Monthly US Outlook
Weighing the Economic Risks for the Second Half of 2012
Economic news continues to disappoint in all sectors, and with half of the year under our belt, it is worthy to determine whether these trends will persist throughout 2H12. Momentum has clearly slowed since the beginning of the year according to the Bureau of Economic Analysis, which confirmed the economic slowdown in 2Q12 with the release of the advance GDP growth rate, coming in at 1.5% on a QoQ seasonally-adjusted annualized basis. This is slightly slower than growth in 1Q12, which was revised up from 1.9% to 2.0%. Second quarter slowing was due in large part to decelerating personal consumption expenditures (PCE), which fell to 1.5% from 2.4% in 1Q12, in addition to lower growth in residential and non-residential fixed investment. Nonresidential structures slowed significantly after jumping 12.9% in the first quarter, despite slightly stronger data on construction spending. Exports accelerated but not enough to offset the gain in imports for the quarter. Private inventory investment was stronger, with the change in real private inventories contributing 0.32pp to GDP following a 0.39pp negative contribution in 1Q12. If consumption does not increase enough to compensate for this inventory build, then we could see more sluggish production in the coming months. Annual growth for 2009 was revised up from -3.5% to -3.1%, 2010 was revised down from 3.0% to 2.4%, and 2011 was revised up from 1.7% to 1.8%. While second quarter growth came in slightly lower than expected, we are still on target in terms of our updated baseline scenario for the year. Our newly revised forecast for 2.1% real GDP growth allows for acceleration in the second half of the year, which we expect could be stronger once temporary factors fade. A more optimistic scenario is one in which economic weakness does not intensify, with growth stabilizing and minimal impact from policy uncertainty or deteriorating global conditions. Inflationary pressures will be limited, in line with our downwardly revised headline forecast to 2.0%, reflecting lower-than-expected commodity prices. Although we revised up our forecast for core inflation to 2.1%, elevated economic slack should help contain labor and production costs. Job growth appears to have rebounded in July, yet the rise in the unemployment rate surely points to continued weakness in the labor market.
Given the latest ups and downs in economic data, it is no wonder why the Federal Reserve remains cautious about the sustainability of the recovery. The latest FOMC meeting announcement did not feature any additional monetary policy announcements but instead highlighted a weaker economic outlook, as recent data have shown. The fact that there were no significant changes to the meeting statement and the lack of policy action highlight the intense debate within the FOMC, and more time is needed for a majority agreement. This view is supported by July's stronger-than-expected employment report. Most importantly, the Fed is waiting for Congress to address the looming fiscal cliff, and we foresee that QE3 will become more and more attractive as time passes by without any fiscal progress. Ultimately, we believe that the Fed is seriously considering further action but needs to see more data with additional time to discuss. We expect that the Fed will take action in September or in the following meeting if economic conditions deteriorate further, with the most likely scenario being additional quantitative easing. Other options on the table are a change in the Fed's monetary policy guidance, a reduction in the interest rate on reserves or a TALF-like program. The Fed could implement its options one at a time or in combination. However, these are not perfect substitutes and their impact on economic activity is highly uncertain.
While we remain relatively optimistic that the recent trends hint at only slowing, not stalling, growth, downside risks remain prevalent. However, if policy uncertainty, the fiscal adjustment, and the European crisis intensify, the economy will likely slide into recession. This situation could be amplified by a deflationary environment which would result in aggressive incremental policy response with limited marginal impact.