Annual Economic Outlook 2011

Executive Summary: Charting the New Course 
Every economic recovery has a different story, with its own heroes and villains, twists and turns
and a lengthy list of surprises—both in the overall pace of growth and its component parts.
Meanwhile, the challenge to decision-makers, in both private and public sectors, is to adapt to
this different story while retaining the same institutional goals. For the year ahead, we anticipate
a change in the composition of growth with less inventory gains and federal spending and greater
support for growth from final private demand. State and local government spending is the one
sector we expect to remain a drag on economic expansion throughout 2011. Inflation will remain
moderate and short-term interest rates low, but longer-term interest rates will rise in anticipation
that the Federal Reserve will succeed in raising inflation.

There is no double-dip or V-shaped recovery. Every economic recovery is a new normal—the
1960s were very different than the 1970s, the 1970s were very different than the 1980s, and so
on... The new normal is not anything new—it happens every economic cycle. In contrast, what we
see is what we have to deal with: moderate economic growth, fiscal deficits, low inflation and a
central bank that is going to explore new paths of monetary policy. Finally, we are faced with the
legacy of decisions made, or often postponed, over the last forty years. We do not start with a
clean slate. Our decisions today are path dependent; they reflect the legacy of prior decisions we
made or avoided.


Economic Fundamentals: Sustained Growth
For the year ahead, sustained growth will reflect the influence of continued improvements in
consumer and business investment as well as  the turnaround in residential and commercial
construction. Consumer spending, representing the majority of aggregate demand in the
economy, will benefit from a streak of positive, yes positive, employment reports by mid-2011,
lower unemployment rates and rising real personal income. Spending will not be as strong as in
the past corresponding phases of earlier recoveries, but will be positive nonetheless. Personal
income is up 4.1 percent year-over-year compared to a decline of 2.1 percent last year at this time.
Personal income less transfers was down five percent last year, but is now up two percent this
year. In part, this reflects a year-to-date gain of over one million jobs as well as gains in
employment in many of the higher paid professional services fields. Positive momentum in
consumer spending would be further boosted by the extension of the Bush-era tax cuts and the
two percent reduction in the payroll tax.

Meanwhile, the saving rate is around six percent while consumers continue to deleverage their
credit exposure. Slower consumer spending growth and deleveraging are reflected in the decline
in home-equity loans, which draw down net home asset values to spend as income today.
Households are right-sizing their debt load and this behavior will likely persist for several more


years for many households. The financial obligations ratio, as calculated by the Federal Reserve,
measures the ratio of consumer interest expense  relative to income. In the second quarter, the
ratio stood at 15.52 percent compared to 16.52 percent a year ago. For 2011, we estimate
consumer spending to pick up 2.4 percent compared to 1.8 percent in 2010 and down 1.2 percent
in 2009.

Equipment and software spending and federal government spending continue to support positive
growth momentum. Solid equipment and software spending has a second effect that is of interest:
productivity gains from better or more equipment are usually associated with better real wages
and corporate profits. Both these effects are positive for the recovery in the long-term.

Growth in non-defense capital goods orders ex-aircraft has slowed in recent months to a 15.35
percent pace compared to 21.03  percent  year-over-year  pace  last  April.  This  slowdown  is
consistent with the moderation we have witnessed in the Institute for Supply Management survey
as well as industrial production. In part, this slowdown reflects the end of the inventory build-up
during the first three quarters of 2010, which made up for the sharp cuts in production and
inventories in 2009. Continued strength in capital goods orders reflects the competitiveness
imperative for global competition. With Asian economic growth so strong, U.S. firms have the
incentive to capture or at least retain their global market share. For the year ahead, we anticipate
growth in equipment and software spending of 15.5 percent compared to 15.7 percent this year.

In 2011, we expect trends in commercial and residential real estate, two areas of the economy that
have been significant drags on headline growth, to turn positive for the first time since the
beginning of the recession. Despite being near record lows, housing starts will begin to gain
momentum breaking 700,000 in 2011. The turnaround in housing is largely attributable to gains
in employment, consumer income, as well as favorable demographic trends. Meanwhile, from the
financing perspective, mortgage rates remain low and housing affordability remains high. Though
broadly positive, these trends do not reflect a return to the boom years, which were characterized
by excessive liquidity and perverse incentives.

Commercial real estate should begin to contribute to growth by the second half of 2011. Operating
fundamentals for all major property types are either improving or showing signs of stabilizing.
Leasing has picked up, rents are rising or stabilizing and sales have increased. Demand for high
quality properties in choice locations remains exceptionally strong, which has helped pull prices
higher for non-distressed deals. There are still plenty of troubled projects that need to be disposed
of, however, and prices for distressed projects  are likely to fall further once lenders become
committed to cleansing their portfolios.


place, including an increase in inquiries to  commercial realty firms and improvement in the
Architectural Billings Index.  The apartment sector now appears to be in full recovery. In the
industrial space, net absorptions are outpacing completions for a second consecutive quarter.
Inflation remains well below the level consistent with the Federal Reserve’s dual mandate, which
has prompted a series of unconventional monetary policies such as quantitative easing. Concerns
about rapid inflation in the near-term are overstated, but the long-term picture is more
complicated given the massive amount of liquidity in the banking system. Our expectation is that
“core” inflation will rise one percent in the year ahead. A by-product of the Fed’s massive
expansion of the money supply was a depreciation of the dollar and a surge in dollardenominated commodity prices. Due to slack consumer demand, producers have been unable to
pass these costs on to their customers, resulting  in a moderation in corporate profit growth. We
expect gains of 6.8 percent for pre-tax profits in 2011 compared to 27.9 percent this year.

Policy and Politics 
The results of November’s midterm elections, and the administration’s reaction to them, will
dictate the framework of economic policy going forward. Both the Republican controlled House
and the Democratic Senate saw broad gains by fiscally conservative candidates. Our expectation is
that these results will translate into further tax cuts, restrained spending, and less support for
state and local governments. Despite mounting criticism of the Federal Reserve’s asset purchasing
program, we believe the Fed will complete its latest round of Treasury purchases, especially given
the slow recovery in employment and the continuing risk of deflation in the near-term.

The recently announced extension of the Bush-era tax cuts is a welcome sign that Washington still
has the capacity to act quickly and compromise on key economic issues. The extension of the tax
cuts for two years does a great deal to reduce uncertainty for the consumer, businesses, and the
financial markets. Coupled with an extension of emergency unemployment benefits, the tax cuts
will boost personal income and spending in  the year ahead, spurring continued forward
momentum for the consumer. During 2010, the majority of growth was contributed by inventory
building and capital investment by firms, but we expect these trends to slow as businesses pass
the torch to consumers in the year ahead. The extension of the Bush-era tax cuts will provide
further positive momentum to the current recovery.

Not a Clean Slate 
In our outlook this year, we have chosen to examine the path dependence issue that defines our
expectations for the economy and the options for private and public decision-makers in their
strategic planning for the year ahead. This economic recovery begins with four main challenges.
First, unconventional monetary policy tools have been employed on a massive scale in an attempt
to prevent a deflationary spiral, a process responsible for deep recessions in the U.S. in the 1930s
and Japan in the 1990s. Second, we are limited by the policy decisions of the past forty years,
which have levered our government, both federal and local, to unsustainable levels. Several of our
most populous and politically important states,  such as California and Florida, are among the
worst examples of these troubling trends. Third, both the public and private sector fueled a
bubble that blinded households and investors alike to the true value of assets in the housing
market. Today, with continued government intervention and oversupply, the market still cannot
indicate the true values of real estate. Finally, the pace of globalization continues to present
challenges to economic actors due to path dependence.

Despite the challenges that face us, we have put the most arduous portion of our journey behind
us. We have turned the corner and emerged from the deepest recession in half a century, but the
road ahead looks to be a long, uphill climb. This recession’s legacy of damaged consumer balance
sheets, experimental monetary policy, and fiscal imbalances will add considerable mileage to our
journey towards renewed economic vitality; however, we believe the American economy will
continue growing mile by mile, quarter by quarter.
-Wells Fargo Economics Group
www.wellsfargo.com/
Full report: Annual Economic Outlook 2011