Interview With Michelle Girard: Second-Half GDP Growth To Be 2.5%, Although True Cost Of Monetary Policies Unknown

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by: Harlan Levy

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

Harlan Levy: What's your takeaway from this week's report of 1.7 percent second-quarter Gross Domestic Product growth?

Michelle Girard: Growth in the first half of 2013 averaged less than 1.5% annualized, so the economy does continue to advance at a very subdued pace, and certainly other data such as employment, housing, and spending do not suggest a sharp deceleration.

The focus now is on how the economy will perform in the second half of the year. Many expect a sharp acceleration in growth as the impact of fiscal drag fades. Some are forecasting growth to rise to the 3 to 3.5 percent range. I don't think the economy will pick up that sharply. My expectation is that growth will move back to the 2.5 percent range.

I don't think that fiscal drag - everything from the expiration of the payroll tax cut, the increase in taxes on the wealthy, and the cutback in spending associated with the sequester - has slowed the economy in the first half of the year perhaps as much as other think. Therefore, when that drag fades I don't think the economy will speed up as much as others think.

H.L.: What do you see for Gross Domestic Product growth in 2014?

M.G.: I think that GDP growth in 2014 will only be slightly better than in 2013. The headwinds continue to diminish, allowing the economy to accelerate somewhat further, but the impetus for a breakout to a much stronger growth pace is lacking.

Companies remain hesitant to hire aggressively, given their own subdued outlook for the economy as well as concerns over regulations and costs and without a noticeably faster pace of job growth it is hard to envision consumer spending in a much stronger performance next year than this year.

H.L.: What's happening with jobs, and what's your prediction on July jobs?

M.G.: The job market continues to grow at a modest pace. We've been averaging job gains at about 200,000 per month, and that is sufficient to gradually lower the unemployment rate. Our expectation is that the job gain in July will be similar to what we've seen in recent months. Our forecast is for an increase of 185,000, and we look for the unemployment rate to hold steady.

H.L.: What does this all mean for the Federal Reserve and its policy of buying bonds and mortgage- backed securities at a rate of $85 billion a month?

M.G.: The Fed has been pretty clear that unless the economy slows sharply it will probably announce a cutback in its monthly purchase pace probably in September.

Our employment forecast for July would keep them on that path. Just as the Fed has guided us, we do expect that tapering will be seen gradually over the next year, with the bond-buying program ending in the middle of 2014.

Importantly, Fed officials have made a clear distinction between tapering and tightening, and they continue to indicate that the timing for the first rate hike coming at sometime in 2015 has not changed.

H.L.: How concerned are you about rising bond prices?

M.G.: We think that a lot of the sell-off in the bond market seen in May and particularly in June was tied to fears about the Fed raising interest rates. With Fed officials calming market concerns on that front, we think the sell-off has run its course and expect that bond yields will remain in the current range over the coming months.

The magnitude in the rise that has been seen in interest rates we do not believe will put the economy at a serious risk. Companies are flush with cash and don't need to borrow to fund capital spending.

Consumer loans are mostly tied to short-term interest rates which have not really moved up, and even in the housing sector, despite the back-up, mortgage rates remain historically low, and tight credit conditions in general remain a bigger problem.

This recovery/expansion has not been based on low interest rates driving credit expansion. To the contrary consumers and businesses have been mainly deleveraging, and thus the recent back-up in interest rates poses far less risk than might normally be the case.

H.L.: What's your biggest worry about the U.S. economy?

M.G.: At the moment my concerns over the expansion being derailed are extremely low. The U.S. economy is on very solid footing, even if the growth rate remains sub-par. Thus we are not particularly vulnerable to an external shock, such as a renewed crisis in the euro zone or a sharp slowdown in China's growth.

That said, in coming years we will find out the true cost of the unprecedented easy monetary and fiscal policy actions taken during the recession. What worries me is that we don't know what the long-term costs will be. For example, maybe this period of easy money has led to another bubble in some area that we don't recognize today.

H.L: The House Republicans have set up a confrontation this fall over the debt ceiling again, and they just stated they'll slash spending on a wide range of programs from environmental protection to services for the poor and children unless Obama's healthcare law is blocked. What effect on the economy will all this have?

M.G.: I do think that political noise from Washington will pick up in the fall, surrounding not only the debt ceiling but, before that, the need to fund the government after September 30. If an agreement cannot be reached, we could face a government shutdown beginning October 1. Both sides do appear to be positioning for a fight.

But I suspect the battles will be far less drawn out than in previous years, in large part because the precedent has been set for Republicans caving in. Assuming that the battles are less drawn out, I do not believe they pose significant risk to the economy.

I think both the public and businesses have gotten used to all this political squabbling and take it with a grain of salt.

H.L.: The euro zone countries other than Germany are in recession. How bad is that for the global economy?

M.G.: Actually the news out of the euro zone has been better of late, although I do not believe all the problems have been resolved. In any case, the channel by which the euro zone would impact the global economy, via financial market stress, has been closed since the European Central Bank made it clear that it will take any action necessary to support the region. So even thought the euro zone problems have not been resolved, the risk to the global economy has been sharply reduced.

H.L.: Are China's economic troubles, its asset bubble among other items, exaggerated in terms of their potential effect on the U.S. and global economies?

M.G.: I do think that China is of greater concern for the U.S. than the euro zone, because China's growth rate will affect all of the region and could have a more noticeable impact on U.S. exports.

If China weakens, the whole region will weaken, and that could be a meaningful development. It won't derail our expansion. The U.S. economy is largely determined by our own domestic demand, but sharply slower growth in the Pacific region would clearly undermine the pace of growth here.

At this time, our overseas economists are not overly concerned by recent developments, and we still expect growth in China at about 7.5 percent this year.

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