The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

The national accounts Core PCE deflator, a measure of prices that does not fix the basket of items so rigidly, is the measure that the Fed watches most closely in setting monetary policy. From Friday’s first estimate of GDP we also have the first estimate of Core PCE inflation for 2010 quarter 1. It is now at its lowest quarter-on-quarter growth rate since 1959 at 0.6 percent. Charts of these data are included below.

It is interesting that with real consumption growth of 3.6 percent, inflation is this low. Apparently, it is the household who has the upper hand in the retail marketplace. This will likely continue for at least another quarter.

Low Core PCE inflation makes the FED’s job easier, as their expansionary monetary policy has not yet created any inflation. This is a good thing, since monetary policy challenges still remain. As the NBER admitted a couple of weeks ago, we are not necessarily out of the woods yet.

The January Producer Price Index (PPI) data released yesterday February 18, appeared to show that price pressures were building up again with finished goods prices rising 4.6 percent over 12 months ago, and rising 1.4 percent over the prior month. The January Consumer Price Index (CPI) data, released today, showed that the all-items inflation measure subsided slightly from December’s 2.7 percent to 2.6 percent. The CORE measure, excluding the volatile food and energy components, was also down, from 1.8 in December to 1.6 percent in January. A chart of the CPI growth measures is included below.

Analysts sometimes see the PPI measure as a leading indicator of the CPI. This is truer for all-items CPI rather than core, since the PPI measure is more easily influenced by energy. So while the all-items inflation rate might grow in coming months, we do not expect that CORE inflation will be influenced much.

FED Policy

Yesterday, the FED announced that they have raised the discount rate from 0.50 to 0.75 percent. They indicated that “continued improvement in financial market conditions” allowed them this change in policy which is an attempt to “normalize” the Federal Reserve’s lending facilities. They noted that this change is not expected to lead to tighter financial conditions for households and businesses.

The FED has been gradually unwinding its extraordinary efforts to support the economy through the financial crises. Those extraordinary efforts have been underway since mid-2008, and the relatively long period of low-cost credit and bond-market support could bring inflation roaring to life. What has held inflation in check since mid-2008 has been the very weak economy.

We applaud these efforts, as long as the economy has indeed recovered from its illnesses, but we are concerned that it is premature. We are worried about ongoing problems in banking and real estate, and so we are worried about how healthy the patient really is. We hope that the FED is right – we hope the patient is truly getting better.

However, inflation is not inevitable. For inflation to occur, increases in the monetary base have to be translated to an increase in money supply. This is the money multiplier that we teach in elementary macro-economics, and it depends on bank lending, something that is just not happening. Even if the money supply increases, velocity declines could offset the inflationary impacts.

We are seeing an alarming increase in deflation around the world. The BBC reported today that Japanese prices have fallen 8.5 percent in the past year. Prices have also been falling in Germany, Spain, Britain, Ireland, and Switzerland.

It is virtually impossible to imagine a recovery if the United States slips into deflation. So far, we’ve had small increases in prices. Let’s hope that continues.