"The recession probably ended in June, if we had to pick a date," according to Jan Hatzius, Chief U.S. Economist at Goldman Sachs. But that doesn't mean it's time to break out the champagne. The return of up-trending charts may sound like good news for the economy, but it's going to be at least a couple of years before growth picks up in earnest, Hatzius and his colleagues Ed McKelvey and Andrew Tilton warned at an award ceremony in his honor in New York.
Hatzius is this year's recipient of the Lawrence R. Klein Award for Blue Chip Forecast Accuracy. The award, which is sponsored by the W. P. Carey School of Business, recognizes the economist who has compiled the most consistently accurate economic predictions over the preceding four-year period among those who contribute to the national Blue Chip Economic Indicators.
Sluggish Growth
His predictions for 2010 are consistently less optimistic than both the Fed's and the Blue Chip consensus. "We don't expect a V-shaped recovery, in fact we think that 2010 is going to be a bit slower in terms of annualized GDP growth than the second half of 2009," said Hatzius, predicting a decline in growth from 3 percent to 1.75 percent by the fourth quarter.
Hatzius says much of the slow economic growth we've started seeing in recent months is due to temporary factors. The first is the effect of the inventory cycle as companies restart production lines following months of stock liquidation. The second is the fiscal stimulus, which he estimates is contributing the majority of the perceived growth. Taken together, these factors represent around a 4 percent boost that will most likely diminish or disappear by the second half of 2010 in the face of continued high unemployment, budget-conscious consumers, and overcapacity in the manufacturing sector and housing market.
Overcapacity and Inflation
Though some observers seem concerned that current expansionary fiscal policies will lead to inflation, Hatzius and his colleagues disagree. "Disinflation is likely and the risk is actually deflation," he said.
"Historically, it's actually typical for inflation to come down after a recession is over, typically 2 percent lower 18 months after the end of a recession because you tend to have all this spare capacity around and more price competition," said Andrew Tilton, Senior U.S. Economist at Goldman Sachs.
"If there's more housing vacant, rents are likely to come down; if there are more unemployed workers, wages are less likely to go up; if there is more excess capacity in factories, companies are going to have a harder time raising prices," he said.
There is ample evidence, both macro- and microeconomic, for Tilton's claims. The economy's actual output is almost one trillion dollars shy of its potential, which represents well over 6 percent of the annualized GDP. The 9.8 percent unemployment rate is nearly double its long-term average; factories are idle and homes vacant in equally alarming proportion.
Unfortunately, there's not much that can be done about most of this overcapacity. Factories can limit production, yes, but vacant homes are already built and even people who retired early are being forced back into the workforce by market losses.
The Federal Funds Rate and the Budget Deficit
Hatzius and his colleagues find it extremely unlikely that the Fed will tighten policy in the face of all this overcapacity, despite widespread sentiment in the market that rate hike is forthcoming.
Using the Taylor rule, which applies actual and desired inflation rates and actual and potential GDP to compute desirable monetary policy, Hatzius and his colleagues have shown that in order to achieve its stated goals, the Fed would have to set interest rates lower than zero. Even relying on the most optimistic forecasts, it will be several years before the calculation yields a positive rate.
"We're nowhere close," said Ed McKelvey, Senior U.S. Economist at Goldman Sachs.
What he does foresee is more fiscal stimulus -- in the form of extensions of existing government programs such as the homebuyer tax credit and asset purchase programs -- though at some point the stimulus also will have to end.
"It's ok to run a deficit in a recession because the private credit markets are shrinking and the government has no difficulty raising the funds," said McKelvey. "In the longer run, the government has an unbalanced fiscal posture," he added, noting that if the government maintains its current 2 percent gap between receipts and expenditures once the economy recovers and interest rates rise, the interest portion of the deficit will grow disproportionately. A rate adjustment isn't exactly looming, but it is on the horizon.
Hatzius expects fiscal restraint by the end of 2010, though it has already shown up in the state and local sectors.
Bad News for the Little Guy
The scarcity of credit means that smaller companies will struggle to grow. "Large business have access to the bond market and the commercial paper market, while small businesses rely on bank financing, which is still very hard to come by," said Hatzius.
This is bad news for workers as well as for small businesses, which according to the U.S. Small Business Administration employ just over half of private sector employees and have generated 64 percent of new jobs over the past 15 years. Unemployment will continue to rise even after the economy begins to rebound, reaching in Hatzius's estimation a peak unemployment rate of around 10.5 percent by next year. Once the temporary growth provided by fiscal stimulus and the swinging inventory cycle fades, he thinks it's possible that we'll actually see wage cuts. Couple this with higher household savings rates and consumer spending falls, delaying recovery even further.
So while big businesses enjoy renewed profitability and vigor in the near term, most Americans will see only incremental improvements over the next eighteen months. This, according to Hatzius, is a necessary evil.
"I'd rather have large businesses recovering and smaller businesses doing poorly than having everybody doing poorly. In an ideal world you help everybody, but if you can't help everybody you help the people that you can."
Bottom Line:
• The recession is most likely over as it appears the economy has stopped shrinking, posting modest growth over the last quarter. Hatzius and his colleagues believe that much of this growth is the consequence of temporary factors -- the swing of the inventory cycle and the effects of fiscal stimulus -- which will have largely disappeared by the end of 2010, resulting in a nearly flat or even possibly negative growth rate.
• Fear of inflation is unwarranted as overcapacity will continue to cast a long shadow over the housing and labor markets and the industrial sector. We might see deflation within the next eighteen months.
• Despite market feeling to the contrary, Hatzius and his colleagues believe the Fed will not raise interest rates any time soon, mostly because of the disinflation they're predicting and continuing unemployment, which they expect to reach 10.5 percent by the middle of next year.
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