MORGAN NORTH

STANLEY

RESEARCH

AMERICA

US Economics Team
Morgan Stanley & Co. Incorporated

Richard Berner
Richard.Berner@morganstanley.com

David Greenlaw
David.Greenlaw@morganstanley.com

January 7, 2011

Ted Wieseman
Ted.Wieseman@morganstanley.com

US Economics
Growth Debate Over, Inflation Debate Begins
Three themes for 2011: 1) Inflation will bottom and gradually turn up; 2) the two-tier economy will persist as strong exports and capex will lead, while weak housing and state and local government outlays will drag; and 3) the shift to fiscal from monetary stimulus will push both real and nominal rates higher. Inflation inflection point: We believe that inflation is bottoming and will gradually move higher, courtesy of stable-to-higher inflation expectations and speed effects from narrowing economic slack. That is especially the case for rents, which are a major inflation component and which are already moving higher. Two-tier economy to persist: 4% growth is likely, perhaps even conservative. But the dichotomy in overall economic performance continues: strong leadership from exports and capital spending versus the drag from weak housing activity/home prices and from cuts in state and local government budgets. Those two headwinds may take one percentage point or more from growth this year. Shift in policy mix implies higher real rates: The shift to fiscal stimulus and the expectation of its success implies that real and nominal yields will continue to move somewhat higher. We expect that 10-year Treasury yields will move 50-75 bp higher, to 4%, over 2011. Six risks to the outlook: A matter of degree: Two are domestic more weakness in home prices and state and local government spending cuts. Four are global: More spillover from Europes sovereign crisis; more Chinese monetary tightening; a surge in crude quotes to $120 or more; and politics interfering with appropriate policy responses.
Recent Reports

David Cho Dane M Vrabac

Higher Energy Quotes: A Risk for the US Consumer, A Push for Inflation Richard Berner How Bullish Is Our Outlook? David Cho & Richard Berner Why Is Our Estimate for Q4 GDP So High? David Greenlaw & Ted Wieseman

Dec. 22, 2010

Dec. 17, 2010

Dec. 15, 2010

For important disclosures, refer to the Disclosures Section, located at the end of this report.

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RESEARCH

January 7, 2011 US Economics

Growth Debate Over, Inflation Debate Begins

Richard Berner & David Greenlaw (New York)

inflation component and which are already moving higher. While weve discussed this view elsewhere at length, we think the uncertainty around the inflation process makes it worth reviewing some fundamentals (see sidebar at end of note). 1
Exhibit 1

Three themes for 2011. We think three themes will dominate the debate around the US economic outlook: 1) Inflation will bottom and gradually turn up; 2) the two-tier economy will persist, as strong exports and capex will lead while weak housing and state and local government outlays will drag; and 3) the shift to fiscal from monetary stimulus will push both real and nominal rates higher. New Normal: RIP? We dont want to short-change the growth debate; it remains central, as this mornings tepid employment report underscores. Nonfarm payrolls rose just 103,000 in December; inclement weather likely depressed the job tally somewhat. Its far from a boom or even a truly vigorous recovery. Nonetheless, average monthly private payroll growth in Q4 10 was the strongest in nearly four years. Thus, despite well-worn and obvious, lingering headwinds, we think the debate about growth is largely over. And several factors at the least assure moderate growth and raise the odds of a more bullish outcome this year and next: the combination of generally better-than-expected incoming data, faster-than-expected deleveraging, the one-two punch from new fiscal stimulus and a Fed committed to achieve its dual mandate, and a dramatic reduction in political uncertainty. Consequently, we continue to expect 4% real growth over the four quarters of 2011. The inflation debate, however, is even more important: It has only just begun, inflation is not in the price, and thus even a genuine bottoming in inflation, let alone an increase, would have significant market and policy consequences. We dont think inflation will rise back to the Feds mandate-consistent rate of 2% or just below until 2012. But a rise in core inflation back above 1% in the next several months is highly likely in our view, and that inflection point will kick off the inflation debate in earnest. Heres why. Inflation inflection point. We believe that inflation is bottoming and will gradually move higher. A tug of war is under way: Significant slack in markets for goods and services, housing and labor will depress inflation. But stable-to-higher inflation expectations will push it higher. While operating rates are low and the jobless rate is high, changes in those gaps so-called speed effects are promoting an inflation inflection point. That is especially the case for rents, which are a major

Change in Operating Rates is Restoring Pricing Power

86 84 82 3 80 78 76 74 72 70 68 66 64
85 87 89 91 93 95 97 99 01 03 05 07 09 11 Capacity Utilization: Manufacturing (9-month lead, left scale) Core PPI (year-over-year % change, right scale)

5 4

2 1 0 -1 -2 -3 -4

Source: Bureau of Labor Statistics, Federal Reserve Board

In addition, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting energy and food quotes. Energy quotes jumped by 17% (not annualized) in the three months ended in December. While the pace should slow from here, our commodity team believes that the direction is higher. Measured in the CPI, meanwhile, US retail food prices have also accelerated admittedly to a modest 2.4% annual rate in the September-December span. But the strength of global demand is pushing food prices higher, and there are upside risks to our November view that food inflation would be limited to 2-3%. 2 Finally, many prices for imported goods are beginning to turn up again, despite the recent stability in the dollar. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, and these price hikes may also contribute to US inflation by reviving inflation expectations. Two-tier economy to persist. The impressive improvement in most incoming data and the onset of new Federal fiscal
1

See Have We Seen a Bottom in Core Inflation? and Higher Energy Quotes: A See Food Inflation: Less Than Meets the Eye, November 12, 2010.

Risk for the US Consumer, A Push for Inflation, December 22, 2010.
2

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stimulus hint that 4% growth is likely, perhaps even conservative. 3 But neither of those developments changes the ongoing dichotomy in overall economic performance: Strong leadership from exports and capital spending will continue to outweigh the drag from weak housing activity/home prices and from ongoing state and local government budget cuts, but those two headwinds may take one percentage point or more from growth this year. The upper tier is strong Reflecting the strength of global growth, exports have been a boost to US growth, but until recently a surge in imports has been an even bigger drag. Now, net exports seem likely to provide a major boost as the import surge reverses and import growth seems likely to be subdued. 4 In addition, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense. Together with the acceleration we expect in economic activity and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year. And we think improving fundamentals will boost capex outlays in 2012 despite the inevitable payback in outlays after the tax expensing provision expires.
Exhibit 2

still tight; indeed, in Q4 banks signaled tighter standards for mortgage lending. The ongoing issues around mortgage putbacks continue to keep origination criteria from loosening, although recent developments have greatly reduced the uncertainty associated with putbacks. Second, state and local government finances remain weak; faced with additional shortfalls, officials are likely to cut spending and employment somewhat further, especially as federal grants fade. In particular, some $26 billion in assistance for Medicaid will disappear in July. The good news is that revenues are starting to improve, which should somewhat mitigate that risk.
Exhibit 3

State and Local Job Losses Not Over Yet

4
State and Local Government Payrolls (YoY % Change)

Pent-Up Demand for Capex

1800
Billions of $, SAAR

-1 1800 1600 1400 1200 1000 800 600

Consumption of Private Fixed Capital

1600 1400 1200 1000 800 600 400 200 0

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

-2
01 02 03 04 05 06 07 08 09 10 11

Source: Bureau of Labor Statistics

Private Nonresidential Fixed Investment

400 200 0

Source: Bureau of Economic Analysis

While the lower tier is still fraught. In contrast, housing imbalances remain the most significant single downside risk; we expect a 6-11% decline in home prices this year, which will limit the supply of mortgage credit, restrain consumer net worth, and thus cap growth in consumer spending. Mortgage credit is
3

Shift in policy mix implies higher real rates. QE2 was aimed at reducing real yields to boost credit-sensitive demand; its impact was always likely to be small, given its limited scope. But anticipation of QE2 did reduce real yields and promote refinancing, and perhaps more importantly, it helped to break the policy logjam and uncertainty that plagued businesses and consumers during the spring and summer. In contrast, the shift to fiscal stimulus and the expectation of its success implies that real and nominal yields will continue to move somewhat higher. Partly for that reason, we expect that 10-year Treasury yields will move 50-75 bp higher, to 4%, over the course of 2011. Fed on hold through 2011 but markets likely will anticipate a move in 2012. In addition, expectations of a change in monetary policy may contribute to an increase in yields across the maturity spectrum. Our Fed call is unchanged: An inflection point in inflation and hearty growth will not be enough to trigger any change in monetary policy in 2011. Inflation will still be below the Feds mandate-consistent rate of 2% or slightly below, and the

For details on the stimulus package and its effects on growth, see Roadmap to See Trade Tailwinds: Coming Strongly in Q4, November 5, 2010 and Why is

Stronger, Sustainable Growth, December 14, 2010.

4

Our Estimate for Q4 GDP So High, December 15, 2010.

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January 7, 2011 US Economics

unemployment rate will still be far above an acceptable level. But by midyear, we think investors outlook for inflation will begin to change as the forces pushing inflation higher start to gain the upper hand and the infection point is clearly in sight. At that point, anticipation of the first step away from zero policy rates that we expect early in 2012 will begin to affect the front end of the yield curve. Six risks to the outlook: A matter of degree rather than of kind. Notwithstanding our more upbeat view for 2011, were acutely aware of the risks that still lurk. In varying degrees, weve tried to capture six in our baseline outlook. So the six risks that we see all represent an intensification of factors that we or our colleagues have flagged as challenges for economic or market performance. Two of these risks are domestic: Housing prices could decline by more than the 6-11% we and our housing research team expect. With seven new GOP governors coming into office, and both budget and funding pressures persisting, state and local government spending cuts could be more intense than we anticipate. 5 Four of the risks represent intensification of global challenges that are already in our baseline global view: more spillover from Europes sovereign crisis; more Chinese monetary tightening; a surge in crude quotes to $120 or more; and politics interfering with appropriate policy responses. 6 On the last risk, the looming battle over budget priorities seems likely to crystallize in a showdown over increasing the Federal debt ceiling, which could prove disruptive to financial markets. 7

agreement on key inflation determinants, but not so much the model that links them to inflation. 8 Most models include three key elements: a measure of inflation expectations, a gauge of slack in the economy, and factors that pass through to underlying inflation, like changes in energy or import prices. But it appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished. The flattening of the so-called Phillips curve may mean that as slack increases, inflation may not fall as much today as it did in the past. 9 The key reason, in our view, is a long period of effective monetary policy. Lower and more stable inflation expectations likely have shifted the slack-inflation relationship down, rather than altered its slope. Indeed, studies show that inflation expectations will influence inflation, and in turn, that monetary policy anchors expectations 10 . Importantly, the inflation expectations link works both ways. Today, courtesy of the Feds efforts to prevent further disinflation, inflation expectations are edging higher. Measured by 5-year, 5-year inflation breakevens, inflation expectations have moved up to 2-3%. And survey-based measures are also edging up; in late December, median long-term inflation expectations in the University of Michigan canvass remained at 2.8%, and year-ahead inflation expectations rose to 3%. To be sure, such surveys are volatile and may be unreliable, as they are based on small samples, do not refer to any specific index, and encompass a wide dispersion of views across households. But directionally they are important to watch. Slack uncertainty. Our inability to measure economic slack and inflation expectations with any precision also adds to uncertainty about the inflation outlook. Measures of slack, like the output gap, are unobserved, and the unemployment rate

Over the 30 years since the Fed held a first conference on inflation modeling,

Reviewing Inflation Fundamentals

We think the Phillips curve has flattened. There is broad
5

the workhorse markup over cost model has proven increasingly less reliable, courtesy of good monetary policy, globalization, and changes in firm pricing behavior. Indeed, our analysis suggests that firms have for two decades priced to market, setting prices based on conditions of demand and supply in global product markets, rather than marking up over costs. See Inflation Model Uncertainty, June 2, 2005.
9

See Oliver Chang, Vishwanath Tirupattur, and James Egan, A Little Credit,

Please, November 17, 2010, and Michael Zezas, Muni Outlook: Risk Redefined, December 9, 2010.
6

See Global Forecast Snapshots: 2011 Outlook: Rebalancing, Reflation and

The price-to-market model may also help explain this phenomenon, as

Reconciliation, December 8, 2010; Elga Bartsch and Daniele Antonucci, Fast Track or Slow Motion to Fiscal Federation? December 17, 2010; China Chartbook: From Goldilocks to Reflation, December 2010; 2011 Outlook: A Commodity Bull Market, December 10, 2010; Global Debates Playbook: 2011 Outlook Rebalancing Toward the Positive; December 14, 2010.
7

companies absorb costs, including currency swings, more readily into margins. See Dora Iakova, Flattening of the Phillips Cure: Implications for Monetary Policy, IMF Working Paper WP/07/76, April 2007.
10

See Brian Sack and Joel Prakken, Inflation Modeling, Macroeconomic

Advisers, December 13, 2006 and The Gravitational Pull Of Inflation Expectations, January 18, 2007.

See The Looming Debt Ceiling Showdown, January 6, 2011.

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January 7, 2011 US Economics

only measures slack in labor markets, not in product markets. 11 Fed Vice-Chairman Kohn recalled a few years ago that faulty estimates of potential output may have contributed to the monetary policy errors of the 1970s. 12 That may be relevant today: In our view, potential growth has declined, but only slightly to about 2%, with scant implications for inflation. Speed effects. Slack is narrowing, and inflation responds to changes in slack as well as to the level. The idea that speed effects or changes in slack as well as the level affect inflation is controversial and difficult to pin down empirically, although it makes intuitive sense. The notion is that a trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses and consumers outlook for the factors that drive inflation. It may be reinforced by the fact that cyclically-sensitive prices, like those for food and energy or other commodities, will rise in recovery. 13 Consequently, such effects are strongest for wholesale or producer prices, but in turn, we believe that they matter for consumer prices as well. 14 15 And they appear to matter in rental markets: Vacancy rates
11

remain high, but they are declining significantly. As a result, nationwide rents reported by Axiometrics have risen by 4.7% over the year ended in November.

Many base their inflation forecasts on the idea that economic slack is even

larger than measured by the CBO, and that the unemployment rate will stay very high even with hearty growth. In turn, such forecasts rely on a tight, Okuns Law connection between product and labor markets, which suggests that potential growth is around 3%. In contrast, we think that Okuns Law relationships have changed, and that the unemployment rate is likely to decline more quickly than consensus.
12 13

See Monetary Policy and Uncertainty, December 1, 2006. See John M. Roberts and Norman J. Morin, Is Hysteresis Important for U.S.

Unemployment? Board of Governors of the Federal Reserve System, FEDS Paper 1999-56, December 1999.
14

Researchers at central banks have also attempted to measure the effects of

changes in economic activity and therefore of changes in slack on underlying inflation using factor models. One such is continuously updated as part of the forecasting process at the Federal Reserve Bank of New York. In the longer term, of course, such speed effects dwindle to zero as short- and longer-term forecasts converge. But their dynamics in recovery typically have pointed to underlying inflation rates slightly higher than the FOMCs central tendency projections of core inflation measured by the PCEPI. For the methodology, see Marlene Amstad and Simon Potter, Real Time Underlying Inflation Gauges for Monetary Policymakers, Federal Reserve Bank of New York Staff Report 420, December 2009.
15

We estimated a simple Phillips curve relationship that incorporates speed

effects, as follows:

crude oil prices; and Pag is the percentage change in prices received by where P is core CPI inflation; GAP is the unemployment rate less the nonaccelerating inflation unemployment rate as measured by CBO; GAP is the change in that gap, or the speed effect term; Poil is the percentage change in farmers. The results do not represent conclusive evidence, but they indicate an important and statistically significant link between inflation and the change in slack.

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January 7, 2011 US Economics

US Economic and Interest Rate Forecast

Real GDP and Related Items, 2010E-2012E
Year over Year 2010E Real GDP Final Sales+ Personal Consumption Expenditures Business Fixed Investment -- Structures -- Equipment Residential Investment Exports Imports Federal Government State & Local Government Business Indicators++ Net Exports of Goods & Services Current Account as a % of GDP Change in Real Nonfarm Inventories Housing Starts (Thous) Light Vehicle Sales (Millions) Industrial Production (Pct Chg) Civilian Unemployment Rate (Percent) After-Tax "Economic" Profits** -- Percent Change from Prior Year After-Tax "Book" Profits -- Percent Change from Prior Year Real Disposable Personal Income (Pct Chg) Personal Saving Rate Prices and Costs (Percent Change) GDP Chain Price Index Consumer Price Index CPI ex Food & Energy PCEPI ex Food & Energy Market-Based PCEPI ex Food & Energy Producer Price Index Compensation Per Hour Productivity Unit Labor Costs 2.9 1.4 1.7 5.4 -14.2 15.0 -3.2 12.0 13.0 5.0 -1.3 -$424.9 -3.3 68.1 585 11.5 5.6 9.6 2011E 3.6 3.7 3.0 9.2 0.5 12.4 -1.8 8.9 5.1 3.8 0.9 -$383.7 -3.1 66.0 561 13.1 6.4 9.0 2012E 3.5 3.2 2.6 8.2 3.6 9.8 4.4 6.9 5.2 2.3 1.9 -$372.2 -3.4 105.2 635 13.4 5.9 8.1 4th Qtr/4th Qtr Percent Change 2010E 3.1 2.3 2.6 9.4 -6.1 16.1 -5.5 10.1 12.4 5.7 -0.8 2011E 4.0 3.8 3.0 11.6 3.0 14.8 2.4 7.6 5.7 2.5 1.4 2012E 3.2 3.0 2.3 5.4 3.3 6.1 4.5 7.1 4.1 2.2 2.2 Percent Change from Prior Quarter* 3Q10A 2.6 0.9 2.4 10.0 -3.5 15.4 -27.3 6.8 16.8 8.8 0.7 -$505.0 -3.5 116.6 588 11.6 5.9 9.6 4Q10E 4.3 6.3 3.9 3.0 -1.4 4.6 -0.4 13.1 -8.0 3.3 -0.5 -$407.4 -3.2 58.3 531 12.3 2.1 9.6 1Q11E 3.3 3.8 2.7 6.2 -1.0 8.9 -1.2 8.5 1.0 2.8 1.2 -$376.8 -3.0 41.7 531 12.8 8.1 9.4 2Q11E 4.2 3.7 3.1 11.4 3.0 14.4 2.2 8.5 6.8 2.3 1.4 -$376.1 -3.1 57.9 551 13.0 7.8 9.1 3Q11E 4.3 3.8 3.3 13.4 5.0 16.4 3.6 7.7 7.9 2.5 1.4 -$384.5 -3.2 73.8 571 13.3 7.4 8.8 4Q11E 4.3 3.8 3.0 15.8 5.0 19.6 5.2 5.8 7.2 2.5 1.4 -$397.3 -3.3 90.6 591 13.4 6.1 8.6 1Q12E 2.9 2.8 2.2 3.0 2.0 3.3 4.3 6.8 3.4 2.5 2.0 -$385.7 -3.3 95.5 606 13.2 5.3 8.4 2Q12E 3.2 3.1 2.4 6.0 3.0 7.0 4.6 6.6 4.1 2.1 2.2 -$378.2 -3.4 99.5 626 13.4 5.3 8.2

Forecast Date: January 7, 2011

$1,239.0 $1,449.6 $1,431.9 23.5 17.0 -1.2 $1,437.5 $1,664.4 $1,658.4 35.4 15.8 -0.4 1.4 3.4 2.4 5.8 6.0 5.5 0.9 1.7 1.0 1.3 1.1 4.2 2.0 3.5 -1.5 1.3 2.3 1.4 1.1 1.1 3.8 3.1 2.6 0.6 1.8 2.3 2.1 1.9 1.8 3.6 3.5 3.0 0.5 1.3 1.2 0.7 0.8 0.8 3.8 1.8 1.7 0.1 1.6 2.5 1.8 1.5 1.5 3.8 3.4 3.3 0.1 1.8 2.3 2.3 2.1 2.0 3.5 3.5 2.6 0.8

$1,210.7 $1,373.4 $1,402.9 $1,438.6 $1,464.8 $1,491.9 $1,398.1 $1,420.2 16.2 24.9 20.6 19.0 21.0 8.6 -0.3 -1.3 $1,416.3 $1,581.3 $1,613.0 $1,651.7 $1,681.2 $1,711.5 $1,620.3 $1,645.2 27.2 28.6 17.8 19.5 18.7 8.2 0.5 -0.4 0.9 1.6 6.8 2.0 2.8 2.9 1.0 2.9 5.9 5.4 6.4 6.0 5.8 5.9 5.3 5.5 2.1 1.5 1.2 0.5 1.1 0.7 2.2 2.3 -0.1 0.2 2.7 0.6 0.5 0.2 6.9 3.0 2.4 0.5 1.0 3.5 1.7 1.3 1.3 4.7 3.3 2.4 0.9 1.7 2.3 1.7 1.4 1.4 3.3 3.4 3.3 0.1 1.8 2.2 1.8 1.6 1.5 3.6 3.4 3.7 -0.3 1.9 2.2 1.9 1.8 1.7 3.6 3.5 3.7 -0.2 1.9 2.3 2.2 2.0 1.9 3.7 3.5 2.4 1.1 1.8 2.3 2.2 2.0 1.9 3.6 3.5 2.6 0.8

*Annualized percent change from prior period, unless noted **Including inventory valuation & capital consumption adjustments E = Morgan Stanley Research Estimates, A = Actual

+GDP less inventory change ++Billions of dollars; real in billions of chain-type 2005 dollars

Interest Rate Outlook

Date* January 07, 2011 11Q1 11Q2 11Q3 11Q4 12Q1 12Q2 12Q3 12Q4 Fed Funds Target 0.13 0.13 0.13 0.13 0.13 0.50 1.25 2.00 2.50 Prime 3.25 3.25 3.25 3.25 3.25 3.50 4.25 5.00 5.50 LIBOR 3-Mo. 0.30 0.30 0.30 0.30 0.40 0.85 1.65 2.40 2.85 3-Mo. 0.14 0.15 0.15 0.15 0.20 0.60 1.40 2.15 2.60 6-Mo. 0.18 0.20 0.20 0.20 0.30 0.80 1.65 2.40 2.85 Treasury Yield Curve 2-Yr. 5-Yr. 0.59 1.96 0.65 0.75 1.00 1.25 1.75 2.25 2.65 3.00 2.03 2.13 2.38 2.63 2.95 3.28 3.35 3.53 10-Yr. 3.32 3.40 3.50 3.75 4.00 4.25 4.50 4.25 4.25 30-Yr. 4.48 4.60 4.72 5.00 5.25 5.45 5.50 5.00 4.75

*All forecast values are for the end of the designated period.

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January 7, 2011 US Economics

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