This article is a guest contribution by ZeroHedge.com.
Just in case you missed Goldman's economic team shift to outright bearishness, Jan Hatzius presents several key observations that other economists (particularly BofA's Bianco and Dutta) have yet to grasp. And even as Goldman openly expects a recommencement in debt monetization tomorrow to the tune of $1 trillion, Hatzius openly acknowledges that this decision could be delayed... And such a decision would be a major mistake, as it is already priced in: "Such a decision could prove to be a serious mistake, because a significant part of the recent easing in financial conditions is probably due to market expectations of a more expansionary monetary policy. Indeed, if a disappointment on Tuesday results in a significant renewed tightening of conditions, the decision might ultimately hasten the transition to further easing steps." In other words, it is pretty much QE or bust for stocks.
1. The July employment report was weak. All three main sources of US labor market information now show a reversal of the prior trend toward improvement. In the establishment survey, the 3-month average of nonfarm payroll gains excluding the impact of the Census has slowed from +143,000 in April to +13,000 in July. In the household survey, the 3-month average of private employment growth has slowed from +234,000 in April to -12,000 in July. And even in the initial jobless claims data, which never showed as much of an improvement in the first place, the pace of applications has drifted up over the past few weeks to a 3-month high of 479,000.
2. Other recent numbers have been more mixed relative to expectations, but are consistent with slowing growth as well. This is most obvious in the manufacturing sector, where Monday’s ISM showed only a slight decline in the composite but a 5-point drop in the new orders index. Most indicators of final demand—including durable goods and retail sales—have also come in on the softer side, although the nonmanufacturing ISM provided a ray of light last week. On balance, we expect final demand growth in the second half of 2010 to stay at around 1½%, the average pace of the past three quarters. With inventory investment stabilizing, GDP growth is likely to converge to this pace as well.
3. Some forecasters who have been holding onto a more optimistic view are blaming the weaker recent data on the shock from the European sovereign debt crisis. But it is difficult to reconcile this view with the fact that the drop in US net exports in the second quarter occurred entirely because of a rise in imports rather than a fall in exports, and that there has so far been no slowdown in US export growth to the euro zone. And while the tightening of financial conditions in the second quarter undoubtedly weighed on confidence, there is little sign that it had a big impact on the hard economic data. Our view remains that the impact of the debt crisis on US growth has been minor and the real reasons for the slowdown are the loss of domestic inventory and fiscal stimulus.
4. On Friday, we revised down our forecast for 2011 and now expect a more gradual acceleration to a 2¼% pace on a Q4/Q4 basis, versus about 3% previously. (We also made a corresponding upward revision to our unemployment forecast and a largely technical upward revision to our core inflation forecast, although we still expect significant further core disinflation to ½% year-on-year by late next year.) The reason for the growth downgrade is that the deterioration in the economic data has coincided with a deterioration in the fiscal policy outlook. By our estimates, fiscal policy—federal, state, and local—added an average of 1.3 percentage points to growth from early 2009 to early 2010 but will subtract an average of 1.7 points in 2011. This number is based on the assumption that the upper-income income tax cuts passed in 2001-2003 expire on schedule and emergency unemployment benefits end in late 2010, but that all other tax cuts including the Making Work Pay program passed in early 2009 are extended. These assumptions are subject to risk in both directions. Depending on the outcome of the November election, it is possible that Congress will decide to extend all of the tax cuts, which would modestly boost the growth outlook, but it is also possible that stalemate ensues and all tax rates rise on January 1, which would substantially hit growth.
5. The risk of a double-dip recession is material, but ultimately the more likely outcome is that we will manage to avoid it. This is partly because the cyclical parts of the economy, which typically account for “more than all” of the decline in real GDP in a recession, are already very beaten down. The most obvious example is homebuilding, where another drop of the magnitude typically seen in recessions is almost mathematically impossible. But auto sales, equipment spending, and nonresidential construction are also at levels implying that the capital stock in these areas, after depreciation, is either shrinking outright or growing at a very slow pace. In our view, this means that a further sizable drop in spending (i.e. a further slowdown in the growth of the capital stock) would require a sizable negative shock, probably of a financial nature. This could happen, but it is not our expectation.
6. In addition, we are counting on another push from monetary policy to ease financial conditions via further another round of large-scale asset purchases and/or a more forceful commitment to a long period of near-zero short-term rates. If our growth, employment, and inflation forecasts are on the mark—and in particular, if the unemployment rate rises back to 10% as we expect—we are reasonably confident that Fed officials will indeed decide to do significantly more.
7. So what will happen at Tuesday’s FOMC meeting? It’s a close call, but we expect an announcement that the proceeds from maturing or prepaid MBS will be reinvested in the bond market (most likely Treasuries). In our view, the gradual tightening of the policy stance that is implied by the current policy of letting the balance sheet shrink is inconsistent with what we expect will be a significant downward revision in the forecasts of the FOMC as well as the Board staff since the last meeting. We have little direct information about any forecast changes, but some insights are available from public documents and speeches by officials and staff at the San Francisco Fed (arguably the most open part of the system in this regard). On May 13—the last available date before the June 22-23 FOMC meeting—the SF Fed expected real GDP growth of 3¾% in 2010 on a Q4/Q4 basis. On July 8—the first available date after the meeting—the forecast had fallen to 3.1%. And on July 28—the most recent update—it had fallen further to 2½%. These numbers require some interpretation since they are affected by a changing picture of H1, and we have no information on any further changes in the wake of the GDP, ISM, and employment data released since July 28. But our interpretation is that the SF Fed has probably revised down its view of H2 growth from about 3½% (clearly above trend) at the June 22-23 FOMC meeting to 2%-2½% (slightly below trend) at the upcoming meeting. If other officials have made similar changes, this would probably be enough to trigger a meaningful shift. And the most obvious meaningful (but not yet radical) shift would be a decision to reinvest MBS paydowns.
8. However, it is also very possible that the committee will require more time for a shift. One reason to think so was Chairman Bernanke’s speech last Tuesday. This was before the employment data, but it was noteworthy that the chairman sounded relatively upbeat, specifically on consumer spending. Undoubtedly, Fed officials are also encouraged by the recent, broad easing in financial conditions. But while this might argue for a decision to do nothing much on Tuesday, such a decision could prove to be a serious mistake, because a significant part of the recent easing in financial conditions is probably due to market expectations of a more expansionary monetary policy. Indeed, if a disappointment on Tuesday results in a significant renewed tightening of conditions, the decision might ultimately hasten the transition to further easing steps.
