The President spoke to the Nation for just the second time from the Oval Office, on Tuesday Aug 31, 2010, to announce the end of America’s combat role in Iraq. President Obama said: "Unfortunately, over the last decade, we’ve not done what’s necessary to shore up the foundations of our own prosperity. We spent a trillion dollars at war, often financed by borrowing from overseas. This, in turn, has short-changed investments in our own people, and contributed to record deficits. For too long, we have put off tough decisions on everything from our manufacturing base to our energy policy to education reform. As a result, too many middle-class families find themselves working harder for less, while our nation’s long-term competitiveness is put at risk."

The US economic forecast for the second-half of 2010 was revised down on Tuesday by economists at US investment bank Morgan Stanley. Also on Tuesday, bank lending was reported to have fallen in the second quarter (Q2) and this year, US agriculture exports will be the second-highest ever. 

The Federal Deposit Insurance Corp, the Depression-era agency which guarantees bank deposits, said Tuesday that 829 of the nation's 7,800 banks were on its "problem list" at the end of June, up from 775 at the end of the first quarter. Already 118 banks have failed this year, well ahead of the rate set last year when 140 were seized by regulators.

Lending by US banks also continues to be weak; loan balances across all major loan categories fell during the second quarter, and total loan and lease balances fell 1.3%. Total assets for the industry fell 1% to $13.2trn during the quarter.

FDIC chairman Sheila Bair said banks are beginning to ease their lending standards for some types of loans but warned that "lending will not pick up until businesses and consumers gain the confidence they need to hire and spend."

The US Department of Agriculture said Tuesday that American farmers will ship $107.5bn in agricultural products overseas in the fiscal year that ends Sept. 30th - - the second-highest amount ever, behind the record $115.3bn in exports in 2008, when commodity prices spiked as global demand for agricultural products was boosted by fast-growing economies in the developing world.

Next year, exports are expected to total $113bn. Tom Vilsack, the secretary of agriculture, said exports of grains and meats were leading the rebound. He called the new estimates “very encouraging.”

From above- to below-trend growth.  MS is downgrading the outlook for H2 US real growth to annualised rates in the range 2-2.5% from 3-3.5% previously.  This downgrade from above-trend to below-trend H2 growth has important implications for forecasts of the unemployment rate, inflation and monetary policy.  If policy does respond to this near-term weakness, the outlook in 2011 could be better than the MS current 3% baseline.

More slack, lower inflation. Economists Richard Berner, David Greenlaw and Ted Wieseman say slack in the economy likely will widen slightly in this below-trend outlook, implying a slower rise in inflation.  With Q2 growth now at just 1.6%, the  new H2 forecast implies growth of 2% for the last three quarters of 2010 - - below the 2.5% that the economists think represents the trend. They say such tepid growth implies a higher unemployment rate at year-end, perhaps 9.7% rather than the 9.4% that was assumed.  Other measures of slack may either stall or perhaps widen as well.  For example, with housing demand weaker than expected, there is a risk that vacancy rates will rise again.

The implications for inflation are important: While MS still think core inflation has bottomed, more slack will mean that ‘speed' effects - - the effect of shrinking slack on pricing and inflation - - will fade, and the rise from today's 0.9% CPI likely will be even slower, keeping inflation below the Fed's comfort zone for longer.   

Debating whether another housing bailout is needed, with Robert Shiller, Yale School of Management; James Altucher, Formula Capital; Michael Ozanian, Forbes National:

The Fed shifts to an easing bias.  Against this backdrop, Fed chairman Bernanke on Friday clearly indicated that the Fed is prepared to ease monetary policy further, if appropriate.  The key paragraph from his speech follows:

"We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool."

The economists say the new outlook and the downside risks associated with it require the Fed seriously to consider such additional easing.  But the odds of such action are still far from certain.  That's because there are still hurdles to actually doing something as opposed to thinking about it. 

Three hurdles to action.  First, despite the weaker data so far, easing is a big step.  There is a possibility that recent data are just a head fake.  The economists ask what would be the costs of taking out deflation insurance that turns out to be unnecessary?  In their view, the real risks in easing aren't so much that it would make policy too accommodative in the near term.  Rather, they stem from the potential confusion among market participants about policy targets and tools. 

In that regard, and second, officials must decide whether they need to articulate more fully the model or framework for additional easing, including spelling out intermediate yardsticks for gauging success and more specific ultimate goals.  In that context, the economists say it's hardly surprising that market participants are looking for more clarity. 

They say specifying yardsticks to gauge policy success might be helpful in a world of zero policy rates.  For example, if additional easing - - through quantitative easing (QE) or some other means - - were aimed at bringing down real rates, will simply announcing additional purchases of securities make clear the Fed's intentions?  Or might the Fed specify a nominal cap on interest rates as an intermediate target?  Regarding specific ultimate goals, might the Fed specify an explicit inflation target to guide the path of policy and the exit strategy?  Careful thought is required before acting.

Third, despite the easing bias, the FOMC (rate-setting Federal Open Market Committee) is not unanimous either about the need for additional easing or how to implement it.  Chairman Bernanke must sell the doubters on the need and the benefits.  More dovish members likely believe that QE (pumping money into the economy by buying Treasury securities) is working but that more large-scale asset purchases (LSAPs) are needed.  Skeptics still doubt the efficacy of QE and are worried about the exit strategy from an even larger balance sheet.  Others are concerned about the potential for persistently low interest rates to create financial imbalances. 

Benefits and costs of three tools to implement easing.  Chairman Bernanke discussed three tools that the Fed could use to implement ease: Ramped-up quantitative easing, stronger language committing the Fed to accommodative policy, or cutting the rate paid on excess reserves (IOER).  He ruled out suggestions to raise the Fed's inflation target.

These three steps all have costs and benefits, but Bernanke indicated a clear preference for additional QE.  Changing communications strategy - - perhaps along the lines of the Bank of Canada's commitment to keep rates unchanged until Q2 2010, announced in April 2009, or the Bank of Japan's to sustain ZIRP until inflation turned positive, announced in 2001 - - would be difficult for the Fed to implement "with sufficient precision and clarity".  And investors already "are not anticipating any significant policy tightening by the Federal Reserve for quite some time".

Why has the economy weakened?  The economists say there's no mistaking the weakness of incoming US data, from slowing employment gains and bigger-than-expected ‘paybacks' in home sales to a sharper-than-expected decline in capex (capital expenditure) bookings and shipments. 

However, unless its known why the economy has weakened, there is trouble assessing the future.  In the MS view, the main culprit for weakness relative to its forecast is waning or less-than-expected support from global growth, which the economists had expected to offset a slower pace of domestic demand.  Net exports have been a drag on output this year, and even a positive swing in H2 won't make up for the Q2 downdraft, when surging imports substituted for US output.  On the export side, global domestic demand growth among US trading partners also seems to be weaker than expected.

Other factors likely also played a role.  Congress did temporarily terminate unemployment insurance (UI) benefits and aid to the states in May and June; that may have created as much as $60bn in fiscal drag, even though these programs have been reinstated.  In addition, uncertainty about the direction of tax and other policies may have caused businesses to hesitate.  Beyond the weakness in incoming data, the battle in Congress over reinstating and finding ‘pay-fors' for UI probably underscored the perception that policy is handcuffed.  The gridlock in Washington over near-term and longer-term fiscal policy goals may also have created the perception that the Administration and Congress will not and cannot respond to weakness in the economy. 

Implications for 2011.  Given that diagnosis, MS doesn't think this slowdown will last beyond H2, much less morph into a downturn.  In his Jackson Hole speech last Friday, Chairman Bernanke seemed to agree that the current economic weakness does not augur a weaker outlook for 2011.  The economists agree.  Among the reasons: Downside risks probably will prompt policy actions, balance sheet repair will be more advanced, and the economists expect net exports to improve in H2 2010 and into 2011.  In fact, they see no reason to downgrade 2011 and possible reasons to upgrade, especially if policy turns more stimulative.