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Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Where Things Stand
February 20 – 24, 2012

Recent economic data have been mixed, but generally on the positive side of expectations. However, an unusually mild winter appears to have had a significant impact. Accounting for weather, the story appears to be largely the same: a moderate economic recovery, restrained by a number of headwinds, but with some potential for much better growth down the line.

Weather: The mild winter appears to have boosted motor vehicle sales, construction activity, and employment. However, it’s difficult to calculate the weather impact with much precision. Looking ahead, the weather story could evolve in a couple of ways. One, weather-related strength could serve as pump priming. Reported “good” economic news could add to business confidence, leading to more hiring, more bank lending, and so on, which, in turn, would add to consumer spending and business investment, leading to even more confidence and hiring, and so. Two, mild weather may simply be pulling forward (or “borrowing”) seasonal gains from March and April. This is often the pattern. Three, most likely, we’ll see more of the latter. So, curb your enthusiasm.

The Longer View: The economy continues to operate far below its potential, which means that an extended period of above-trend growth is needed to mop up current slack. Real GDP growth has long trended about 3% per year. This trend is not the same a potential output. In fact, potential output should be below this trend partly due to the aging of the population. However, those arguing that the housing sector has either permanently reduced potential output or overstated potential output prior to the housing correction are off base. We have a lot of ground to make up, especially in the job market.

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The Consumer Outlook: The household sector drives the bus. Consumer spending accounts for 70% of overall growth. Business investment is there, ultimately, to satisfy the consumer. Recent figures have been spotty. Personal spending figures ended 2011 on a weak note and retail sales figures for January were disappointing. Adjusted for inflation, disposable personal income, the main fuel for consumer spending growth, slipped 0.1% in the 12 months ending in December. January numbers should look better, helped by job market improvement (which was aided by the weather) and a 3.6% cost-of-living adjustment in Social Security. However, gasoline prices have crept up since mid-December, limiting the purchasing power of most middle class families. Gasoline prices are always a wildcard in the economic outlook. Last year, as the economic gears seemed to begin to catch, $4 gasoline slammed the consumer in the spring and early summer. Gasoline prices bear watching closely over the next several weeks.

Europe (the never-ending story): Greece is the biggest concern in the short term. See Daniel Davies’ excellent post on the political and economic perils for European policymakers (but not after lunch). Of course, there are many other troublesome issues for Europe beyond Greece. However, the European Central Bank’s liquidity program has significantly reduced the odds of a broader banking crisis in Europe in the near term.

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Energy: A recent piece by Raymond James’ energy team calls for a long-term reduction in the price of natural gas relative to the price of crude oil. This has important implications for energy consumption in the U.S. In particular, low natural gas prices would be a boon for manufacturing (especially energy-intensive industries). There’s no arguing the direction, but I’m much less enthusiastic about their conclusions about the dollar and the trade deficit. Still, as part of a general economic recovery, low natural gas prices ought to play a key role.

The story remains essentially the same: moderate economic growth in the near term, with some headwinds and downside risks, but an optimistic long-term outlook. USA, USA, USA.

The Federal Budget Outlook
February 13 – 17, 2012

The White House’s Office of Management and Budget will release its revised budget outlook this week. That outlook is expected to show a substantial reduction in the 10-year budget deficit, largely due to the required discretionary spending cuts specified in last year’s Budget Control Act. For the most part, the legislative battle ahead is not whether to cut, but what to cut. More importantly, tax policy, and in turn, the economic outlook, remains a major uncertainty into 2013.

As Fed Chairman Bernanke recently testified, the exceptional increase in the deficit in the last three years (to an average of around 9% of GDP) “has mostly reflected the automatic cyclical response of revenues and spending to a weak economy as well as the fiscal actions taken to ease the recession and aid the recovery.” As the economy recovers and stimulus plans are phased out, the budget deficit should narrow. However, “even after economic conditions have returned to normal, the nation will still face a sizable structural budget gap if current budget policies continue.” More importantly, substantially greater strains lie beyond the ten-year horizon, as the retirement of the baby-boom generation and escalating healthcare cost will lead to a surge in Medicare spending. These structural imbalances and future stresses did not appear overnight. These budget strains were projected 10, 20, and even 30 years ago.

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A few weeks ago, the nonpartisan Congressional Budget Office released its revised budget outlook. The CBO projects that the annual budget deficit will shrink to less than 2% of GDP in just a few years. However, that projection is based on current law, which has the Bush tax cuts expiring at the end of this year and assumes that physician payment rates in Medicare will be capped – seen widely as unrealistic. Unless altered, current law would imply about a 4% fiscal drag on GDP growth next year. Most likely, tax cuts will be at least partially extended into 2013.

The failure of the super committee on the budget to reach an agreement on deficit reduction before the Thanksgiving holiday, triggered future cuts in discretionary spending. These will begin in 2013 (conveniently after the election) and fall heavily on defense. However, Congress may legislate around this. As we’re seeing clearly in the UK and the troubled European economies, while austerity makes good sense in the long term, it weakens economic activity in the short run. Simply put, contractionary fiscal policy is contractionary. The trick is to find the appropriate balance and timing to achieve long-term deficit reduction without thwarting a fragile economic recovery. For the U.S., large deficits are clearly not a problem in the short term. The government’s borrowing costs are very low (and would still be low, albeit somewhat higher, if the Fed had not undertaken its asset purchase programs and Operation Twist). The deficit will narrow as the economy recovers, but more deficit reduction will be needed at some point. We need a credible plan to reduce the deficit over time.

I found this graph in an old spreadsheet. It addresses the budget debate of 12 years ago: what to do with the surplus?

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The decision whether to bank the surplus or reduce taxes came down to a choice of when the day of reckoning arrives. Social Security is not a major problem and cannot go bankrupt – as long as individuals are paying into the program, there are funds available for senior citizens. Medicare, on the other hand, is clearly on an unsustainable track. Tax cuts simply brought the day of reckoning closer. The rosy budget surplus projections of 12 years ago were not worth the paper they were written on (and many said so at the time) and the recession worsened the longer-term budget outlook. So, we’re left with mass hysteria over the near-term deficit, which isn’t that big of a deal, a lack of a clear plan to reduce the deficit over the intermediate term, which is a big deal, and little recognition of what lies beyond the 10-year horizon, which is a huge problem. Have a nice day.

The January Jobs Report
February 6 – 10, 2012

Nonfarm payrolls rose more than expected last month and the unemployment rate fell further. The report wasn’t nearly as strong as it appears at first glance, but it was encouraging.

Recall that the Employment Report is composed of two separate surveys. The Household Survey, a telephone survey of 60,000 households, provides reasonably good estimates of ratios (labor force participation, the unemployment rate), but unreliable estimates of levels (the monthly number of employed individuals, for example). The Establishment Survey, which covers about 486,000 worksites, yields nonfarm payrolls, average weekly hours, and average hourly earnings.

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Prior to seasonal adjustment, nonfarm payrolls fell by 2.689 million in January. Seasonal adjustment turned that into a 243,000 adjusted increase. In other words, we had fewer seasonal job losses than usual last month. Fewer jobs losses is a good thing, no doubt, but that’s not the same as job gains. The bigger test for the job market will come in the spring. Unadjusted payrolls typically ramp up from February to June.

Monthly Change in Nonfarm Payrolls, selected sectors (BLS):

The details of the Household Survey showed that 206,000 individuals were unable to work due to adverse weather during the survey week in January (the week that included the 12^th of the month). That compares to an average of 425,000 over the five previous Januarys. This figure is not directly comparable to the payroll data (which come from the Establishment Survey), but it gives you an idea of the impact from January’s mild weather.

The unemployment rate fell to 8.3% in January, down from 8.5% in December, 9.1% a year ago, and a cycle peak of 10.0% in October 2009. However, the employment/population ratio held steady at 58.5%, the same level as when the unemployment rate peaked. Labor force participation fell in January, and has accounted for much of the improvement in the unemployment rate over the last two years. Labor force participation was expected to ebb as the baby-boom generation aged, but that’s not what’s happening. Rather, the rate for those aged 55 and over is trending higher, likely reflecting the impact of lower home prices (since many had counted on their homes being their chief retirement asset). In contrast, participation rates for younger workers have declined. This is the tragedy of the last few years. Unemployed workers are losing valuable job skills and young workers are not getting the job skills they would normally acquire if the economy were near full employment. The soft job market has resulted in a loss of output (relative to potential) over the last few years, but there is significant heartache for millions of people.

Make no mistake. The labor market is improving and there’s hope for strong job growth this spring. Moreover, average weekly hours have been trending higher, consistent with an expected increase in new hiring in the months ahead. However, not to harsh your mellow, the January employment data were not as rosy as the headline figures would seem to suggest. These data should not change the picture for the Fed. We still have a lot of ground to make up in the labor market.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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