Interview With Michelle Girard: Another Year Of Subpar Growth, With GDP Losing 0.5% If Sequester Happens

Includes: DIA, QQQ, SPY
by: Harlan Levy

Michelle Girard is a managing director and senior economist at Royal Bank of Scotland.

Harlan Levy: What does the economy look like, and what do you see for this year?

Michelle Girard: The economy ended 2012 on a relatively soft note. We look to Gross Domestic Product growth of just 7 tenths of a percent in this first quarter, with hindered activity to some extent. We continued to see softness in the business sector, business investment in particular.

As we look ahead it's going to feel very similar to 2012. We're looking for the economy to expand at about a 2 percent pace, which is very close to what we will have seen in 2012.

The economy has both negative and positive factors at work. The housing sector is improving, and household balance sheets are stronger. On the other hand you do have fiscal policy uncertainty, and you do have higher taxes. In particular the expiration of the payroll tax cut will restrain consumer spending a bit. On balance, you end up with another year of sub-par growth.

H.L.: Did the compromise in Congress to deal with going over the fiscal cliff do much to solve our need for spending cuts and increased revenue?

M.G.: The deal to avert the fiscal cliff really has done little to alleviate the longer term deficit issues. It was simply a small down-payment, and the bottom line is it didn't clear the air at all. We still have several big battles ahead of us in the near term, which pose risks to the economy and the financial markets.

The battle over the rest of the issues in the next eight weeks could be far uglier than the last go-round. The debt limit has to be raised by March 1. We'll debate about whether the trillion-dollar sequester cuts go into effect, and also the continuing resolution that funds the government expires at the end of March.

There's going to be a lot of nervousness as these deadlines approach, just as with the year-end deal. Both parties are very dug in, and it's not clear how it all will turn out.

H.L.: How do you think the fights will end up?

M.G.: I don't think we'll default on the debt, and the debt limit will be increased for at least a short period of time. It may only be three to six months, but we will get an increase.

The sequester cuts could go into effect. The Republicans have said they're willing to take the defense cuts, so they're trying to put pressure on the Democrats to come up with other spending cuts to replace the sequester. If the sequester were to go into effect, I think the impact on the economy would be about half a percent and lead to downward revisions in GDP growth.

The disaster related to the debt limit will ultimately be averted, but it's quite possible that the battle over replacing the continuing resolution to fund the government, which ends on March 27, could be where everyone digs in. We could get a partial shutdown of the government. The impact on the economy would depend on how long it lasts, but clearly it would be destructive.

Given all this, certainly the risk is that the economy in the first part of the year remains soft. It's just ugly down there. I'm surprised that the markets are so complacent right now.

H.L.: What do you see happening with unemployment?

M.G.: We expect the unemployment will continue to decline but very gradually. Our forecast calls for a fall to 7.25 percent by the end of this year. Our expectation is that we'll get about 185,000 new jobs each month, slightly better than the 150,000 a month we saw in 2012. Overall, we have a very subdued labor market environment. That's why we just don't think the consumer can end up being a whole lot stronger than what we saw last year. Income growth will still be relatively modest.

H.L.: When do you think the housing market will have a sustained recovery?

M.G.: I think the housing market is in the midst of a sustained recovery. Activity was better in 2012 than expected, and on a national level home prices are rising. The sector has turned, and the recovery will be sustained, if slow, in the sense that we have a lot of ground to make up, but I think the market has bottomed.

Still housing accounts for only 2.5 percent of the economy now, so even if housing were to grow 10 percent, it would only add about a quarter of a percent to GDP.

H.L.: Is the Federal Reserve doing the right thing by continuing to buy Treasurys and continuing interest rate easing until the jobless rate hits 6.5 percent?

M.G.: The Fed's accommodative policies will create longer-term issues and problems. I am concerned about the ultimate consequences. But, that said, what you're seeing is the Fed is successfully pushing investors out the risk curve. Yields are so low on Treasurys and mortgage-backed securities that investors are moving into other areas, in particular the equity market. In that way the Fed policy is effectively getting liquidity out into sectors that need it.

We just had a small test of what will happen if the Fed stopped buying Treasury securities. The latest Fed meeting minutes showed that half the committee members were anticipating the end of such purchases in the middle of 2013, much sooner than the market was expecting. On that news, Treasury yields rose sharply. We don't expect the Fed will stop that early, but I do think it underscores the risk of what could happen to bond yields when the Fed starts to unwind its current stance. Yields would rise very sharply, and that would hurt the economy, because borrowing costs would go up. Mortgage rates could go up, and that would hurt the housing sector, for example. For the economy that would not be a good thing

H.L.: Do you think the euro-zone countries are on the road to resolving their sovereign debt problems, or is that a pipedream?

M.G.: I think there are still challenges in the euro zone. Right now there are greater concerns about developments in the U.S., and the focus has moved back to the U.S., but there are still challenges in the euro zone that will show up later this year.

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