Washington Tempers Expectations for the Recovery

The Congressional Budget Office released an update to its economic outlook last week, projecting that this year's budget deficit will be the second largest in the post-World War II era and that economic growth will fall well below rates observed during previous recoveries. These findings diverge from estimates by the White House and Federal Reserve, emphasizing the need for caution when developing projections for property fundamentals in spite of recent suggestions of an early turnaround.

Key elements of the CBO report include the following:

GDP Growth

Real GDP growth will fall from 2.8 percent in 2010 (fourth quarter to fourth quarter) to 2.0 percent in 2011. Growth is expected to accelerate in later years but will ultimately converge on a long-term rate of 2.4 percent; 

The White House is significantly more optimistic than the CBO in its most recent update, projecting 2010 growth of 3.1 percent, following by growth of 4.0 percent in 2011. For its part, the Federal Reserve's central tendency projection ranges from 3.0 percent to 3.5 percent for 2010 and 3.5 percent to 4.2 percent for 2011. The Blue Chip consensus is closer to the CBO's outlook, projecting growth of 2.8 percent in 2010 and 3.0 percent in 2011;

Unemployment

Calendar year average unemployment will not fall below 9.0 percent until 2012. Between 2012 and 2014, the unemployment rate will average 6.7 percent, above the structural rate for the US economy;

The White House and the Blue Chip consensus are consistent with the CBO outlook in projecting 2011 average unemployment of at least 9.0 percent;

Interest Rates and Inflation

The ten-year treasury rate will hold within a small range around 3.5 percent until at least 2012;

Consumer price inflation will fall within the Fed's target range during the next few years, leaving monetary policy makers unconstrained in their focus on supporting growth.

Not one of these projections suggests that the economy will double dip. But the question is worth asking since even the most basic measures of activity show that the economy has slowed. According to the Bureau of Economic Analysis' advance estimate, released July 30, real gross domestic product increased at an annualized rate of 2.4 percent in the second quarter, slowing to less than half the pace reported for the fourth quarter of 2009.

In fact, each of the major domestic contributors to activity expanded in the second quarter. Personal consumption was reasonably strong, slowing only slightly from the first to second quarters. It could have slowed more dramatically given mediocre income growth, constrained credit and the buffeting of job security by persistent unemployment. While the rate of growth in consumer spending slowed, a wide range of investment spending, in areas as varied as business equipment and housing, actually picked up over this period.

As for the slowdown in the headline GDP numbers, the most significant drag on the economy in the second quarter was the widening trade deficit. Imports increased by 29 percent at a seasonally adjusted annual rate, almost three times faster than exports. If only consumers' appetites favored domestic goods and a lot less oil, the overall numbers would look a little better.

Of course, profits have been very strong at some firms. So why the reserved outlook? Much of the conflict between the macroeconomic view and the micro data on firm performance reflects differences in the ways and means of measurement. Macro data on the economy and the abysmal job reports tend to rely on serial seasonally adjusted comparisons of month-to-month or quarter-to-quarter changes. On the other hand, the brighter company earnings reports compare current performance to a year ago. In early 2010, those have been easy comparisons to make. Large firms have dominated earnings increases, but revenue growth has lagged behind cost-cutting and productivity gains. All things being equal, this suggests that corporate profit growth will be more mixed in the coming quarters. Neither firm investment nor firm hiring show signs of leading the economy to an upside surprise.

Among other key measures of the economy's underlying trends and direction, gauges of sentiment and behavior are telling. While consumers and businesses are fickle in their assessments of the outlook, the readiness of each group to spend, invest or hire is a function of confidence, among other things. Because objective and quantifiable measurement of confidence is such a problematic exercise, discussions of sentiment are often treated as an afterthought.

But both groups show waning confidence in the recovery, and so the subjective measures cannot be ignored. The National Federation of Independent Business reported last week that small business confidence has slipped to its lowest level in four months. Consumer sentiment edged up in mid-August, according to last week's update from Thomson Reuters and the University of Michigan. But the index is still only slightly higher than a year ago, when payroll employment was contracting at a troubling pace.