U.S. Economic Forecast: Gale Warning

Perhaps with an eye toward the America’s Cup yacht sailing races set for September, U.S. financial markets have ventured into rough seas. Volatility has returned as investors try to gauge what mixed reports mean for the economy in the midst of cooling headwinds coming out of Washington.

Varied signals are making it harder for investors to decipher whether the recovery meets the Federal Reserve’s measures for a “sustainable” economic rebound with “substantial improvement” in the jobs market–in other words, a recovery strong enough for the central bank to start tapering its bond purchases as soon as September. (We still expect a December move.) The sharp downward revision in the first-quarter GDP estimate from the Bureau of Economic Analysis (BEA) to a paltry 1.8% indicated that fiscal shocks (the sequestration and January tax hikes) hurt the economy more than many economists and investors thought. Market participants are increasingly worried that Congress and the Administration will not reach a compromise, which would likely make for even slower growth this year.

The Fed may take comfort from news that the private sector is staying warm despite dysfunction in Washington. The strong June jobs report shows that monthly gains have averaged about 200,000 jobs in the six months through June–something the Fed could gauge as “substantial improvement.” And while consumers didn’t open their wallets as much in the first quarter as earlier reported, spending was at its fastest pace in almost two years, and retail sales data remained robust in the second quarter. Americans may have been busy shopping for items to fill their new homes, since the housing market continues to improve.

However, signs of weakness showed up elsewhere. Businesses have cut back on stocking their shelves, with the outlook cloudy. They may have been wise to hold off on building inventory, with manufacturing activity and sentiment readings down sharply since the start of the year. Slower economic expansion across the globe has hurt U.S. export growth, while modest domestic activity has restrained imports.

The longer that sequestration drags on, the harder it will be for the private sector to sustain a strong recovery. So it looks like another year of subpar U.S. growth is in store for 2013. Although we expected the biggest effects of federal spending cuts would be felt in the second quarter of this year, it now looks to us that no compromise will be reached to reverse sequestration. No action through year-end means our forecast for 2013 GDP growth would fall to 2.0% from our 2.4% forecast in June.

It could be worse. Last year, the Congressional Budget Office projected that a full year of sequestration would mean recession. Now they, and we, see merely slow growth if sequestration remains in place.

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