Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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The “fiscal cliff” has become a bogeyman for our time – a shapeless monster hiding under beds, lurking in closets, and haunting Congressional hallways, threatening to leap from the shadows and devour the economy in a large, greedy gulp.

Virtually every discussion of the economy cites evidence that cliff fears have already stunted growth and warns direly of the consequences should lawmakers and President Obama fail to reach a compromise that will prevent the economy from hurtling into a financial abyss.

The warnings are becoming more apocalyptic as the year-end deadline nears for preventing the $607 billion in automatic spending cuts and tax increases that will take effect January 1. Like some American tourists who think that speaking more loudly will make their words more comprehensible to people who don’t speak English, commentators seem to think that ratcheting up the cliff rhetoric will force Republicans and Democrats who have as yet been unwilling to compromise to do so.

Those who view a compromise as more likely than not are probably right, although it is political and economic reality, not hyperbole, that will produce it. But in the meantime, investors, analysts and consumers are exhibiting bipolar symptoms, their moods soaring on reports that a compromise is near and plummeting on reports that it is not.

Promise and Threat

Offering a restrained, though pointed, assessment of this ongoing debate, Federal Reserve Chairman Ben Bernanke noted in a recent speech that “cooperation and creativity to deliver fiscal clarity — in particular, a plan for resolving the nation’s longer-term budgetary issues without harming the recovery — could help make the new year a very good one for the American economy.” On the other hand, he warned, “the realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery.”

Fannie Mae’s economic forecast for next year notes similarly that failure to resolve the debate over the fiscal cliff and the debt ceiling “are likely to create the most significant barriers to meaningful growth” for the economy and the housing market.

Optimistic predictions for 2013 assume that the cliff will be averted; more pessimistic forecasts, or less certain ones, fear that it won’t. Economists polled by Reuters in late November agreed that concerns about the cliff have been weighing heavily on both businesses and consumers, discouraging investment and hiring by the former and depressing spending and confidence for the latter.

Some polls clearly reflect the bipolar symptoms noted earlier. For example, spending on equipment in the third quarter fell to its lowest level since the second quarter of 2009, but plans for future spending, reflected in orders for non-defense capital goods, increased by 1.7 percent in October – the strongest reading in this Commerce Department survey since May of last year.

The preliminary reading in the Thomson-Reuters consumer confidence index showed an increase of nearly 2 points between October and November, but the final reading, two weeks later, the increase was only 0.1 percent. Although consumers weren’t asked specifically about the fiscal cliff, many expressed concerns about it, representing “one of only a handful of surveys over the past 50 years in which consumers spontaneously mentioned their uncertainty about government policies,” a Thomson/Reuters press release observed.

Some Favorable Trends

If you remove the fiscal cliff from the equation – admittedly, not easy to do – many of the economic trend lines look favorable, and some of them look very favorable indeed:

  • Employment: The November labor report was stronger than expected. Shrugging off the impact of Hurricane Sandy, employers added 146,000 workers to their payrolls, beating consensus forecasts, and offsetting, somewhat, a downward revision in the October numbers. Although the unemployment rate fell to 7.7 percent – the lowest rate in four years — analysts agreed that reflected a decline in the number of workers seeking jobs rather than an increase in the number of unemployed workers finding them.
  • Consumer confidence. The two major confidence measures (Thomson/Reuters and the Conference Board) are at five- and four-year highs, respectively; more than 35 percent of consumers responding to a recent Bloomberg survey said they think the economy will improve over the coming year. Some analysts think consumer confidence will offset business caution, providing enough spending momentum to keep the recovery on track. “It puts a floor under growth,” Harm Bandholz, chief U.S. economist at UniCredit Group, told “With consumer spending rising at even a moderate pace,” he predicted, “the expansion will carry on.”
  • Manufacturing activity: Reversing several successive monthly declines, Markit Economics’ manufacturing index increased to 52.8 from 51, remaining above the 50-mark indicating expansion. Durable goods orders, meanwhile, remained flat in October after rising more than 9 percent in September
  • Growth. The third quarter growth rate, measured by GDP, was stronger than expected, at 2.7 percent. The Leading Economic Indicators, predicting future growth, also increased in October, although the gain (0.2 percent) was anemic. But while the growth pace is slow, analysts noted, the direction remains positive.

Housing: A Tail Wind Now

Housing continues to generate much of the energy evident in the economic grid and is fueling most of the optimism about growth prospects for next year.

After being blamed consistently for impeding the economic recovery, housing is now being credited with bolstering it. “The housing sector has turned from a headwind …into a tailwind,” a Goldman Sachs analyst wrote recently in a note to clients. The Fed’s Bernanke also expects housing to be “a source of economic growth and new jobs over the next couple of years.” Some analysts are predicting the housing sector could account for as much as 20 percent of GDP growth this year, “and growth means jobs; jobs mean a stronger housing market; and that means more jobs and so on and so on,” an article in Builder Magazine noted, “and that means an end of the vicious economic cycle triggered by housing’s collapse and the real start of a robust recovery.”

There are many reasons for that optimism, including: Continued strength in home sales, shrinking inventories and rising home prices, which have moved more than 1 million homeowners above the negative equity line this year, according to a CoreLogic report. The impact of rising prices can’t be underestimated, Patrick Newport, chief economist at CoreLogic, says. As he explains in a recent report:

“Higher prices are giving home builders more leeway in raising prices, incentivizing them to ramp up housing starts….Higher starts are also boosting home sales by nudging fence sitters, who up to now have been waiting for home prices to bottom out before jumping into the market, [and they are] lubricating the labor market,” by making it easier and “less painful” for homeowners to accept jobs that require them to relocate and sell their homes.

The Standard & Poor’s/Case-Shiller 10-city and 20-city price indexes both rose to their highest levels in the past two years. The monthly gains (0.3 percent) were small, but still significant, David Blitzer, chairman of S&P’s index committee said, because “we are entering the seasonally weak part of the year. And despite the seasons, housing continues to improve.”

Some analysts point out that, the improving trends notwithstanding, home sales, starts and prices remain well below where they were during the boom years. “This is clearly a recovery,” one analyst told Reuters recently, “but it is hardly a boom.”

That conclusion is distressing, however, only to those who think a return to the boom years is possible or desirable, according to Frank Nothaft, Freddie Mac’s chief economist. “What a healthy housing market should look like will dismay those who keep comparing housing to what it was during its peak years,” Nothaft notes in Freddie’s annual housing forecast. Housing is not likely to return to its halcyon days, he agrees but it is returning to health. And though the recovery is slow, he acknowledges, it is steady and strong and “the long-term prognosis is promising. Just don’t expect the housing market to wake up at 98.6 degrees tomorrow morning.”