Thoughts on the US Economy, Trade Data, Sequester and Deleveraging

The US trade figures for Q4 2012 came out this morning and they surprised analysts by showing a trade deficit that shrank 21% to $38.5 billion in December. According to Bloomberg News this was a lower deficit than any of 73 economists estimated prior to the release.

For me the significance of this report is that it means that the 0.1% contraction in GDP for Q4 2012 will likely be revised up to an increase in GDP when figures are revised next month. And while the trade figures were flattered in large part due to a surge in petroleum exports and a decline in petroleum imports, the eventual adjustment to GDP underlines the fact that the US economy, independent of wrangling over fiscal policy is in the midst of a sustainable cyclical recovery. There is no reason to believe this recovery would turn to recession at this juncture in the absence of federal budget cuts or tax increases.

The latest update on the federal budget sequester is that it still looks likely that the sequester will happen as I have been predicting for some time. The real question is whether the cuts in the budget will be enough to cause the economy to dip into recession. Of all of the items on the US federal fiscal agenda between the fiscal cliff and the sequester, the payroll tax increase will have the largest drag on GDP growth as the tax is a regressive tax that tops out at about $200,000. The increase in payroll taxes will lead to a large, perhaps as much as 70-80% reduction in spending and debt relief, since we know that the lion’s share of the cuts were used for spending when the payroll tax cut was implemented. For national income and product accounts, debt reduction and increased spending are materially the same. And we know from estimates by Fed economists that about 36% of the payroll tax cut was spent, with the rest being saved or used to pay down debt.

The bottom line here is that outside of the sequester, economists including myself are increasingly optimistic about the US economy. My optimism outside of the sequester is tempered by the fact that my first derivative analysis of the employment survey data indicates that this business cycle may have peaked in June of 2012 when the year-on-year growth in jobs was highest according to the household survey. As I wrote in the Grantham piece yesterday, my secular view of the US economy is dominated by my belief we have moved to net reductions of private debt as a percentage of output. Right now, there is some releveraging as one should expect during a business cycle upswing. However, given the large reduction in year-on-year job growth indicated by the household survey, I believe we are entering a mid-cycle slowdown that will be exacerbated by deficit fatigue and a secular change toward private deleveraging. These trends increase the chance that this mid-cycle slowdown will turn into a recession – where deleveraging will occur in much greater measure.