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Q&A on the 2014 Outlook

In this post I will hijack the questions intended for Jan Hatzius and answer them while pretending that my responses matter half as much as his do (see his answers here for comparison):

1. Will the economy accelerate to above-trend growth?

No.  The US economy has historically grown at a rate of 6.7% NGDP since 1945.  The most recent economic crisis left the USA mired in an unusually deep hold where credit growth would not sustain higher aggregate demand and fiscal and monetary policy failed to bring the economy back to full strength.  Although the US economy has made tremendous progress in recent years and the private sector is improving, I think it is highly unlikely that the credit environment is strong enough to sustain high historical levels of growth.

2. Will consumer spending improve?

Consumer spending is likely to continue stagnating.  The credit crisis left the household sector unusually vulnerable.  Although the consumer is much healthier than they have been, this remains an environment in which the consumer remains unusually fragile due to relatively weak balance sheets and a lack of demand for credit that results.  This means income expansion and hiring is likely to remain somewhat tepid, which, when combined with weaker than average demand for credit, will leave the consumer relatively weak.

3. Will capital expenditures rebound?

Corporations are increasingly picking up the slack in the US economy and as has been historically true, as we enter the latter stages of the business cycle, capital expenditures are picking up.  Inventories are likely to continuing building in the coming year and modest capex expansion should continue, however, due to the fragile consumer, we must remain wary of this trend as corporations could easily be the catalyst of the next recession should they rein in spending at a time when it is most needed.

4. Will housing continue to recover?

National housing prices have risen too far too fast in many areas of the USA and should see much more modest improvements in the coming years.  Many markets that have boomed in the last 12 months (such as San Francisco, San Diego and Phoenix) could be at risk of substantially lower year over year gains.  I do not foresee national declines, however.

5. Will labor force participation rate stabilize?

The trend in the labor force participation rate is part structural and partially the result of the deep economic contraction from the crisis.  The improvement in the economy combined with the structural negatives do not leave me entirely optimistic that the labor force participation rate will see material improvement in 2014.

6. Will profit margins contract?

Profits as a whole should continue modest single digit expansion in 2014, however, I would not expect the robust margin expansion of the last five years to continue.  The likely risk to profit growth and margins is to the downside, however, as of Q1 2014 I do not see substantial negative risk.  Rather, the more likely scenario is moderating margin expansion and modest single digit profit growth.

7. Will core inflation stay below the 2% target?

At 1.7% core inflation does not have to climb much higher to hit the Fed’s target rate of 2%.  I would expect core inflation to remain low as consumer demand for shelter, autos and other core items remains tepid.  There is, in my opinion, very little chance of high inflation in 2014.

8. Will QE3 end in 2014?

QE is likely to taper in increasing increments during 2014, but I do not think the Fed will pull the punch bowl away just yet.  We are more likely to see a slow and methodical approach to tapering.  Given the likelihood for another year of below historical levels of growth and low inflation, I think there’s a high probability we could still be talking about tapering 12 months from now.

9. Will the market point to the first rate hike in 2016?

I am going to go way against the consensus here and argue that the next recession is likely to occur before the next rate hike.  ZIRP is here to stay and likely means QE is the policy variable of choice for the Fed in the coming few years.  Will a recession hit by 2016?  I am entirely unable to predict that far into the future, but I do think there’s a high probability that we will be in a recession before the Fed raises interest rates next.

10. Will the secular stagnation theme gain more adherents?

The most hated economic recovery in the history of the USA is turning more and more people into bulls.  So no, I do not think the fear trade is winning.  In fact, I think the fragile economy combined with the potential for an overly bullish stock market could pose risks to the economy in the coming years.

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