The fundamental question for the U.S. macroeconomic forecast is if the pandemic recovery can continue or if the economy is heading into a recession. This outcome will be determined largely by Federal Reserve actions during the quarters ahead. Given how long the Fed waited to fight the current bought of inflation, it is not likely they can return inflation to its target rate without monetary policy changes which would also induce a recession.

It is an open question if the Fed has the fortitude to follow-through fighting inflation. The forecast then, is either for recession, or anemic growth accompanied by continued inflation.

CERF’s baseline forecast embodies the assumption that the Fed will cease substantive hikes by December 31^st of 2022 and that the economy will not be pushed into recession. We do have one 25 basis point hike in early 2023, but no other hikes. This is a low confidence forecast, since it necessarily involves predicting the behavior of a body of political actors at the Fed.

This forecast for the Fed’s policy rate has implications for inflation. Inflation, with substantial momentum at the current time of writing, will not be much reined in by this forecast of Fed policy.

How strong is the Fed’s policy stance on inflation? The real ten-year Treasury yield was -3.1 percent using September yields with the core PCE deflator. As conventional wisdom has always argued, a negative interest rate of that magnitude indicates policy that is massively stimulative.

The presumed level of short term interest rates under this forecast scenario is that they reach 4.625 percent (based on the midpoint of the Fed’s target range) by mid-2023. By the Fed’s own analysis the rate needs to be above 6 percent in order to adequately combat inflation.

Inflation will subside, but it will not subside quickly, and the real 10-year Treasury yield will remain in negative territory for all of 2023, indicating that instead of being restrictive, the Fed’s policy will remain stimulative, for about a year.

We forecast that the Core PCE deflator will still be 4.8 percent at the end of 2022, and that it will still be 4.3 percent at the end of 2023. This is higher than the consensus forecast of 3.2 percent, but our forecast is lower than inflation expectations, such as the University of Michigan’s survey value of 4.8 percent.

This forecast is one where rates are not really that high. The chart below shows the third quarter real 10-year Treasury is still quite negative, and it shows real rates during the Volcker policy era in the early 1980s that did succeed in fighting inflation, and also pushed the economy into recession.

Because rates are not really that high, inflation will remain persistent, and, growth will be weak but positive. We do not forecast a recession in this scenario, in part because rates are not actually that high. They will not get high enough to halt inflation, and they will not be high enough to cause a recession.

CERF has argued that monetary and fiscal policy has been much too stimulative. While it is possible to justify stimulating the economy in the time of crises, policies have been a ratchet, ramping up support through payments and credit in times of crises and not subsiding thereafter. This occurred after the 2007-08 financial crises and again during the Pandemic in 2020.

Overly-stimulative policies help us understand the macroeconomic environment we are in today. Some forecasters are saying that the Fed’s impotence against inflation, with 300 basis points of hikes in seven months having failed to slow inflation momentum, has surprised almost everyone. This does not surprise CERF. The economy is overstimulated. According to CoBank estimates the U.S. household sector still has $2 Trillion in excess savings. And, we point to the most recent University of Michigan survey data, which as of October showed consumer’s expect inflation will still be 4.8 percent a year from now.

There are risks to this forecast. One alternate scenario is that the Fed does continue raising rates aggressively during 2023, sending the short term policy target well-over 6 percent. In this scenario, the real 10-year Treasury yield would surge into positive territory more rapidly, inflation would subside more quickly during 2023, and the economy would experience a recession.

Why is our baseline case that the Fed does not get in front of inflation? They have shown before that they are sensitive to markets, especially, the stock market. In October of 2018, they announced a balance sheet normalization policy that sent the S&P 500 into a 24 percent decline in just 3 months. On January 4, 2019, Fed chair Jerome Powell signaled a reversal of policy normalization, and in March of that year, stated that a multi-trillion dollar balance sheet might go on indefinitely. This of course, gave rise to the notion of QE-infinity, the idea that the Fed would never normalize policy.

The effect of significantly higher rates will have an important follow-on effect of raising the debt service costs for the U.S. This is more of an issue now, where the debt to GDP ratio is 120 percent, a historically high level for the U.S. This will be another source of pressure against further Fed rate hikes to levels above 5 percent.

CERF’s economic forecast for the next eight quarters is for growth substantially below potential. Many forecasters, including the Fed, point to demographic factors and make post-industrialized economy arguments to rationalize below potential growth. CERF disagrees. Most of the sub-par growth is driven by poor policies, policies that throw a blanket on what would be a much more healthy and robust economy.

Monetary and fiscal policies should follow policy rules, or a logic that is guided by economic theory and analysis. Policies since 2008, especially monetary policy, have been ad hoc. They depress economic activity through the specific disincentivizing impacts they impart on investing for the future, but in addition, they depress the economy through policy uncertainty. This uncertainty doesn’t just add difficulty to forecasting, but it also reduces the ability of households, establishments, and governments to make decisions for their, and the our nation’s, future.

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There are no surprises in our California forecast.  There aren’t any changes either.  We expect California to continue plugging along as it has for several years now.  The growth on average will be slow, but the Bay Area will do better.

We don’t see much upside potential.  That is, we would be very surprised if California’s economy did a lot better than the forecast.

We see plenty of downside potential.  New regulations and taxes will have a negative impact, but we would not expect to see an immediate or dramatic drop.  Instead, we’d expect to see California’s economy slowly lose vigor.

A national or global financial—it’s possible, leverage is high and banks are stressed worldwide, particularly in Europe—crisis would have more direct impact.  The immediate impact would be a large fiscal deficit at the state level.  The State’s response would likely be as always.  Taxes would go up.  Transfers to local governments would go down.  Debt would go up.

California’s financial situation has improved during Brown’s two terms, but California has not made the fundamental changes necessary to increase the budget’s resiliency.

Making California’s budget less susceptible to business cycles would require a major tax restructuring, reducing the reliance on a wealthy few while broadening the tax base.  It would also require that the State’s pension obligations be brought under control.

Is Sacramento likely to make the changes necessary to strengthen California’s budget?  Probably not, but now seems like an excellent time to do so.

A one-party state provides opportunity.  While the required changes would help most Californian’s, some groups would be hurt.  Those groups are part of the ruling party’s coalition, government employees and those who despise the existence of wealthy people.  The opportunity comes from the fact that these people have no place else to go.  They will not vote Republican.  The worst they could do to Democrats is sit out the election, but the party could easily retain power if that happened.

California’s Democrat Party now dominates California’s politics to such an extent that it has a unique opportunity to confront California’s long-standing issue without paying a political price.  It’s a perfect time for Governor Brown to cement a legacy.

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I have complained for years that California’s economy is not performing as it should, and it’s not working for a large part of the population, young people, minorities, less educated workers, even much of the middle class.  Those who disagree with me point out that, measured by job growth and GDP growth, California is doing better than the United States.  Therefore, California is doing great, and Bill Watkins is a cranky old hack.

Bill Watkins may be a cranky old hack, but that argument is ridiculous.

The argument that California is doing better than the U.S. and therefore doing well is based on the implicit assumption that the U.S. economy is doing well.  It’s not.

We are almost a decade into America’s weakest post-war recovery, a recovery characterized by low investment, slow economic growth, slow productivity growth, slow job growth, a falling labor force participation rate, increasing welfare rolls, and persistent high poverty rates.

It’s not like its close.  This recovery is dramatically weaker than previous recoveries.

Doing better than the weakest recovery in 70 years is not good enough for California.

At one time, the very name California was synonymous with prosperity and opportunity.  The state attracted people from throughout the world.  California was the model of the good life.

Today, California has the nation’s highest poverty rate, after consideration of housing costs.  Net domestic migration is negative, as Californians move to places like Texas and Oklahoma to find the prosperity, opportunity, and life-style they can’t find in California.  Businesses are leaving, and taking their jobs with them.  College graduates must leave to find appropriate jobs, because California creates more college graduates than jobs.  Home ownership is beyond the imagination of most young families.

California is not doing well because its policies have been hijacked by a coastal elite, which has molded policy to meet their utility functions, utility functions with no consideration for the well-being of California’s less fortunate.

California’s elite are really no different than our two presidential candidates.  Trump was born into wealth.  He was sent to the best schools.  He had every advantage.  Much of that advantage has been squandered as he followed his whims into gambling casinos, beauty pageants, reality shows, buildings, whatever attracted his attention at the time.  In his wake, he’s left failed businesses and consequently destroyed lives.  But, as they say, he’s a winner.  He’s maximized his wealth without concern for the lives of the less fortunate he’s used to maximize that wealth.

Clinton didn’t start with Trump’s wealth, but she went to the best schools, and along with her husband, has risen to the heights of power and wealth.  Like Trump, Clinton rose without concern for the lives of the less fortunate that she used to maximize her wealth and power.  From Arkansas to Washington DC and beyond, she has left a landscape that is littered with broken lives.

So it is with California’s coastal elite who dominate policy.  They have their homes and their lives in beautiful places with world-class weather and abundant amenities.  Economic growth threatens their lifestyle.  They don’t want factories or even other people’s homes marring their viewsheds.  Their attitude is that if you can’t find a job or buy a home here, well you can probably do both in Texas or Arizona.  Never mind that many people can’t afford the cost of the move.  If you live in poverty, they tell you about California’s generous safety net, ignoring the devastating impacts of a life on the dole.

Of course, California’s coastal elite who dominate policy aren’t the majority.  It seems to me that when policy is optimized for a fortunate few and actually detrimental to the interest of the majority of the population, something is seriously wrong.  Somehow, we managed to lose our way with how we select policy makers and how we make policy.

It’s not a just a California problem.  When I look at the presidential candidates and the political leaders of both parties in Congress, I see failure, failure to put competent leaders in important leadership positions.  The problem is worse in California than most other states.  Is there anywhere else in America where policy is optimized for so few at the cost to so many?

It’s difficult to believe that this is a sustainable situation.  It seems that it must reach a crisis at some point.  For California that crisis is likely to be financial, a fiscal crisis.  California’s fiscal position is fragile and volatile.  At some point, California’s under-achieving economy won’t generate the resources needed to meet California’s commitments.

California’s commitments were made based on the twin assumptions that California’s golden economy is everlasting, and there is nothing policy makers do can do to harm that economy.  Those assumptions aren’t true.  For many Californians, the state is already in crisis.  That sounds extreme, but when you can’t find a job, you have a crisis.

We need to make California work for everyone.  I’m not sure how to do that.  I am sure that we won’t make California work for everyone until we admit we have a problem.  Only then, we can start trying to find a way to choose policy makers and set up a policy infrastructure that works for everyone.

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It’s time for another presidential election.  Each candidate is promising new initiatives that will bring prosperity to Americans.  So, we’re forecasting vigorous economic growth?  No.

Our forecast is pretty much the same as it’s been for years, anemic economic growth as far as we can see.

Either Trump or Clinton will be president, but which one is president doesn’t matter for our forecast, because neither has a program that will generate the promised growth.

Trump’s economic plan is as brash, contradictory, and dishonest as he is.  He begins by assuming that countries compete economically.  This is a long-standing and popular misconception.  While not fans of Paul Krugman, we refer readers to his book Pop Internationalism for a readable, but sarcastic and arrogant, discussion of why this is not true.

Trump does offer tax, energy, and regulatory reform, which would increase our economy’s growth rate.  Those gains would be offset by his trade policies and his intention to export immigrants.  Decreasing trade and exporting workers, regardless of how the workers got here, are extraordinarily contractionary policies.  The plan is dishonest because he presents it as a unified pro-growth plan when he has advisors who have surely told him of the contradictions.

Clinton’s plan is as old, tired, and dishonest as she is.  It’s tax.  It’s spend.  It’s free stuff.  It’s more government.  It’s the same thing we’ve seen out of the Washington establishment for decades.  We all know, and she must know, it won’t bring the growth she promises.

We believe that presidents can have an impact on economic growth.  However, the president must be extraordinary and have congressional support, either because of party loyalty or political pressure.

President’s Kennedy, Reagan, and Clinton each initiated strong recoveries, recoveries that lasted for many years and saw several years of 4.0 percent or greater economic growth:

There were similarities between each of these presidents’ dominant economic policies.  Each relied on incentives and generally free-market solutions.  Kennedy cut taxes.  Reagan cut taxes and the regulatory burden.  Clinton expanded trade and changed welfare’s incentive structure.

We could have a similarly vigorous economy today, but the challenges are daunting.  It would require eliminating the negative incentives in three major pieces of legislation: Sarbanes-Oxley, The Affordable Healthcare Act, and Dodd-Frank.  It would also require rolling back the bureaucratic albatross that has built itself, increment by increment, into a formidable obstacle to economic growth.

Taxes should be reformed.  Eliminating taxes on repatriation of foreign earnings and on dividend income would be expansionary.

Monetary policy may be the biggest challenge to any president’s plan for a sustained vigorous economy.  It’s hard to see how the distortions built up by years of near-zero interest rates can be corrected without a dramatic decline in asset prices, a decline that would likely precipitate at least a short recession.  In a sense, the Fed has painted itself into a corner.

Whatever the Fed’s challenges, they are supposed to be independent of the other branches of government.  Presumably, the President’s only input is the nomination of the Chair and other board members.  We don’t believe the Fed is as independent of the political pressure as is advertised.  That said, it would take a very special Fed Chair to correct the current distortions.

Volker famously conquered inflation through a bold and controversial monetary policy, at the cost of what was until then our deepest recession.  The president would need to nominate and have confirmed another Volker.  We have no idea who that might be.

The four percent economic growth that Trump promises is possible, but it would require an extraordinary president to achieve it.  Unfortunately, our nomination process appears incapable of nominating extraordinary people.

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A decade of slow or declining economic and job growth has been accompanied by fundamental changes in America’s job composition.  Those changes have caused profound disruptions in the lives of millions of workers, primarily low-educational-attainment workers, and their families.

The situation is not improving.

Economic growth (GDP) appears to have slowed, even from its previously anemic pace.  Job growth has been weak too, but it’s a little better than economic growth.  Weaker economic growth than job growth implies declining or very weak productivity growth, and we’ve recently seen quarters with each.

Declining productivity doesn’t necessarily mean that individual workers productivity has declined.  It could.  If demand fell and businesses were slow to lay off workers, perhaps because of the cost of firing and hiring, individuals’ productivity would fall.

That’s not what we’re seeing now.  Instead, we’re seeing the impacts of changing job composition.  We’ve lost, and continue to lose, high-productivity jobs.  Our job growth has been in low-productivity sectors.  Naturally, high productivity jobs pay more than low-productivity jobs.

Combined, Mining, Construction, Manufacturing, and Wholesale Trade are still down over 2.5 million jobs since their pre-recession highs.  Other sectors have seen strong growth over the same period.  The generally very low paying Leisure and Hospitality sector has grown by over two million jobs.  The surprisingly low paying, on average, Education and Health sector has been our fastest growing sector.  It’s up 3.9 million jobs, almost all of which are in health care.

Technological change, increased trade, poorly incentivized safety net programs, regulation, and slow economic growth are all claimed to contribute to the change in job composition.

Technological change is an appealing explanation, but the past decade has been characterized by low business investment and slow productivity growth.  This is not what we’d expect if we were going through a generalized technological revolution.  As it is, the most visible gains from advancing technology have been in oil and gas exploration and production.  Oil prices are consequently down, but many governments, organizations, and people are doing all they can to limit or erase the gains from these technologies.

People have worried about technological change’s impact on employment since the dawn of the industrial revolution.  Time and again, those worries have proved unfounded.  I do believe, though, that the spread of electricity throughout the economy and the adoption of tractors in agriculture contributed to the persistent unemployment of the Great Depression.

The Great Depression and the Great Recession share some similarities.  So, we can’t reject the possibility that technological change is contributing to persistent unemployment, low investment and productivity growth notwithstanding.  If so, its impact is relatively minor.

Increased trade, combined with an ineffective safety net, has contributed to persistent unemployment.  This is a bit sacrilege for an economist.  If there is anything approaching a consensus among economists, it is that trade is good.  The proofs are elegant and convincing.  I have no doubt that countries that voluntarily trade are better off.  But, this ignores distributional issues, and distributional issues can be important.

As a free-trade enthusiast, I’ve argued, and deeply believe, that the benefits of free trade are sufficient to allow us to protect the workers, and the families of workers, displaced by the increased trade.  But, we don’t.  Maybe we shouldn’t expand trade until we do?

Our safety net is so bad that it actually contributes to persistent unemployment.  Means-tested welfare programs create cliffs, where small amounts of new income cause the loss of thousands of dollars in benefits.  So, why work?  Extended unemployment benefits encourage workers to be idle long enough that their skills atrophy.

Our regulatory environment is increasingly onerous, and contributes to persistent unemployment.  Perhaps the worst example is coal.  Our government has declared war on our coal industry, with the avowed goal of eliminating the industry, and by extension the livelihoods of the industry’s workers and their families.

Other regulations may be well meaning, but they are laced with pernicious consequences.  These include minimum wages, licensing requirements, and mandated benefits.

Recently, we’ve adopted more reckless ways to increase our economy’s regulatory burden.  Sarbanes-Oxley, Dodd-Frank, and the Affordable Healthcare Act are examples of massive regulations that were written in a short time in response to a perceived crisis and passed with insufficient consideration and debate.  Unemployed workers and their families pay a disproportionate share of costs of the poorly-considered regulations.

These regulations have performed one service.  For those willing to see, it’s clear that micromanaging markets by politicians and their bureaucratic lackeys is a terrible idea.

Slow economic growth contributes to persistent unemployment.  Unfortunately, it’s becoming increasingly fashionable to accept slow economic growth, or even argue that slow economic growth is good.  This is terrible thinking.  Our low and declining labor force participation rate, is one result of slow economic growth.  The fact remains that the best opportunity for a low-productivity worker exists with higher-productivity workers are employed.

How do we know when the higher productivity workers are employed?  The unemployment rate won’t help.

Unemployment numbers are distorted by labor force participation rates.  If a worker becomes discouraged and stops looking for a job, the unemployment rate falls.  The media, who engage in only the shallowest analysis, report this as if it were good news!  They say the world is better, when what really happened was that a person gave up looking for a job.  The once proud and self-sufficient worker surrendered to the soul-crushing life of a ward of the state.

The correct measures of economic vigor are labor force participation rates, new jobs as a percentage of the population, and per-capita GDP growth.  By those measures we aren’t doing very well.

What to do?

Lots of economists would say increase trade and public capital investment.  I disagree with both.  My arguments against public capital investment are here.

My reluctance to increase trade are not because I doubt the gains from trade.  Trade will increase the wealth of both trading partners.  Instead, it’s based on our inability to protect those displaced by increased trade.

Over the past year, I’ve had the opportunity to meet many men who lost their jobs because a factory moved to Mexico.  Yes, everyone was a man, and every factory moved to Mexico.

In every case, the impacts were devastating and long lasting.  Sure, some have bounced back and are now doing relatively well, but they bear the scars of divorce, destroyed families, extended unemployment, and reduced living standards.  More aren’t doing well, having slipped into a mind-numbing life of drug abuse and round-the-clock television.

We’re back to what to do?

One thing we need to do is completely revamp our safety net, in a way that always provides an incentive to work, to keep at least some of that next dollar earned.  Replacing our existing system with a negative income tax would do the trick, and save billions in administrative costs.  It would improve economic growth.  It would save families and lives.

We need to completely revamp our regulatory regime, reducing the compliance burden on businesses, embracing market-oriented solutions, and subjecting new regulation to rigorous cost-benefit analysis.

Just these two things need to be done.  Revamping our safety net and our regulatory environment would release Americans to do what they have always done: work hard, create wealth, and create opportunity.  We would see a sustainable boom, one like we haven’t seen in decades.

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One of the Big Five banks is BofA, and I am one of their customers. It is convenient for me to walk up to a BofA ATM machine in Michigan, Florida, Oklahoma, or anywhere in the U.S. and withdraw cash without paying fees.

It is also convenient for regulators at the Fed, the FDIC, and the Treasury to maintain surveillance over just 50 banks rather than say, 500.

The justification for the consolidation in late 2008 went something like this: size helps offset the bad assets on the books and we (the Federal government) will watch over these institutions very carefully now.

I strongly object to current U.S. banking policy. This is despite the convenience to me and despite the convenience to the regulators, although these are trivial. Policy should not be justified by convenience.

Size matters. The risks that $7 trillion in assets pose to a $17 trillion dollar economy are massive. A loss of “just” $1 trillion in 2015 would be six percent of 2014 GDP. One trillion dollars is double the contraction in GDP from 2008 Q3 to 2009 Q2.

Further, the trend is in the wrong direction. This, interestingly, is despite one of the intentions of the Dodd-Frank legislation. The top five’s share of total U.S. banking system assets has grown impressively, growing in every year but one since 1990. In 1990, they held less than ten percent of total assets, and by 2014, they held 44 percent. Soon, the top five banks will be fifty percent of GDP.

Returning to the carefulness of the regulation, just because the government is more involved with managing these large banks does not necessarily mean that the economy is safer. There is often a revolving door between regulatory agencies and those they regulate. This creates the wrong incentives for protecting the economy, and these incentives worsen as the large banks get larger.

We should change policy to begin the process of breaking up these banks. It will not be easy, and it will take time, so we should get started sooner rather than later.

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The first estimate of 2015’s second quarter economic growth is 2.3 percent, down a bit from the consensus forecast of 2.5 percent, and up from our forecast of 1.7 percent. The previous estimate of the 2015 first quarter’s contraction of 0.2 percent is now revised up to an expansion of 0.6 percent. Given there is some path dependence in our model of the economy, our forecast would have been a bit higher if it had the benefit of seeing the revised quarter one data.

GDP growth rate revisions for the period from 2011 to 2014 were negative. In previously published estimates, average annual economic growth was 2.3 percent; revisions put this statistic at 2.0 percent. This result was driven by downward revisions to 2012 and 2013 growth, 2014 was unrevised. It may yet be revised in future years.

While overall 2014 growth was unrevised, the growth rates within the year were revised, importantly, the second half of 2014 economic growth was revised down. Third quarter was revised down from 0.7 percentage point and fourth quarter was revised down 0.1 percentage point.

The new estimates imply that in the current expansion from the second quarter of 2009 through the first quarter of 2015, the average growth rate of 2.1 percent is 0.1 percent less than previously published estimates and compares with an average growth rate of 3.5 percent from 1947 quarter 2 to 2007 quarter 4.

The improvement in growth from the first quarter to the second quarter was mainly due to improvements in consumption and trade. The first quarter had a sizable negative export shock that was almost completely reversed in the second quarter. Consumption growth improved from 1.8 percent in the first quarter to 2.9 percent in the second, amounting to about 87 percent of the contribution to GDP. This was driven by strong durables consumption growth, where second quarter expenditures on motor vehicles and parts was 10.4 percent.

Overall, this release indicates a moderately expanding economy that is congruent with weak World growth, a relatively slow U.S. labor market, elevated debt levels, and historically low per capita housing starts.

Given this, and given that inflation remains relatively low, I do not see the Fed raising rates in September.

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But the global economy can be characterised (sic) as only achieving a muddling-through “B-minus ” grade. Global growth in the first quarter of 2015 was weaker than in any quarter since the crisis. And although this softness is seen as transitory, productivity growth continues to disappoint, reflecting in part tepid business investment which has weakened the spread of new technologies.

But, then they say this:

US GDP growth is projected to be 2.0% in 2015 and 2.8% in 2016, a downward revision from the November 2014 forecast of 3.1% this year and 3.0% in 2016. While the stronger dollar and adverse weather weighed on growth in early 2015, unemployment continues to fall. Supportive monetary policy and lower oil prices should continue boosting demand.

So far, lower oil prices haven’t boosted demand, and the impacts of post-recession monetary policy will be debated for years.  Our forecast for 2015 U.S. GDP growth, 1.4%, is significantly below the OECD forecast of 2.o%.  The OECD is likely to be disappointed again.

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Consumption expenditures grew at 2.2 percent in quarter four, compared with 1.6 percent in quarter three. Fixed investment grew 9.7 percent, compared with 0.9 percent in quarter three.

I put a table with relevant data here:

Forecasting GDP is hard enough, but the volatility makes the task even harder. The drivers of the volatility in recent quarters have been inventory investment and government, where the contribution to GDP growth each has changed sign twice in the last two quarters.

I do not actually try to forecast the volatility in GDP, our GDP growth forecast is purposely “smoother” than recent history. This makes our forecast easier to explain to our clients, and reduces the risk of a large forecast error, particularly the error of getting the sign wrong. This strategy did not help this time, as our forecast was 1.5 percent for fourth quarter.

What we try to do with our forecasts is to be closer to the truth than our competition. Our competition is the Wall Street Journal consensus of forecasters, a survey of 50 of the top forecasters from around the country. The consensus forecast was 1.6 percent. We were slightly closer to the reported truth than consensus.

The partner to the numerical calculation of the forecast is the story we tell our clients. From this point of view, we have been more accurate than our competitors. We have cautioned our clients about underlying weakness in the economy for many years now, in fact, ever since the fall of Lehman Brothers in September 2008. The new quarter four data provide evidence that weakness still exists.

Residential investment has been strong now for five quarters in a row, and home prices are indicating a gradual housing market comeback. This is good, but the housing comeback will take time and it might never reach pre-recession highs. This probably means some of those construction workers will never again work in that field.

Our January 10 forecast for 2013 quarter one was 1.2 percent, weaker than our forecast for quarter four of last year. With the new quarter four data, I will rerun the model, and while the negative contribution to GDP from government expenditure will likely need to be viewed as a one-time hit, the slowdown in inventory investment and export growth will likely be viewed as indication of weaknesses that will continue to exist in the this quarter.

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Third quarter growth was driven by private consumption and government defense consumption. Investment expenditures were weak, and trade was a small drag on third quarter growth. Business investment expenditures actually contracted, while residential real estate investment was strong at 14.4 percent.

The residential investment is welcome and appears to be a bounce off of the bottom for the residential real estate market. The recovery in housing will likely be bumpy, so we should not expect 14.4 percent residential investment growth rates in the next few quarters.

This report indicates a weak economy despite indicating third quarter’s growth was greater than second quarter growth of 1.3 percent. If we take out “computers” which was boosted by the release of a new I-phone and government expenditure growth, then economic growth would have been 1.1 percent rather than 2 percent.

As one might suspect with third quarter consumption expenditures of two percent, up from 1.5 percent in second quarter, the BEA measure of the personal savings rate fell from 4 percent in the second quarter to 3.7 percent in the third quarter. This report indicates that savings and investment was relatively low in the third quarter.

We have come to a point where short-run Macroeconomic stimulus policies are a waste of resources. The trough of the Second Great Contraction, 2009 Q2 as measured by the level of real GDP, was over three years ago. We are way past it, and we need to get over it. What is needed now are economic behavior and policies that will foster medium-term and long-run growth.

What is healthiest for U.S. medium and long-run economic growth is savings and investment. Households should continue rebuilding their balance sheets and governments should put policies in place for dealing with structural budget problems over time. These activities would provide the environment for private business to invest and grow the economy.

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