U.S. outlook for 2013.

• Author: Witte, Willard E.

The U.S. economy in 2012 managed to underachieve even relative to our unambitious expectations. A year ago, we thought growth might be a little above 2.5 percent for the year, which would have been a modest improvement from the 2 percent achieved in 2011.

Instead, as shown in Figure 1, through three quarters the economy has expanded at an annual rate of only 1.7 percent. Job creation has been equally disappointing. We anticipated job growth would average close to 170,000 per month. Through October, the actual outcome has been just 157,000 (see Figure 2). The unemployment rate, on the other hand, has come down more than we anticipated--to 7.9 percent in October. A significant drop in the labor force participation rate explains this apparent contradiction. Individuals who stop looking for work (and thus drop out of the labor force) are no longer considered to be unemployed. If such discouraged workers were included, the unemployment rate would be about 1.5 percent higher. In addition, another 5 percent of the labor force who are employed part-time would rather have a full-time job.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

Explanations for this depressing situation are not entirely convincing, but a list of usual suspects is available. Part of the problem lies abroad: Europe is making little progress in dealing with its sovereign debt problems, and China is clearly transitioning to a slower growth path. Part of the problem is domestic: The winding down of the stimulus package implied an inevitable shrinkage in the government sector. 2012 will be the third straight year in which government spending on goods and services (not including transfers such as Social Security and Medicare) has declined. The inability of the federal government to reach any firm decisions about tax policy and its budget has created great uncertainty. This uncertainty has left businesses unwilling to hire or invest.

These headwinds are unlikely to disappear in 2013. The problems facing both Europe and China are chronic. The domestic political situation was not clarified by the election, and divided government is still likely to thwart dramatic progress. As a result, we expect that 2013 will be generally similar to 2012: unacceptably slow growth without much progress in the labor market.

The Forecast

* We expect output to grow about 2.5 percent on a fourth-quarter to fourth-quarter basis. This will be better than 2012, due to somewhat better household spending, significant...