Managing Expectations
6/29/2011
By Patrick O'Keefe, Director of Economic Research, J.H. Cohn
As the recovery from the “Great Recession” approached its second anniversary, a spate of economic indicators fell short of consensus expectations, including inter alia: jobs growth, retail sales, and business sentiment.
Collectively these data were characterized as “disappointing.” Pessimists suggest the feeble recovery is faltering and the risks of contraction are increasing. Optimists view this as a lull in the recovery, after which growth is expected to resume.
Both perspectives are data-driven revisions of near-term outlooks, but neither says much about the broader trends that will shape the business climate over the next couple of years.
Although the recent numbers have been disappointing, some monthly fluctuation was to be expected. Indeed, that would be the case even in a robust expansion. In the aftermath of severe recessions that coincide with financial crises, such as occurred in 2008-2009, recoveries tend to be more subdued and stutter-step statistics are to be expected.
Further, despite the month-on-month “disappointments,” most indicators continue to trend upward (i.e., rising over the year). There are, however, some notable exceptions (e.g., housing).
The expectation here has long been that the slow-growth trend that began mid-2009 will most likely continue because the convulsions of 2007-2008 entailed a retrocession: a long-term reduction in the economy’s growth potential (i.e., the long-term, non-inflationary expansion of output, jobs, and incomes).
In other words: the U.S. economy will grow, but not as rapidly as in the past because it is still grappling with the retrocession’s causes and consequences. And while there are no quick fixes—policymakers’ pretensions notwithstanding—there has been some progress. But, as discussed below, the record is mixed.
Global Imbalances: Although the nation’s persistent (35 consecutive years) trade deficit dropped by more than one-half (54.5%) during the recession, it has expanded fairly steadily during the recovery on rising domestic demand and higher commodity (especially oil) prices.
Perhaps most noteworthy, however, is that exports have expanded at a faster rate than imports due to a sharp rise in demand for American manufactures. Indeed, in the most recent six months, the increase in manufacturing exports has been equivalent to one-half of the total gain in manufacturing shipments.
Although increased external demand for America’s manufactured goods is welcome progress, much more needs to be done—and much of that will require policy accommodations among interdependent, but competing, nations.
Fiscal Imbalances: It would be difficult to exaggerate the implications of the nation’s ballooning public debts, which at the Federal level have been well documented.
There does appear to be a growing consensus on the need to restrain further borrowing at all levels of government, but as of yet there is no similar consonance on how that is to be accomplished.
It must be recognized, however, that fiscal restraint—no matter how urgent the need—will exact a toll on near-term growth, with the degree and timing dependent on the mix of measures by which the fiscal gap is closed.
Household Indebtedness: Between the beginning of 2000 and mid-2008 when the borrowing binge ended, household indebtedness increased by more than 115%. Mortgage debt increased by almost 140% over that same period, but after-tax incomes rose at less than half that pace.
Since mid-2008, household mortgages have been whittled a bit (-5.8%), but consumer debt (credit cards, auto and student loans) has been reduced substantially. Credit card balances alone are down by almost one-fifth (-18.8%) from the mid-2008 peak.
These reductions, together with a steady increase in incomes, have reduced the proportion of after-tax incomes that is dedicated to debt service. That is tantamount to an increase in the amount of income households have to spend or save.
Despite households’ success in reducing outstanding debts, the balances remain elevated relative to after-tax income. That, combined with the substantial decline in housing values, has significantly reduced household net worth. And efforts to increase it—especially important for Baby Boomers as they approach retirement—will impinge on consumer spending, which accounts for 70% of Gross Domestic Product.
Monetary Policy: In its ultimately successful campaign to stem the financial panic of 2008, the Federal Reserve injected some $1.5 trillion into the financial system by more than doubling its balance sheet through quantitative easing (“QE”). In late 2010, it undertook a second asset expansion (dubbed “QE-2”) in an effort to spur the recovery.
With QE-2 at its end, monetary policy will shift from a stimulative to stable posture. To the extent QE-2 spurred growth (modestly, at best), there could be some drag.
Of more concern in business planning are the potential impacts of the eventual shrinking of the Fed’s balance sheet, which are unknown. The Fed has a plausible “exit strategy” and has tested the tools to implement it. But in the absence of practical experience with such an undertaking, it is proceeding more on faith than confidence.
Financial Sector Re-Regulation: In an effort to prevent future financial crises, policymakers globally are rewriting the policies governing the financial system.
In the United States, this is being done through implementation of the “Wall Street Reform and Consumer Protection Act” (colloquially, “Dodd-Frank”), a 2,300-page compendium directing the re-regulation of the domestic financial sector, including its international interactions.
While focused on the financial sector, Dodd-Frank will significantly impact the nonfinancial sectors. Indeed, anticipation of impending regulations is already subtly influencing the availability and allocation of credit.
Although it is not possible to project the statute’s ramifications with any precision, we can discern at least a few of Dodd-Frank’s implications for the nonfinancial sectors.
Most significantly, Dodd-Frank will result in less credit for fewer borrowers on more restrictive terms and at higher costs. In other words, as a consequence of Dodd-Frank, credit will be less available and more expensive in the future, which will constrain economic activity.
Outlook: The retrocession of 2007-2008 was due to the convergence of several long-term trends. And its legacy is an economy whose growth potential has been diminished—not eliminated, but lessened. It will grow, but slower than in the past.
As a consequence, the outlook between now and the end of 2012 is for the steady, but sluggish, trend of the past two years to continue. Certainly not what we’d like, but better than what we had.
Patrick J. O’Keefe is director of economic research at J.H. Cohn. He can be reached at pokeefe@jhcohn.com or 1-877-704-3500.
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