Prospects for Growth Improving, But Risks Remain: Outlook for 2012

Martha Gilchrist Moore

April 1, 2012

In recent months, the economy appears to be
gaining some forward momentum. The job market continues to improve, housing
inventories have edged down, and confidence in the recovery is cautiously
growing.  After meager job growth in 2010, the economy gained 1.8 million jobs
during 2011 (the vast majority from the private sector) and the unemployment
rate, which seemed to be stuck above 9 percent, improved substantially by early
2012. While this last point is of paramount importance to the millions of
Americans still looking for work, it is also important to President Obama’s
reelection prospects, as this key economic indicator is closely linked to
approval ratings. Even though employment levels remain below their
pre-recession peak, improvement in private sector employment is essential to
the recovery. As more Americans return to work, households become increasingly
optimistic. Spending has risen, especially on durable items like cars and
appliances, as some of the pent-up demand that accrued during the previous 4
years is slowly being released. Sales of light vehicles rebounded, and retail
sales have strengthened. Improving job growth and confidence will propel the
recovery forward in the months ahead.

In
contrast to other business cycle recoveries that were led by sharply rebounding
consumer spending, income growth continues to be weak as the job market remains
relatively slack. Average production worker wages grew by only 2.1 percent in
2011, the slowest annual gain since 2004. This will constrain consumer spending,
as households continue to bolster their balance sheets. In addition, many
market watchers believe the recession brought about a new frugality among
American consumers. As with the generation that survived the Great Depression,
there may be a cultural shift toward less consumption relative to the decades
leading to the 2008 financial crisis. This shift in consumer behavior will
offset, to some degree, the pent-up demand starting to unfold.

The
housing market is finally starting to show signs of life after 6 years of
declines. The multifamily segment (i.e., condos and apartments) revived in 2011
as foreclosures and tight lending conditions pushed many former homeowners and
new entrants into the rental market. Existing home sales have risen from their
lows. Inventories of new and existing homes available for sale are returning to
a balanced position. However, a steady stream of foreclosures continues to put
downward pressure on home prices. In early 2012, roughly a third of existing
home sales were so-called distressed properties (foreclosures and short sales),
which sell at steep discounts. At the end of 2011, nearly 23 percent of all
mortgages were “underwater,” suggesting defaults and foreclosures will continue
to be a part of the housing landscape. On the demand side, improvements in the
job market are key. During the recession, household formation?the main driver
in housing demand?slumped, as unemployed young people returned to their
parents’ homes and families doubled and tripled up. As employment grows, demand
for housing will increase. New homebuilding will occur in areas of the country
not overbuilt during the boom years and where job growth is strongest.

The
industrial sector recovery continues with industrial production up and capacity
utilization tightening, though at the beginning of 2012, production climbed
back only about three-quarters of its peak-to-trough decline. The Conference
Board’s index of leading economic indicators points to continued gains in the
months ahead. Inventories are balanced against sales through the supply chain
and, according to the Institute for Supply Management, many manufacturers think
their customers’ inventories are too low. Order books and unfilled orders
continue to expand, suggesting a broadening pipeline of manufacturing activity.
A lower dollar and increasingly competitive natural gas prices in the United
States have helped U.S. exports.

Despite
recent gains, however, the U.S. economy remains vulnerable to a number of
risks. Europe is in recession, curbing demand for U.S. exports to that part of
the world. That Greece may leave the Euro is no longer considered unimaginable,
and financial markets are bracing for a Greek default. Fiscal and debt problems
in Italy, Portugal, and Spain also are troubling. While U.S. banks are not as
heavily exposed to European debt as they were to U.S. mortgaged back
securities, a disorderly unwinding in Europe could trigger another global
financial crisis. In China, meanwhile, manufacturing activity in the world’s
second largest economy has slowed, and property prices are sliding following a
government-funded building binge. A so-called hard landing for China, while
unlikely, could destabilize the global economy. Recent gains in gasoline prices
also are worrisome. Higher gasoline prices act like a tax, reducing households’
discretionary spending. Longer term, deficit spending and growing U.S.
Government debt may weaken growth prospects. Inopportune tax and trade policies
also could threaten to derail the recovery.

Another
real concern is price inflation. When growth in money supply exceeds economic
growth, inflation results, as too many dollars chase the goods and services
available in the market. Following the financial crisis, actions by the Federal
Reserve to prop up U.S. banks resulted in unprecedented excess reserves. As of
early 2012, the economy remains weak. Beyond the run up in oil prices fueled by
Iran’s nuclear ambitions, there remains little evidence of broad-based
inflation. However, as the economy strengthens, the Federal Reserve must be
ready and able to mop up the excess liquidity in the money supply. Higher price
inflation, possibly triggered by sharply higher oil prices, could seriously
dampen economic growth prospects.

As
global oil markets absorb the increased geopolitical risk from events in the
Middle East and threaten global economic stability, a not-so-quiet revolution
is occurring much closer to home. Natural gas production in the United States
is expanding as once ignored shale gas resources are developed. This has
significant implications for large segments of the U.S. manufacturing base.
Shale gas is not new. The technology known as hydraulic fracturing whereby
water is pumped at high pressure to create fractures in gas-containing shale
rock, allowing natural gas to be extracted, has existed for decades, but was
not an economic option until recently. As U.S. natural gas markets tightened in
the early 2000s, and Hurricanes Katrina and Rita in 2005 pushed natural gas
prices to unforeseen highs, previously uneconomic methods for extracting
natural gas from shale formations suddenly became economic. As learning-curve
effects and scale economies came into play, the cost of extracting shale gas
declined. The Energy Information Administration projects that natural gas production
will increase by about 1 percent per year through 2035 as production from shale
becomes a major supply of domestic energy.

As
a result, the economics have changed significantly for a number of
gas-intensive manufacturing industries, including chemicals, metals, paper, and
glass. The chemical industry, in particular, is dependent on natural gas for
fuel to generate the heat and pressure required to split and recombine
molecules. It is also unique among industries in its use of natural gas and
natural gas liquids such as ethane as feedstock for the materials it produces
from ammonia-based fertilizer to ethylene, a building block molecule used in
thousands of materials. A decade ago, there was little to no investment in this
segment of the U.S. manufacturing base. The new economics of shale gas and
natural gas liquids, however, has spurred a wave of announcements for new U.S.
petrochemical capacity, as the competitiveness of U.S. petrochemicals based on
natural gas feedstocks has increased. Estimates of as much as a 25-percent
increase in U.S. ethylene capacity have been announced by major producers.
Pipelines are being built to ship ethane from the Marcellus shale formation (in
West Virginia, Pennsylvania, and Ohio) to petrochemical producers in the Gulf
Coast and also to Canada for use in petrochemicals. Other gas-intensive
manufacturers stand to benefit as well. A recent Price Waterhouse Coopers
report suggests that lower feedstock and energy costs could save U.S.
manufacturers $11.6 billion annually by 2025.1 This, combined with a
lower dollar, has made U.S.-based manufacturers more competitive than they have
been in decades, which bodes well for a long-lasting resurgence in U.S.
manufacturing.

As abundant shale gas supplies in the U.S. bolster domestic
manufacturers, the export potential looms large. Roughly a dozen applications
are in various stages of review to build liquefaction capacity to export
liquefied natural gas (LNG) to Europe and Asia, where prices are several
multiples higher than in the United States. Following the tsunami-induced
nuclear disaster at Fukushima in 2011, natural gas demand in Japan has soared.
In Europe, many natural gas consumers are captive to Russian supply and likely
would welcome new supplies from across the Atlantic. In all, domestic shale gas
resources offer tremendous opportunity for businesses along the supply chain
from well head to burner tip or LNG terminal.

In summary, despite the near-term risks, the consensus
outlook for the U.S. economy is for continued moderate growth. Most indicators
point to steady growth, though still constrained somewhat by the excesses of
the last decade. As jobs become increasingly plentiful, incomes will grow and
demand for goods and services will increase, which in turn will create more
jobs. Barring a shock, 2012 may be the year that the economy finally reaches
the “escape velocity” that Larry Summers (former director of the National
Economic Council) looked for in 2010. In the years to come, the evolving
expansion will be further driven by a revitalized U.S. manufacturing sector
that capitalizes on domestic shale gas resources.

 

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