Q&A with Jan Hatzius, Chief U.S. Economist, Goldman Sachs

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\"TheWe talked with the Goldman Sachs Chief U.S. Economist, who is responsible for setting the firm’s U.S. economic and interest rate outlook, about his forecast for economic growth and employment, the likelihood of another economic decline, and the future role of the U.S. in the world economy.

Q. What are your expectations for the economy in the next two years?

A. We expect real GDP growth to be 3.25% in 2011 and 3.8% for 2012, roughly a percentage point above the economy’s underlying trend. It means that some of the excess capacity that built up from 2007 to 2009, especially in the labor market, is starting to be filled in. We estimate consumer spending will grow 3.5% in 2011 and 2012, caused by growth in personal income and employment, which underpins spending. The unemployment rate should come down gradually. It’s at around 9% now, and we have it declining to about 8% by the end of 2012.

Q. So unemployment will drop by only a percentage point in the next year and a half?

A. Yes, we have it falling slowly, because economic growth will be slow compared to the period after the previous two recessions. In 1975-76 and 1983-84, the years after the last two really deep recessions, the economy grew 6%, not 3.5-4%. However, the recovery is more visible in the labor market than it had been, which should underpin personal consumption. The last few months of labor increases have not been representative because of a number of special factors. One factor is a steep decline in labor force participation, which will come back when news of the improving job market gets more people looking for jobs. We think full employment, which we define as 5.5%, will take until 2015 to achieve, however.

Q. Isn’t a lot of the increase in personal income going toward paying off consumer debt?

A. Demand is coming back gradually, as the household sector particularly has made progress deleveraging. If you look at the ratio of household debt service (interest and principle) to disposable income, it’s back to pre-debt-boom levels. Some of that has been achieved through subdued issuance of new debt, some through defaults, and some through interest rate reduction and mortgage refinancing. All are part of the adjustment process, which has progressed to the point where the growth in spending is going to be firmer than where it was the last couple of years.

Q. In the face of inflation in non-discretionary areas like gas and food, isn’t it true that consumers are likely to steal share of wallet from discretionary areas to help pay for necessities?

A. The increase in energy prices in particular, and foodprices to some extent, are likely to be a drag on consumer spending growth. If you had less inflation in those areas, you’d have more consumer spending growth, but for now, we think the hit is manageable. We think rising oil prices may take a half percentage point or so off consumer spending growth in the next year. Oil is a moderate downside risk, but has already been figured into our forecasts – we’ve been working with $110 per barrel oil for 2012 on average for the last few months. If we were to see further increases from here, it would be a reason to take the forecast down a little.

Q. With respect to the apparel and general merchandise categories that many of our retailers are involved in, many are estimating 10-20% increases in labor and raw material costs like cotton. Retailers and wholesalers claim they’re going to raise prices, which many people contend, as I do, will not stick. Your thoughts on this?

A. So far, we’re not really seeing much apparel price inflation. As far as particular apparel pricing strategies, I’ll have to defer to your expertise on that. Input prices are higher, but the likelihood of passing that through, given the amount of excess capacity, is low. Most of the increase in input prices will be absorbed. Labor costs in the economy are very well-behaved; we’re not seeing any wage inflation at all.

Q. Is there any scenario in which we’ll see widespread deflation?

A. If we were to see another downturn in the economy,which I don’t expect but I can’t rule out with certainty of course, given where unemployment and inflation are, the latter below the Fed’s target, it would take an even weaker economic growth picture than we’re expecting. Ben Bernanke said that he feels the risk of deflation is negligible. I think it’s declined, and give it a 10% probability, but wouldn’t say it’s negligible.

Q. How, in the aggregate, does one measure supply/demand equilibrium in the retail market?

A. Economic statisticians don’t have a great idea about that.
It’s not measured by the government. The Fed measures capacity utilization in the industrial sector, but it’s tough to get a number for total retail square footage, and even if you had one, the number would be pretty meaningless, given the growth in online retailing.

Q. Let’s go back to the employment topic. You say the situation has improved. How many jobs are being created, and where is job growth happening?

A. You have different measures of employment, such as the Household Survey of Employment and the Payroll Survey, that at times have been inconsistent, but now are starting to converge and show a pretty convincing story of improvements in the employment market. Other measures, like surveys of hiring intention and online help-wanted ads, indicate that new job growth will continue. We estimate an average increase of 200K jobs added each month for the next several months.

Q. Where are the jobs coming from?

A. A disproportionate number — 20-30K per month — are in manufacturing. We see an increase across the board in manufacturing, particularly in machinery, technology, oil and gas, and industrial supplies.

Q. What about productivity – we hear all the time that labor productivity is increasing. Is that true, or are we just cutting costs, and working harder for the same wage? Is it impeding job growth?

A. Cost-cutting is always part of an increase in productivity– doing more with less. Productivity growth is 2-2.5%, and remains one of the bright spots of the recovery. It might be impeding job growth in the short term, but it also means that you are able to increase output with a given level of employment growth, which should result in increased employment eventually.

Q. There’s a rather vocal debate now over whether small or big business is the main contributor to job growth. How does the increase in employment break down between small and large companies?

A. Large companies are responsible for much of the employment growth so far. Small businesses are beginning to climb out of the deep trough they were in during the recession, but they’re still not in anything approaching robust growth. It may be that we’ll see some improvement, but they’re still facing pretty tight credit standards. Not only are they credit constrained, but also pretty concentrated in industries, like construction, retail and others that have not yet begun to recover to the extent that others have.

Q. What about the recession surprised you most?

A. The depth of it, the rapid pace of decline in output, and the extent of the negative feedback effects between the real economy and the financial sector. We did expect a sizable impact on house prices and consumption, but did not expect the large hit on the willingness and ability of financial markets to extend credit. How close the dominoes were standing together in the financial markets was a big surprise.

Q. What scenario will find the United States a dominant economic growth engine in the world for the next 25 years?

A. I think it is unlikely that the US will be the dominant economic growth engine of the world. I do think it will be the largest economy for the foreseeable future, but given that the US is at the frontier of technological developments, poorer economies – developing economies like China and others — are having a much easier time moving toward that frontier, and are likely to grow faster. There shouldn’t be anything surprising about that, and it’s not a bad thing – in fact it’s a good thing for other countries to have a chance to catch up. It shouldn’t make Americans feel badly about themselves, it’s just the natural order of things.

Jan Hatzius earned a Ph.D. in Economics from Oxford in 1995, and worked as a research fellow at the London School of Economics prior to joining Goldman Sachs in 1997 as an associate economist in the Frankfurt office. He moved to New York in 1999, and became a managing director in 2004. He has published widely on monetary and fiscal policy, the Goldman Sachs Financial Conditions Index, the housing market, inflation, corporate profits, consumption, and capital spending. Jan is frequently quoted in the financial press, such as the Economist, the Financial Times, and the Wall Street Journal, and writes a regular column on the US economy for the German daily Frankfurter Allgemeine Zeitung.



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