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Global Economic Outlook
United States: Q1 2010 Outlook
By Arpitha Bykere, Prajakta Bhide, Mikka Pineda and Christian Menegatti
Editor's Note: The data used in the following analysis is current as of January 30, 2010.
- The U.S. economy will weaken in H2 2010 due to the waning impact of the inventory cycle and fiscal stimulus. Growth will remain around potential during H1 2010 and then fall back below potential in H2 2010.
- Personal consumption will remain sluggish going forward due to further correction in home prices, gradual deleveraging by households and a jobless recovery.
- With weak credit growth and high unemployment rate, the Fed will stay on hold at least until Q1 2011 and additional fiscal stimulus will be needed and implemented.
Settling Into Subpar Mode
In December 2008, the NBER made it official: the United States was in recession and had been so since late 2007. Now, a little more than a year after that announcement, U.S. equity markets have posted one of their strongest rallies since the Great Depression. But pointed uncertainties about macroeconomic conditions remain, and the NBER has yet to call the recession’s end.
After a sharp contraction (of around 2.4%) in 2009, subpar GDP growth (below potential) will be the story for 2010. RGE estimates that U.S. real GDP will grow 2.7% in 2010, against a potential growth rate of around 3%. U.S. real GDP growth displayed a less-than-flattering 2.2% rate in Q3 2009, with 90% of this growth attributable to monetary easing and unprecedented government intervention (fiscal stimulus). Q4 2009 saw a stronger than expected inventory liquidation that pushed growth all the way to 5.7% (advanced estimate) against a consensus expectation of 4.5%. RGE expects growth momentum to continue into 2010. RGE expects “a year of two halves,” —with the first six months stronger (average quarterly annualized growth of 2.6%) than the second six (average quarterly annualized growth of 1.5%)—as the effects of stimulus and inventory restocking begin to show signs of fading out during H2 2010. Stronger growth in H1 2010 could bring further steepening of the yield curve, which is already historically steep. Weaker growth in the second half of the year will contribute to some flattening of the curve.
The U.S. consumer still faces headwinds from weak labor markets, weakness in the housing sector, ongoing balance sheet repair and persistent tightness in credit markets. We will likely see net payroll gains in 2010, but the materialization of job creation will bring discouraged workers back into the workforce, thereby driving the unemployment rate up toward the 10.8% peak expected by Q1 2011. Estimates show that net monthly payroll gains on the order of 100,000-125,000 are needed just to absorb trend growth of the workforce. Given our subpar growth scenario, that seems an ambitious pace for job creation. However, temporary job creation (related to Census hiring) is expected to prove quite strong. Even with strong job creation, say of 250,000 per month (which seems to be the core assumption of the most bullish views so far—and definitely is not our main scenario), it would take at least five years to employ new workers entering the labor force and recover the jobs lost during this recession.
In the residential real estate sector, price declines will likely resume as foreclosures continue to run at a high pace and inventories remain high. The pace of appreciation seen in the summer appears to be slowing. Also, the effect of removal of first time home buyer tax credits, scheduled for April 2010, and the pullback of mortgage backed security purchases by the Federal Reserve, will merit attention. In this environment the Fed will stay on hold throughout 2010. RGE expects the first rate hike in Q1 2011 at the earliest. However, risks to this forecast are tilted toward a delay of monetary tightening rather than earlier tightening in Q3 2010 as consensus currently expects. Before proceeding with rate hikes, the Fed will start removing quantitative easing. In particular, the possible termination of the Mortgage-Backed Securities (MBS) program is stirring up debate about the possible effects on yields and 30-year mortgage rates—an increase in mortgage rates following the termination of the program, and therefore a decrease in housing affordability, could force the Fed to intervene further in that market.
The boost to GDP growth from the inventory cycle, which began in Q3 2009, will wane in H2 2010. RGE expects the restocking cycle in H1 2010 to proceed at a slower pace compared to the sharp inventory liquidation seen in H2 2009. As a result, inventory contribution to growth in H1 2010 will be less pronounced. Due to low capacity utilization (around 71% compared to the pre-recession average of 81%), weak consumer spending and tight credit access, especially for small businesses, and business fixed investment will move into positive territory only in 2011, at which point they will grow sluggishly.
U.S. Consumer: Muddling Through
Accounting for over 70% of U.S. aggregate demand and about 16% of global demand, a change in the spending behavior of the U.S. consumer bears significant implications for U.S. and global growth in the coming quarters and even in the coming years. We believe that the severe loss of income and erosion of net worth in the current cycle has left a deep and lasting impact on the U.S. consumers, leaving little room for a bounce back to the heady days of the past decade, when spending grew at a stellar 3.6% per year.
In Q3 2009, private consumption grew at an annualized pace of 2.8% and contributed 1.9% to GDP growth, driven by government measures to boost spending like “cash-for-clunkers” and the first time homebuyer tax credit. Despite substantial government support, the pickup in spending remained measured, and well below the advance estimate of 3.4%. Moreover, the boost to consumer spending from such “use-it-or-lose-it” initiatives can only be of a temporary nature, as it largely represents demand borrowed from the future. The temporary growth momentum in the economy from the inventory cycle and aid from fiscal programs will provide some support to consumer spending in H1 2010, causing spending to grow by 2%. Personal taxes and social security contribution paid by households are, for the first time in over seven decades, lower than personal tax receipts. This has boosted disposable personal income by roughly 10% and clearly has helped sustain personal consumption during the deleveraging process. However, given that the key elements that determine spending—namely, labor income, wealth and credit growth—remain challenged for the foreseeable future, consumer spending is expected to slow in H2 2010.
As detailed in the next section, the U.S. labor market remains very much impaired. While RGE expects payrolls to expand in early 2010, the record declines in hours worked and the slack in the labor market will keep wage growth sluggish throughout 2010, constraining growth in consumer spending. The bleak labor market conditions together with the poor state of personal finances have kept consumer confidence at historically depressed levels. Between Q3 2007 and Q1 2009, the housing market crash and negative returns from financial markets led to a massive US$17.5 trillion decline in U.S. household net worth, leading consumers to embark on a process of retrenchment, cutting back on consumption to repay debt. In Q3 2009, households shed a record US$70 billion in mortgage debt, and in H2 2009, revolving consumer credit declined at an annualized rate of over 10% (18.5%in November 2009). Given sluggish income growth and the continued pressure from the still-elevated debt service ratio, consumers will continue to deleverage throughout 2010, causing the household savings rate to creep upward to 6% by the end of 2010, from 4.7% in Q3 2009. Current lending standards for consumer credit remain highly restrictive. As a result of widespread losses for lenders on consumer credit and mortgages—and regulations such as the impending Credit Card Accountability, Responsibility and Disclosure Act (CARD)—the eventual growth in credit will be much slower than in the pre-recession era.
Those predicting a V-shaped recovery of U.S. consumer spending suggest that positive wealth effects of the recent boost to household wealth from the stock market recovery will limit the prospects of prolonged consumer retrenchment. However, wealth in the form of financial assets is largely concentrated in the hands of the 20% of Americans with the highest incomes. Research suggests that wealth effects of a recovery in financial wealth are slow to manifest and can only boost consumption after a lag of several quarters. Additionally, the eventual wealth effect will be limited as marginal tax rates for high income individuals are set to increase in 2011. For the rest of the population, housing plays a more prominent role in wealth. As described in detail in a section to follow, given the real estate inventory overhang, the U.S. housing market recovery will be a slow and protracted affair, keeping housing wealth depressed in the coming quarters.
That the process of household deleveraging is already underway is clearly evident, but debt reduction remains only half the story. The fallout of the consumer deleveraging process is that capital gains on assets occur slowly, in turn slowing the recovery in net worth. The scale of wealth destruction over recent quarters may cause households to divert a greater share of income to rebuilding their net worth, causing the savings rate to climb even further, to 8% in the medium term. This includes the baby boomer generation of U.S. consumers approaching retirement, who will need to boost savings and rebuild wealth in order to compensate for sharp losses in retirement savings. Data from the Federal Reserve seems to suggest that such a net worth building process may already be underway, and the savings rate according to the Flow of Funds accounts stands much higher, at 14.3% in Q3 2009.
A Jobless Recovery
Payrolls will show positive print starting late Q1 2010 or early Q2 2010, led by Census-related hiring by the government. The Census impact on payrolls will be peak during March, April and May, and wane during August and September. This will contain the rise in the unemployment rate during H1 2010. Improving economic conditions will cause workers who are discouraged and part-time for economic reasons to reenter the labor force. But hiring in the private sector will grow sluggishly in 2010 and will be less than the 100,000-125,000 job creation that is required every month to absorb the increase in labor force. Private companies will maintain a lean workforce and high productivity growth far into the recovery in order to maintain profit margins. Companies can cater to consumer demand during 2010 converting part-time workers to full-time, increasing work hours of the current workers and hiring temporary workers. Weak hiring will cause the unemployment rate to rise through H2 2010 and peak at around 10.8% in Q1 2011.
During the recovery, companies will face several uncertainties—the strength of the recovery in consumer spending, structural changes in consumer habits, and the impact of healthcare reform on employee benefits—making them reluctant to hire workers and leading to a jobless recovery. The large pool of unemployed workers, companies’ focus on cost-cutting, and higher taxes going forward will lead to a sluggish recovery in wages. Legions of jobs in construction, mortgage services, retail, finance and autos have been lost permanently and job creation during the recovery will be led by services, including education, healthcare and business and professional services. However, the reallocation of workers between these sectors will take time, keeping the unemployment rate high.
The unemployment rate will remain over 10% through 2011 and around 8.0% in 2013. The economy will need to generate 230,000-260,000 jobs per month in order to employ a growing labor force and population, and to recover the eight million jobs lost during this recession. Income constraints, wealth erosion and signs of economic recovery will lead discouraged workers and female workers to reenter the labor force, and baby boomers to delay retirement, thereby keeping the unemployment rate high for a long time. Due to sluggish economic recovery, weak hiring and lower potential growth, the unemployment rate will not fall back to the structural unemployment rate (close to 5.0%) at least until 2015—when the growth in labor force might slow due to the baby boomers.
By the end of 2009, around six million workers had lost their jobs “permanently”— far exceeding job losses in previous cycles. The average unemployment duration was over six months. Close to 40% of unemployed workers had been jobless for six months or more, and around 58% of the unemployed were jobless for three months. Prolonged underutilization of workers will lead to deterioration in human capital and labor productivity. This might negatively affect the potential growth rate of the economy and raise the structural unemployment rate in the coming years.
Residential Real Estate: The Long, Hard Road to Recovery
Following the sharp collapse in the U.S. housing sector in 2008, the market stabilized by mid-2009 with both home sales and starts posting gradual recoveries. Entering 2010, the prospect for the residential housing sector looks significantly less bleak than it did a year ago. However, the stabilization in the housing sector remains fragile, given that the weak underlying fundamentals have been masked by substantial support from government incentives. As measures deployed to prop up the housing market are phased out, the market is likely to realign with fundamentals, facing further downward correction before embarking on a sustainable recovery.
In 2009, demand for housing received a significant boost from a US$8,000 tax credit for first time homebuyers, while the Fed’s MBS purchases substantially lowered mortgage rates, boosting home affordability. The government incentives, together with significantly lower home prices, cause home sales to pick up, with new single family homes climbing by 20% between Q1 2009 and Q3 2009. However, new home sales weakened toward the end of 2009, suggesting that a large portion of the gain in sales comprised demand stolen from the future, as buyers sought to complete the purchase of a home before the scheduled expiration of the first time homebuyer tax credit, on November 30, 2009. Thus, though the tax credit has been extended through April 2010, new home sales are likely to remain subdued in coming months. The extension of the tax credit to step up and higher income buyers might provide some respite to new home sales; however, existing home sales are likely to fare better on sales of distressed properties, which comprise about 30% of total sales. Mortgage rates will remain supportive to homebuyers in early 2010. Following the completion of the Fed’s MBS purchase program by Q1 2010, though, mortgage rates will rise, adversely affecting affordability and lowering sales. A high unemployment rate and weak personal finances will remain as key constraints on the demand side through 2010, preventing a sharp rebound in sales.
The sharp slowdown in residential construction through the early months of 2009 paved the way for inventories of new homes to move closer to their historical average. Since mid-2009, housing starts began to pick up, and by Q3 2009 were about 39% above the record low reached in Q1 2009, only to flatten toward the end of 2009. Over coming months, residential construction will continue to be challenged by still elevated inventories of existing homes on the market and a large supply of foreclosed properties available at bargain prices. According to the Office of Comptroller of Currency, a significant number of delinquent mortgages entered trial modification in 2009 through the government’s Home Affordable Modification Program (HAMP), which aimed at stemming the tide of foreclosures in the housing market. However, less than one percent of trial modifications have entered the permanent modification stage, and more than half of the modified loans have re-defaulted within six months. The threat of more foreclosures in the pipeline and a substantial “shadow inventory” of homes on the market will keep residential construction subdued in 2010. As per RGE’s forecasts, around 2 million “excess” homes on the market will be absorbed by the housing market by 2011. Regional differences in supply fundamentals suggest that residential construction will continue to creep upward in areas where the inventory overhang is lower, causing total starts to continue moving, albeit horizontally. On a nationwide basis, we expect single family housing starts to improve from current levels in Q1 2010, climbing to around 530,000 SAAR in H1 2010 and remaining around 550,000 SAAR level for most of 2010.
As per the S&P/Case-Shiller Home Price indices, U.S. home prices showed signs of stabilization by mid-2009, with monthly returns turning positive in several cities. According to RGE’s home price forecasts, home values in some cities have likely bottomed and are expected to continue to post a slow recovery through 2010. On a nationwide basis, RGE’s forecasts suggest that in 2010, as government support is phased out, home values are likely to dip downwards again and correct further by about 6-7%. Indeed, the latest S&P/Case-Shiller figures already show a faltering in the recent strength in home prices, with monthly returns beginning to turn negative in several cities.
Commercial Real Estate: Bumpy Ride Still Ahead
The downturn in U.S. commercial real estate, which began toward the end of 2007, gathered pace in early 2009, with values falling about 39% below peak by mid-2009, as per Moody’s/REAL Commercial Property Price Index (CPPI). Toward the end of 2009, the pace of decline showed signs of slowing, with a slight pickup in transaction volume. However, through 2010, the outlook for commercial real estate remains bleak, with vacancy rates expected to continue edging up and rents and property values expected to decline across sectors.
Firms have cut office workforce and consolidated operations sharply in the current cycle, causing a sharp increase in vacant office space. As of Q2 2009, values in the office sector were down 21.1% y/y. Despite the recent moderation in payroll job losses, RGE estimates that the unemployment rate will climb through H2 2010 and peak at 10.8% in Q1 2011. The lack of demand for new office space will continue to keep office space absorption negative in 2010. According to the National Association of Realtors, office rents will decline by 8.5% in 2010, putting downward pressure on property values through 2010.
As of Q3 2009, property values in the apartment sector were down 34.1% y/y. Demand for apartments continues to languish due to weakness in the labor market. The apartment sector is also bearing the brunt of a large glut of vacant properties on the market, with the U.S. Census estimates listing national rental vacancy rates at a record 11.1% as of Q3 2009. Demand for apartments is likely to remain weak until there is a meaningful decline in the unemployment rate and a pickup in household formation. Given the supply glut in the multifamily sector, rents and apartment values are likely to continue falling over the coming year.
The demand for retail spaces has been sharply affected by the sharp pullback in U.S. consumer spending in the current recession. In addition to a number of retailers forced out of operation due to bankruptcy, dwindling profit margins have caused retailers to close store outlets to pare costs, causing the retail vacancy rate to rise sharply. Retail space absorption is likely to remain anemic in 2010, depressing retail rents and property values. As of Q3 2009, retail property values had fallen 19.4% y/y, a slower pace of decline than Q2 2009. According to the National Association of Realtors, retail vacancy is expected to rise to 13% by Q3 2010, with rents expected to decline a further 3% in 2010.
A slowdown in domestic and foreign demand led to a sharp cutback in production and record‐low capacity utilization in the U.S. industrial sector. The ensuing decline in demand for industrial spaces led property values to fall by 29.6% y/y as of Q3 2009. While industrial production has improved since mid 2009, capital expenditure will remain on hold till demand shows a sustainable recovery. The pickup in capacity utilization will be a gradual process and industrial space absorption will remain sluggish through 2010.
While the decline in non residential construction spending has been broad-based, the downturn has been particularly sharp in the commercial sector, where construction spending was down 40.5% y/y as of November 2009, while office construction was down 39% y/y and manufacturing construction was down 7% y/y. Even as investment in the residential sector slowly stabilizes, the drag on GDP from the contraction in the non-residential structures is set to intensify in the coming quarters. Given the excess supply in nearly all sectors, non-residential construction will continue to contract in the near future, imposing a drag on GDP growth in the coming quarters.
Along with weak fundamentals, tight credit is exacerbating the downturn in the commercial real estate sector. In the commercial mortgage backed securities (CMBS) market, the eligibility of new CMBS issues to TALF provided some respite to the CMBS market, and spreads have fallen significantly. While CMBS issuance showed signs of improving by late 2009, issuance remains historically depressed. About half of outstanding commercial real estate debt is held by banks. According to Fed estimates, the delinquency rate on commercial real estate loans and leases at commercial banks rose to 8.74% as of Q3 2009, the highest level since Q1 1993. The increase in delinquency rates has caused a sharp decline in lending. As per the Q3 2009 Federal Reserve Senior Loan Officer Survey, a net 35% of surveyed banks continued to tighten lending standards for commercial real estate loans. According to the Mortgage Bankers Association, as of Q3 2009, new commercial and multifamily mortgage‐loan origination remains down 54% y/y, with origination by commercial banks down 52% y/y. Refinancing of commercial real estate credit remains difficult, with many banks opting to extend maturing commercial real estate debt. Estimates suggest that several smaller regional banks are heavily exposed to commercial real estate lending. While further deterioration of commercial real estate market poses a risk to the banking system, the imminent threat is that the exposure to commercial real estate debt will cause banks to restrain lending to other ends, such as the small businesses and consumer credit.
Waning Inventory Cycle and Sluggish Business Investment
Investment in equipment and software, which bottomed out in Q3 2009 and increased over 10% in Q4 2009, will post growth in the single-digits in 2010, due to weak consumer spending in H2 2010 and large excess capacity. After contracting severely between Q3 2008 to Q3 2009, business fixed investment moved into positive territory in Q4 2009 and might remain flat in Q1 2010 as companies adjust to the marginal improvement in consumer spending and utilize the bonus deduction on capital investment under fiscal stimulus. Amidst weak equipment investment, continued contraction in commercial structures investment, and tight credit access, especially for small businesses, business fixed investment will remain in negative territory for the remainder of 2010 and grow sluggishly in 2011, thus lagging economic recovery. High inventories of durable goods and new orders will be a drag on investment. Companies' strategies to maintain profit margins by cutting labor costs will backfire via subdued sales and pricing pressures, while commodity prices will raise cost pressures. However, if President Obama’s proposals under the second fiscal stimulus are implemented—to eliminate capital gains tax and extend bonus depreciation expensing for one year—investment in equipment and software might get a boost and help business fixed investment bottom out sooner.
Due to aggressive inventory reduction by firms and improving sales, the inventory-to-sales (I/S) ratio approached stabilization in H2 2009, especially at the wholesale and retail levels, while the I/S ratio remains high at the manufacturing level. A slower pace of inventory destocking boosted GDP growth in Q3 and Q4 2009—a trend that will continue into Q1 2010, albeit at a slower pace. By Q2 2010, firms should begin restocking inventories, but due to weak consumer spending the pace of restocking will be slow and the inventory contribution to GDP growth will be small—less than 1.0% in Q2 2010 and less than 0.5% during H2 2010. The boost to GDP growth from the inventory cycle, which began in Q3 2009, will wane in H2 2010.
The “cash-for-clunkers” program revived auto production and industrial activity in Q3 2009. But as the program ended and the auto companies finished building inventories, its impact on industrial production began fading (Q4 2009). Given near-stabilization in the inventory-to-sales ratio and the orders-to-shipments ratio, subdued consumer spending, and the slow pace of inventory restocking, industrial production will continue to weaken and grow in the low single-digits through 2010.
After hitting a record low in June 2009, capacity utilization picked up, led by the increase in industrial production. But excess capacity remains high—capacity utilization as of November 2009 was around 71% compared to the pre-recession average of 81%. Due to the slow pace inventory restocking and industrial production, capacity utilization will increase sluggishly, not reaching its pre-recession average at least until mid-2011.
Small Support from Net Exports
Inventory restocking, fiscal stimulus and the revival of industrial activity in several emerging markets and European countries boosted U.S. exports in H2 2009. However, export growth will slow into single-digits in H2 2010 due to base effects and the waning impact of inventory restocking and fiscal stimulus abroad. The “cash-for-clunkers” program, fiscal stimulus, inventory restocking and higher oil prices, along with slight improvement in consumer spending, boosted U.S. imports in H2 2009. However, import growth will slow to single-digits during 2010 as consumer spending weakens and inventory restocking fades. According to RGE, exports will grow slightly more than imports during 2010, leading to a positive but small contribution of net exports to GDP growth.
Appetite for More Fiscal Stimulus?
Analysts estimate that over US$260 billion of the US$787 billion fiscal stimulus was given out in 2009, boosting GDP growth by more than 2.0% during Q2 and Q3 2009 and by up to 2.0% in Q4 2009. The number of jobs created by the stimulus has been small, though the stimulus might have “saved” several jobs. In November 2009, the Congress approved US$24 billion in additional stimulus to extend unemployment benefits (the fourth extension of the duration and benefit amount since June 2008), and refund taxes on profits for businesses that have incurred losses in 2008-09.
Large transfers to households such as unemployment insurance, food stamps and one-time payments to senior citizens, provided high multiplier effects while households spent only 20% of the tax cuts. The US$150 billion funding for state and local governments is inadequate to fill their estimated budget gaps of over US$300 billion for FY 2010 and FY2011. Federal grants somewhat alleviated the spending cuts and layoffs in public services and slowed the tax increases in states during 2009. Federal government spending on infrastructure and other projects is delayed and miniscule so far, limiting the multiplier effects.
Close to US$290 billion of the stimulus package might be allocated in 2010. This might boost growth during H1 2010 with a fading and negative impact on GDP growth in H2 2010 and early 2011. With the mid-term elections in November 2010, the Congress and White House are under pressure to implement a second fiscal stimulus that is well targeted and reduces unemployment. The package will likely have high multiplier effects and might somewhat alleviate or neutralize the expected stimulus drag on growth during late 2010 and early 2011.
The possible second stimulus will be around US$150 billion and will mostly include extensions of unemployment and healthcare benefits for unemployed workers, additional funding for states, increases in outlays for infrastructure and transportation, and tax and credit incentives for small businesses to hire new workers and invest. However, in order to receive enough Republican votes, the composition of the stimulus package might shift from spending measures toward tax incentives. If approved (in H1 2010), the stimulus will affect the economy during H2 2010 and H1 2011. The stimulus package will burden the fiscal deficit, though a fraction of the stimulus might be financed by TARP funds.
The proposed funding for state governments under the second stimulus will be inadequate to fill the budget deficit of states during 2010-11. And amid lower revenues from property, sales and income taxes, state governments will continue to cut jobs, raise taxes, and reduce spending on education, healthcare and other public services—which will be a drag on growth during 2010-11. Past experiences suggest that tax or credit incentives for businesses to induce hiring are ineffective since companies face weak consumer demand and tight bank credit. Such measures also suffer from inefficiency, implementation problems and misuse by companies, and have a limited positive impact on job creation relative to their fiscal cost. In most cases, the boost to employment comes merely from shifting hiring forward temporarily.
The Fiscal Train Wreck
After posting a fiscal deficit of over US$1.4 trillion (10% of GDP) in FY2009, the deficit will exceed US$1.6 trillion (over 10% of GDP) in FY2010 and US$1.3 trillion (over 8% of GDP) in FY2011, and remain over 5.0% of GDP during FY2012-19. This will be the result of high stimulus spending, lower corporate and financial sector tax revenues, and higher entitlement spending, though the payback of TARP funds by banks at a profit is a plus. In January 2010, the Congress raised the U.S. debt ceiling from US$12.4 trillion to US$14.3 trillion as debt approached the ceiling level. The debt ceiling will be raised further during 2010. The IMF, in a November 2009 report, forecasted that gross U.S. government debt will rise from 62% in 2007 to 94% in 2010 and 108% in 2014, led by higher healthcare and Social Security spending and financial sector support.
The administration’s plans to generate revenues by raising taxes on investors and high-income households, reducing tax exemptions and loopholes, and cracking down on offshore tax havens will be inadequate to fill the budget deficit. There is little room to reduce government spending outside of defense, and Obama’s decision to exempt national security from the proposed three year freeze on government spending will render the plan less effective. The increase in entitlement spending will emanate not just from the aging population but also from high healthcare costs and delayed reform of the Social Security system. The healthcare legislation will burden the fiscal deficit over the next decade as healthcare mandates and subsidies will increase spending while cost-saving from the proposed reforms will be small and lagging. Raising taxes on households and expensive insurance premiums will be inadequate to fund the reform. To reduce the fiscal deficit and stabilize the debt burden, the government will need to generate primary surpluses in the coming years by cutting spending and raising taxes by more than what is being currently proposed by the U.S. administration. But weak private demand will keep tax revenues subdued and stimulus spending high, and constrain aggressive tax hikes. With the mid-term and presidential elections in November 2010 and 2012, respectively, President Obama will lack the political support from Congress to implement aggressive fiscal reforms.
Continued quantitative easing and monetization of the fiscal deficit will eventually raise inflation expectations, and foreign investors and central banks will be willing to finance the U.S. only at higher real yields. As quantitative easing is withdrawn, upward pressure on rates will raise government spending on interest payments and crowd out consumer spending and private investment. Analysts forecast that interest on public debt will rise from less than 1.5% of GDP currently to over 3.5% by 2019. According to the IMF, the ratio of net interest payments to GDP will double from 2.2% in 2007 to 4.5% in 2014 while the ratio of interest payments to total revenues will double from 7.2% to 15.2% during the same period. High public debt will be one of the factors constraining U.S. economic growth going forward.
Notwithstanding the net debtor status of the United States, however, risks to U.S. sovereign debt and credit ratings might be overstated, at least in the short term. Reserve diversification by foreign central banks away from U.S. treasuries will happen only gradually over the years. The same holds true for private investors who consider U.S. treasuries a “safe-haven” and remain confident about the country’s debt servicing ability relative to several other developed economies. The dollar’s role as the global reserve currency and the unrivaled depth and liquidity of U.S. debt markets bolster this case. However, investors will turn increasingly cautious if policymakers remain biased towards quantitative easing and monetization rather than fiscal consolidation.
To gain credibility from foreign investors, the administration and the Congress can pass legislation to “commit” to undertake gradual fiscal consolidation as the economy recovers through a combination of tax increases and spending cuts. They can commit to phase out the income, capital gains and dividend tax cuts on the above US$250,000 income group in 2011. But weaknesses in the household and financial sectors and the need to receive adequate Republican votes imply that while tax rates on these groups will go up, policymakers can still keep these rates below their pre-2001 levels. Spending on defense and federal and state pet projects should be cut, and tax reforms such as VAT should be introduced overtime. But given the extent of fiscal deterioration, the administration will have to raise taxes on most income groups down the road in order finance its deficit. When the economic recovery strengthens, the administration can raise the federal and state tax rates on the middle and upper-middle income groups, and also raise the tax rates on high-income groups, capital gains and dividends to their pre-2001 levels. Higher taxes in the coming years will affect saving and investment decisions, as well as labor supply.
Monetary Policy: No Rate Hike in Sight
In 2010, the Fed will start scaling down its emergency liquidity facilities, then will end Large-Scale Asset Purchases (LSAP), and finally will reduce its excess reserves. RGE does not see the Fed making it first rate hike until Q1 2011. Risks to this forecast are tilted towards the Fed possibly staying on hold for longer. Rising commodity prices will push up headline CPI inflation to around 2% in 2010, which could generate a rise in inflation expectations—though a large output gap and rising unemployment with likely keep them at bay. Core inflation pressures will be contained by the anemic and jobless nature of the economic recovery. RGE believes that rate normalization will not begin until sustained inflationary pressure in wages appears. If unemployment does not peak until 2011 and the U.S. output gap remains deeply negative throughout 2010, the first rate will materialize in Q1 2011 at the earliest.
The Fed has scheduled most of its remaining emergency liquidity facilities to shut down in Q1 2010. The closure of the Money Market Investor Funding Facility (MMIFF), the Schedule 1 Term Security Lending Facilities (TSLF) auctions and the TSLF Options Program in 2009 left only the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), the Primary Dealer Credit Facility (PDCF), the Commercial Paper Funding Facility (CPFF), the Term Asset-Backed Securities Loan Facility (TALF), the Schedule 2 TSLF auctions and swap lines with foreign central banks available as liquidity backstops. However, demand at these facilities has been declining since Q2 2009 – AMLF and PDCF assets have stood at zero since October 21, 2009 and May 20, 2009 respectively. The Fed has slated AMLF, CPFF, TSLF, PDCF and swap lines with foreign central bank to end on February 1, 2010; TALF for ABS and legacy CMBS on March 31, 2010; and TALF for new CMBS on June 30, 2010. TAF has no fixed expiration date but the frequency and size of auctions have been reduced due to a surfeit of credit on offer.
The Fed has signaled that the US$1.725 trillion large scale asset purchase (LSAP) programs will end March 31, 2010. The Fed completed its US$300 billion purchase of Treasurys in October 2009 and has about US$345 billion worth of MBS and agency debt left to purchase as of January 13, 2010. These purchases will expand the Fed's balance sheet to a peak of US$2.5 trillion, most likely in March 2009, barring program extensions or reductions. The Fed's assets will henceforth shrink as the credit provided by the Fed matures and TAF demand declines.
Sales of securities held outright will whittle down assets further, but RGE does not see this occurring as long as the mortgage market recovery stands on shaky foundations. The financial support provided by the Fed to AIG and Bear Stearns via the Maiden Lane LLCs, AIA Aurora LLC and ALICO Holdings LLC will also take some time to leave the Fed's balance sheet. The Fed's holdings in these LLCs stood at US$89.7 billion as of January 13, 2010. The Fed expects its loans to AIG to get repaid by September 16, 2013.
As long as the Fed doubts the strength of the U.S. economic recovery, it will begin shrinking excess reserves only gradually. Low interest rates and increased liquidity may be fueling the asset bubbles that reappeared in commodities, corporate bonds and equities but the continued contraction in consumer credit indicates that the benefits of cheaper credit and increased money supply have yet to be passed on to consumers. Moreover, the end of emergency liquidity facilities and, more importantly, the LSAP programs poses an uncertain amount of credit tightening that will keep the Fed in wait-and-see mode. When it is ready to shrink excess reserves, the Fed has several options at hand, such as conducting reverse repurchases and asset sales or selling term deposits to banks.
Inflation: Not Happening Here… Yet
Whereas 2009 saw headline deflation due to the negative and strengthening base effects of commodity prices, 2010 will see the opposite. A rebound in commodity prices, particularly in oil, will cause headline inflation to rise from -0.33% in 2009 to around 2% in 2010. However, deflation will extend its reign over core price indexes in H1 2010 before slowly letting up in H2. Just as core inflation (excluding food and energy) lagged behind the fall in headline inflation in 2009, it will lag behind the recovery in headline inflation in 2010.
Property market weakness and consumer deleveraging will slow core CPI inflation from 1.7% in 2009 to 1.0% in 2010. The housing glut will weigh on owner's equivalent rent, the largest portion of both headline CPI (43%) and core CPI (63%). Sluggish growth in income and employment will mitigate inflation in consumer discretionary items, such as apparel and automobiles, but to a smaller extent than in 2009. A gradual economic recovery in 2010 will lift consumer demand, keeping core inflation from turning negative. Moreover, the return of positive growth in import prices and producer prices throughout the production chain suggests upward pressure on consumer prices is in the pipeline. However, the wide output gap and large stock of excess homes means the risk of protracted deflation has not gone away. Increased liquidity in the financial system has only minimized the risk of core price deflation. Though consumer inflation expectations and breakeven inflation rates in TIPS have moved up since 2008, they neither signal hyper-inflation nor deflation.