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Monday, March 07, 2011

Downside Risks

by Calculated Risk on 3/07/2011 12:40:00 PM

We continue to be reminded of the downside risks to economic growth this year: higher oil prices and the potential for a supply shock, the European financial crisis, state and local government fiscal issues, Federal government budget issues, and the two sides of the inflation coin (inflation increases or policymakers overreact).

• U.S. oil prices were near $107 per barrel this morning before declining slightly to $105. I think this is the key risk to U.S. economic growth in the short term.

Not only is the situation in Libya looking more and more like a prolonged civil war, but the unrest may spread to Bahrain and Saudi Arabia (March 11th is the "Day of Rage" in Saudi).

• The European financial crisis has been on the back burner, but yields are still elevated and there are key Euro Zone meetings scheduled in March - including a special eurozone debt crisis summit scheduled for Friday, March 11th. Ireland is asking to renegotiate the terms of their bailout, Greece debt was downgraded this morning, and Portugal is probably next in line. And the European Banking Authority has now launched the next round of bank stress tests.

I expect this to be front page news again soon.

• State and local governments reduced employment by 30,000 in February, and several state budgets are in the news, especially the ongoing Wisconsin political battles. I expect state and local government cutbacks to continue all year.

• On the Federal government, some drag from fiscal policy was expected due to some spending cuts, and also from the decline in spending from the 2009 fiscal stimulus package. However the "debt ceiling" debate is just political grandstanding, but it is possible that more cuts will be enacted this year - slowing growth in 2011.

• Inflation is a two sided coin: if inflation increases in the U.S., then the Fed might move quicker on tightening policy (I think core inflation will remain below the Fed's target all year), and it is possible policymakers will overreact to price increases in commodities and raise rates too soon. However if oil prices continue to increase, then QE3 is more likely:

"If [the rising price of oil] plays through to the broad economy in a way that portends a recession, I would take a position we would respond with more accommodation," [Atlanta Fed President Dennis Lockhart said this morning].
These are all risks to 2011 economic growth. For now I'm sticking with my over forecast of 3.5% to 4.0% real GDP growth in 2011, but I'm watching all of these issues closely.