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What’s Ahead for the U.S. Economy?

Mar 7, 2012 || Blu Putnam || No Comments

After more than three years, the economy is finally showing signs of recovery from the worst financial crisis in a generation. But can GDP and employment numbers continue to improve even as the Eurozone struggles for footing, and Washington appears headed for more gridlock?

Recent data indicate the U.S. economy is improving, and our projections are that for the whole year of 2012, real gross domestic product (GDP) growth could reach 3.5 percent to 4 percent, and the unemployment rate may drop to 8 percent and head toward 7.5 to 7 percent by year end.  If these projections come to pass, the economy will finally have gained some meaningful traction from the highly disruptive events of 2007 and 2008 that sent the economy into a tailspin.  

Indeed, the main reason we think the economy is likely to be much improved in 2012, is that we can finally say that 80 or 90 percent of the adjustments to the financial shocks of 2008 have been completed.  The financial shock to the fabric of the U.S. economy was so large that it has taken three years for most of the adjustments to take place.  Other reasons for economic improvement in 2012 come from the sustained low interest rate policy of the Federal Reserve.  The outlook would be even better if it were not for some international headwinds, while the main risk to the long-term economic outlook is the uncertainty over U.S. tax and spending policies at the federal level.

Completing the adjustments to the financial shocks of 2008

Consumers have taken three years to reduce their debt loads and better align their spending plans with their income potential.  Data on consumer credit and retail sales suggests a much more sustainable spending path for the future.

Corporations cut millions of jobs in 2009 as events unfolded, but were able to return to reasonable profitability in 2010.  Yet, corporations remained highly guarded about the economic future and played 2011 very conservatively.  One can hardly blame companies for being risk-averse with all the uncertainties over the U.S. debt ceiling and fiscal policy last summer, and the constant flow of bad news from Europe over the Greek debt crisis and the related capital adequacy problems of many European banks.  Corporate hiring plans and capital expenditures are set to rise in 2012 in many sectors of the economy.

State and local governments also had to take serious and painful retrenchment measures to cope with the fall in their tax revenues after the 2008 financial crisis.  This process was slow to start in 2009, but it was well underway in 2010 and 2011.  It now appears that the vast majority of state and local governments completed their adjustments to the new economic reality during 2011, which signals the end of job losses from this important sector.

The housing sector of the economy remains quite depressed, but there were important signs in 2011 that the worst was over.  There are many foreclosures yet to come and many homeowners are still underwater in terms of the value of their house compared to the size of their mortgage.  Nevertheless, these factors are now well understood by everyone from home buyers to builders to lenders, and the housing market in 2012 seems poised for solid growth albeit from a much lower and depressed base of activity.

A supportive Federal Reserve

For its part, the Federal Reserve has signaled that it plans to keep its low rate policy in place for several more years so as not to take any risks with the budding economic recovery.  The Fed has a dual mandate to promote price stability and full employment.  With unemployment still perceived as much too high, the Fed is more than willing to take long-term risks with inflation and maintain a highly accommodative policy stance.

This being said, there are a few members of the Federal Reserve Open Market Committee (FOMC) who feel that the economy will be able to stand on its own feet sooner, rather than later, and they are increasingly worried about long-term inflation pressures.  How this internal debate inside the FOMC will evolve depends mostly on whether the U.S. economy really does have a very good year in 2012 or not.  That is, the published unemployment and real GDP projections from FOMC members suggest that as a group, they remain cautious and unconvinced that the economy has turned the corner toward a more sustainable growth path with lower unemployment.  If the economy posts a good year in 2012, as we are suggesting, then how the FOMC views the relative risks between future inflation and falling back into recession could change dramatically.

International headwinds

We would be even more optimistic about the U.S. economy in 2012, if it were not for some important headwinds coming from the rest of the world.  Risks remain in the Eurozone, China’s growth path is decelerating, and geo-political events have the oil market on edge.

The European Central Bank (ECB) took decisive steps in the fourth quarter of 2011 to provide liquidity to European banks and remove the risk of a Lehman-style financial disaster for the world.  The Greek problem, however, remains unresolved for the long term and more bad news may appear.  But the world no longer faces a European crisis, just a long-term debt problem.

China has posted 10 percent real GDP growth on average for over 20 years based in no small part on its massive program of modernization and infrastructure building.  As a natural progression toward economic maturity, that source of economic growth is slowing.  China’s growth will remain impressive by international standards, just not as high as in the past.

From the geopolitical sphere, oil prices have moved higher to reflect tensions with Iran, even as oil demand has been mitigated by economic stagnation in Europe and slower growth in China and other emerging market countries.  High oil prices represent an important drag on the U.S. consumer, preventing an even better economic growth picture.

Long-term risks are with fiscal policy

The U.S. federal government remains mired in its fiscal crisis, but Congress has effectively decided, by its inability to compromise, to delay all the important fiscal policy decisions to 2013 or beyond.  It will be a very messy legislative plate for the new Congress in 2013, as the Bush-era tax cuts will have just expired, the automatic spending cuts from the failure of the Joint Budget Super Committee will be starting to hit, and yet again in the spring of 2013, the debt ceiling will be breached.  In fact, the largest risk to the economy in the longer-term is totally home grown.  If the electorate sends legislators to Congress that cannot work together to develop a long-run compromise for the fiscal stability of the country, then the growth implications for the U.S. economy are huge, despite what is looking like a pretty good year in 2012.

Blu Putnam is Chief Economist at CME Group. Read more of his economic analysis on CME Group’s Market Insights.