Updating the Economic Outlook

Updated assessments of the economic outlook have been colored by the last week’s wild swings in the stock market.  On August 8, the VIX, which measures expectations of volatility in the S&P 500 index, jumped to its highest level since the apex of the financial crisis in the weeks just after the collapse of Lehman Brothers. How quickly the mood shifts. Less than a month ago, the Dow Jones Industrial Average was approaching a new post-recession high. 

Investors’ despondency reflects data that show a slowing economy and stronger headwinds to growth in the coming quarters. The S&P downgrade of the US debt rating was only the proximate cause that brought this data, and the counterproductive course of things in Washington, into focus.

The July labor report, released just hours before the country’s sovereign downgrade, offered mixed signals regarding the economy’s health. Net job growth beat economists’ expectations. That is a significant result given the uncertainty surrounding the debt negotiations leading up to the August 2 deadline. August will prove more difficult for job growth, given the erosion of business and consumer confidence and legislators’ lack of focus. According to the Michigan/Reuters mid-August measure, consumer confidence has fallen to its lowest level in 30 years.

Private employment increased by 154,000 jobs in July, with gains concentrated in Professional and Business Services, Health Care, Retail Trade, and Durable Goods manufacturing. The unemployment rate fell by 10 basis points, to 9.1 percent, but that result followed from nearly 400,000 people leaving the workforce. The employment-population ratio slipped to 58.1 percent.

The Outlook by the Numbers

Growth expectations are reserved. Corporate profits have rebounded, especially amongst large businesses, but firms remain unwilling to invest for the time being.  If Washington makes an about face and refocuses on supporting an environment conducive to private investment, conditions could change for the better.

We are not there as yet. This point was driven home by the Federal Open Market Committee’s August 9 decision to signal that it would keep the Fed Funds target rate at “exceptionally low levels” through mid-2013. The FOMC statement telegraphs monetary policymakers’ belief that growth will remain slow enough over the next two years that inflationary pressures will be subdued.

As for the specifics of the growth outlook, the FOMC’s June central tendency calculations show growth between 2.7 and 2.9 percent in 2011 and between 3.3 and 3.7 percent in 2012. These estimates seem implausibly optimistic given current data and are not matched elsewhere.  The International Monetary Fund, in its June outlook, projected 2.5 percent growth in 2011 and 2.7 percent growth in 2012.

The probability of recession has risen in recent weeks, so even the IMF’s more reserved estimates are likely to be revised downward. Whether the outlook improves will depend significantly on the private assessment of what happens in Washington as we head into the next round of the budget debate and the mandated decision timeframe for building consensus on budget rebalancing.