2011 Might Be a Breakout Year for the U.S. Economy

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The U.S. economy's recovery from the 2007-2009 recession has been rather anemic by historical standards. During the first four quarters of the recovery (from the third quarter of 2009 to the third quarter of 2010), real GDP increased by only about 3.3 percent, which is roughly half as much as the typical post-WW II recovery. Most disappointingly, private job gains remain exceptionally weak, and the unemployment rate was nearly 10.0 percent at the end of 2010. Most forecasters expect to see only a grudgingly slow decline in the unemployment rate in 2011. In many ways, the lack of job growth in the current recovery parallels the exceedingly weak job gains that occurred following the 1991-1992 and 2001 recessions. Accordingly, the structure of the U.S. labor market in the immediate aftermath of the recession may be changing in important ways that are not yet understood. At the same time, many in the business and financial communities have regularly cited uncertainty about the economic, political, and regulatory landscape as a reason for their reluctance to hire, invest, and lend.

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Despite these hurdles, business conditions are on the mend, and economic activity is expanding at a modest pace. Importantly, the U.S. economy's momentum appears to have accelerated in the fourth quarter of 2010. Eventually, as the economy gathers steam, the layers of uncertainty plaguing firms, households, and financial markets will ebb, paving the way for rising levels of employment and real incomes. The temporary extensions of the 2001 and 2003 tax cuts and another year of extended unemployment insurance benefits, as well as a temporary reduction in the payroll tax and a business investment tax credit, should also give the economy a boost--if only temporarily and at the expense of increasing the size of the already large federal budget deficit. Importantly, though, the recovery will be assisted by the economy's natural recuperative forces, improvements in financial conditions, and an expansion of the global economy.

On balance, then, the U.S. economy's growth rate should exceed its long-run average (about 3.0 percent) in 2011, with continued low and stable inflation. If growth surprises to the upside, then the unemployment rate will fall by more than expected; if not, it will continue to drift downward at a turgid pace. But, there are risks, which include the possibility of spending cuts and higher taxes to reduce yawning budget deficits at the federal, state, and local levels. In addition, because of the size of the Federal Reserve's balance sheet and rising commodity prices, there is a budding amount of disagreement among forecasters about the direction of inflation over the next few years. For 2011, though, most forecasters continue to see relatively low and stable inflation rates. In the remainder of this article, I will focus on some of the more important details about the outlook for the U.S. economy in 2011.

Hurdles Become Lower

Construction remains the economy's soft spot. In a typical economic recovery, housing construction is a key driver of growth. Because of the housing bust and the large number of foreclosures, there is a sizable inventory of houses that limits the need for new construction. This excess supply also helps to put downward pressure on house prices. An additional factor that weakened prices significantly further over the second half of 2010 was the expiration of the homebuyer's tax credit, which triggered an appreciable pullback in home sales. However, home sales and new housing starts have recently stabilize-albeit at a low level--and forecasters expect housing construction to contribute positively to real GDP growth in 2011 for the first time in six years. As housing begins to recover, prices should also begin to stabilize. However, the probability of any significant increase in home prices nationally in 2011 must be considered rather small. …