Goldman on the Economy

US Views : OK for Now, But Slowdown Ahead By Jan Hatzius October 9 (Goldman Sachs) 1. After the sharp slowdown earlier in the year, the US economy seems to have grown at roughly a trend pace over the summer. Our GDP “bean count” now stands at 2½% for the third quarter, the ISM indexes are broadly stable in the low 50s, payroll employment is growing at a pace of around 100k per month, and the unemployment rate has been flat for the past three months. 2. Although the recent US growth news has generally beaten low expectations, we expect a renewed deceleration to just a ½%-1% growth pace in the next two quarters and see the risk of renewed recession at about 40%. The main reason is the turmoil in the euro area, where we switched to a recession forecast last Monday. To be sure, there is more talk in Europe about the types of action that we think would help, including a larger financial safety net for sovereign issuers (perhaps achieved by “leveraging” the EFSF), proactive bank recapitalization, and monetary easing. But policy continues to move very slowly relative to the building risks in the financial system and the deterioration in the real economy. A true turnaround in the financial situation does not yet appear to be in sight, let alone a bottoming in the real economy. 3. There are several channels through which the European crisis is likely to weigh on US growth. The impact via reduced exports is the most obvious, but it is unlikely to be very large. Exports to the Euro area account for about 2% of US GDP, so an impact of much more than 0.1-0.2 percentage point would probably require a much deeper European recession than we are forecasting. The bigger issue is the significant tightening in financial conditions and the availability of credit. Since early summer, our financial conditions index has tightened by more than 50bp, a move that might shave ½ percentage point from growth over the next year. In addition, there are some early indications of tightening credit availability including an increase in the percentage of small firms reporting in the NFIB survey that “credit was harder to get” last time they tried to borrow (the next update is due on Tuesday). Tighter credit could easily shave another ½ point or more, for a total impact from Europe on US growth of 1-1½ percentage points. Should the European recession deepen, the risk of further dislocations in the financial system and greater spillovers into the US would grow (for more on this, see Andrew Tilton’s US weekly dated September 16 at US Economics Analyst: 11/37 – Will the European Storm Cross the Atlantic?). 4. One key question is whether the European crisis—and the unsettled fiscal policy environment more generally—has caused a sufficiently large increase in uncertainty to lead companies to postpone hiring and capex decisions in a self-reinforcing manner. There is some evidence that corporate behavior may be changing, as online job ads have dropped off and the percentage of firms increasing employment in the nonmanufacturing ISM survey has declined at the most rapid pace on record over the past two months (data go back to 1997). No such deterioration was visible in Friday’s payroll numbers, but online job ads lead by a month or two and most of the ISM responses probably came after the payroll survey week, so the jury is still out. 5. The other key drag on US growth is the tightening of fiscal policy. Our baseline assumption remains extension of the employee-side payroll tax cut and passage of a small business hiring incentive; we do not assume extension of emergency unemployment benefits (although this is a close call), a further expansion of the payroll tax cut as proposed by the President, additional infrastructure spending or aid to state governments, or another foreign repatriation tax break. We also expect the Congressional “supercommittee” to agree on spending cuts and revenue increases that cover part of the mandated $1.2 trillion in savings over 10 years; the remainder will likely come via automatic cuts that take place from 2013. Overall, we view the risks around our assumption of just under 1 percentage point of fiscal drag (excluding multiplier effects) in 2012 as roughly balanced at present. 6. Even in the baseline case of no recession, we expect additional monetary easing as the Federal Reserve supplements “Operation Twist” with yet more purchases of long-term securities financed by creation of excess bank reserves (that is, additional QE). We believe that this could still boost growth a bit by further reducing the term premium in the Treasury yield curve and thereby ease financial conditions. But policymakers are clearly running into diminishing returns. If they want a bigger impact, they will probably need to supplement additional QE with changes to the Fed’s monetary policy framework. A relatively incremental version of this is the proposal by Chicago Fed President Evans to promise no monetary tightening until the unemployment rate falls back to 7%-7½% and/or inflation rises to 3%. A more radical version would be a temporary increase in the Fed’s inflation target or a move to price level or nominal GDP level targeting as discussed by Jari Stehn a couple of weeks ago (see US Economics Analyst: 11/38 – The Fed’s “Unconventional” Unconventional Options). 7. While additional easing is likely eventually, we currently do not expect a big move at the November 1-2 FOMC meeting. This is based partly on the somewhat better data and partly on Fed Chairman Bernanke’s remark in his congressional testimony that Fed officials had “no immediate plans” to ease further. Of course, since Bernanke also said that he saw the economy as “close to faltering,” it probably would not take a huge amount of new information to change his mind, but for now our best guess is that the next statement will be less eventful than its two predecessors.