NORTHERN TRUST GLOBAL ECONOMIC RESEARCH

2012 As the Fundamentals Improve Stateside, They Deteriorate Abroad

December 2011 Paul L. Kasriel, Chief Economist PH: 312.444.4145 plk1@ntrs.com

2006 Northern Trust Corporation

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There is a strong positive correlation between growth in MFI credit and growth in gross domestic purchases.

Monetary financial institution (MFI) credit is credit created figuratively out of thin air. Credit created out of thin air enables the recipients of this credit to spend while no other entity needs to cut back on its spending. Thus, an increase in MFI credit implies a net increase in spending in the economy. There was a post-war record contraction in MFI credit after the financial crisis of 2008, which resulted in the most severe recession and the weakest recovery in the post-war era.

Mon etary Fin an cial In stitu tion Credit* -- % Ch an ge - Year to Year

* Su m o Co m f m ercial B an k, Sav g & L an an Cred U io Cred in s o d it n n it

Gross Dom estic Pu rch ases

% Ch an e - Year to Year g 16 12 8 4 0 -4 -8 65 70 55 60 S ource: H er A av nalytics 75 80 85 90 95 00 05 10 r = 0.66 SA R B A , il.$ 16 12 8 4 0 -4 -8

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The previous headwind of contracting U.S. bank credit has now shifted into a tailwind.

Break-Adjusted Bank Credit: All Commercial Banks

6-m onth %Change-ann 8 SA, Bil.$ 8

-4

-4

-8

-8

-12 Source: Federal R 10 eserve Board/H aver Analytics 11

-12

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Consumption spending is rebounding from its 2011 spring doldrums.

Real Personal Consumption Expenditures

4-m onth %Change-ann 4 SAAR, Bil.Chn.2005$ 4

0 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT 11 Source: Bureau of Econom Analysis /H ic aver Analytics

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With their recent rebound, 2011 car and truck sales will be the strongest since 2008.

Total Light Vehicle Retail Sales {Imported+Domestic}

SAAR, Mil. Units 14.25 14.25

13.50

13.50

12.75

12.75

12.00

12.00

11.25

11.25

10.50 Source: Autodata /H 10 aver Analytics 11

10.50

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Although still weak in absolute terms, home sales are beginning to pick up
Sum of New and Existing Home Sales
thous. units

Sum of New and Existing Home Sales

thous. of units, 3-m onth Mov ingAv erage 5800 5600 5400 5200 5000 4800 4600 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT 11 Source: H aver Analytics 5800 5600 5400 5200 5000 4800 4600

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 as well they should with homes more affordable now than in over 40 years

Composite Housing Affordability Index

Median Inc=Qualifying Inc=100 200 175 150 125 100 75 50 75 80 85 90 95 Source: N ational Association of R ealtors /H aver Analytics 00 05 10 200 175 150 125 100 75 50

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 and with banks starting to make mortgages again.

Break-Adj Real Estate Loans: Other Residential Loans: All Comml Banks
3-m onth %Change-ann 8 4 0 -4 -8 -12 -16 10 Source: Federal R eserve Board/H aver Analytics 11 SA, Bil.$ 8 4 0 -4 -8 -12 -16

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With the inventory of new homes for sale the lowest in almost 50 years and with housing demand starting to pick up, so, too, is housing construction.

Private Construction: Residential: New Housing Units

3-m onth %Change-ann SA, Thous 15.0 7.5 190 0.0 -7.5 -15.0 170 -22.5 -30.0 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT 11 Sources: Census Bureau/H aver Analytics, Census Bureau 160 180 200 SAAR, Mil.$

New 1-Family Houses For Sale: United States

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Before businesses start hiring, they have to stop firing. And they are doing less firing in recent months.

Unemployment Insurance: Initial Claims, 4-Week Moving Average

SA,Thous 460 460

440

440

420

420

400

400

380 JAN FEB MAR APR MAY JUN JUL 11 Source: Departm ent of Labor /H aver Analytics AUG SEP OCT NOV DEC

380

10

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And hiring actually is picking up.

Civilian Employment: Sixteen Years & Over

Change - Period to Period 400 SA, Thous 400

200

200

-200

-200

-400

-400

-600 DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV 11 Source: Bureau of Labor Statistics /H aver Analytics

-600

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Although the unemployment rate remains high in absolute terms, it is moving lower, even taking into consideration labor-force drop-outs.

Unemployed + Marginally Attached/CLF + Marginally Attached

SA, % 11.50 11.25 11.00 10.75 10.50 10.25 10.00 10 Source: Bureau of Labor Statistics /H aver Analytics 11 11.50 11.25 11.00 10.75 10.50 10.25 10.00

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Growth in U.S. exports is moderating and will likely continue to do so as economic growth in the rest of the world slows.

Exports, f.a.s.
% Change - Year to Year 14 SA, Mil.Chn.2005$ 14

12

12

10

10

4 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT 11 Source: Bureau of the Census /H aver Analytics

13

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The 27-nation European Union, collectively the largest economy in the world, likely entered a recession in Q4:2011.

European Union [EU27]: IP: Manufacturing

% Change - Annual Rate 15.0 SA/WDA, 2005=100 15.0

7.5

7.5

0.0

0.0

-7.5

-7.5

-15.0

-15.0

-22.5 OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP Source: Statistical O ffice of the European Com unities /H m aver11 Analytics

-22.5

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Eurozone monetary financial institution credit, which currently is growing only moderately, will likely begin to contract, prolonging the European recession.

Euro Area11-17: Total MFI Lending

12-m onth %Change-ann 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 06 07 08 09 Source: European Central Bank /H aver Analytics 10 11 EOP, SA, Bil.Euros 12.5 10.0 7.5 5.0 2.5 0.0 -2.5

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Growth in the Chinese economy, the third largest economy in the world, is moderating, but by no means collapsing.

China: PMI: Manufacturing

SA, 50+=Ex pansion 58 58

56

56

54

54

52

52

50

50

48 10 11 Source: China Federation of Logistics & Purchasing/N BS /H aver Analytics

48

16

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The primary factor accounting for the moderation in Chinese economic growth is central bank policy tightening in order to rein in growth in money and credit.
China: Total RMB Loan: 12-Month Percent Change
%

China: 6-Month Lending Rate

EOP, % per annum 36 32 28 6.0 24 5.6 20 16 12 09 08 Sources: People's Bank of China /H aver Analytics 10 11 5.2 6.8

6.4

4.8

17

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In addition, demand for Chinese exports is weakening, which will be exacerbated by the EU recession.

China: PMI: Manufacturing Export Orders

3-m onth Mov ingAv erage 56 SA, 50+=Ex pansion 56

54

54

52

52

50

50

48 10 11 Source: China Federation of Logistics & Purchasing/N BS /H aver Analytics

48

18

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The slowing in Chinese economic growth has led to a slowing in Chinese import demand.

China: PMI: Manufacturing Imports

SA, 50+=Ex pansion 54 54

52

52

50

50

48

48

46 11 Source: China Federation 10Logistics & Purchasing/N of BS /H aver Analytics

46

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Because China has become a large importer in the past 10 years, the slowdown in its import demand has and will have a significant negative effect on the rest of the worlds exports, including U.S. exports.

Dollar Value of Chinese Imports as a % of Dollar Value of U.S. Imports

4-qtr Mov ingAv erage 80 80

60

60

40

40

20

20

0 85 90 Source: H aver Analytics 95 00 05 10

20

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Chinese consumer inflation has begun moderating significantly

China: Consumer Price Index

3-m onth %Change-ann 12 SA, 2005=100 12

-4

-4

-8 10 Source: China09 N ational Bureau of Statistics/H aver Analytics 11

-8

21

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 and the Chinese real estate market has begun to deflate, both of which give the Chinese central bank latitude to begin easing monetary policy aggressively.
China: Shanghai: Price of Existing Residential Buildings
% Change - Annual Rate % Change - Annual Rate 16 NSA, 2010=100 NSA, 2010=100 16

China: Shanghai: Price of New Residential Buildings

12

12

-4 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT 11 Sources: China N ational Bureau of Statistics /H aver Analytics

-4

22

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After spiking in the first half of 2011, U.S. inflation now is moderating.

The first-half spike in U.S. inflation resulted from a surge in commodity prices, which was due to the overheating of developing economies and concerns about interruptions in the supply of North African oil. With growth slowing in developing economies, commodity prices are falling. Despite a moderate pick up in U.S. bank credit growth, global bank credit growth is moderating, which implies that global inflation also will moderate. With global inflation moderating, central banks will have the latitude to pursue more accommodative monetary policies if need be.
CPI-U: All Item s
3-m n o th % Ch an e-an g n SA 1982-84=100 ,

FIBER In du strial M aterials In dex All Item : s

1990=100 8 187.5

180.0

172.5

165.0

0 DEC JA N FEB M R A A PR S u o rce : B S F s L , IB R /H v r E a e M Y A JU N JU L 11 A G U SEP O CT N V O

157.5

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Conclusions

Europe, collectively the largest economy in the world, likely has entered a mild but prolonged recession, which will have an adverse effect on the rest of the worlds exports, including those of the U.S. Prior to the onset of the European recession, growth in developing economies was moderating in reaction to deliberate tightening policies of central banks. The European recession will further moderate growth in the developing economies. Assuming continued growth in bank credit, the U.S. economy is likely to avoid slipping back into a recession in the next 12 months as moderate strength in domestic demand offsets weaker foreign demand. Although a recession is likely to be avoided, U.S. growth will not be sufficient to bring down the unemployment rate significantly, which, in the context of moderating inflation, could prompt another round of Federal Reserve asset purchases, i.e., quantitative easing (QE). The Federal Reserve will keep the federal funds rate near zero and the ECB will continue to lower its policy interest rate. Central banks in developing economies will ease their policies aggressively. Sluggish global economic growth and the sovereign-debt problems in the eurozone are likely to keep global investors risk aversion at a relatively high level.

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Appendix: Effect of Fiscal Policy Changes on Economic Activity?

According to mainstream commentary, a tax cut and/or government spending increase is supposed to result in faster economic growth. Thus, according to mainstream commentary, changes in the cyclically-adjusted federal deficit should be negatively correlated with changes in GDP. That is, a tax cut and/or an increase in government spending resulting in a larger cyclically-adjusted federal deficit should be associated with faster GDP growth. Almost 50 years of U.S. data show no significant relationship, i.e., a very low correlation coefficient, between changes in government deficits and changes in GDP.
Ch an e - Perio to Perio g d d Fis cal Yr, % B il.$ 30

Cy clically Adj Fed Bu dget Su rplu s/Deficit as a % of Poten tial GDP [-2] Fiscal Year Gross Dom estic Produ ct
% Ch an e - A n al R g n u ate 4 r =-0 2 .0

20

10

-2

-4

-10

-6 65 70 75 80 S u o rce : C O O B /H v r s B , M a e 85 90 95 00 05 10

-20

25

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Why might there no significant relationship between fiscal policy and economic activity?

If

the government borrows more, it has to get the extra funds from somewhere from either the nonfinancial sector or the financial sector. the government obtains the funds from the nonfinancial sector, this sector cuts back on its current spending, i.e., increases its saving, and transfers spending power to the government. an increase in government borrowing financed by the nonfinancial sector results in no net change in aggregate spending, just a change in the composition of spending. contrast, if the government obtains the funds from the financial sector, which is able to create credit out of thin air, then an increase in government borrowing can result in a net increase in aggregate spending.

If

Thus,

In

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The historical data show that increases in federal government borrowing are closely associated with increases in nonfinancial sector saving by nearly the same magnitude.

Income + Borrowing = Spending on Nonfinancial Goods/Services/Assets + Acquisition of Financial Assets Income Spending = Acquisition of Financial Assets Borrowing Income Spending = Saving; Acquisition of Financial Assets Borrowing = Net Financial Investment Saving = Net Financial Investment
U.S. Governm ent: Net Financial Investm ent
SA R B A , il.$

Com bined Net Financial Investm ent* SAAR, Bil.$

*H ouseholds+N onfinancial B us.+State/Local G t.+ R ov est of World 1500 1000 500 0 -500 -1000 -1500 65 70 75 S ource: H er A av nalytics 80 85 90 95 00 05 10 r =-0.88 1500 1000 500 0 -500 -1000 -1500

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US Economic and Interest Rate Outlook, December 2011

Table 1: US GDP, Inflation, and Unemployment Rate

2011 11:1a 11:2a 11:3a 11:4f REAL GROSS DOMESTIC PRODUCT (% change, SAAR) Dec-2011 Nov-2011 CONSUMER PRICE INDEX (% change, ann. rate) Dec-2011 Nov-2011 CIVILIAN UNEMPLOYMENT RATE (avg.) Dec-2011 Nov-2011 0.4 0.4 1.3 1.3 2.0 2.5 3.5 2.2 12:1f 2.1 1.5 2012 12:2f 12:3f 2.3 2.0 2.8 2.2 Q4 to Q4 change Annual change 12:4f 2010a 2011f 2012f 2010a 2011f 2012f 3.3 2.8 3.1 3.1 1.8 1.6 2.6 2.1 3.0 3.0 1.8 1.8 2.5 2.0

5.2 5.2

4.1 4.1

3.1 3.1

1.1 2.4

1.6 1.9

1.7 1.7

1.9 1.9

2.3 2.3

1.2 1.2

3.4 3.7

1.9 2.0

1.6 1.6

3.2 3.2

2.0 2.3

8.9 8.9

9.1 9.1

9.1 9.1

8.8 9.1

8.7 9.3

8.7 9.4

8.5 9.3

8.3 9.1

9.6* 9.6*

9.0* 9.0*

8.6* 9.3*

a=actual f= forecast * - annual average

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US Economic and Interest Rate Outlook, December 2011

Table 2: Outlook for Interest Rates

11:1a Federal Funds Dec-2011 Nov-2011 2-yr. Treasury Note Dec-2011 Nov-2011 10-yr. Treasury Note Dec-2011 Nov-2011 a = actual f = forecast 0.16 0.16 11:2a 0.09 0.09 Quarterly Average 11:3a 11:4f 12:1f 12:2f 0.08 0.10 0.10 0.10 0.10 0.10 0.10 0.10 12:3f 0.10 0.10 Annual Average 12:4f 2010a 2011f 2012f 0.10 0.10 0.18 0.18 0.11 0.11 0.10 0.10

0.69 0.69

0.57 0.57

0.28 0.28

0.25 0.25

0.25 0.25

0.25 0.25

0.25 0.25

0.25 0.25

0.70 0.70

0.45 0.45

0.25 0.25

3.46 3.46

3.21 3.21

2.43 2.43

2.10 2.10

2.05 2.05

2.05 2.05

2.20 2.20

2.50 2.50

3.21 3.21

3.14 3.14

2.20 2.36

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