of the year and about 7% at year-end 2013. The latter value is two-tenths percent lower than our previous estimate.

Risks
Our baseline forecast is that the U.S. economy will continue to muddle through the next year. We believe that the upside and downside probabilities are relatively equally weighted at the current time. The downside represents mainly the possibility of a negative shock, while the upside is more a prospect that we were simply a little too conservative regarding the potential for growth – there is no indication of a specific industry or event that would lead to a better economic outcome.

The list of potential negative shocks includes the same suspects as in recent months. While the probability of each of these is quite low, the combined probability of any one occurring cannot be ignored:

1. Euroland collapse (a little more likely than a month ago)
2. Middle East conflagration (unchanged)
3. Chinese slowdown (a little less likely in the near-term)
4. U.S. political/policy meltdown (unchanged).

The basic underlying problem for seeing a stronger economy is that the household sector (consumption and housing expenditures) will not be able to provide the impetus for a really strong expansion anytime soon. Given the international situation, exports won’t either. Given the fiscal situation, the government won’t either. And business investment is simply not large enough. So we are stuck with slow growth or maybe a little better.

We assign a probability to the main economic scenarios to highlight where your concerns and efforts should be most concentrated. Our downside potential increased minimally this month, at the expense of stronger growth. We are fairly confident in our moderate growth outlook for 2012, but the headwinds still persist. Below are our current thoughts:

• Strong Growth (GDP better than 3%): 20% probability
• Current Forecast (GDP between 2% – 3%): 60% probability
• Weak Growth (GDP less than 2% or recession): 20% probability