A Happy New Year for U.S. Economy? - Analyst Blog

We are counting down to the New Year with about 9.8% of the population unemployed, 18% underemployed and a continuously worsening budget deficit. But mainstream economists appear upbeat about the year ahead, with increased expectations for the economy as the recently passed tax-cut extension bill will essentially give Americans a pay raise in 2011.

Following the pessimistic economic analysis by Federal Reserve officials in November, the general direction of expectations has taken a 180-degree turn based on certain indicators. However, we should not be overconfident with this optimism, as most of the predictions by mainstream economists over the past several years have not been very accurate.

Although most projections indicate an improvement in 2011, questions about the swiftness and perpetuation of the economic recovery linger.

Let's take a quick look at what lies at the root of economists' optimism and what might betray?

Tax Deal to Boost GDP?

With the increased purchasing power of Americans as a result of sustained Bush-era tax cuts, most economists expect Gross Domestic Product (GDP) growth to be 3% in 2011. The more optimistic predict 4% growth. These compares favorably with 2.8% growth expected for 2010. If GDP grows at 4%, it would be the strongest rate since 2000, though probably still not enough to fully address concerns related to high unemployment.

According to a report by the U.S. Department Commerce on Wednesday, the GDP grew at a reasonable pace last summer. This was primarily a result of stronger spending by businesses to fill up on supply. The GDP growth was 2.6% in the third quarter. As consumer spending usually accounts for about 70% of GDP, increased consumer spending due to higher income would help achieve the target growth rate.

However, given the current pace of consumer spending, inventory building is likely to slow going forward. Also, soaring imports remain a major negative. According to the Department of Commerce, trade imbalance has significantly threatened the economic growth rate. Without the trade deficit, the economy would have grown at 5% in 2010.

Business Spending: A Strong Contributor?

Business spending has significantly increased inventory in the third quarter to $111.5 billion, contributing 1.3 percentage points to GDP. As demand from consumers and other businesses remains strong, the pace of inventory addition is expected to remain intact.

Mild Growth in Inflation

Inflation is expected to rise to about 1.5% in 2011. In November, the Consumer Price Index (CPI) increased 0.1%, keeping inflation at 1.1% over the past 12 months. The inflation rate is expected to wind up at 1.3% at the end of 2010.

Economists also expect core inflation, which excludes food and energy prices, to increase more slowly. In November, the core CPI also increased 0.1%. This represents the slowest pace since this CPI data set started in 1958 despite considerable improvement in economic activity in the recent quarters.

As the jobs are increasing at a very slow pace, inflation is not expected to increase aggressively in the coming year. However, there is also no chance for deflation.

Interest Rates to Remain Low

As inflation rate remains low (around 1%) and the unemployment rate hangs very high (9.8%), the Federal Reserve is expected to keep its short-term interest rate low (near zero) through 2011 in order to avoid a deflation, which may again result in another recession.

Since further cuts in interest rates are just not possible, the Federal Reserve is in the process to buy up to $600 billion in long-term Treasuries by mid-2011. According to Federal Chairman, increasing money supply in the credit markets will accelerate economic recovery.

Housing Market: Still a Pain?

Though housing data remained discouraging during the second half of 2010, existing home sales and mortgage lending data showed signs of improvement. According to a report from the National Association of Realtors on Wednesday, sales of previously owned homes jumped 5.6% in November to an annual rate of 4.68 million. However, the inventory of homes on the market dropped 4% in November to 3.71 million units.

We think the housing market still remains a pain. On a year-over-year basis, existing home sales were down by about 30%.   

Job Growth Challenged?

According to Center for American Progress, the tax-cut deal is expected to create about 3.1 million new jobs in total after adding up different provisions. The estimate is based on the Congressional Budget Office's estimate of one million new jobs for each 1% of GDP growth.

However, based on the same assumption, the Obama administration had previously claimed that the $787 billion American Recovery and Reinvestment Act would create 3.5 million jobs. But the unemployment rate stood at 9.8%. This is basically because the government is a bit reluctant to create jobs in the private sector directly by implementing rules or laws.

Though the government stimulus packages can increase GDP, most of the private sector firms are on the verge of recovering their financial conditions with cost savings by limiting recruitments. We don't think the new tax-cut deal will be able to address the unemployment problem to a great extent, as many of the companies are still struggling with weak financials.

The recession continues to take its toll on banks. There have been 151 bank failures so far this year. With loan losses on commercial real estate on the rise, hundreds of more banks are likely to crash in the next few years.

The bank failures have resulted in a wave of consolidation in the industry. When Washington Mutual was in the red in 2008 and was deemed as the largest bank failure in the U.S. history, it was acquired by JPMorgan Chase & Co. (JPM). The other major acquirers of failed institutions since 2008 include U.S. Bancorp (USB) and BB&T Corporation (BBT).

If the current pace of consolidation continues, we will see the emergence of a handful of large banks. As a result, the overall economy will not remain unscathed and job creation will become vulnerable.

Better 2011: A Mirage?

There are enough reasons to be confident on the economy at this point. The improving stock market will help Americans recover their recession-related losses plus the job market is improving, though at a slow pace. However, there are no reasons to be over optimistic as job insecurity remains a major problem.

Probably, some of the visible positive indicators are delusions. The retail sales have primarily increased due to investor gains from the improving stock market. Businesses are just experiencing this increase in retail spending which could be temporary. However, businesses have started recruiting based on increased demand, which could again be a passing phase. So we may see job cuts again.

More importantly, the structure of the tax-cut legislation to support the economy on a temporary basis is disappointing. The government should have additional policy efforts to address deterioration in America's budget deficit. Probably, a significant push is needed to improve America's long-term competitiveness.

 
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