Outlook and Market Review - Second Quarter 2012

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Real GDP growth for the second quarter of 2012 was revised upward to 1.7% from 1.5% in the preliminary announcement by the Bureau of Economic Analysis. The revised GDP growth rate in the first quarter was 2%. Overall, the economy is performing well below the long run average of 3.3% GDP growth and even further below what would be expected in a recovery period. While there is some momentum for the economy going into the third quarter, growth for the remainder of the year is not likely to exceed a 2.5% annual rate. Inflation remains consistent with the 2% target of the Fed due to weak aggregate demand. There is little chance of demand pull inflation, but cost push inflation may occur as the extremely hot and dry weather causes food prices to spike. The Fed is committed to a low interest rate environment as long as inflation remains moderate The labor market is improving but payroll expansion will be offset by an uptick in the labor force participation rate. The unemployment rate of 8.3% is not likely to move more than a small fraction of a percent in any direction for the remainder of the year. Conditions for an improvement in hiring are in place with low costs of employment if the business environment for hiring and expansion improves. Consumer and investor sentiment remain low and are more consistent with a downturn than an expansion. But, equity values have climbed and the housing market is improving, offering some hope for a rebound in confidence. Major drags on the economy continue to be uncertainty over taxes and fiscal restraint, concern for the growth of the national debt and the lack of a consensus for a long term plan to address debt reduction, worry over unsustainable entitlement programs, and regulatory constraints on energy and business expansion. The fall elections will play an important role in shaping expectations and directions for the future. On one hand, the current administration’s policies for traditional short run stimulus with higher taxes on both investment returns and high income households will be pitted against a longer run vision of investment incentives, major tax reform, major entitlement reform, and a long run plan to limit and reverse the national debt. A key issue is that long run plans to improve the economy tend to offer more favorable tax treatment for higher income households. Short run plans emphasize higher tax breaks to lower income households but offer little or no incentive for long term growth and expansion. A compromise on the key elements of the “fiscal cliff” is likely, easing the planned budget cuts and automatic tax rate increases. However, there will be a battle over debt limits and types of budget cuts and/or tax changes that will retard real progress on needed fiscal changes. Without an extension of current tax rates and a delay of budget cuts the economy will likely go into a recession in 2013.