US forecast update: slower growth in 2011

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This post is a guest contribution by David Greenlaw, Ted Wieseman, David Cho and Dane Vrabac of Morgan Stanley.

Another downgrade to US growth. We are adjusting our GDP growth forecast lower for the third time this year. We now look for +3.3% GDP growth over the four quarters of 2011 (versus +3.6% in our April update). Essentially, this puts us back to where we were in early December – before policy-makers enacted a package of tax cuts aimed at stimulating the economy.

The logic behind this round trip in the forecast is fairly straightforward. The payroll tax cut enacted in December was worth a little more than $100 billion of stimulus for 2011. However, gasoline prices started off the year at $3/gallon and now stand at about $4/gallon. A good rule of thumb is that each $1/gallon change in gasoline prices subtracts about $120 billion from discretionary spending power. Since the elevation in gasoline has been largely exogenous (unrelated to internal demand forces) and since the personal savings rate is expected to be relatively steady, the move in gasoline just about fully offsets the impact of the payroll tax reduction.

Energy is still the big swing factor. To be sure, there are plenty of cross-currents in energy markets at present. And, if the collapse in prices seen over the past couple of trading sessions is sustained, this would provide some meaningful support to the consumer.

Sustaining job growth is key. Cross-currents are also evident in the labor market. We continue to believe that the US economy is currently in the midst of a transition from a recovery driven by a short-term surge in productivity growth to a more mature expansion sustained by job creation and associated income gains. Thus, it is critical that the recent acceleration in employment growth is sustained. While the latest results from the establishment survey were quite encouraging (+244,000 for April together with 46,000 of combined upward revisions to February/March), the household survey was less impressive and jobless claims have been drifting higher. We expect to see continued employment gains ahead – although perhaps not quite as strong as seen in recent months.

Stronger performance over the balance of 2011. Otherwise, the key sources of upside for the US economy going forward from here are expected to be: 1) an eventual pick-up in motor vehicle output, 2) ongoing momentum in capital spending, 3) significantly better performance from net exports, and 4) a rebound in defense outlays.

Keep an eye on core inflation. From our standpoint, the inflation story has been getting overlooked to some extent in recent months. In fact, we believe that inflation represents a far more important policy driver than the growth story at this point. Since troughing in October, the core CPI has moved from +0.6%Y to +1.2%Y. Most importantly, we don’t see anything that is likely to derail this trend in the months ahead. In particular, we have been emphasizing the fact that a significant tightening in rental market conditions across the US is putting a good deal of upward pressure on shelter costs. In fact, the story that we described in our December 22 note (Have We Seen a Bottom in Core Inflation?) has been playing out according to script. Moreover, anecdotal information – including recent comments by the CEOs of Wal-Mart and Kimberly-Clark – suggest that consumer goods prices will be on the rise in coming months.

CPI versus PCE. Admittedly, the Fed likes to emphasise core PCE, which has been somewhat better behaved – moving up to +0.9% in March versus a trough of +0.7% back in December. However, the combination of developing fundamentals and base effects suggests that the year-on-year readings for core PCE will be trending sharply higher going forward. Indeed, we suspect that core PCE will reach +1.5% by October.

Exit ramp ahead. If one is betting on a ‘Fed on hold’ scenario for the rest of 2011 (‘on hold’ meaning no change in statement language, no change in MBS reinvestment policy, no reserve draining operations – and no rate hikes), then one appears to be betting on a scenario in which the Fed ignores a sharp run-up in core inflation – to a rate that just about matches its long-run target. Moreover, one is also betting that, despite the combination of such a huge move in core inflation and a complacent Fed, inflation expectations will somehow remain well anchored. This seems far-fetched to us. A bet on a ‘Fed on hold’ scenario is really a bet that the recent trend in core inflation will dissipate – despite fairly widespread empirical and anecdotal evidence to the contrary.

Sequencing intact. The bottom line is that the exit sequencing timetable we have been highlighting for a while still seems quite reasonable. We continue to look for the Fed to stop buying in June, stop reinvesting in August or September, start draining some time in 4Q, and hike the interest rate on reserves (IOR) in early 2012.

Source: David Greenlaw, Ted Wieseman, David Cho and Dane Vrabac, Morgan Stanley, May 10, 2011.

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