December 22, 2011
|Alan Levenson, T. Rowe Price Chief Economist|
The U.S. economy has been on a disappointing rollercoaster over the past two years—the steepest postwar recession followed by the period's most gradual recovery.
In some sense, this is not surprising given that the recovery is not firing on all cylinders. Residential construction has not bounced back following the financial crisis, as it often does following a business cycle recession. State and local expenditures have continued to fall since the overall economic recovery began in June 2009, also defying typical recoveries.
Although a weak recovery might have been expected, the European credit crisis is likely to lead the Continent into recession and weigh further on U.S. economic growth in the coming year. The decline in asset prices as a result of the crisis should create a negative "wealth effect" for U.S. consumers, elevated uncertainty will likely weigh on business spending and hiring, exports to Europe (although a modest segment of the U.S. economy) stand to suffer, and banking sector strains will crimp the availability of credit domestically, as well as in Europe.
Several factors point to resilience in the U.S. economy, however. Most notably, adjustments we have seen in the private sector since the financial crisis limit the risk that the U.S. economy will relapse into recession.
Profit margins at U.S. nonfinancial corporations have continued to rise to record levels in recent months, a starkly different pattern than witnessed before previous recessions.
Businesses do not appear likely to cut back on hiring and capital spending to restore margins, as they have in the lead-up to past downturns. Similarly, household finances are healthier than they were a few years ago, making consumers less likely to rein in purchases.
Progress made in reducing slack in the economy should also keep inflation pressures intact, even as the recovery remains sluggish. Cutbacks in capacity and employment have lowered the level and growth rate of potential output. As household formation resumes in earnest, tight rental markets will boost rental price inflation. Commodity prices should continue to increase, driven by the long-term growth of emerging markets. Finally, the weak U.S. dollar and inflation in emerging markets will boost the cost of imports.
Despite some pick-up in inflation pressures, we expect that the Federal Reserve will lean toward further easing. We do not anticipate a rate hike until at least mid-2013. The Fed's efforts to bring down long-term interest rates by trading short-term Treasury holdings for longer-term bonds is set to run through the middle of 2012, and more action from the central bank is likely if economic growth lags policymakers' expectations—as we expect.
The three-ring fiscal circus in Washington that captured the nation's attention during the debt limit debate this summer is likely to keep going, unfortunately. A continuing political stalemate would weigh on economic growth in coming years by allowing currently scheduled fiscal tightening to occur. The scheduled end of stimulus package infrastructure spending and state and local government transfers in 2012 is likely to slow economic growth, as would a failure to extend the payroll tax holiday and expanded unemployment benefits due to expire at the end of 2011, as well as the expiration of the Bush tax cuts at the end of 2012.
The failure of the ill-named Joint Select "super committee" to come up with a $1.2 trillion debt reduction plan in late November augurs poorly for future debt deals and starts the clock ticking on substantial cutbacks in federal spending in 2013. Unfortunately, Americans may not have to wait until then to witness the consequences of political gridlock, however. The budget agreement last August was intended to postpone further debate about the federal debt limit until past the November elections, but slower-than-anticipated economic growth and tax receipts may lead to another showdown in coming months.
In our economic forecasts, we always examine a range of potential outcomes in an effort to assist our fund managers' thinking about the implications for their portfolios. At all times, we acknowledge that the economy might be either weaker or stronger than we expect, so we develop "base case," "weaker growth," and "stronger growth" scenarios. Outlining a range of plausible outcomes can help guide managers' thinking about how to protect their portfolios should conditions take a turn for the worse, while allowing for gains if conditions improve.
As of this writing, our base case scenario envisions the economy expanding by 2% in 2012. Nevertheless, we acknowledge several downside risks to our outlook, including a worsening of the eurozone crisis, deepening fiscal austerity in the U.S. (whether intended or not), and a hard landing for the Chinese economy. On the positive side, however, stronger export performance and lower commodity prices may lead the economy to exceed our expectations in the coming year.