Growth debate over, inflation debate begins

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This post is a guest contribution by Richard Berner and David Greenlaw of Morgan Stanley.

Three themes for 2011. We think three themes will dominate the debate around the US economic outlook: 1) inflation will bottom and gradually turn up; 2) the two-tier economy will persist, as strong exports and capex will lead while weak housing and state and local government outlays will drag; and 3) the shift to fiscal from monetary stimulus will push both real and nominal rates higher.

New normal: RIP? We don’t want to short-change the growth debate; it remains central, as the tepid employment report underscores.  Non-farm payrolls rose just 103,000 in December; inclement weather likely depressed the job tally somewhat.  It’s far from a boom or even a truly vigorous recovery.  Nonetheless, average monthly private payroll growth in 4Q10 was the strongest in nearly four years.  Thus, despite well-worn and obvious, lingering headwinds, we think that the debate about growth is largely over.  And several factors at the least assure moderate growth and raise the odds of a more bullish outcome this year and next: the combination of generally better-than-expected incoming data, faster-than-expected deleveraging, the one-two punch from new fiscal stimulus and a Fed committed to achieve its dual mandate, and a dramatic reduction in political uncertainty.  Consequently, we continue to expect 4% real growth over the four quarters of 2011.

The inflation debate, however, is even more important: It has only just begun, inflation is not in the price, and thus even a genuine bottoming in inflation, let alone an increase, would have significant market and policy consequences.  We don’t think inflation will rise back to the Fed’s ‘mandate-consistent’ rate of 2% or just below until 2012.  But a rise in core inflation back above 1% in the next several months is highly likely, in our view, and that inflection point will kick off the inflation debate in earnest.  Here’s why.

Inflation inflection point. We believe that inflation is bottoming and will gradually move higher.  A tug of war is under way: Significant slack in markets for goods and services, housing and labor will depress inflation.  But stable-to-higher inflation expectations will push it higher.  While operating rates are low and the jobless rate is high, changes in those gaps – so-called ‘speed effects’ – are promoting an inflation inflection point.  That is especially the case for rents, which are a major inflation component and which are already moving higher.  While we’ve discussed this view elsewhere at length, we think the uncertainty around the inflation process makes it worth reviewing some fundamentals.

In addition, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting energy and food quotes.  Energy quotes jumped by 17% (not annualized) in the three months ended in December.  While the pace should slow from here, our commodity team believes that the direction is higher.  Measured in the CPI, meanwhile, US retail food prices have also accelerated – admittedly to a modest 2.4% annual rate in the September-December span.  But the strength of global demand is pushing food prices higher, and there are upside risks to our November view that food inflation would be limited to 2-3%.  Finally, many prices for imported goods are beginning to turn up again, despite the recent stability in the dollar.  We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4-month lag, and these price hikes may also contribute to US inflation by reviving inflation expectations.

Two-tier economy to persist. The impressive improvement in most incoming data and the onset of new federal fiscal stimulus hint that 4% growth is likely, perhaps even conservative.  But neither of those developments changes the ongoing dichotomy in overall economic performance: Strong leadership from exports and capital spending will continue to outweigh the drag from weak housing activity/home prices and from ongoing state and local government budget cuts, but those two headwinds may take one percentage point or more from growth this year.

The upper tier is strong… Reflecting the strength of global growth, exports have been a boost to US growth, but until recently a surge in imports has been an even bigger drag.  Now, net exports seem likely to provide a major boost as the import surge reverses and import growth seems likely to be subdued.  In addition, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense.  Together with the acceleration we expect in economic activity and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year.  And we think improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback’ in outlays after the tax expensing provision expires.

…while the lower tier is still fraught. In contrast, housing imbalances remain the most significant single downside risk; we expect a 6-11% decline in home prices this year, which will limit the supply of mortgage credit, restrain consumer net worth, and thus cap growth in consumer spending.  Mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending.  The ongoing issues around mortgage ‘putbacks’ continue to keep origination criteria from loosening, although recent developments have greatly reduced the uncertainty associated with putbacks.  Second, state and local government finances remain weak; faced with additional shortfalls, officials are likely to cut spending and employment somewhat further, especially as federal grants fade.  In particular, some $26 billion in assistance for Medicaid will disappear in July.  The good news is that revenues are starting to improve, which should somewhat mitigate that risk.

Shift in policy mix implies higher real rates. QE2 was aimed at reducing real yields to boost credit-sensitive demand; its impact was always likely to be small, given its limited scope.  But anticipation of QE2 did reduce real yields and promote refinancing, and perhaps more importantly, it helped to break the policy logjam and uncertainty that plagued businesses and consumers during the spring and summer.  In contrast, the shift to fiscal stimulus – and the expectation of its success – implies that real and nominal yields will continue to move somewhat higher.  Partly for that reason, we expect that 10-year Treasury yields will move 50-75bp higher, to 4%, over the course of 2011.

Fed on hold through 2011 – but markets likely will anticipate a move in 2012. In addition, expectations of a change in monetary policy may contribute to an increase in yields across the maturity spectrum.  Our Fed call is unchanged: An inflection point in inflation and hearty growth will not be enough to trigger any change in monetary policy in 2011.  Inflation will still be below the Fed’s ‘mandate-consistent’ rate of 2% or slightly below, and the unemployment rate will still be far above an acceptable level.  But by mid-year, we think investors’ outlook for inflation will begin to change as the forces pushing inflation higher start to gain the upper hand and the infection point is clearly in sight.  At that point, anticipation of the first step away from zero policy rates that we expect early in 2012 will begin to affect the front end of the yield curve.

Six risks to the outlook: A matter of degree rather than of kind. Notwithstanding our more upbeat view for 2011, we’re acutely aware of the risks that still lurk.  In varying degrees, we’ve tried to capture six in our baseline outlook.  So, the six risks that we see all represent an intensification of factors that we or our colleagues have flagged as challenges for economic or market performance.

Two of these risks are domestic: Housing prices could decline by more than the 6-11% we and our housing research team expect.  With seven new GOP governors coming into office, and both budget and funding pressures persisting, state and local government spending cuts could be more intense than we anticipate.  Four of the risks represent intensification of global challenges that are already in our baseline global view: more spillover from Europe’s sovereign crisis; more Chinese monetary tightening; a surge in crude quotes to $120 or more; and politics interfering with appropriate policy responses.  On the last risk, the looming battle over budget priorities seems likely to crystallize in a showdown over increasing the federal debt ceiling, which could prove disruptive to financial markets.

For full details, see US Economics: Growth Debate Over, Inflation Debate Begins, January 7, 2011.

Source: Richard Berner, Morgan Stanley, January 11, 2011.

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