Economy: The National Outlook

Exiting from 2012, there is very little momentum. I expect the economic recovery that began in the second half of 2009 to be sustained, but the rate of U.S. GDP growth will be very low – 1.8 percent in 2013.

With the year-over-year rate of GDP growth below 2 percent, the economic recovery will be extremely vulnerable to economic shocks and/or policy mistakes. The anemic growth reflects the expectation of tighter federal fiscal policy, reduced spending by many state and local governments, the lagged effects of the property bust, disciplined spending by consumers and turmoil in the European Union.

Uncertainty regarding the sustainability of the U.S. economic expansion and the anxiety that goes along with it will not decline in 2013. Although a recession is not the most likely outcome, the odds of another are still elevated. The risk of recession is 30 percent.

In 2013, private final domestic demand rather than fiscal stimulus or net exports will be the primary driver of U.S. GDP growth. Indeed, the government sector will subtract from – rather than add to – GDP growth.

Since fiscal policy will be quite restrictive, the Federal Reserve will 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 into 2015.

To reduce the stresses associated with widespread domestic deleveraging, the Federal Reserve will strive to keep inflation-adjusted interest rates negative and inflation expectations positive – albeit not too high.

One side effect is that yields on many types of financial assets will remain quite low. The Federal Reserve has done a good job of keeping both deflation and another recession at bay, but the marginal benefits of each additional round of its quantitative easing has diminished. Much of the new money created does not get put to work in the economy. Mean-while, the federal government has yet to re-solve its massive structural budget problems, a prerequisite to moving from a sub-par growth trajectory.

A fundamental reason U.S. GDP growth will be subdued is that we are going to see restraint in spending by U.S. consumers. People lack confidence in the current and the future economic situation and will remain cautious. Moreover, many households will still be deleveraging (spending money to pay down debt rather than purchasing goods and services).

Housing will make a significant positive contribution to U.S. GDP growth, but growth of our major trading partners will be slow and will limit the rate of growth of exports. The pace of import growth will be moderate, so net exports will not contribute significantly.

Europe’s banking and sovereign wealth problems are still far from resolved and could precipitate a full-blown financial crisis that would spread quickly to U.S. financial markets. The historical correlation between U.S. GDP growth and EU GDP growth is extremely high, implying that a major deepening of the ongoing recession in the EU will push the U.S. economy into recession.

Meanwhile, many state and local governments will reduce spending in 2013.

Additionally, the labor market is recovering much more slowly than production. It will be 2015 before the U.S. 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-2012, only 46 percent of the jobs lost had been replaced.

Many forces will power U.S. GDP growth in 2013, but there will be some powerful headwinds. Uncertainty is extreme in many critical federal government policy areas, including the budget, the tax code and regulation.

Spending by many state and local governments will continue to drop, but the severity of the declines will diminish. The EU is in recession, and its policy with respect to its sovereign debt problems is not inspiring confidence.

Efforts by the federal government to re-regulate certain industries, or to protect at-risk economic sectors, will have the unintended consequence of reducing U.S. job growth. Finally, consumers will exercise restraint due to delev-eraging, the lagged effects of massive wealth losses, volatility in the financial markets, high levels of uncertainty and low expectations regarding their economic situations.