WORD ON THE STREET: The U.S. economy has grown at an average 2.2% annual rate since the recovery officially began in June 2009. Data suggest that growth was likely a bit below that rate for the most recent quarter, and the employment report for December 2012 showed that the national economy continues to only gradually improve.
Given that many businesses and households were deferring decisions until there was more clarity on the fiscal outlook, the emerging picture of the fourth quarter (stemming from sources such as the employment report) is encouraging. The national fiscal uncertainty cast a shadow on the economy, but it seems there have been some signs of underlying strength.
I consider it particularly encouraging that some interest-sensitive sectors, which are likely to be especially responsive to monetary stimulus, are clearly showing themselves to be on the mend. Both the housing sector and purchases of consumer durables have been recovering, in part as a response to the accommodative monetary policy the Federal Reserve has been pursuing.
Unfortunately, recent economic improvements have been partially offset by the deferral of spending decisions by households and firms. In all likelihood, these deferrals result in part from uncertainty over national fiscal policy, as well as from the impact of fiscal austerity that has already taken place – particularly at the state and local government levels. If some of the headwinds from fiscal austerity discussions here and in Europe abate, we should begin to see growth come in at a pace that is above the economy's long-run potential growth rate. Such growth would bring about both economic expansion and improvements in labor markets.
The sectors of the economy that are showing the most improvement recently are those that economists generally consider to be the most responsive to monetary policy and interest rates. Particularly notable is the improvement in the outlook for the housing market. Over the past year, real gross domestic product (GDP) growth has averaged 2.6%. In contrast, growth in residential investment occurred at much higher rates, and I expect this positive momentum to continue through 2013.
Housing prices in many parts of the country have begun to rise, and this includes some of the areas that were hardest hit by declines in housing prices. In addition, mortgage rates remain near their cyclical lows and well below the average mortgage rate experienced over the past 25 years.
With prices edging up and interest rates at historic lows, there is now something of an incentive for a potential home buyer to actively pursue buying a home. This is the case because both mortgage rates and house prices could be higher if potential buyers delay their purchase decisions.
In my view, this current dynamic substantially improves the outlook for housing, along with the fact that houses have become more affordable. The ratio of house prices to rental prices – a summary measure of the cost of owning versus renting – has fallen back to traditional levels after rising to significant heights during the housing bubble.
Finally, in the wake of the financial crisis and recession, many people postponed creating new households as they sought to improve their financial position. But there has been an improvement in household formation recently, and many of these new households will be potential home buyers.
The weakest links
A major source of economic weakness during the recovery has been the need for state and local governments to cut budgets. Whatever your views are on the political economy of government spending, in the short term, fiscal austerity removes spending from the economy. In many cases, this drop in public spending increases unemployment as teachers, police officers and other workers are laid off.
In part due to the weakness in housing that strained state and local government finances, state and local government spending has been a large drag on the economy. This spending accounts for close to 12% of the goods and services purchased in the economy.
While state and local government spending remained a drag in late 2011 and the first half of last year, there was actually a slight increase in real state and local government spending in the third quarter of 2012. Many expect that state and local government spending will increase modestly this year, too. Federal spending has been more volatile, but generally has been a source of weakness as a component of economic activity.
Since federal spending accounts for roughly 8% of the goods and services purchased in the economy, this is a major source of uncertainty for 2013. Given the large fiscal deficits still being run, the process by which the nation can reach a more sustainable long-term fiscal policy remains rather uncertain. What does seem certain is that there will be cuts in government spending which, like higher taxes, will by the simple math of the GDP calculation slow down overall economic growth.
There is substantial uncertainty over the fate of federal government grants to state and local governments. Substantial cutbacks in these grants would have a ripple effect on the economy. Similarly, there is the issue of potential federal tax base broadening in order to reduce the federal budget deficit. This will have implications for business and family budgets.
While the need for long-run sustainable fiscal policy is both clear and uncontroversial, I believe it is important to achieve sustainability in a way that does not risk the tentative economic improvements the country has experienced to date.
One area that has been impacted by the uncertainty surrounding fiscal policy has been business investment. Nationally, business investment had been a source of strength in the early stages of the recovery, but capital spending by firms weakened significantly in the third quarter of last year – as many firms sought more clarity on government tax and spending decisions before committing to long-term investments. Fiscal uncertainty therefore accounts for at least some share of the recent weakness in business spending and, unfortunately, this potential cause for weakness in business spending is likely to persist this year.
A third source of weakness remains the weak outlook for many of our trading partners. Both Japan and Europe have grown more slowly than the United States. Additionally, Japan still struggles with a serious deflation problem, and Europe continues to address fiscal imbalances in many of its peripheral countries. Both regions are also experiencing aging populations, which brings some difficult fiscal and economic challenges.
Despite these headwinds at home and abroad, I do expect improvement in U.S. economic growth this year. While in the first half of 2013 I think the economy is likely to grow at roughly its potential level of growth, I expect growth in the second half of the year to be closer to 3% – assuming that headwinds from fiscal imbalances around the world are not resolved in economically disruptive ways.
Eric S. Rosengren is president and CEO of the Federal Reserve Bank of Boston. This article is adapted and edited from a Jan. 15 speech delivered before the Greater Providence Chamber of Commerce Policy Forum in Providence, R.I. The original text is available online.
