Executive Summary: Charting the New Course

Trading was fundamentally transformed by the European Age of Discovery, which was pioneered by Portuguese navigators, such as Bartolomeu Dias and Vasco da Gama, who set sail down the West African coast, eventually making it to India by the end of the 16th century. The new course broke the stranglehold that the Ottoman Turks had on the overland spice trade and the considerable wealth that it provided. Ferdinand Magellan and Juan Elcano further altered world navigation by 1522 when their expedition circumnavigated the globe. In the 21st century, financial trading has been permanently altered by the global crisis associated with subprime mortgages, structured products and credit default swaps. Yet, there still exists an imperative need to finance economic activity.

Our economic ship has been thrown off course and is still listing. We face three problems. First, how can we right our ship with new and traditional policy tools to regain a sense of stability in the economy? Second, what is our new course and at what speed can our ship move forward? Finally, how has our destination changed in terms of growth, inflation, employment and the dollar?

Economic forecasting, like sailing, requires constant adjustment to changing winds, currents and the occasional hazard. While the worst of the storm has passed, our ship is still struggling against fierce winds. We are far from an equilibrium point in the economy. We continue to anticipate subpar growth in 2010, with both the pace and composition of the expansion being very different than what we are used to or what we may wish. The pace of the expansion is characterized by real growth of 2.2 percent in 2010 with inflation at just 1.8 percent. Positive contributions to growth will likely come from rising consumer spending, business investment—particularly equipment and software, housing and of course, federal spending. Improved consumer spending will reflect the upturn in real personal income due to eventual job creation, a longer work week and rising wages. We expect real incomes to benefit from continued low consumer inflation. Business investment should improve as financing costs remain low and business expectations of final sales improve. Corporate profits will likely grow, which would improve cash flow and provide liquidity for business investment. We expect housing to continue its recovery as income and consumer confidence improve demand and housing finance continues to be supported by low interest rates. Our forecast shows federal spending stimulus will continue to be applied in the first half of next year and will only gradually begin to slow in the second half as election-year imperatives take over. As for trade, global growth and the weak dollar will stimulate exports but rising domestic consumption and increased energy prices will temper some of the positive effects.

Also putting a damper on hopes for a swift recovery are both the disappointing outlook for housing and the slow growth in consumer spending. For our society, the modest pace of expansion implies only slow improvement in the labor market with the unemployment rate remaining high. We expect sustained positive monthly payroll numbers will start to appear in the late spring of 2010. Our complete forecast can be found beginning on page 26.

Already, we sense that the convergence process to a new economic equilibrium has been more difficult than policymakers estimate. Job growth has been non-existent. Credit growth has been restrained and the recovery in housing far less significant than expected. Still, inflation remains subdued as unemployment limits the acceleration in wages and unit labor costs. Our central tendency for inflation, as measured by the Consumer Price Index (CPI), is 1.5 to 2.0 percent. Slow real growth will run into political pressures in the year ahead as economic realities fall short of political rhetoric. Finally, concerns remain about the long-run pace of growth in the economy as well as the ability of the recovery to sustain itself at a pace that meets the expectations of consumers and workers especially as an election nears. It is not clear how much of the recent economic upturn can be sustained without government support. Recent improvements in business surveys and capital goods orders may have peaked, at least near term. The remaining downside risks reflect weakness in the labor market, with implications for income growth and consumer confidence.

When the tempest in financial markets made the seas wild and hazardous in autumn of last year, most market-watchers were grateful the government stepped in to provide emergency financing to shore up the banks and provide liquidity to the frozen credit markets. The threat of a complete collapse of the financial system made otherwise free market capitalists willing to accept government help—any port in a storm. But how long can expansionary economic policy persist before the negative feedback effects from excess support begin to show? This is the crucial question for decision-makers in the coming year. A general willingness to spend by government is facing a populace less willing and less able to fund that spending. The nation adds to its debt load each year and depends upon foreign savers to supply the financing. As we move into 2010, the Federal Reserve will face a difficult economic environment. While an exit strategy represents our base case estimate for the path of monetary policy, considerable risks exist to both the expected path as well as execution of an "exit strategy.” We discuss how policy-makers could right the ship in our policy outlook section which begins on page 6.

Just as the Federal Reserve and the Treasury took measures to calm the U.S. financial system, their counterparts in foreign countries took action as well. Indeed, governments of the world’s major countries averted catastrophe last year by taking steps to recapitalize, provide loan guarantees and increase deposit insurance while at the same time engaging in stimulative economic policies. As the storm clears, another unique aspect of this recovery is that the U.S. is not the primary catalyst for global economic growth. Quite the contrary, the speed and character of the U.S. recovery reflects the influences of global capital flows and the allocation of production to serve global needs. There will be a new growth model for global economies going forward. Which countries will be the catalysts for growth? Will growth be export-driven or will internal economic growth take the lead? We consider the new course and speed for the global recovery in our international outlook section on page 12. We also consider whether the dollar will continue to play the role of the world’s most important reserve currency.
Real estate markets around the country have seen some modest improvement in recent months, but much of that improvement can be attributed to tax rebates that effectively subsidize the cost of housing. The residential real estate market is not actually making way. The recovery in this sector seems to have more to do with government subsidies than it does with a resurgent private demand for real estate. Federal government support, with massive purchases of mortgage-backed securities by the Federal Reserve is helping drive down mortgage rates even as a tax-credit for first-time homebuyers lifts demand. This has created a sense of stability; but what happens when that support is withdrawn? Is the housing recovery self-sustaining in any way? Meanwhile, commercial real estate remains in the midst of the storm. Nonresidential construction has pulled back significantly as many commercial projects have been delayed or canceled outright as financing has become much harder to secure. The ongoing correction in both residential and commercial real estate continues to hang over the economy as the rising tide of defaults and foreclosures of residential and commercial properties continue to put stress on the financial system. Supply and demand fundamentals are still deteriorating. In our real estate section on page 16, we discuss our view that residential construction may grow modestly through continued support from the government, while the commercial real estate sector will continue to deteriorate.

California and Florida were two of the hardest hit states during the recession, as both were key participants in the housing boom and bust. Overbuilding in residential and commercial construction will continue to weigh on both states over the next few years but signs of growth are beginning to emerge, particularly in northern California and parts of central Florida. Find out if fairer winds are headed for California and Florida in our regional spotlight section on page 21.

Just as the Portuguese explorers found a new route to wealth in East Asia, so too must the U.S. economy chart a new course to prosperity in today’s changing global financial markets. In this outlook, we explore how that new course is likely to take shape in the coming year and we describe some of the hazards that might be encountered along the way.

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