US Economics Analyst

Issue No: 11/28 July 15, 2011

FOR THOSE PERMISSIONED: Goldman Sachs Global ECS Research at https://360.gs.com

More Downgrades to Our Growth Forecasts

Following another week of weak economic data, we have cut our estimates for real GDP growth in the second and third quarter of 2011 to 1.5% and 2.5%, respectively, from 2% and 3.25%. Our forecasts for Q4 and 2012 are under review, but even excluding any further changes we now expect the unemployment rate to come down only modestly to 8% at the end of 2012. The main reason for the downgrade is that the high-frequency information on overall economic activity has continued to fall substantially short of our expectations. In particular, our bean count for secondquarter GDP has deteriorated further and our monthly Current Activity Indicator (CAI) is showing growth of just 1.3% in June. Some of this weakness is undoubtedly related to temporary factors, namely supply chain disruptions and (the temporary part of) the oil shock. But the slowdown of recent months goes well beyond this. One major concern is the anemic growth in domestic final sales of just % (annualized) in the first half of 2011. There is only one precedent in the postwar period for such weak demand growth outside the immediate vicinity of a recession. We have no hard information about final sales in Q3 yet, but Fridays preliminary consumer sentiment index for July from the University of Michigan fell to the lowest level since March 2009 (!) and is now back in territory normally associated with recession. Our forecast remains no fresh monetary easing from the Federal Reserve, but the probability has risen. In particular, Fed officials would undoubtedly ease if the economy returned to recessionnot our forecast, but clearly a possibility given the recent numbers.
Important disclosures appear at the back of this document.

Final Demand Was Exceptionally Weak in 2011H1

2-qtr annualized percent change 16 Real Domestic Final Sales 12 12 2-qtr annualized percent change 16

Jan Hatzius jan.hatzius@gs.com 212 902 0394 Zach Pandl zach.pandl@gs.com 212 902 3393 Alec Phillips alec.phillips@gs.com 202 637 3746 Sven Jari Stehn jari.stehn@gs.com 212 357 6224 Andrew Tilton andrew.tilton@gs.com 212 357 2619 Shuyan Wu shuyan.wu@gs.com 212 902 3053 Maria Acosta-Cruz maria.acosta-cruz@gs.com 212 902 6709

-4

-4

-8 47 52 57 62 67 72 77 82 87 92 97 02 07 Note: 2011Q2 is estimated from our GDP tracking. Source: BEA. GS Global ECS Research.

-8

Michigan Sentiment Consistent with Contraction in Final Sales

Percent change, year ago 7.5 Index 120 110 5.0 100 90 80 0.0 70 60 -2.5 Real Domestic Final Sales (lef t) University of Michigan Consumer Sentiment (right) -5.0 85 90 95 00 05 10 Source: BEA. University of Michigan. GS Global ECS Research. 50 40

2.5

GS Global ECS US Research

US Economics Analyst

More Downgrades to Our Growth Forecasts

Following another week of weak economic data, we have cut our estimates for real GDP growth in the second and third quarter of 2011 to 1.5% and 2.5%, respectively, from 2% and 3.25%. Our forecasts for Q4 and 2012 are under review, but even excluding any further changes we now expect the unemployment rate to come down only modestly to 8% at the end of 2012. The main reason for the downgrade is that the highfrequency information on overall economic activity has continued to fall substantially short of our expectations. In particular, our bean count for second-quarter GDP has deteriorated further and our monthly Current Activity Indicator (CAI)a broader and higher-frequency measure that takes into account 25 different indicators of monthly and weekly activityis showing growth of just 1.3% (annualized) in June, with a pattern of deceleration through the second quarter (see Exhibit 1). Some of this weakness is undoubtedly related to the disruptions to the supply chainspecifically in the auto sectorfollowing the East Japan earthquake. By our estimates, this disruption has subtracted around percentage point from second-quarter GDP growth. We expect this hit to reverse fully in the next couple of months, and this could add point to third-quarter GDP growth. Moreover, some of the hit from higher energy costs is probably also temporary, as crude prices are down on net over the past three months. But the slowdown of recent months goes well beyond what can be explained with these temporary effects. One piece of fresh evidence comes from the New York Feds Empire State survey for July, which Exhibit 1: CAI Slows through Q2
Percent change, annualized 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 J F M A M J J A S O N D J 2011 F M A M J 2010 Source: GS Global ECS Research. Percent change, annualized 4.5 4.0
12 16 Real Domestic Final Sales 12

Exhibit 2: Empire Index Remains Soft

Index 50 40 30 20 10 0 -10 -20 -30 -40 -50 01 02 03 04 05 06 07 08 09 10 11 Empire State Manuf acturing Survey: General Business Conditions New Orders -50 Index 50 40 30 20 10 0 -10 -20 -30 -40

Source: Federal Reserve Bank of New York. GS Global ECS Research.

showed another sub-zero reading for both general business conditions and new orders (see Exhibit 2). And while the Empire State is still clearly in midcycle slowdown territory, final demand growth has slowed to a pace that is typically only seen in recessions. This is illustrated in Exhibit 3, which shows that real final sales to domestic purchasers that is, real GDP excluding inventories and net exportshas grown at an estimated rate of only % (annualized) in the first half of 2011. There is only one precedent for such a weak demand growth pace outside the immediate vicinity of a recession. One key question in coming months is whether final demand recovers to the 2%-2% pace that is probably Exhibit 3: Final Demand Was Exceptionally Weak in 2011H1
2-qtr annualized percent change 2-qtr annualized percent change 16

Current Activity Indicator

3.5 3.0 2.5

4 4 8 8

2.0 1.5 1.0

-4 -4 0 0

0.5 0.0
-8 47 52 57 62 67 72 77 82 87 92 97 02 07 Note: 2011Q2 is estimated f rom our GDP tracking. Source: BEA. GS Global ECS Research. -8

Issue No: 11/28

July 15, 2011

GS Global ECS US Research

US Economics Analyst

Exhibit 4: Michigan Sentiment Consistent with Contraction in Final Sales

Percent change, year ago 7.5 Index 120 110 5.0 100 90
4 8

Exhibit 5: Signs that the Inflation Spike May Be Ending

Percent change, annual rate FRB Cleveland CPI: 7 6 5 Trimmed Mean Median 7 6 5 4 3 2 1 0 -1 01 02 03 04 05 06 07 08 09 10 11 Percent change, annual rate 8

2.5

80
3

0.0

70 60

2 1 0 -1 Source: Federal Reserve Bank of Cleveland.

-2.5

Real Domestic Final Sales (lef t) University of Michigan Consumer Sentiment (right) 50 40 85 90 95 00 05 10

-5.0 Source: BEA. University of Michigan. GS Global ECS Research.

necessary to keep GDP growth near trend and prevent the unemployment rate from rising more noticeably.1 Obviously, we have no hard information about Q3 in this regard yet, but Fridays preliminary consumer sentiment index for July from the University of Michigan was highly discouraging. The index fell to the lowest level since March 2009 (!) and is now back in territory normally associated with a contraction in real consumer spending and overall final demand (see Exhibit 4). Admittedly, consumer sentiment does not have much forward-looking value, and it is possible that the extensive media coverage of the negotiations around the federal debt ceiling has depressed sentiment. If so, agreement on this issuewhich we believe may be coming closercould lead to a rebound in sentiment. However, we would probably need to see a substantial improvement to undo the dramatic message of Exhibit 4, and to avert further downgrades to our GDP growth estimates in Q4 and 2012. Unfortunately, our confidence in the growth forecast remains relatively low. The bugbear is that we are still unsure about the precise reasons for the slowdown in 2011 to date, which is sharply at odds with our expectation at the end of last year that growth would accelerate in 2011. Logically, the explanation presumably has to involve a combination of a) unforeseen shocks from the Japan earthquake and the oil market, coupled with b) more vulnerability to these shocks, because c) the housing and credit market downturn is weighing on private-sector balance sheets for even longer than we thought. But the relative importance of these issues is exceptionally difficult to
1

sort out, and it makes a great deal of difference for the outlook. The weaker data on economic activity have clearly raised the probability of renewed monetary easing by the Federal Reserve. In his monetary policy testimony this week, Chairman Bernankes main argument against renewed easing was that inflation is now significantly higher than it was in the summer of 2010. Indeed, the core CPI for June released on Friday showed a pickup in the 6-month annualized inflation rate to 2.5%, clearly above the mandate-consistent rate of 2% or a bit less. However, we may well have seen the highest inflation figures. Exhibit 5 shows that underneath the surface, both the median and trimmed-mean indexesstatistically based measures of underlying inflation that may be preferable to the better-known core CPIshowed a notable slowdown. Therefore, we still expect core inflation to slow substantially on a sequential basis over the next year. Moreover, if the economy returns to recessionnot our forecast, but clearly a possibility given the recent numbersFed officials would undoubtedly ease anew even if inflation is close to their target. Indeed, Chairman Bernanke laid out the possible options for such a move in his monetary policy testimony this week, namely a change in the forward-looking language in the FOMC statement, a cut in the interest rate on excess reserves, andlast but certainly not leastan increase in the size and/or composition of the Feds balance sheet.

Jan Hatzius
This assumes that real potential GDP growth is 2% and that the contribution from inventories and net trade adds up to between 0 and point.

Issue No: 11/28

July 15, 2011

US Calendar
Focus for the Week Ahead Housing activity was probably more or less flat in June, at least as measured by starts and existing home sales (July 19, 20). The Philadelphia Feds manufacturing survey should improve a tad from its dismal June reading, although the soft Empire State factory survey suggests that improvement will likely be small (July 21). Economic Releases and Other Events
Date Mon July 18 Tue Jul 19 Time (EST) 9:00 10:00 8:30 19:30 10:00 18:15 8:30 8:30 8:30 10:00 10:00 10:00 10:00 Indicator Net Long-Term TIC Data (May) Homebuilders Survey (Jul) Housing Starts (Jun) KC Fed Pres Hoenig spks on monetary policy at Fed conf Existing Home Sales (Jun) NY Feds Brian Sack spks to the Money Marketeers; NYC Chicago Fed Pres Evans spks to reporters in Chicago Initial Jobless Claims Continuing Claims Philadelphia Fed Survey (Jul) Leading Indicators (Jun) FHFA House Price Index (May) Bernanke testifies on Dodd-Frank Anniversary GS n.a. n.a. Flat Estimate Consensus Last Report +$40.0bn +$30.6bn 14 13 +2.7% Flat +2.9% -3.8%

Wed Jul 20 Thu Jul 21

-1.0%

n.a. n.a. -6.0 Flat n.a.

410,000 3,705,000 +2.0 +0.2% +0.1%

405,000 3,727,000 -7.7 +0.8% +0.8%

We, Jan Hatzius, Zach Pandl, Alec Phillips, Sven Jari Stehn and Andrew Tilton, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firms business or client relationships. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs,and pursuant to certain contractual arrangements, on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs & Partners Australia Pty Ltd (ABN 21 006 797 897) on behalf of Goldman Sachs; in Canada by Goldman Sachs &Co. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs & Partners New Zealand Limited on behalf of Goldman Sachs; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman Sachs &Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International, authorized and regulated by the Financial Services Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman Sachs & Co. oHG, regulated by the Bundesanstalt fur Finanzdienstleistungsaufsicht, may also distribute research in Germany. General disclosures This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Other than certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgment. Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have investment banking and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division. SIPC: Goldman, Sachs & Co., the United States broker dealer, is a member of SIPC (http://www.sipc.org). Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research. We and our affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Investors should review current options disclosure documents which are available from Goldman Sachs sales representatives or at http://www.theocc.com/publications/risks/riskchap1.jsp. Transactions cost may be significant in option strategies calling for multiple purchase and sales of options such as spreads. Supporting documentation will be supplied upon request. All research reports are disseminated and available to all clients simultaneously through electronic publication to our internal client websites. Not all research content is redistributed to our clients or available to third-party aggregators, nor is Goldman Sachs responsible for the redistribution of our research by third party aggregators. For all research available on a particular stock, please contact your sales representative or go to www.360.gs.com. Disclosure information is also available at http://www.gs.com/research/hedge.html or from Research Compliance, 200 West Street, New York, NY 10282. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group, Inc. Copyright 2011, The Goldman Sachs Group, Inc. All Rights Reserved.

Issue No: 11/28

July 15, 2011