The National Outlook

Highlights

• Growth of U.S. economic output (real GDP) definitely swung into the positive zone in the third quarter, apparently posting an above-trend rate, and we expect maintenance of solid GDP growth in the final quarter of this year as well as a strengthening pattern during the 2010-2011 period. Considering the depth of the Great Recession (the deepest hole since the 1930s), our growth forecast for 2010-2011 can be viewed as moderate, and it leaves a large gap between projected and potential levels of GDP at the end of the period - providing a lot of growth room for future years.

• The descent of the economy into the Great Recession can be pinned primarily on the global financial market crisis that crested late last year. The recent firming of economic conditions can be traced largely to strenuous efforts by the Federal Reserve and foreign central banks to rescue the financial markets, along with complementary actions on the legislative front to support financial institutions and to spur spending by households, businesses and state and local governments.

• The strengthening financial market foundations should give adequate support to a moderate economic expansion that’s been jump-started by fiscal stimulus measures, including the temporary tax credit for first-time home buyers and the cash-for-clunkers program for the auto sector. Our current forecast does not assume another round of fiscal stimulus, although several possibilities are on the table at this time. (Stay tuned)

• The recent firming of GDP growth partly reflects the beginning of a turn in the inventory cycle, as the rapid liquidation by American businesses has begun to wind down, but both recent performance and our forecast for sustained economic recovery are grounded upon stabilization and expansion of real final sales to both domestic and foreign purchasers. Most major components of final sales (other than investment in nonresidential and multifamily residential structures) figure to post positive growth in the second half of this year, and all major components should gain strength at various points during the 2010-2011 period.

• As expected, the U.S. labor market has continued to deteriorate even as economic output has begun to rise, reflecting a typical early-recovery rebound in labor productivity (output per hour) as businesses squeeze all they can out of workers on payroll. However, the rate of deterioration has begun to slow down and we expect stabilization of payroll employment along with a cyclical peak in the unemployment rate by early next year. Our projections for growth of real GDP and labor productivity, along with estimated growth in the civilian labor force, generate systematic reductions in the unemployment rate during the 2010-2011 period, although a substantial degree of slack is likely to remain in labor markets at the end of that period - along with the remaining GDP gap.

• Key inflation rates have continued to move downward, particularly the producer and consumer core rates that exclude food and direct energy prices. The massive amount of slack in resource markets that’s been generated by the Great Recession has put heavy competitive pressures on both workers and business firms, shepherding core inflation downward during the past year to historic lows.

• The persistence of substantial slack most likely will foster further declines in core inflation even as the economic expansion moves forward, particularly if long-term inflation expectations ratchet downward toward actual inflation rates. Inflation already is running below the Fed’s longer-term target zone, and further declines most likely will be viewed as unwelcome developments by our central bank. (Believe it or not!)

• Monetary policy remains extraordinarily stimulative, with the federal funds rate close to zero and with the Fed’s balance sheet still in an extremely expansive mode. The Federal Reserve recently has been telegraphing its "exit strategy" from this unprecedented monetary policy stance, and it’s clear that the Bernanke-led Fed will proceed quite cautiously toward the exits as long as the "real" economy is operating well below its potential level and inflation is running well below the FOMC’s longer-term target zone. The Fed clearly expects these conditions to persist for "an extended period."

• We expect evolution of the economic and inflation picture to prompt modest increases in the federal funds rate beginning in the second quarter of 2011, accompanied by increases in the rate paid on reserve balances at the Fed. The Fed’s emergency short-term lending programs for financial institutions already are winding down naturally, and the need for targeted lending programs to address specific credit market dysfunction is fading as well. The Fed may actively drain excess reserves from the banking system at some point, although outright sales of long-term securities (including housing agency debt and MBS) from its portfolio presumably will be a last resort.

• The Fed's massive purchases of housing agency securities are scheduled to run their course by early next year, removing a key factor behind the major compression of spreads between 10-year Treasury yields and rates on both GSE-related and FHA-insured fixed-rate home mortgages since late last year. We expect the Fed to resume purchases of housing agency securities if the spreads begin to widen out seriously, and we expect the spreads to remain close to current levels going forward.

• The projected evolution of the U.S. and global economies, combined with ongoing healing in financial markets and our monetary policy assumptions, point toward an attractive interest rate environment across the short-term forecast horizon. Short-term rates (including the bank prime rate) should remain historically low, longer-term Treasury rates and federally-related mortgage rates should move up only gradually, and quality spreads in corporate bond and private mortgage-backed securities markets should continue to narrow. The capital-strapped banking sector will remain tight-fisted, however, making life difficult for smaller companies (including private home builders) that rely on depository institutions for credit.

• An evolving swing in residential fixed investment from sharp contraction to a positive growth pattern, along with stabilization of house prices following stunning contractions in many parts of the country, are necessary conditions for our projected pattern of economic recovery and expansion. But the evolving housing recovery is not likely to be up to the standards of previous cyclical patterns, at least in its early stages, due to the moderate nature of the economic recovery and a number of headwinds on both the demand and supply sides of the housing market.

• The key factors weighing on the early stages of the housing recovery include historically large overhangs of vacant housing units on both for-sale and for-rent markets, a huge foreclosure wave that has not yet crested, foreclosure-related appraisals, persistent problems in components of the mortgage market lacking government support, and unusually tight supplies of credit for builders and developers--particularly for those relying on depository institutions. Furthermore, home-buyer demand appears to be fading at this time as the expiration date for the federal tax credit (November 30) is approaching.

• Despite the impressive list of negative factors holding down home sales and housing production in the near term, we believe that greatly improved affordability and brighter house price expectations, combined with gathering economic momentum and ongoing repair of the financial system, have stemmed the record-breaking housing contraction and will support a housing recovery process that has the potential to run for many years. Indeed, housing starts most likely will not get back to their sustainable trend level for about four years, the same kind of timetable that most likely will be needed to close the glaring GDP gap and eliminate the huge degree of slack that’s still accumulating in the labor market.

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