Faced with the bruising headwinds of high unemployment, weak manufacturing and an otherwise listless economy, Goldman Sachs has slashed its forecast for gross domestic product.
The firm cut its second-quarter GDP outlook to 2 percent from 3 percent, a stunning blow for an economy expected to be well on the path to recoveryfollowing the financial crisis of 2008 and 2009.
From a policy standpoint, Goldman said it does not expect the subpar growth to change the Federal Reserve's plans to end quantitative easing later this month. However, Goldman economist Sven Jari Stehn acknowledged that "the deterioration in economic activity, on its own, would call for fresh monetary easing."
The primary thing keeping the Fed from going to another round of easing — or QE3 in market jargon — is that, while the economy languishes, inflation actually is rising more than expected, he said.
"The Federal Open Market Committee is therefore stuck between a rock (slow growth) and a hard place (higher inflation)," Stehn wrote in a research note to clients. "We expect Chairman (Ben) Bernanke to indicate at next Wednesday’s FOMC press conference that there is little prospect of either monetary tightening or monetary easing anytime soon."
Goldman's move comes amid a week of disappointing manufacturing indicators from both the Philadelphia and New York Feds that compounded market fears over debt contagion from Greece and other peripheral eurozone nations. The International Monetary Fund also has reduced its GDP forecast from the US, cutting its view to 2.5 percent.
On the bright side, Stehn wrote that the firm still expects economic activity and GDP to pick up later in the year, though the bar has been raised.
"At this point, we still expect a bounceback in Q3 and beyond, but will need to see significant improvement in the data over the next few weeks to maintain that view," he said.
From the Fed's perspective, Stehn said the central bank remains within a "zone of inaction" that requires negative real interest rates — in this case about negative-0.6 percent when comparing inflation to interest — until a more robust recovery can be declared.
More Fed easing, or QE3, would come only if unemployment increases 1.25 percentage points from its current 9.1 percent, while inflation also would have to ease and drop 1 percentage point from its current 3.6 percent annualized rate.
The Fed's easy money policies, which have pushed its balance sheet past the $2.5 trillion mark, are cited by some economists as a key factor in the current rise in inflation.
"Our analysis therefore suggests that larger surprises than those seen in recent weeks are needed for the FOMC to move out of its zone of inaction," Stehn said. "We conclude that the unexpected weakness in growth and uncertainty about the effect of temporary factors will keep policy and, most likely, policy communication unchanged for the foreseeable future."
But for Bernanke, explaining Fed policy, which he will do following next week's Open Market Committee meeting, has become even trickier.
"Most likely, he will be 'balanced' by emphasizing both the disappointment in the activity indicators and the higher inflation data," Stehn said. "So the press conference is unlikely to be pleasant for either the chairman or his audience."