Outlook and Market Review - First Quarter 2011

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In the first quarter of 2011 the U.S. economy suffered through unusually bad weather, unrest in the Middle East, disruptions due to the earthquake and nuclear disasters in Japan, and spikes in oil prices. Real GDP growth for the quarter was a disappointing 1.75%, according to the advance estimate from the Bureau of Economic Analysis. GDP growth on a year-over-year basis was 2.3%. The housing and labor markets have yet to provide consistent support for economic expansion. There is no clear bottom to housing prices and downward pressure on prices from foreclosures and short sales continues. Job growth in the first quarter created some optimism for an improved labor market, but the unemployment rate moved back to 9% as workers re-entered the labor force faster than new jobs were created.

Inflation measures offer mixed signals. Core inflation measures for the CPI and PCE remain low but the top of the line measures show creeping inflation beyond the Fed target of 2.5%. Even without the classic definition of high inflation (rise in the overall index), consumers are forced to make hard choices to substitute higher portions of their budgets to energy and food while paring down spending on other goods.

Over the past three years monetary and fiscal policies created large government stimulus spending, rapid growth in bank liquidity, and historic low interest rates. Nevertheless, the economy’s response to these massive moves has been disappointing. Low interest rates have not prevented declining housing asset prices nor have they stimulated consistent investment by the private sector. Companies have maintained profits by cutting costs, especially labor costs. They have good cash positions and have exhausted labor productivity gains, suggesting that hiring will improve. Business and consumer confidence is improving, but it is fragile. Uncertainty over the future of taxes, costs of benefits, and unknown details about regulatory initiatives encourage firms to delay long run commitments. Fiscal policy is likely to be neutral, if not contractionary, as deficit reduction takes center stage. Monetary policy will end its second round of expansion by mid-summer and will likely be neutral until early 2012 when higher interest rate policies may be necessary to prevent inflation beyond the 2.5% target. The question is whether or not a self sustaining recovery can emerge without expansionary policy tailwinds.

Prospects for economic growth in the remainder of 2011 now look dimmer than they did at the start of the year. Growth for 2011 is likely to be in the 2.5% to 3% range with very modest improvement in the unemployment rate to 8.8%. Interest rates are most likely to move up slightly as modest inflation pressures, improved private sector demand for credit, and neutral monetary policy phases in. Price pressures currently developing in the wholesale and producer levels of the economy should filter through to higher overall inflation in the 2.75 to 3% range. Relief in energy prices will be modest at best and households will be forced to either cutback on other forms of consumption or reduce the 5% savings rate that has been achieved.