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Research US: Recovery On Track, but Not Fast Track

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The economic recovery is on track with ongoing, but gradual, signs of progress among consumers and businesses, but with some more erratic developments in housing. In Q4 09, the economy delivered its second positive quarter on growth following the recession, with GDP expanding at 5.9% q/q AR. Indeed this turned out to be even stronger than we had forecast in December's Global Scenarios, the main reason being a faster-than-anticipated stabilisation of inventories.

Given this front-loaded impact from inventories, the short-term growth profile is somewhat lower. The forecast is now for a 3.5%q/q AR growth rate in Q1 slowing to 2.5-3.0% for the remainder of the year. The forecasts for annual growth for 2010 and 2011 remain unchanged at 3.2% and 3.0%, respectively. Hence, we still expect a moderate recovery compared with historical standards and relative to the depth of the recession.

There is little doubt that the majority of the boost from the inventory cycle has already arrived. A stabilisation in inventories will add around 0.25pp to annualised growth in H1, while a return to a normal post-recession pace of inventory building could boost this estimate to 1pp. In any case, this is minuscule compared with the 2.5pp boost that arrived in H2 09.

The concern is now how the recovery should proceed. Domestic demand growth is still running subpar and the impact of fiscal stimulus is fading. Furthermore, much of the positive snapback effect on growth from improving financial conditions has already arrived and there has been renewed weakness in housing data lately.

Fortunately inventory cycles usually have dynamic effects and there is little reason to believe that this time should be different. Most recoveries have been helped by a significant boost from inventories, in turn materialising into job and capex growth. In fact there are already signs of this happening.

Equipment and software spending recovered sharply in Q4 09 and is set to enjoy further solid progress in the coming quarters helped by an ongoing manufacturing recovery, pent-up demand for new production equipment and maintenance. Furthermore, most indicators now point to an imminent and possibly rapid recovery in the job market. In addition, employment is set to get a significant short-term boost from census hiring in the coming months (Research US: Census - a springtime hiring shot).

With the recovery now entering a phase where underlying demand - in particular private consumption - is needed to take over, a return to positive job growth remains essential. Despite the slower-than-anticipated turnaround in the job markets, the outlook for consumers has turned somewhat brighter over the past few months.

First, compensation growth has picked up to about 4-5% propelled by a recovery in total working hours and a slower-than-anticipated decline in hourly earnings. Second, the unemployment rate has peaked and is now set to move gradually lower. Third, the pressure on household balance sheets is easing as credit tightening is ceasing and net wealth is recovering (Research US: Limited risk of a violent rise in the savings rate). Finally, oil prices have been steady, giving room for the disinflationary dynamics to support real purchasing power.

Although wage dynamics are set to slow further due to the huge slack in the labour market, a recovery in job growth during this year should facilitate an ongoing, but moderate, growth in personal consumption.

Aside from a slower-than-usual recovery in consumption, there are other headwinds which will keep a lid on the pace of recovery both in the near and longer term.

Up-front is the recent severe setback in housing demand, which will most likely drag residential construction back into the red for a couple of quarters. In combination with a huge amount of foreclosed homes heading for the market, this could add some renewed downward pressure on home prices. That said, the adjustment in housing is close to complete and the weakness is most likely temporary and caused by the impact of the first-time home buyer tax credit and unusually inclement winter weather. On the longer horizon, pent-up demand and improving economic conditions should lift home sales and support prices.

Meanwhile, there are other reasons to be cautious about the outlook for 2011 and 2012.

The most obvious is the relatively tough fiscal consolidation that lies ahead for the coming years. The current budget proposal from the Obama administration looks for a tightening of the structural budget from -7.3% in 2010 to -3.0% in 2012. This is likely to produce a negative growth effect in the region of 1.6-1.7% for 2011 and 2012. Hence, to obtain a 3% growth rate, the underlying pace of demand must be 4.5-5.0% - a level that could be hard to achieve. Another and much more difficult assessable factor is financial regulation, which comes on the top of this and might act as a monetary tightening on the economy.

In spite of these obvious long-term headwinds, we expect the recovery to be sustained but, due to these headwinds, moderate. As emphasised in December's Global Scenarios, pent-up demand for housing, investments and durables in combination with a smaller drag from net exports are likely to make up for some of the missing strength in consumer demand over the coming years, providing some much needed support for the economy. Further, as emphasised below, monetary policy will only be tightened to the extent that economic conditions, fiscal tightening and financial regulation allows.

Annual headline inflation has started its descent towards 2% following the spike in late 2009 caused by base effects from the low raw material prices at end-2008. We expect inflation to break below the 2% y/y level by June and fluctuate around a modest 1.6% y/y for the remainder of the forecast period. Underlying this forecast is an assumption of a moderate increase in oil and food prices over the next two years and a muted path for core inflation.

There is little doubt that significant deflationary pressures will push core inflation lower over the coming year (Research US: Core inflation - a worry for the Fed). The NAIRU gap has reached its highest since WW2 and will only trend gradually lower over the coming years. This will put significant downward pressure on labour costs and core inflation. In addition, the correction in the housing market has sent vacancy rates higher which is keeping rents and owners' equivalent rent for houses down. Finally, low capacity utilisation in manufacturing industries is putting downward pressure on core producer prices. We thus expect core inflation to trough at 0.5% by late 2010 and increase only gradually to 1.2% by end-2011

Over the past nine months, core inflation has stayed surprisingly high given the intense deflationary forces. A closer look at the data shows that core goods prices have been rising rapidly. This can largely be attributed to an extraordinarily large increase in vehicle prices and a tax-related boost to tobacco prices. Both are temporary in nature. This implies that when price developments in these components return to normal, core inflation touching zero is a non-negligible risk.

There is no doubt that the projection for core inflation presented above is well below the Fed's comfort zone. Add to that a fragile economic recovery which is sensitive to new negative shocks and you have the reason why the Fed will be cautious not to tighten too aggressively. We look for the first fed

funds rate hike to arrive in November this year, reflecting the desire to move away from a zero interest rate policy. The Fed may pause hiking already close to the 1% level in 2011 (Research US: A roadmap for the Fed's exit).

The exit is however already under way. Most short-term liquidity and lending facilities have already been terminated and the Fed has started to normalise the discount rate. The unwinding of the extraordinary measures has so far been smooth as the use of these facilities has shrunk to almost nothing. We see the biggest risk for a disruptive market reaction from the termination of the MBS/agency purchase programme by end-March. A surge in mortgage yields could potentially delay the first rate hike.

We expect that the next step in the exit strategy will be to remove the 'extended period' language from the policy statement, in order to prepare markets for a rate hike. This is likely to be implemented in Q2 and will be followed by an active draining of excess reserves through reverse repos or term deposits starting by late Q2 or Q3.

Given the benign outlook for core inflation, the uncertainty surrounding the timing and size of fiscal tightening and the impact of possible new financial regulation, we judge the risk to our forecast to be tilted towards rate hikes arriving later than in our main scenario.

Danske Bank


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