Lynn Reaser is Chief Economist for the California State Controller's Council of Economic Advisors. Previously she was managing director and chief economist for the Investment Strategies Group at Bank of America.
Harlan Levy: Looking at data from August and September so far, is the economy weakening?
Lynn Reaser: The economy continues to struggle. It does not appear to be weakening, but it's on a very slow track of economic activity.
Jobs are being added, and the unemployment rates is slowly coming down. But this economy is clearly not performing up to its potential. Businesses are still reluctant to step up to the plate and take the risk of investing significantly or hiring actively. It appears that they are uncertain about the fundamentals of the economy. The Federal Reserve is creating somewhat of a false sense of security, and there continues to be enormous uncertainty about the future of taxes, government spending, the growth of the federal debt, health care costs, and interest rates.
H.L.: The deficit actually is declining at a significant rate. Isn't that a good sign?
L.R.: It is a good sign, because it reflects a cyclical recovery that we've seen in the U.S. economy which has boosted revenues and reduced some spending, but the long-term prospect for the deficit is still very troubling, because of the impact that the baby boomers will have both on Social Security costs and Medicare payments.
H.L.: What does the future look like for jobs?
L.R.: Job growth is likely to continue to be moderate, but many of the jobs will still be part-time, and wages will rise only modestly. As a result, for the next couple of years, it still will be a buyer's market with companies retaining leverage over workers. It will be a situation where employees will face significant competition to find jobs in general, except for very highly skilled occupations, like engineers and software technicians. It will also be an environment where workers will only keep pace with or slightly stay ahead of inflation. As a result many people will question whether we are in a recovery, and median family incomes are likely to show only limited improvement.
But the outlook for the U.S. economy is by no means gloomy. We do have a significant amount of innovation and growth in technology, but it will only be in limited parts of the country such as Northern California, parts of Southern California, Boston, and parts of Texas where we have clusters of high-tech companies and enterprises.
H.L.: In light of that job outlook, is the housing recovery weakening?
L.R.: The housing recovery has moved back a notch, but the upswing is clearly underway. Some markets, in fact, are very hot, including Phoenix, parts of Florida, Las Vegas, and much of California.
But the rise in mortgage rates has dampened some of the speculation, which is probably constructive. It was becoming a risk that the market was heading toward another bubble, with affordability declining significantly and the run-up becoming too hot to be sustainable.
Overall, the housing upturn will be a major underpinning of the U.S. economy over the next two years.
H.L.: When do you think the Federal Reserve will begin cutting back on its monthly bond and security purchases?
L.R.: The Fed now only faces bad choices. The economy is still by no means strong, but at some point, the Fed does need to reduce what has been a crutch for growth. At this point I think the Fed will start to announce a scaling back of its purchases at its meeting this week, but it will be modest. The monthly purchases are probably going to be reduced to about $75 billion, with an assessment taken over the next two or three months before a subsequent decision is made.
Much of the tapering has already been priced into the market, but there will likely be an increase in interest rates and a drop in stock prices. I think that will be fairly modest and short-lived until the next economic data point arrives.
The stock market is conflicted. Better economic news means higher interest rates, which is negative for equities, but it also means higher sales and profit growth, which is positive.
Better economic news is negative for bonds, because it suggests more Fed tightening down the road and also more competition for funds.
H.L.: What do you see the economy doing next year?
L.R.: The economy should perform somewhat better next year as we continue to see household balance sheets improved, with individuals reducing their debt and the value of assets and stocks rising. But higher interest rates will restrain growth to some extent.
Overall, Gross Domestic Product in real terms is likely to climb at a pace somewhat better than 2.5 percent but probably less than 3 percent. That should be enough to generate more job growth and reduce the jobless rate, but there will continue to be significant income inequality, with individuals with technical skills and companies at the forefront of the technology revolution prospering, while others endure mediocre gains.
H.L.: How much will the political wrangling over the debt ceiling and funding government operations affect the U.S. economy?
L.R,: Financial markets and Americans have become more accustomed to the wrangling in Washington, but budget issues continue to pose a threat to us. The disruption to many companies from the lack of a budget, even with a continuing resolution -- under which we continue to operate under last year's budget -- means that companies cannot move forward on contracts even though those contracts have been previously approved.
The risk of another year of sequestration will also weigh on companies until Congress passes a budget for another year. This will impact defense contractors, scientific research firms, universities, and various providers of public services, which will be unable to plan or prepare their own budgets until they have greater clarity on what federal revenues may turn out to be.
H.L.: Is it a potential disaster?
L.R.: It's a major threat for the economy and particularly for companies and regions like San Diego, a region very dependent on federal grants. Most Americans do not realize that a continuing resolution wreaks on the overall economy because of the uncertainty and the inability to go forward on previously approved contracts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.