Economy: The National Outlook

I firmly believe that the longest and most severe recession since the Great Depression is over. The recovery that began in the second half of 2009 is not going to fall apart, but it will be bumpy. I don’t expect a double-dip recession, but the economic recovery almost certainly will be subdued.

The primary reason is that we are going to continue to see restraint in spending by consumers, who are still de-leveraging. Capital must be reallocated from overcapitalized economic sectors – housing and commercial real estate – to more productive uses. The banking system is still not completely fixed. We will continue to feel the aftershocks of the financial panic that seized up the credit markets in September 2008.

On an annual average basis, inflation-adjusted GDP will expand by 1.7 percent, far below the long-term trend rate of growth of approximately 3 percent. The pace of GDP growth will not approach its trend rate until the fourth quarter of 2010. Since the setbacks in U.S. GDP that occurred in 2008 and 2009 were quite large, it will take eight quarters for GDP to surpass its previous peak.

In terms of inflation-adjusted GDP, the economic recovery will not be complete until mid-2011; and it will take two additional years before the labor market replaces the 7.9 million jobs lost to the recession.

The expectation that the recovery will be sustained depends on several positive developments. Credit markets will continue to thaw; sales of new and existing homes and spending on new home construction will increase in 2010. Business spending for new equipment will recover slowly, held back by low operating rates and still tight credit markets. Federal fiscal policy will continue to provide powerful economic stimulus in 2010; and net hiring will resume in the second quarter. Crude oil and gasoline prices should remain at roughly the same levels in 2010 as in mid-2009; and limited inflation should reassure the bond markets and the Federal Reserve.

If most of these expectations are realized, then the U.S. economy will experience slow-paced recovery.

Although many forces will power GDP growth in 2010, there will be some headwinds. Consumers will exercise restraint due to ongoing de-leveraging, recent wealth losses and poor labor market conditions; spending on nonresidential construction will decrease, and spending by state and local governments will continue to drop. Tight credit will not loosen much as long as financial institutions continue to de-leverage; government efforts to re-regulate certain industries may have the unintended consequence of reducing the potential for growth.

The major downside risk is that the financial crisis intensifies. With the system still under considerable duress, the risk of a negative event will be much higher than normal. The outcome of re-clogged credit markets would be an even more severe housing downturn and a much sharper collapse of equities. Tighter credit and even more wealth destruction would produce additional pullbacks by consumers and businesses.

As credit becomes scarcer and corporate profits dive, even long-term capital spending projects would be scaled back. Foreign economic growth would be lower. Because the shocks themselves would be deflationary, the Federal Reserve would ease, but it has already eased very aggressively and in many unconventional ways.

Thus, there is precious little ammunition left for more monetary largess. Another massive federal fiscal stimulus probably would not be forthcoming, and, if it were, it would take time to gain traction. The result would be further quarterly contractions in GDP through at least the third quarter of 2010, and potentially longer.

On the plus side, gains in confidence and productivity could be stronger than I expect, which would spur U.S. GDP growth while dampening both inflation and nominal interest rates.

Spending by businesses and consumers would be more vigorous. Revenue collections by governments would be higher, reducing the size of the federal deficit and providing much needed relief to cash-strapped state and local governments. Home sales would be higher, prompting some appreciation in home prices. Equities prices would benefit, restoring a larger portion of the household wealth that was destroyed in the 2007-09 recession.