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Further evidence of a recovery

Contributed by Raymond James

By Scott J. Brown

The economic recovery has played out largely as anticipated. Helped by monetary and fiscal policy stimulus, the downturn stopped last year. However, faced with a number of significant headwinds, the rebound was expected to be relatively gradual. The labor market would lag in the recovery, as it always does. Looking ahead, the recovery appears to be somewhat fragile. The biggest risk is still a policy mistake.

Some part of the fiscal stimulus went to aid to the states and to extending unemployment insurance benefits. These do not “boost” the economy, but instead fill holes – very large holes. The crisis in state and local budgets has led to job cuts and tax hikes, both contractionary. The federal aid has helped offset some of the pressure on state budgets, preventing substantially worse economic conditions. The extension of unemployment insurance benefits has largely offset a sharp decrease in labor income. This has helped consumer spending to bottom out and start growing again. Unfortunately, these aid efforts have been transitory. To succeed, we’re going to need job growth.

The inventory correction has progressed, but we still have some way to go. The inventory cycle has been dampened over the last few decades due to technology (scanners, computer management) and a greater tendency to hold inventories overseas. The large part of the inventory correction has not been an adjustment to excess inventories, but rather, to a significantly lower level of sales. Adjusted for inflation, inventories continued to fall in 4Q09. In the next few quarters inventories are likely to rise more in line with sales, which will add somewhat to GDP growth. However, inventories will not be the main driver of the economic recovery – they never are.

Global trade sank sharply in the recession. In the U.S., the decline in imports was greater than the drop in exports, narrowing the trade deficit significantly. Both imports and exports are rebounding now, a sign that the global economy is improving. In the near term, the trade gap is likely to continue growing, which will subtract slightly from overall GDP growth.

Normally, at this stage in a recovery, growth would be gathering much more steam. However, in the near term, the U.S. economy will continue to face some serious headwinds: the residential housing hangover, severe strains on state and local government budgets, tight credit, a weak job market, and problems in commercial real estate.

As always, the price of oil will remain an important wildcard in the outlook. A drop in oil prices would be helpful to the consumer outlook. A sharp rise would dampen recovery prospects. Most likely, oil will remain in the $70 to $80 range.

Research shows that the common mistake made in recoveries from financial crises is to remove accommodation too soon. The Fed has prepared its exit strategies, but in nowhere near ready to pull the trigger on tightening credit. Fiscal stimulus will ramp down later this year. A job stimulus has already been scaled back in the Senate and the populist call for deficit reduction could indirectly lead to not enough being done in fiscal policy.