The US economy has been in recovery for two years, but the pace has been frustratingly slow, well below that of past rebounds from deep recessions and inadequate to repair the damage done by the crisis of 2008-’09.
The main problem is that persistent headwinds from the bursting of the housing and credit bubble — a housing overhang, efforts by households to repair balance sheets, lingering credit restraint, and retrenchment by state and local governments — continue to impede normal recovery dynamics.
Every time it seems the recovery may be gaining traction, the momentum peters out. That’s certainly been true this year. After some encouraging signs — a pickup in consumer spending in late 2010, an improvement in the labor markets earlier this year, and the enactment of additional monetary and fiscal stimulus — the economy hit a soft patch, with consumer spending decelerating and the labor market seeming to stall out again. Part of the recent weakening may be transitory, due to the spike in energy prices and disruptions related to the earthquake in Japan. But some may be more enduring, reflecting a persistent hangover from the crisis. Specifically, a lingering housing overhang is preventing a rebound in a sector that has typically been in the vanguard of economic recoveries, households don't seem to have completed their balance sheet repair, and credit conditions have not fully recovered.
In addition, a federal fiscal drag may be looming.Negotiations over the debt ceiling remain fluid, and though we continue to expect a deal to be reached, there is a palpable risk the deadline will not be met. Uncertainty about this may already be denting confidence. And whatever deal ultimately emerges, some fiscal belt-tightening is coming, adding a further drag to an already-sluggish recovery.
Still, the economy retains important supports. First, energy prices have eased some, and the Japan-related disruptions are receding. In addition, the headwinds from the crisis, though not all gone, are gradually dissipating. Home prices have been brought back into better alignment with fundamentals, and the housing overhang is slowly being worked off. Households have trimmed debt (and especially debt service), while benefitting from a partial recovery in asset prices. Credit conditions have improved, and the weaker dollar should help net exports. Also, the Fed's easy monetary policy, coupled with the fiscal stimulus enacted at year-end, continue to provide support. Finally, pent-up demands are large as the stocks of household durable goods and business equipment remain low.
All told, we think the recovery will gradually shift into an above-trend, self-sustaining phase. But it's likely to take time, and there are considerable downside risks (including those stemming from Europe’s debt crisis). Also, it will take years to absorb all the economic slack. All that spare capacity, together with tame inflation expectations, should help keep inflation in check. True, the run-up in commodity prices has pushed up headline inflation, but that should soon start to recede. And though core inflation has moved higher too, that’s partly due to transitory factors, and it still remains within the bounds the Fed views consistent with its price stability mandate.
Monetary Policy Outlook
Having just completed its second round of asset purchases, the Fed is likely to shift to the sidelines. Policymakers expect the recovery to regain momentum, and with inflation off the lows of last year — reducing the risk of deflation, which was a key rationale for “QE2” — another round of policy stimulus is unlikely. To prompt “QE3,” the economic outlook would have to deteriorate substantially further and disinflation pressures would have to re-emerge — not impossible, but a high hurdle.
At the same time, the Fed will likely be in no hurry to begin removing policy accommodation. The recovery has to get much stronger for much longer for that. The “false dawns” we’ve seen will likely prompt policymakers to be especially wary of premature tightening. If the recovery improves modestly, as we expect, and a large reservoir of underutilized resources persists, along with tame inflation expectations, the Fed is likely to be on hold well into 2012. Things are unlikely to get bad enough to prompt more easing, but also not good enough to prompt the Fed even to stop reinvesting the proceeds of maturing securities any time soon, let alone to drop the “extended period” language, raise the funds rate, or sell assets.
Financial Market Outlook
Concerns about the outlook for economic growth, worries about the US debt limit and a flare-up of European debt woes have weighed on risk assets. Markets are apt to remain edgy as these worries persist. But if something close to our base-case were to pan out — the debt limit is raised, a credible but gradual long-term debt consolidation package is passed, the current soft patch gives way to modestly above-trend growth with low inflation and a steady Fed —risk assets should be supported and Treasury yields would probably move higher. Any backup in rates is apt to be modest, though, restrained by low inflation, a not-too-exuberant recovery, and a patient Fed. Similarly, a recovery in risk assets would likely be tempered by the relative sluggishness of the recovery.
Josh Feinman is a Managing Director and Chief Global Economist of DB Advisors in the Americas. In this position, he provides portfolio managers and clients around the world with timely analysis of global macroeconomic trends and their implications for financial markets. Josh is also responsible for authoring and editing a series of publications on global economic and financial market issues for distribution among the Bank’s offices and clients. A frequent guest lecturer and commentator, Josh delivers speeches around the world and is a frequent guest on financial television programs and is often quoted in major print and electronic media.