- Data reports out of the US have been consistently stronger-than-expected in recent weeks, leading many (including ourselves) to revise up estimates for first quarter GDP.
- However, whether this strength can be sustained in the coming quarters remains unclear. We continue to believe the odds of a sustained upside breakout in growth this year are limited, given the headwinds of fiscal consolidation, higher taxes, and increased regulation.
Stronger GDP Growth
US economic data releases in recent weeks have consistently surprised to the upside. Reports on employment, business investment, manufacturing activity, housing, and consumer spending have all shown impressive strength.
The resilience of the household sector in the first quarter has been particularly impressive. After real consumer spending advanced at a better than 2% annualized pace in the fourth quarter last year, we had thought the pace would cool noticeably in Q1, as a result of the payroll tax cut expiry and the sharp run-up in gasoline prices.
However, in the wake of February’s stronger-than-expected retail sales report, the Q1 gain in real consumer spending looks poised to rival that of Q4.
We now look for real GDP growth to accelerate in Q1 to a 3.2% annualized pace following an essentially flat reading in Q4 because of this development, combined with:
- a pickup in the pace of stockpiling (which could boost real GDP by a full percentage point in Q1 after subtracting 1.6 percentage points from growth in Q4)
- stabilization in government spending (following its late-2012 plunge)
- on-going strength in housing and capital spending
But Can It Be Sustained?
The strength of the data in recent weeks (and the growing optimism among market participants about the US outlook) gives us a strong sense of déjà vu. Exactly one year ago, we wrote:
“While the recent strengthening in economic activity is a welcome development, we again find ourselves hesitant to extrapolate the pace of improvement too far forward. Throughout this recovery, views on the economy have swung from extremely pessimistic to overly optimistic and back again. However, the economy has never been as strong as the optimists have hoped nor as weak as the pessimists have feared. The key has been to fade the extremes. Once again, market participants have begun to position for an upside breakout in growth. Similar bets were made in 2010 and 2011 but they proved wrong.”
Indeed, in each of the last three years, the economy has begun the year strongly but, in every case, that momentum faded in the spring. The factors behind the acceleration and subsequent deceleration have differed from year to year (e.g. tax cuts, mild winter weather, the Japanese earthquake/tsunami, the Eurozone crisis), but the pattern has held nonetheless.
The chart below illustrates this point. The Chicago Fed National Activity Index (CFNAI) is a weighted average of 85 indicators of national economic activity covering four broad categories (production and income; employment, unemployment, and hours; personal consumption and housing; and sales, orders, and inventories). A positive value for the CFNAI indicates that the national economy is expanding above its historical trend rate of growth; negative values indicate below average growth.
In each of the last three years, the periods of above-trend growth proved short-lived. After a few months, the economy returned to its subpar state.
The CFNAI suggests that the economy is once again expanding at an above-trend clip. The question is whether another slowdown will follow this year. There are some reasons to think it may not. For example, one possible explanation for the winter acceleration and spring slump in recent years may be faulty seasonals in the wake of the financial crisis.
Standard seasonal adjustment methodology relies heavily on the experience of the most recent three years to determine the expected seasonal changes in activity. Thus, even if the sharp contraction in late 2008/2009 led to faulty seasonal adjustment in 2010 through 2012, those distortions should now be much less pronounced.
Indeed, in his post-FOMC press conference last week, Fed Chairman Ben Bernanke noted:
“There’s been a certain tendency for a spring slump that we’ve seen a few times . . . One possible explanation is seasonality. Because of the severity of the recession in 2007 to 2009, the seasonals got distorted. And they may have led – and I say may because the statistical experts, many of them deny it – but it’s possible that they led job creation and GDP to be exaggerated to some extent early in the year. Our assessment is though that at this point that we’re far enough away from the recession that those seasonal factors ought to be pretty much washing out by now.”
The fact that the long-awaited recovery in housing is now under way has also raised hope that the economic strength seen in early 2013 can be sustained. To be sure, the positive implications of a rebound in housing are broad-based –from increased employment to higher consumer wealth to greater labor mobility. Still, we can’t help but feel that the expectations for this sector (and all that its turnaround can do) are getting too high.
The Sequester Is the Wildcard
While the recovery in housing is an added element supporting the economy this year, the degree of fiscal drag is an offsetting negative. So far, the consumer has shown resilience in the face of higher taxes, but we cannot rule out the possibility that the impact of the payroll tax cut expiration will begin to weigh more heavily on households in the months ahead.
That said, the real wildcard for the growth outlook over the remainder of 2013 is the sequester. Last week, Congress passed a Continuing Resolution (CR) to fund the government through the end of the fiscal year (September 30). The CR locks in the sequester. The only means of eliminating the cuts now is either through a fiscal year 2014 budget agreement or some kind of ‘Grand Bargain’ deal, neither of which appears likely at this time.
The Congressional Budget Office has estimated that the sequester cuts will shave 0.6 percentage from real GDP growth this calendar year and result in the loss of about 750,000 full-time jobs.
In February, the independent research firm Macroeconomic Advisers analyzed the sequester using their model. They estimated that sequestration would reduce real GDP by 0.6 percentage points in 2013. In the fourth quarter of 2013, the unemployment rate would be ¼% higher under sequestration versus their baseline forecast and the level of payrolls would be 600,000 lower.
Their simulation (based on the information in hand in February) found the largest impact of sequestration would occur in the second quarter, when growth was reduced by roughly 1¼ percentage points. The chart below illustrates the difference in quarterly real GDP growth rates under Macroeconomic Advisers’ baseline forecast and an alternative scenario incorporating the sequester.
At this time, we have not incorporated the impact of the sequester cuts into our GDP forecast, in part because we are waiting for more clarity over the timing and nature of the cuts.
In the Continuing Resolution, the House and Senate detailed appropriations for a number of government agencies (e.g. Defense, Veterans Affairs, Justice, Commerce, Agriculture and Homeland Security, as well as the Food and Drug Administration, National Science Foundation and NASA) to protect some important programs, which will help to blunt some of their impact.
Following the resolution’s passage, the Pentagon announced that it will delay sending out furlough notices (which are required to be sent 30 days in advance) until at least April 5. Previously, the Pentagon had planned to start furloughs around April 15. So, the furloughs will get pushed back by roughly three weeks.
Thus, exactly when and how much drag will be seen as a result of the sequester cuts remains unclear.
Impact May Be Weaker
It is also possible that the impact on real GDP and payrolls will be smaller than feared. The degree to which the broad economy is affected depends on the multiplier. Estimates for the multiplier commonly range from 0.5 to 2.0 (so, at the most extreme, a $1 dollar reduction in government spending leads to a $2 decline in real GDP).
In their February report, the Congressional Budget Office projected that sequestration will reduce the deficit by US$42 billion in fiscal year 2013 and US$89 billion in fiscal year 2014, which would imply a cutback in government spending of about US$65 billion in calendar year 2013.
Assuming a multiplier of 1.0, this would imply a reduction in real GDP of closer to 0.4% (if we had to guess, we’d say the multipliers on government spending are smaller, not larger, than generally assumed).
Another point to keep in mind is that, while the number of furloughs announced may seem staggering (e.g. roughly 800,000 civilian workers at the Department of Defense are facing furloughs), the direct impact on high-profile employment indicators (payrolls, initial claims) should be minimal.
For example, the 22-day furloughs expected for those civilian Defense workers will mean one day a week off work without pay for 22 weeks. Under that scenario, employees would still be counted as employed and will not receive unemployment compensation because the decrease in income will not be significant enough to qualify (if the furlough days were taken consecutively, and the employee was not paid during that time, the employee would be likely eligible for unemployment compensation).
Thus, while hours worked and also wages and salaries may be adversely affected, the impact on nonfarm payrolls and initial unemployment claims from the government furloughs should be limited.
Indeed, we are beginning to think that the impact of the sequester on activity in the coming months and quarters might prove too small and drawn out to be identified. That is, after a strong performance in Q1, real GDP may settle back to around 2%, the trend in non-farm payroll growth could slip back below 200,000, and declines in the unemployment rate may slow or stall – all because of the sequester, but with no public recognition of that fact.
However, even if the fiscal drag is not apparent, we think our real GDP forecasts are more likely to be revised down rather than up in the months ahead. With the headwinds from Washington continuing to blow, sustained above-trend growth this year seems unlikely.
Our near-term growth forecast has been raised, but our longer-term views have not changed. We still expect 2013 to be a year of continued economic improvement but also continued challenges.
About the Author
This article is excerpted from “US Economics Weekly,” a report by Royal Bank of Scotland and affiliated companies that was published on 22 March 2013. It has been re-edited for conciseness and clarity.
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