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January 24, 2014

Alan Levenson Alan Levenson, T. Rowe Price Chief Economist

Global growth this year will remain on the lower track that has prevailed since the 2008–2009 financial crisis but will be stronger than last year and with fewer major risk factors lurking in the background.

A supportive Federal Reserve and less fiscal drag are important policy underpinnings for stronger U.S. growth this year. The private economy is poised to accelerate, and a reduction in policy-related uncertainty should catalyze a pickup from 2.25% to 2.50% real growth in gross domestic product (GDP) in 2013 to 3% in 2014.

The rest of the world is on a similar growth trajectory. (See chart below.) The postcrisis downshift in growth has been broad because the 2000s' debt bubble and subsequent bust, though centered in the United States, was global.

GDP Growth Rates Have Slowed Everywhere

Note: 2013–2015 data are International Monetary Fund (IMF) estimates and forecasts. 2004–2012 data are historical.
Sources: IMF, World Economic Outlook, October 2013; Haver Analytics; and T. Rowe Price.

If the U.S. borrowed too much—principally to fund malinvestment in housing—then other nations, principally China, lent too much. Similarly, if the so-called peripheral countries of the euro area borrowed too much, then others—principally Germany—lent too much.

Now, countries that borrowed too much are deleveraging, curtailing consumption in the process, while those that lent too much are seeking to boost and diversify sources of domestic growth to make up for slower demand from previously vibrant (and credit-fueled) export markets.

From this perspective, it is somewhat misleading to view the 2002–2007 rise in emerging economies' growth relative to that of advanced economies as a major "decoupling," as it was described at the time. In fact, both the lending nations and the borrowers rode the same credit-fueled growth wave, and so were very much coupled.

Since the financial crisis, however, there has been a more substantive decoupling of countries' growth prospects, with the strength and staying power of national recoveries depending on the quality of policymakers' crisis responses and the vigor of subsequent restructuring.

The United States scores relatively well on these criteria.

The Federal Reserve moved aggressively in late 2008 to restore liquidity to short-term funding markets. The Fed and the Treasury conducted a credible asset quality review and stress test of the banking system, forcing loss recognition and recapitalization that put the financial system on a sounder footing. Fiscal stimulus bridged some of the shortfall in private demand in 2009–2010. Overextended sectors— housing, finance, and state and local government—downsized sharply, and lower interest rates helped households slash periodic debt service.

These actions paved the way for a gradual accumulation of forward momentum in the private economy—consumer spending, housing, and business capital spending—though this process has been disrupted by a fractious political process, from the "fiscal cliff" a year ago to the government shutdown in October.

Most substantively, last year's increases in payroll and income tax rates and the imposition of spending sequestration had a combined drag on 2013 growth of roughly 1.75%, according to the Congressional Budget Office. Looking ahead, the drag from fiscal policy is set to ease substantially. There is no "fiscal cliff" of major tax changes looming, and the two-year U.S. budget deal reached last month relaxes previously binding budget caps, resulting in slightly higher federal spending in 2014–2015 relative to the 2013 level.

These fading fiscal headwinds are a key component of the U.S. growth pickup expected in 2014. With fiscal uncertainties diminished, investment sectors should resume their recovery trends, fueled by stores of pent-up demand.

Indeed, the Business Roundtable's October CEO survey showed a bounce in capital spending plans to the highest level since April 2012 (when fiscal cliff fears crimped business planning), pointing to a resumption of 5% to 10% growth in plant and equipment outlays.

There also is substantial further upside in housing, with the current rate of new construction about 30% below the rate required to meet the needs of our growing population. (See chart below.) Residential construction should contribute roughly 0.5% to real GDP growth this year.

U.S. Housing Starts Still Below Long-Term Demand

This outlook suggests that job growth over the next 12 months will be at least as strong as it has been over the last year, when nonfarm payrolls added 2.3 million positions and the unemployment rate fell from 7.8% to 7.0%. Monthly payroll growth will rise from roughly 180,000 currently to 200,000 over the course of 2014, with the unemployment rate reaching 6.5% by the end of this year.

These job gains and still-modest growth in average earnings are generating inflation-adjusted growth in wage and salary income of 2.5% to 3.0%, sufficient to lift real consumer spending into a similar range (from 1.5% to 2.0% in 2013). Low inflation, particularly courtesy of energy costs tamed by rising domestic production, adds a final impetus to prospective consumer purchasing power.

Inflation in the personal consumption expenditures (PCE) price index, the Fed's preferred measure, is currently at about 1.2%, well below policymakers' long-run objective of 2%. Inflation will rise gradually this year, but likely not much above 1.5%, leaving room for monetary policy to maintain its focus on supporting growth and further decline in unemployment.

The Fed has been funneling this support through two channels: policy interest rates and asset purchases. The Fed had been buying $85 billion per month since December 2012 ($40 billion of mortgage-backed securities and $45 billion of Treasury securities), aiming to suppress long-term interest rates and lift other measures of financial conditions, thereby spurring the labor market recovery.

Tapering
On December 18, the Federal Open Market Committee announced a $10 billion reduction in monthly purchases to take effect in January, with a phaseout of the program anticipated over the course of next year. Even as this "tapering" proceeds, however, the Fed will add roughly $450 billion to its portfolio in 2014.

While the Fed cannot cut policy rates further, it has used "forward guidance" to increase the impact of its 0.00% to 0.25% fed funds target rate. In the past, it has indicated its intention to maintain that low rate at least as long as the unemployment rate is above 6.5% and as long as its one- to two-year inflation forecast does not exceed 2.5%.

In tandem with the December announcement of its first tapering step, the Fed strengthened its interest rate guidance, adding that it will likely be appropriate to maintain the current low fed funds rate, as the Fed put it, "well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee's 2% longer-run goal."

The bottom line: While the mix of policy instruments has changed, the stimulative thrust remains substantial, and the Fed's commitment to spurring a faster recovery remains unaltered. Indeed, policymakers anticipate a very gradual profile of interest rate hikes to 1% at the end of 2015 and 2% a year later.

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