Outlook and Market Review - Second Quarter 2010

Summary: 

The economy is in a “soft” and “fragile” condition relative to more normal performance in a recovery. GDP grew at a real rate of 2.4% in the second quarter, according to the advanced estimate of the Bureau of Economic Analysis. There is a good chance that second quarter growth will be revised downward closer to 2% when the full impact of international trade is recorded. GDP growth at less than 5% is low for the early stages of a recovery. Even with the upward revision of first quarter real GDP growth to 3.7% the first phase of this recovery is not typical. Unemployment remains at 9.5% with little chance for lower unemployment rates anytime soon. Normal growth in the supply of labor plus increased labor productivity tend to be about 2% to 2.5% annually, meaning that the economy must grow at an annual rate of 2% to 2.5% just to keep unemployment at the current level. For example, the 2.4% real GDP growth in the second quarter did not move the 9.5% unemployment rate. The levels of GDP growth in this recovery are far from sufficient to bring unemployment back to the 4% to 5% targets.

Interest rates are at historic lows but expectations for rising interest rates are on hold due to the economy’s poor performance. Inflation pressures remain very low due to insufficient demand and excess capacity. Since the consumer sector makes up about 70% of GDP, a fundamental resurgence in consumer spending is critical to a more rapid recovery. Consumers are servicing high debt loads and paying off debt balances rather than buying goods and services. Poor job prospects, reduced wealth due to lower real estate and stock values, insufficient and uncertain retirement income, and overall pessimism are key factors behind lower consumer spending and these factors are not likely to improve soon.

Risks are weighted to the downside. Debt levels relative to the ability to pay off debt are excessive and the economy is vulnerable to global shocks such as a new debt crisis in Europe, trouble in the Middle East, or oil shocks. With fiscal stimulus running out later this year and an end to inventory growth, the economy is likely to grow in the 2% to 3% range at best in the second half of 2010. There are no indications of inflation any time soon. With the unemployment rate heading back to 10% and slack prevalent throughout the economy, it is very difficult for firms to raise prices. The Federal Reserve is unlikely to make any move to higher interest rates with low inflation and a weak economy. An increased attention to the size of government debt and the growth of the deficit will make it difficult to put a second stimulus in place.