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Will Fed Pump More Money as US Economy Sinks?

After the drama of the debt ceiling talks that went down to the wire, investors are now refocusing on the sharp slowdown in the US economy, as downgrades of historical growth estimates show how weak the recovery has been.

Growth estimates going back to 2003 were revised using a new methodology, with the period between 2008 and 2010 seeing a significant downgrade. On Monday, the Institute for Supply Management's (ISM) benchmark manufacturing data added to the gloom, showing a slower-than expected expansion.

Flat consumer spending and lower government consumption is driving this weakness, according to Devina Mehra, chief strategist at First Global.

“The worst part about the revisions was that the US economy has still not been able to beat its pre-crisis GDP level” said Mehra in a research note.

In Mehra’s view, the pace of the weakening in the United States raises questions about proposed cuts in government spending and supports the case for more quantitative easing (QE) from the Fed.

“Since the onset of QE2, we have believed that QE3 was a possibility. The disappointing job market numbers for the last two months and the current weak GDP growth data will force the US Federal Reserve to postpone any monetary tightening and instead focus on strengthening the recovery,” said Mehra.

“Government spending cuts have already begun and have also started impacting economic growth. With further cuts in government spending, either the Federal Reserve will have to announce QE3 earlier than expected, which will partly offset the fiscal tightening, or the possibility of the US economy once again falling into a recession cannot be fully ignored,” said Mehra.

The view that economic weakness will lead the Fed to pump more money into the system is gaining ground with others as well.

“The report adds to the picture of weak growth in the US as also evident from the GDP data on Friday. This poses serious questions on the strength of the US recovery and points to an increasing risk of QE3 from the Fed,” said Allan von Mehren, the chief analyst at Danske Bank.

However, he is confident that the second half of the year will see a significant improvement in growth, despite others predicting a very difficult end to the year.

“We continue to look for a rebound in growth in the second half in response to lower oil prices and fading uncertainty about the debt ceiling.

“However, any rebound is likely to be in the 2.5-3.0 percent range, compared with the previous expectation of 3.5 percent. We also look for the ISM to bottom soon and increase gradually to around 55 during the autumn,” said Mehren.

Corporate profits have been very strong amid the economic weakness, but one economist is warning this could be about to change.

“The growth in profits has to a large extent reflected labour-shedding and tight control over wages; the counterpart has been the softness in consumer spending,” said Stephen Lewis, chief economist at Monument Securities in London in a research note.

This trend could be about to come to an end, according to Lewis, with significant consequences for profits and therefore stock valuations.

“Through 2010, the rising trend in the ratio of corporate profits on this measure to nominal GDP flattened off; suggesting that the shift in income shares from labour to corporates had gone as far as it could without undermining profits growth.

“The sequential performance of S&P 500 earnings has followed a similar trajectory to that of the official profits series. The chances are, then, that continued sluggishness in economic activity will, from now on, act as a brake on corporate earnings growth,” said Lewis.

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