Economic Commentary
Daniel Laufenberg, Ph.D.

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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.

What's Going On
(October 15, 2010)

What's going on? When asked this question, my response now is the same as it has been for a year. The recession is over and the recovery is underway, albeit at a slower pace than history would suggest but at a faster pace than most now expect. First, the recession is officially over. It ended in June 2009, which is what I have been saying for a year. In this regard, I wrote in the November 2009 issue of the Laufenberg Economic Quarterly that the National Bureau of Economic Research (NBER)—the group responsible for timing business cycles—eventually will “date the recession’s end sometime during the summer of 2009.” In other words, the recovery is underway, and it has been for over a year.

Unfortunately, not everyone agrees with the NBER. One of the more famous to disagree is Warren Buffet, who claims that his common sense tells him that the recession is not over. Needless to say, people do not feel great about the economy, but they never do during the recovery phase of the business cycle. There is always the concern that the economy cannot sustain any upward momentum it has, especially if the pace of such momentum is sluggish by historical standards. The other day I came across an article written by Rhoda Fukushima in the Fresno Bee. In the article I was quoted to say that the “Recession is over” but that “It’s not your typical recovery.” “It’s very hard to detect, but it is still growth.” The date of the article was April 25, 1992. The NBER announced in December 1992 that the 1990-91 recession ended in March 1991.

Is there reason to be concerned? I believe it is prudent to always be cautious, but cautiously optimistic rather than fearfully pessimistic at this stage of the business cycle. After all, the economy has gone through a very difficult period; more difficult than anything that we have experienced in a very long time. Cautious behavior should be expected. Indeed, it should be encouraged, given that it was the absence of caution that got us into the mess in the first place. But we should not be fearful. Fear causes us to take no risk, whereas caution encourages us to take measured risks. I contend that we are taking risks, but they are very measured risks. For policymakers to expect more than that is foolish in my opinion.

Actually the economy seems to be doing okay and probably better than the consensus now seems to expect. Consumer spending, after adjusting for inflation, is on track to increase at a 2.5 percent annual rate in the third quarter, up slightly from the 2.2 percent pace registered in the preceding quarter. Whether consumer spending accelerates in the fourth quarter as I expect will require a substantial improvement in consumer spending on services, which represent over two-thirds of all consumer spending. In the second quarter, real consumer spending on services was up a mere 0.4 percent from a year earlier, while real spending on goods was up 4.5 percent over the same period. Needless to say, consumer spending on services has been disappointing so far in the current recovery but I think that is about to change. As jobs return, incomes grow, and confidence rises, spending on services will follow suit. Look for real consumer spending to be up at a 3.0 percent or better pace in the fourth quarter of this year, owing in large part to more spending on services.

Business spending on equipment and software will continue to climb, albeit at a somewhat slower pace than it did over the first two quarters of this year. Nevertheless, it still will be fast enough to allow the economy to sustain the recovery at a solid pace. For now, spending on nonresidential structures will be a mild drag, but this too will pass.

Residential investment took another turn downward in the third quarter, following an impressive jump earlier. Obviously, the temporary nature of the federal tax credit for first-time homebuyers probably had something to do with the rollercoaster nature of housing over the last two quarters. Now that fundamentals rather than the tax code are driving decisions to buy a house, I expect new construction to edge up again in the fourth quarter of this year and continue to improve into 2011. It is not that housing will contribute markedly to overall gross domestic product (GDP), but it will contribute.

Government spending was surprisingly robust in the second quarter, adding markedly to real GDP growth. Indeed, without the surge in government spending in the second quarter, real GDP growth would have been less than 1.0 percent. The argument is that this pace of government spending cannot be sustained, especially given the budget problems of state and local governments. I agree that state and local government spending on operations will suffer. However, it is my experience that state and local governments boost their capital budgets in the second and third quarters of an election year. Thus, I do not expect government spending to retrench nearly as much as many now seem to suggest. That being said, capital budgets cannot sustain state and local government spending, which means such spending takes a hit in the fourth quarter of this year and early next year.

In contrast, net exports (which are exports less imports) detracted a whopping 3.5 percentage points from real GDP growth in the second quarter. The bad news is that net exports probably detracted from real growth again in the third quarter, but the good news is that it most likely will be less than 1.0 percentage point rather than 3.5 percentage points. In other words, if everything other than net exports grew in the third quarter at the same pace as they did in the second quarter, real GDP growth would be 2.5 percentage points higher than the 1.7 percent pace in the second quarter. As outlined above, however, everything else will not be the same.

Finally, the change in business inventories is expected to contribute to growth again in the third quarter, adding as much as a percentage point. This, combined with the roughly 2.0 percent increase in final sales, would result in real GDP growth of about 3.0 percent in the third quarter, which is substantially better than the consensus estimate at the moment of 2.0 percent.

Beyond the third quarter, growth will be somewhat complicated by the uncertainty about the future course of tax policy, regulatory policy, trade policy, and monetary policy. In fact, the uncertainty about various policies may do more harm to spending than actual changes to policies. Tax policy is a good example. First, not all tax cuts scheduled to expire at the end of the year are likely to go away permanently. Even the Obama Administration favors some cuts to remain. And if some tax cuts are reinstated, they most likely will be retroactive to the beginning of 2011. Hence, much of the adverse effect on spending from higher taxes will be temporary. Second, once it is clear what the tax structure will be, more economic decisions can be made without fear of surprising tax consequences. Since most of the higher taxes likely to survive will be on higher-income individuals, they will influence portfolio decisions more so than spending decisions. As such, care should be taken not to exaggerate the adverse near-term effect of higher taxes on the economy. Tax uncertainty may be more of an issue.

A less robust first half of 2010 than anticipated in May
(July 21 2010)

The data over the last couple of months have fallen short of my expectations when I put together the latest forecast shown in the May 2010 issue of the Laufenberg Economic Quarterly (LEQ). As such, I am lowering my estimate of real gross domestic product (GDP) for the second quarter to 3.5% from 4.4% earlier. However, much of the downward revision to the growth rate in the second quarter will likely be pushed out to the second half of 2010 and the first half of 2011. I will first discuss the increased likelihood that I will be disappointed with the advance estimate of second-quarter GDP and then explain why I expect any softness in the pace of the recovery to be temporary.

A disappointing second quarter . . . .

The data released since my last commentary have continued to disappoint. In particular, it now looks as if real consumer spending and residential investment will contribute far less to real GDP growth in the second quarter than I was anticipating, and that net exports will be a substantial drag on growth.

To start, the Bureau of Labor Statistics reported that retail sales adjusted for inflation fell the second consecutive month in June (down 0.4%, following a decline of 0.9% in May). Many economists lowered their estimate of second-quarter real consumer spending after the May data were released. I thought such a response was premature since it looked as if real consumer spending still would register a gain in May despite the weak retail sales number. Indeed, according to the Bureau of Economic Analysis, real consumer spending increased 0.3% in June from a month earlier, led by solid gains in spending on durable goods and services. For this reason, I remained confident that consumers would deliver a solid gain in spending in the second quarter.

My confidence was shaken by the release of the disappointingly weak June retail sales data. For this reason, I joined the legion of economists who had lowered their estimates of second-quarter real consumer spending growth. However, I was not as aggressive as most in this regard. For example, many had lowered their estimate to 2.0% or so, down from their earlier estimate of 3.0% to 3.5%. Although I agree that real consumer spending will not grow at the 3.7% pace shown in the May issue of the Laufenberg Economic Quarterly (LEQ), it still should increase faster than the 2.0% annual rate most now expect.

Residential investment is the other area of concern. Housing starts, which drive the residential investment component of GDP, were disappointing as well in June, causing the average level of starts in the second quarter to fall short of my expectation. In the May issue of the LEQ, I estimated housing starts to average 656 thousand units at a seasonally adjusted annual rate for the second quarter versus an average of 617 thousand units for the first quarter. They came in 602 thousand units. As such, residential investment will add very little if anything to growth in the second quarter.

In contrast, government spending, both federal and state and local, seem to be on track to register very solid gains in the second quarter, far exceeding the small increase shown in the May issue of the LEQ. Indeed, government spending adjusted for inflation is estimate to be up about 5.0% at an annual rate in the second quarter based on monthly federal budget data and the value of public construction put in place. This component alone is expected to add a percentage point to real GDP growth in the second quarter. Moreover, real business fixed investment, led by equipment and software spending, should add another percentage point top growth based on monthly data of nondefense capital goods shipments and the value of private nonresidential construction put in place.

Indeed, on balance, real domestic final sales—final sales less net exports—still are expected to register a gain of nearly 4.0% in the second quarter. The difference is that the wider trade gap reported for May suggests that real net exports could detract over a percentage point from real final sales in the second quarter. In May (the most recent data available), imports of goods in constant dollars jumped 2.9%, while exports of goods in constant dollars climbed 2.2%. The implication is that a large part of the still solid domestic final sales growth in the second quarter was satisfied with imports rather than domestic production. But according to the industrial production data, manufactured output grew at a 7.9% pace in the second quarter, up from the 6.1% pace of the first quarter. The implication is that there were far more goods produced and imported than there were goods consumed, exported or currently reported in inventory. Something must give—either the trade deficit was narrower, consumer spending was stronger, or business inventories were much higher in the second quarter than the data currently suggest, or the industrial production data will be revised lower. Although I have lowered my estimate of second-quarter real GDP growth to 3.5%, I remain confident that domestic final sales growth was solid in the second quarter and will remain so through the end of 2010.

. . . . but a better second half

This gets me to the second point I want to make today—any softness in the second quarter will simply shift to the second half of 2010 and the first half of 2011. In other words, I continue to expect job growth to accelerate as business managers increasingly become more optimistic rather than frightfully pessimistic about the economic outlook. I believe this renewed confidence is already starting to be reflected in the stock market. More jobs mean more income, which in turn means more spending. Housing, which has shown a slight upward trend over the last year, should begin to improve more dramatically by year end (see Chart 1). With further solid gains in final domestic sales, businesses will see the need to invest in new equipment and software, and eventually structures. On the other hand, government spending cannot continue at the pace it likely grew in the second quarter. However, unlike most economists, I expect the private sector to more than pick up the slack in government spending in the second half. As such, I do not expect the possible drag coming from any attempt at fiscal austerity to be a significant problem for the U.S. economy. In fact, it may provide a boost to the private sector, especially housing, if the government would just stop trying to help.

Climbing the proverbial "wall of worry"!
(June 28, 2010)

The economic data released over the last few weeks have not been as widely positive as they were earlier in the year, causing many market participants to question the ability of the U.S. economy—or the global economy for that matter—to sustain the recovery now in place. Selling fear is always easier than selling optimism. And given the extreme unpleasantness of the last recession, including the huge stock market drop and the severe penalty assessed for owning risk of any kind, even a mild disappointment in the data causes considerable consternation in markets. Some are concerned that the U.S. economy is double-dipping back into a recession, while others contend that the U.S. economy has hit an “soft patch” that may persist for some time. I definitely do not buy into the double-dip scenario and I doubt that the soft patch is anything more than a temporary pullback from the 4.0% average pace of real growth over the last two quarters.

Indeed, based on my assessment of the data releases over the last few months, it still looks as if real gross domestic product (GDP) will register an annualized gain of over 4.0% in the second quarter, even with the downward revision to real GDP growth in the first quarter. More importantly, I continue to forecast a relatively solid rate of real GDP growth over the second half of the year as well. The consensus at the moment is far less constructive on real growth than I am, both for the second quarter but even more so for the second half. Although I admit that there are plenty of things to worry about, including sovereign debt crises, oil spills, new regulations, and eventually higher taxes, I believe the underlying economic fundamentals for the next couple of years at least still point upward.

Let’s start with a quick review of the downward revision to real growth in the first quarter. According to the final estimate from the Bureau of Economic Analysis, the U.S. economy grew at a 2.7% annual rate in the first quarter rather than the 3.0% preliminary estimate or the 3.2% advance estimate. The bulk of the downward revision to the first quarter came from less robust growth in consumer spending, as well as nonresidential fixed investment. In addition, the change in business inventories contributed even more to the first-quarter real GDP than estimated earlier.

Next, let’s assess real GDP growth in the second quarter, given the data available. First, real consumer spending, which grew at a 3.0% annual rate in the first quarter, is on track to match that growth rate at least in the second quarter. According to the personal consumption expenditures data for May released today, real consumer spending is already up 2.5% in the second quarter versus the first quarter assuming no change in June and no revisions to April or May. I continue to expect real PCE to register a gain of 3.2% in the second quarter. This is down from the 3.7% pace shown in the May issue of the Laufenberg Economic Quarterly (LEQ), owing to the slight downward revision to spending in March reported in today’s release. In other words, the positive momentum in consumer spending at the end of the first quarter was not quite as robust as estimated earlier, but still strong enough to deliver another solid performance for the second quarter. I remain convinced that with interest rates as low as they are and with jobs starting to return, consumers will continue to acquire the wherewithal to spend at least through the end of this year.

Second, business fixed investment will continue to push higher over the remainder of the year. In the second quarter, shipments and orders of nondefense capital goods shipments excluding aircraft continue to trend higher, supporting a very high single-digit percent gain in business spending on equipment and software. This has not changed from the May issue of the LEQ. More importantly, the accelerator effect on business investment should continue to push business spending over the second half of the year.

Third, residential investment (housing) most likely will not grow at a 23% annual pace in the second quarter as shown in the May issue of the LEQ, given the disappointing housing starts data for May. My best guess now is that it will increase in the neighborhood of 12%, about half as fast. Nevertheless, because housing is now such a small component of GDP (only about 2.5%), such a slowdown in residential investment would detract a mere 0.3 percentage point from second-quarter real GDP growth.

Fourth, the offset for a less robust consumer sector, as well as a much slower housing sector, is a much larger increase in real government spending than anticipated a month ago. In particular, both federal and municipal governments are expected to boost spending considerably in the second quarter, following the sizable decline in municipal government spending in the first quarter. Indeed, real spending in the government sector is expected to increase over 5% at an annual rate in the second quarter, compared with the 0.5% gain shown in the May LEQ. Since government spending accounts for nearly 20% of GDP, this adjustment to the forecast adds 0.9 percentage point to second-quarter real GDP growth. Government spending will continue at a solid pace in the third quarter before slowing in the final quarter of the year. After all, this is a mid-term election year and incumbents will do their best to postpone any major austerity programs until after the election.

Fifth, exports may not add as much to and imports may detract a bit more from real GDP growth in the second quarter than estimated in the May LEQ. However, these data are subject to huge revisions and can move dramatically from month to month. I doubt that the June international trade data will be as onerous for real growth in the second quarter as many now seem to anticipate. In fact, I remain convinced that export growth may actually match import growth in the second quarter, suggesting that the drag on growth coming from this sector may be smaller than most now expect.

Finally, the change in business inventories, which are also subject to large revisions and can be very volatile from month to month, still seem on pace to add about 0.2 percentage point to real growth in the second quarter, following contributions of 3.8 percentage points in the fourth quarter of 2009 and 1.9 percentage points in the first quarter of 2010. For the most part, the contribution to growth likely to come from the change in inventories over the remainder of 2010 will be very close to zero. For this reason, my forecast relies on real final sales growth to drive overall real GDP growth in the second quarter and beyond. In this regard, real final sales are on track to grow about 4.0% at an annual rate in the second quarter. The question is whether this pace can be sustained. I expect that it will, assuming that employment continues to improve on average and longer-term interest rates remain subdued.

Caution is warranted, fear is not
(June 8, 2010)

Fear has returned to financial markets. The concern is that risky assets, which include stocks and corporate bonds, will return to their previous lows of March 2009. Although they certainly could if people become fearful enough, I am very doubtful that fear will become that intense. After all, despite the European contagion concern, the global economy still seems to be doing quite well. Public sector spending may slip, but the likely gains in private sector spending should more than offset it. In fact, do not be surprised if the European economy performs better than expected over the next few quarters (due to improving manufacturing fundamentals in Germany, France and Italy), while the U.S. economy grows at a slightly less robust pace than it might have without the European debt problem.

Of course, it is important to assess what rate of growth the U.S. economy would have delivered in the absence of the concern about Europe. I contend that it would have been much stronger than most other economists were expecting anyway. As a result, the U.S. economy may not perform as well as it generally does in the early stages of an economic recovery following a severe recession, but it still may grow in real terms nearly 4.0 percent in the first year or two of the recovery. This compares with the historical average of 6.6 percent real output growth in the first year of the ten recoveries since World War II.

Consumers are cautious, but they are not afraid. This is far different than the situation in 2009 when consumers were petrified about their situations, both current and future. For example, in early 2009, the present situation index of consumer confidence, as reported by the Conference Board, fell to its lowest reading in decades. Adding to the problem at the time was that consumers did not feel much better about the future, as the Conference Board's expectations index also fell to a similar low level. More recently, consumers still are cautious about their present situation (the present situation index has moved up from its low) but they seem far more optimistic about the future than they were a little over a year ago. I contend that this makes it very difficult-although unfortunately, not impossible-for risky asset prices to retreat much more than they have already.

For consumers to feel better about the present situation, they need jobs. The Bureau of Labor Statistics reported earlier this month that nonfarm payroll employment increased 431 thousand in May, following a gain of 290 thousand in April. Indeed, through the first five months of 2010, the U.S. economy has created 982 thousand net new jobs. Unfortunately, not all jobs are considered quality jobs. During the May reference period in which the employment survey was conducted, the number of temporary Census workers stood at 564 thousand. The conclusion is that private-sector job growth still looks a bit anemic by historical standards for the early stage of an economic recovery. However, there may be a positive side to this result. In particular, with businesses still extremely cautious about adding to payrolls, it is very difficult for anyone to become irrationally exuberant about the economy or markets. As such, there seems to be a far greater chance of more upside surprises to economic growth than downside surprises. That being said, I continue to anticipate job growth in the private sector accelerating markedly before year end, resulting in a net gain in payroll jobs over the twelve months of 2010 of over two million. Although this would be a huge improvement, job creation most likely will not really get rolling until 2011.

According to another more recent release from the Bureau of Labor Statistics, private-sector job openings were up and separations were down in April 2010--from a month earlier as well as a year earlier. Unfortunately, private-sector hires also were down in April from a month earlier, but they were up from a year earlier. Nevertheless, the total number of private-sector hires exceeded the total number of separations in April. On balance, I would characterize the report as encouraging, especially since the Census was so actively recruiting temporary workers during that time.

The implication is that more jobs are ahead and probably more than enough to sustain consumer spending growth at a solid pace. Again, consumers may be cautious, but they are no longer afraid. In this regard, look for consumer spending growth to lead the anticipated jump in real final sales growth over the remainder of 2010 and into 2011.

First-Quarter GDP report: The economic recovery continued
(April 30, 2010)

Today the Bureau of Economic Analysis (BEA) reported that real gross domestic product (GDP) grew at a 3.2% annual rate in the first quarter, which was a tad light of both my estimate of 3.5% and the consensus estimate of 3.4%. The number reported this morning was the “advance” estimate, which will be followed by two revisions over the next two months—the “preliminary” estimate and the so-called “final” estimate. Of course, even the final estimate will be subject to benchmark revisions in each of the next three years. In other words, I still have several opportunities to be right. The problem is that no one will care by the time it happens, if it does.

Of course, the consensus was not always so optimistic about the first quarter. Indeed, the consensus estimate had been raised considerably over the last few months, as the monthly data for the most part surprised on the upside. In the February 2010 issue of the Laufenberg Quarterly (Quarterly), I noted that there would be “more upside surprises ahead and that real GDP would grow at about a 3.5% pace in the first quarter.” Although some may claim that I missed on my call, anytime I am only off by roughly $10 billion in a $14,601.4 billion economy, I consider it a victory. Of course, my opinion never counts in these matters.

Moreover importantly, despite the growth rate of first-quarter real GDP falling a tad short of expectations, it does nothing to change my outlook for 2010 or 2011—real GDP growth of roughly 4.0% this year and 3.5% next year. This is clearly above consensus in both cases. In fact, the consensus expects the U.S. economy to weaken considerably in the second half. Obviously, I do not. As such, if I am right, then several more upside surprises in the economic data are in store in the months ahead.

Let’s take a closer look at the components of first-quarter GDP. First, real final sales (which are defined as real GDP less the change in business inventories) increased 1.6% at an annual rate, somewhat slower than the 2.5% gain I anticipated. However, the shortfall definitely was not in consumer spending. Real spending by consumers increased 3.6% in the first quarter, which was ahead of my 3.0% estimate and followed gains of 1.6% and 2.8% in the third and fourth quarters of 2009, respectively. In addition, the gains in the first quarter were widespread, led by an 11.3% jump in durable goods spending. I doubt that durable goods spending will increase at this same torrid pace over the remainder of the year, but solid gains in nondurable goods spending and more importantly spending on services likely will more than offset the difference.

Real nonresidential fixed investment increased at a 4.1% annual rate in the first quarter, roughly in line with my expectation of 4.3%. All of the gain came from the 13.4% surge in spending on equipment and software. Businesses reduced their spending on real structures by 14.0% last quarter. Going forward, business spending on equipment and software should remain robust. However, one of the keys to better final sales growth over the remainder of 2010 will be that business spending on structures stops falling in the second half of the year.

Another key to better final sales growth over the remainder of 2010 and into 2011 will be if residential investment (i.e., housing) will show some improvement. Unusually bad weather from December through February in many areas of the country had a lot to do with the disappointing performance of residential investment in the first quarter. Now that the weather is back to normal and housing starts are showing some signs of improvement, residential investment should improve as well. I am not forecasting a return to the housing boom of old. Starts are still at very depressed levels and are likely to remain below trend for quite some time. However, since starts are at such depressed levels, it will not take much improvement to register very sizable percent gains in residential investment.

Real government spending also was a bit of a disappointment. I knew that large budget deficits at state and local governments would restrain spending in the near term, but I did not expect state and local government spending to fall as much as it did in the first quarter. Indeed, it looks like a large part of the spending cuts that I expected from this sector for all of 2010 occurred in the first quarter. I doubt that state and local government will register declines as large over the remainder of the year. As such, the anticipated gains in spending expected at the federal level should more than offset the weakness in spending by state and local governments. For this reason, I expect total government spending on goods and services to increase in each of the next three quarters, which in turn will be another key to stronger growth ahead.

Finally, international trade should be a mild drag on growth over the remainder of the year, but maybe not quite as much of a drag as it was in the first quarter. According to the BEA’s advance estimate, real net exports (which are defined as real exports less real imports) were a negative $367 billion in the first quarter. This was about $19 billion wider than the trade gap in the previous quarter and detracted about 0.6 percentage point from first-quarter real GDP growth. I expect that the international trade sector will be a net drag on growth for all of 2010 but it will detract only about half as much for the year as it did in the first quarter.

The bottom line is that real final sales, which grew at an anemic 1.6% pace in the first quarter, still are expected to increase about 3.5% for all of 2010. For this to happen, some major upside surprises are needed soon. I believe it can happen and will. Consumer spending and business spending on equipment and software, are off to a very good start. This means that about 78% of the economy is on track to deliver the growth in real final sales that I anticipate this year. And I believe that it will be only a matter of time before nonresidential structures, residential investment, and government spending get on track as well.

The only major component of GDP not discussed so far is the change in business inventories. Inventories contributed more to growth in the first quarter than I expected—adding 1.5 percentage points versus my expectation of only a percentage point. Nevertheless, it still fits my inventory story for the year. That is, I remain convinced that the change in inventories will add about 0.5 percentage point to real GDP growth over the four quarters of 2010. This seems like a lot to expect from the change in inventories after the huge contribution it made to growth in recent quarters, but it still would not offset the total drag from the change in inventories over the prior three years. And the only difference in the forecast now versus the forecast in the February issue of the Quarterly is that the expected contribution from inventory accumulation apparently will occur earlier in 2010 than initially anticipated.

March employment report--finally some job growth
(April 8, 2010)

According to the Labor Department, nonfarm payroll employment increased 162,000 in March, reflecting widespread gains across several several industries. Jobs in the goods-producing sector rose 41,000, with both manufacturing and construction industries registering gains. An increase in factory jobs was expected given the positive readings recently in the Institute of Supply Management index, but an increase in construction jobs was not. Obviously if there is one industry that is influenced by the weather, it is construction. Do not be surprised if March housing starts, which are scheduled to be released mid-April, register a gain.

Private service-producing jobs rose 82 thousand in March and are up 183,000 so far this year. In March, the bulk of the new jobs were in the temporary services and health care industries. Nevertheless, most industries registered gains, except for the information and financial services industries. The government sector reported a gain of 39,000 jobs, owing to the hiring of 48,000 temporary workers for the decennial census. Most forecasters were expecting a much larger number of temporary workers to be hired by Census. Given the increases in jobs, as well as the work week, the index of hours worked was up 0.7 percent in March and the index of aggregate weekly payrolls was up 0.6 percent. This suggests that the wages and salaries component of personal income will registered a very solid gain in March when it is reported in early May.

The civilian unemployment rate remained at 9.7 percent in March, as the 264,000 increase in persons employed was offset by the 398,000 increase in the civilian labor force. In March, the unemployment rate for adult men was 10.0 percent and the unemployment rate for adult women was 8.0 percent, both unchanged from a month earlier.

Latest reading on consumer spending bodes well for outlook

Real personal consumption expenditures, which account for roughly 70 percent of gross domestic product (GDP), increased 0.3 percent in February following a gain of 0.2 percent in each of the preceding two months. As such, real consumer spending through February is already 2.8 percent at an annual rate above the level of spending in the fourth quarter of 2009. The implication is that if real consumer spending was unchanged in March, it would add nearly 2.0 percentage points to the growth rate of first quarter real GDP. However, based on what we already know about consumer spending in March, it is unlikely to remain flat with February. In particular, light-vehicle sales came in at 11.8 million units in March, up from 10.4 units in February, or a gain of 13.5 percent on a monthly basis. The forecast in the February 2010 issue of the LEQ was for real consumer spending to increase 3.0 percent.

Based on more recent data, I now anticipate real consumer spending in the first quarter to grow at least 3.0 percent. Unlike a month ago, the forecast shown in the February LEQ has now become the consensus. Most economists now expect real GDP to grow about 3.0 percent in the first quarter and about 4.0 percent in the second. The disagreement among economists now seems to be the outlook for the second half of the year. Very few forecasters agree with the view that the U.S. economy will probably deliver something close to 4.0 percent growth in the second half of this year and about 3.5 percent for all of 2011. The skeptics seem to rely on the lack of personal income growth so far this year as the reason for a their caution. I agree that income growth is essential to sustaining the consumer but expected permanent income gains can be just as important to spending as realized income gains. More jobs will boost realized income but they also boost expected income gains. Based on the employment report for March, payroll jobs increased 162,000 but more importantly, jobs growth was not as anemic in January and February as estimated earlier.

Also, the personal saving rate fell again in February to 3.1 percent from 3.4 percent in January and 4.2 percent in December. This remains well below its recent peak of 6.2 percent in the second quarter of 2009. Recall that not long ago, many economists argued that cautious consumers would save more and spend less. I disagreed then and I still do. Given the way the government measures personal saving, I continue to believe that the personal saving rate as reported in the personal income and outlays data will trend lower over the next few years rather than higher.

Chart of the Month--Housing starts searching for a bottom

Some analysts had expressed concern that the U.S. economy could not recover without a recovery in housing. I did not share this expectation. I argued that housing only had to find a bottom and that the other sectors of the economy, especially the consumer sector, would lead the way. That seems to be what has happened. Residential fixed investment's (housing's) direct share of GDP declined to 2.5 percent in the second quarter of 2009 from a peak of about 6.3 percent in the third quarter of 2005. More recently, housing's share has stopped falling and is starting to improve slightly. Indeed, one of the reasons I expect real growth to remain solid in the second half of 2010 is the expectation that housing will be adding to rather than detracting from to the pace of activity.

Housing starts are the key to this scenario, since new construction accounts for the bulk of the residential investment component of GDP. As shown in the chart below, housing starts were disappointing in January and February, causing some analysts to revive the old story that a weak housing sector would derail the overall recovery. However, unusually bad weather in January and February most likely helped depress housing starts, which means that once the weather returns to normal, starts should rebound a bit. From all indications, March may have been the turning point. This is reinforced by the increase in construction jobs reported in the March employment report. Some had suggested that the jobs were related to government spending on new construction, but with state and local governments strapped for cash and private nonresidential construction still in a funk, the March increase in construction jobs were probably in the housing sector.

Housing Starts Chart of Housing Starts

In January, personal consumption held up but personal disposable income did not
(March 15, 2010)

The headline statistic for personal consumption expenditures, which accounts for roughly 70 percent of final demand in the overall U.S. economy, showed a monthly gain in January of 0.6 percent before adjusting for inflation, following a monthly gain of 0.3 percent in December. However, the more relevant measure of consumer spending with regard to the economy's overall performance is adjusted for inflation (i.e., real personal consumption expenditures). After making the adjustment for price changes, consumer spending increased a less robust 0.3 percent in January, but still was enough to push real personal consumption expenditures to a level that was already 2.1 percent at an annual rate above the fourth-quarter average. In other words, if real consumer spending is unchanged in February and March, it would add nearly 1.5 percentage points to the growth rate of real gross domestic product in the first quarter. I do not expect real consumption expenditures to be unchanged over the last two months of the current quarter. Indeed, I now anticipate real consumer spending to grow even faster than the 3.0 percent pace shown in the February 2010 LEQ.

Of course, not everyone agrees. Some economists contend that the decline in real personal income in January was a precursor to a weaker consumer going forward. This is a perfect example of the advantage gained by looking at the details of the income data rather than simply assuming why income fell. In particular, the wages and salaries component of personal income rose 0.4 percent during the month of January, which is far better than many had expected. After all, there are only two ways for the wages and salaries component of income to rise--more jobs or higher wages. The reason disposable income, which is income less taxes, fell in January was in large part due to a surge in estimated tax payments. Such a jump in estimated tax payments tend to suggest that more rather than less income was being generated in late 2009 and into early 2010. More income means more purchasing power for consumers in the months ahead and not less.

Also, the personal saving rate fell to 3.3 percent in January from 4.2 percent in December and well below its recent peak of 6.2 percent in the second quarter of 2009. Recall that not long ago, many economists argued that cautious consumers would save more and spend less. I disagreed then and I still do. Given the way the government measures personal saving, I continue to believe that the personal saving rate as reported in the personal income and outlays data will trend lower over the next few years rather than higher.

Productivity and costs in the fourth quarter were impressive

According to the Bureau of Economic Analysis, labor productivity (output produced per hour worked) in the nonfarm business sector surged in the fourth quarter of 2009 at a 6.9 percent annual rate, which was up from the initial estimate of 6.2 percent. In addition, unit labor costs (average labor cost per unit of output produced) fell an annualized 5.9 percent in the fourth quarter, compared with an initial estimate of minus 4.4 percent. This bodes well for inflation because companies can generate profits without raising prices. Nevertheless, if the past is any guide, unit labor costs will not continue to fall indefinitely. At some point, businesses will need to hire more workers to maintain their current level of activity, let alone grow the business. I suspect that this point in the business cycle is very near.

Chart of the Month--Jobs, regardless of how they are measured, may be here soon

The civilian unemployment rate was unchanged at 9.7 percent in February, a better outcome than the 9.8 percent anticipated by the consensus. An interesting aspect of this report was that employment in the household survey, which is the survey data used to calculate the unemployment rate, increased 308 thousand in February. Generally such a large increase would have solicited considerable attention if not for the fact that household employment skyrocketed 541 thousand in January. In other words, the household survey data show that employment increased 849 thousand over the first two months of 2010, providing a much different picture of the labor market than the 62 thousand decline in payroll jobs as measured in the establishment survey data.

As encouraging as this may seem at first blush, be careful not to read too much into it. Although monthly changes in employment in the household data are far more volatile than monthly changes in employment in the establishment data, changes in the two series tend to track reasonably well over a longer period of time. As shown in the chart. the recent jump in employment in the household data relative to the establishment data basically narrowed the gap between the year-over-year changes in the two series. Over the twelve months ending in February 2010, the number of employed in the household data still were down 3.0 million, while total nonfarm payroll employment in the establishment data were down 3.3 million. After all, the jobs lost during the latest recession were unprecedented. Nevertheless, this does not alter my forecast that jobs, regardless of how they are measured, will register solid gains soon. Also, the anticipated jump in jobs will be more than just the temporary hiring of government workers to conduct the 2010 Census.

Chart of Change of US Employment

Source: Bureau of Labor Statistics.

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.


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