Economic Commentary
Daniel Laufenberg, Ph.D.

Also See our Special Report: Health Care Legislation:
Essay No.1 - Costs
Essay No.2 - Revenue
Essay No.3 - Budget Deficits

Numerous economic data series are released between the publication dates of the Laufenberg Economic Quarterly (LEQ). Therefore, this page is designed to provide commentary on the more recent data and their implications for the economic outlook.

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Risks to the forecast
(March 7, 2012)

There is always a great deal of interest in the media about what could go wrong with the
forecast, but very little discussion about what could go right. The forecast that I just published
is my best guess at what will happen over the four quarters of 2012, knowing full well that my
point estimate of 3.2 percent real gross domestic product (GDP) growth is very unlikely to be
spot on. Indeed, if real GDP growth this year comes within a percentage point on either side of
this estimate, I would consider it a good forecast.

Using the same criteria, my forecast of real GDP growth in 2011 was not a good one. It was far
too optimistic. In the February 2011 issue of the Laufenberg Economic Quarterly (LEQ), I
expected real GDP growth of 3.9 percent over the four quarters of the year. It was 1.6 percent. I
failed to anticipate the one - off events in the first half of 2011 that contributed to this shortfall. I
did not anticipate the earthquake, tsunami and flooding in Japan in the first half of the year, but
more importantly, I failed to realize how much of an adverse effect they would have on the
supply of parts and components around the world. I also failed to anticipate the budget
shenanigans in Washington and how they adversely affected consumer spending in 2011. But
what I did anticipate was that the impact of both would be short - lived. The point is that
forecasting is extremely difficult, regardless of who the forecaster might be or how they come
up with their forecast.

I was also wrong on interest rates in 2011. I thought the Federal Reserve would very gradually
move to a less accommodative stance before the end of last year and that long-term interest
rates would drift higher. The Fed did not shift its policy stance, and, as a result, long-term
yields drifted lower last year rather than higher. Clearly, I underestimated just how sticky
interest rates can be, especially if the Fed wants them that way. For that reason, any increase in
interest rates likely this year probably will be even more gradual than I expected a year ago.

Of course, I got a few things right as well. A year ago, I expected the civilian unemployment
rate to fall to about 8.2 percent by the end of 2011. It got to 8.5 percent and slipped even further to 8.3 percent in January 2012. I now expect the unemployment rate to fall further on average in 2012 to about 7.5 percent by the end of this year. Finally, I expected S&P 500 operating earnings to total $96 a share in 2011. At the moment, it looks as if they will $96 a share. At the moment, I expect operating earnings to be slightly better in 2012.

Nevertheless, it is important to remember that the likelihood of a miss in the forecast can work
in either direction. After all, even though I was too optimistic about the U.S. economy in 2011,
there were others who turned out to be too pessimistic. Remember all the chatter last year
about a double-dip recession? In other words, it is possible to error in either direction. Of
course, the probability of a miss is not always symmetrical. Under certain circumstances, the
risks to the downside may outweigh the risks to the upside, such that the probably of missing
on the low side with a forecast may be greater than the probability of missing on the high side.

At the moment, I would argue that for the first time since the recovery began in mid-2009, the risks to the forecast are skewed to the upside. You may ask how that is possible with all of the negative news, ranging from a recession in Europe, increased fiscal drag at home, higher crude oil prices and Iran, and the ongoing struggles in the housing sector, just to mention a few. I would argue, however, that many of these fears are already priced in the outlook. Indeed, the surprise may be more to the upside because the negatives will prove to be less negative to the U.S. economy as many fear. This is illustrated by recent data, including a falling unemployment rate, more payroll jobs, an improving stock market, housing prices stabilizing according to the FHFA index, very low natural gas prices, subdued inflation, growing improvement in state and local government budgets, and an uneven but slightly upward trend in consumer confidence, just to mention a few.

I am not going to address each in detail here but I do want to discuss a few of these items. First, the sovereign debt problems in Europe cannot be resolved as quickly as the debt problems in the U.S. I don't understand why this is so hard for many to grasp. The solution is stronger growth-and stronger growth does not magically appear. In fact, we probably will tire of talking about the European debt crisis long before it is resolved. The reason is that "structural" problems are not corrected quickly, and Europe's structural problems far outnumber those in the U.S.

Second, higher energy prices are a problem for consumers if they are perceived to be a permanent condition. According to the permanent-income, life-cycle hypothesis of consumer spending, which is the hypothesis I adhere to in a fashion, any temporary loss or gain in real income will affect the saving rate more so than the consumer's propensity to spend. So long as higher energy prices are viewed as temporary, the drag on consumer spending will be minimal. The converse is also true; if lower energy prices are viewed as temporary, the boost to consumer spending will be minimal. However, if consumers become convinced that energy prices are on a permanent upward spiral, the loss of purchasing power due to higher prices will be perceived as permanent as well. And a permanent loss of purchasing power will cause consumers to lower their spending. At the moment, I doubt that consumers are convinced that the recent increase in energy prices is permanent, although they may be moving in that direction. In particular, the Michigan Consumer Sentiment survey includes a question about inflation expectations. In the February 2011 survey, inflation was expected to be 3.3 percent over the twelve months of 2012, well ahead of the Fed's forecast and even ahead of mine. Consumer inflation expectations over the next year tend to reflect recent experience. Over the 12 months ending in December 2011, the overall consumer price index was up 3.0 percent.

Finally, at a recent meeting of the Council of Economic Advisers for the State of Minnesota, I
was asked what I thought house prices would do this year. My response was that I thought
they would be up slightly. That was not the majority view. Most of the members of the Council
expected prices to fall further, in large part because of the much anticipated preponderance of foreclosures and short sales. However, a high frequency of foreclosures and short sales will
have more of a negative impact on one price index than on another.

There are two major house price indices that are available, the Federal Housing Financing
Agency (FHFA) index and the S&P Case Shiller index. The two have a tendency to trend in the
same direction but do not always follow each other at turning points. I contend that we may be
at or very near a turning point for house prices. That is, after registering huge declines since
late 2006 or so, prices seem to be close to leveling off. I expect prices to be higher by the end of
the year, albeit slightly.

Of course, one index may start to show improvement before the other. I contend that the FHFA
index has already started to show some improvement. Although I did not mention it, this is the
measure of house prices I had in mind when asked about 2012 at the Council meeting. (For
more details about house price indices, see the latest Perspective, “House prices: The bottoming
process continues.”
) period

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


2012 Commentary

Risks to the forecast
-- March 7, 2012

A good finish to 2011 but still not good enough
-- January 27, 2012

2011 Commentary

More evidence of a strong finish
-- December 22, 2011

Finishing Strong
-- October 14, 2011

Living in interesting times
-- September 8, 2011

A not so pleasant surprise!
-- September 2, 2011

Surprise!
-- August 16, 2011

Debt ceiling politics
-- July 25, 2011

Q2 growth: Another disappointment likely
-- July 14, 2011

Interpreting the ISM manufacturing index and the employment situation report for May
-- June 4, 2011

A slower start to 2011 than anticipated earlier
-- April 14, 2011

Is the dollar's status as the reserve currency at risk?
-- March 21, 2011

More trouble in the Middle East
-- February 26, 2011

Searching for the next debt crisis
-- January 13, 2011

2010 Commentary

What's going on?
-- October 15, 2010

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