Economy: The National Picture

My baseline forecast for our nation’s economy is that the recovery that began in the second half of 2009 will be sustained, but the rate of 2012 Gross Domestic Product (GDP) growth will be very low – 1.8 percent – and the risk of recession will be very high – 40 percent. 

With the year-over-year rate of U.S. GDP growth below 2 percent for an extended period of time, the recovery will be vulnerable to economic shocks or policy mistakes. The anemic rate of GDP growth reflects the expectation of tighter federal fiscal policy, less spending by many state and local governments, depressed home prices, the continuing downturn in nonresidential construction and disciplined spending by consumers. 

Uncertainty regarding the sustainability of the economic recovery will not decline in 2012. Although a back-to-back or double-dip recession is not the most likely outcome, the odds are uncomfortably high.

In 2012, private final demand rather than fiscal stimulus will be the primary driver of GDP growth. The federal government sector will subtract from rather than add to GDP growth. Since federal fiscal policy will be restrictive, the Federal Reserve will need to be unusually supportive of growth in private demand by maintaining a monetary policy stance that is very stimulative – characterized by near-zero short-term policy interest rates until mid-2014.

We are going to continue to see restraint in spending by U.S. consumers, who lack confidence in both the current and the future economic situation. Consumers will remain cautious. Moreover, many households will still be deleveraging and especially reluctant to take on much risk. GDP growth of our major trading partners will slow in 2012, which will reduce the rate of growth of U.S. exports. The European Union is already in recession. The pace of import growth will decline even more sharply than the pace of export growth. 

Net exports will make a contribution to GDP in 2012. Even though much progress was made over the last several years, capital still must be reallocated from overcapitalized economic sectors – housing and commercial real estate – to more productive uses.  Spending on business structures will subtract slightly from real GDP growth in 2012. Due to weaker than expected growth of end markets, spending on inventories is expected to subtract slightly from real GDP growth in 2012.

Despite ample liquidity, the U.S. banking system is still not fixed. We will continue to feel aftershocks of the financial panic that seized up the credit markets in September 2008. Europe’s banking and sovereign wealth problems are far from resolved and could easily precipitate a full-blown financial crisis. Meanwhile, many state and local governments will continue to reduce spending, creating substantial fiscal drag. 

GDP will expand by only 1.8 percent, far below the long-term trend rate of growth of approximately 2.6 percent. So, in terms of inflation-adjusted GDP, the economic recovery will not be complete.

It will be at least 2015 before the labor market replaces the 8.8 million jobs lost during the period leading up to, during and in the immediate wake of the recession. As of mid-2011, only 20 percent of the lost jobs had been replaced. Full recovery by 2015 assumes that another recession is avoided in the interim, a heroic assumption given that the year-over-year pace of GDP growth may remain below – or only slightly above – two percent for several years.

The expectation that economic growth will be sustained depends on several positive developments. Credit markets must continue to thaw. New jobs will be created in the private sector, which will boost consumers’ buying power. Business spending for new equipment and software will continue to expand and will be motivated by a need to expand capacity rather than to improve efficiency. 

Crude oil and gasoline prices should remain at roughly the same levels in 2012 as in mid-2011. Sales of new and existing homes as well as spending on new home construction will increase slightly. Finally, limited inflation should reassure the bond markets and the Federal Reserve. If most of these expectations are realized and major policy mistakes and external shocks are avoided, then the U.S. economy will experience sustained but unusually slow-paced economic expansion in 2012.