US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

August 31, 2015 MORGAN STANLEY & CO. LLC Ellen Zentner US Economic Autumn Outlook [email protected] +1 212 296-4882 Ted Wieseman Sobering Up On Supply Side [email protected] +1 212 761-3407 Paula Campbell Roberts [email protected] +1 212 761-3043 Domestic momentum should be enough to lead the Fed to deliver a Robert Rosener December rate hike as downside risks to inflation ease. Thereafter, [email protected] +1 212 296-5614 depressed productivity and lower potential growth take center stage.

Forecast Highlights: More muted growth outlook—productivity picks up only moderately; potential GDP growth and NAIRU are lower. Slower path for policy tightening—we have removed 50bps of tightening in 2016 via one less rate hike and delayed balance sheet action. Job growth slows sharply in 2017—we expect 50k average monthly job growth by the end of 2017 on a gradual rise in productivity and renewed downtrend in participation, just enough to keep the unemployment rate steady. Outlook for inflation little changed—headline inflation remains largely oil-driven. For core inflation, housing-led upside in core services prices is offset by dollar appreciation and weakness in more globally-driven core goods prices. Downward revision to growth in 2015/16—2015 GDP revised lower to 2.4%Y vs 2.5% previously, 2016 comes down by 0.8pp to 1.9%Y and we initiate 2017 at 1.8%Y. A US recession enters the bear case—in our bear case we explore the possibility of a US recession within the next 12 months.

For important disclosures, refer to the Disclosures Section, located at the end of this report.

1 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 1: US Economic Autumn Outlook: Forecast Update (4Q/4Q)

New Forecast Previous (4Q/4Q % Change) 2014 2015 2016 2017 2015 2016 Real GDP 2.5 2.0 1.8 1.8 2.3 2.5 Final Sales 2.6 2.1 2.0 1.8 2.5 2.5 Final Domestic Demand 3.0 2.6 2.2 1.9 2.6 2.6 PCE 3.2 2.5 2.0 2.0 2.7 2.3 Business Fixed Investment 5.5 3.1 3.1 2.6 2.3 3.9 Residential Fixed Investment 5.1 11.3 8.9 3.5 8.5 7.2 Exports 2.4 1.1 2.2 3.8 3.2 4.0 Imports 5.4 4.6 3.9 4.1 3.5 4.1 Government 0.4 1.1 1.1 0.6 1.3 1.7 CPI 1.2 0.3 1.9 2.4 0.5 2.1 Core PCEPI 1.4 1.4 1.6 1.9 1.2 1.8 Unemployment Rate* 5.7 5.1 4.8 4.8 5.1 4.8

*Projections for the unemployment rate are for the average in 4Q of the year indicated. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Morgan Stanley Research forecasts

A nd the Beat Goes Marching On

One year ago we released collaborative analysis with our US equity strategists in which we stressed that this business expansion could be the longest on record (see 2020 Vision: Long Live the Expansion, September 4, 2014). With this forecast update the "lower, but longer" argument has only strengthened. Macro signs of overheating are few and far between, we have sobered up on productivity trends and lowered our assumption of the economy's potential, as well as shallowed out the path of monetary policy response. Long live the expansion.

At the same time, we are more than six years into this business expansion, the world remains a scary place, and monetary policy missteps lurk in the shadows. In this outlook we introduce a bear case that explores the possibility of a mild US recession in 2H16, assigning it a symmetric probability of 20% against the bull case in which a more "normal" normal emerges. Read on.

Our Updated Outlook: Slower Growth, Lower Policy Path

We have revised lower our estimate for 2015 growth to 2.4%Y (2.0% 4Q/4Q) compared with 2.5%Y (2.3% 4Q/4Q) in our Spring Outlook owing primarily to a mark-to-market for transitory headwinds early in the year. We have also sharply lowered our growth forecast for 2016 by 0.8pps to 1.9%Y (1.8% 4Q/4Q) to account for weaker global trade than previously assumed, and what we believe to be undeniable evidence of a lower sustainable trend growth rate for the economy that anchors our forecasts.

We maintain our expectation the Fed first raises rates at the December 2015 meeting, but we have lowered our assumption for the Fed’s end-2016 target range by 25bps to 1.375% compared with 1.625% in our Spring Outlook baseline. We have also removed an additional 25bps in balance sheet equivalent tightening by moving out our assumption of when the Fed begins tapering reinvestments in MBS, to 4Q16. With this forecast update we initiate our take on growth in 2017 at 1.8%Y (also 1.8% 4Q/4Q).

Throughout the forecast horizon, growth persists above the economy’s potential, which we currently peg at around 1.5%Y. Lower potential growth is associated with a lower neutral real rate, which we expect to rise gradually over the coming years as persistent headwinds fade. The Fed will aim to move in line with the drift higher over time. This gradual path of tightening puts the Fed’s target range at 2.375% by end-2017.

2 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH We expect the rate of productivity to improve to around 1%Y in 2016 after remaining about flat in the prior two years on a lack of capital deepening. A steady participation rate in 2016 would suggest average monthly payroll gains slow to about 175k compared with 200k in 2015. But as the downtrend in participation resumes, we expect average job gains to slow materially to 50k per month by late 2017—just enough to hold the unemployment rate about steady.

Productivity gains coupled with sluggish global growth lead to improved, but moderate overall investment, while the drag from energy investment diminishes. Commercial building and R&D activity are the bright spots for growth in investment.

After being on a tear since late summer 2014, we expect the trade-weighted USD to rise moderately in 2016 before flattening out as global growth picks up steam. Year-over-year growth in core PCE remains at a low of 1.3% through 3Q before bumping up to 1.4% in 4Q15 and rises only gradually to reach 1.9% by end-2017.

Household formation rates have finally moved back above the historically normal 1 million mark, credit conditions slowly improve, and residential investment is a bright spot in our outlook. Growth in home prices continues to whittle away at negative equity, while years of strong job gains coupled with lower energy expenses and prudent control over balance sheets keep consumer liquidity elevated. The personal savings rate falls back to around 5% over our forecast horizon, supporting a moderate pace of spending.

Exhibit 2: US Forecast Update: Comparison to Previous Forecast & FOMC Projections

Source: Federal Reserve, Morgan Stanley Research

3 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

The Near-Term Fed Outlook

I nflation and the December Fed Call

Recent policymaker rhetoric implies the Fed sees downside risks to the outlook as having increased and will take a pass on raising rates at the September meeting, but keeps hopes alive that conditions will warrant a rate hike before the end of the year. We expect the Fed to first raise its target rate at the December meeting, having judged by then that downside risks have eased.

In our Spring Outlook, we made the decision to move our long-standing call that the Federal Open Market Committee (FOMC) would first raise rates in 2016 forward to December 2015. Our judgement was that an important part of the Fed's reaction function—its rhetoric—had changed. At its March meeting forecasts for growth and inflation were marked measurably lower yet no policymaker shifted their expected timing of the first rate hike into 2016. This was the start of a strong unwavering message that has carried through to its June meeting, the latest in which the Fed delivered forecast materials.

In April, when we pulled our rate hike expectation forward to December, clients asked why not earlier? To be sure, at the time the Fed was still telling us that a mid-2015 rate hike would be appropriate. Then, as today, we let the expected path of inflation guide us.

The Fed aims to raise rates once it "has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term." On the former, there's room for only "some" improvement as the unemployment rate, at 5.3% in July, is closing in on the level the Fed considers to represent fully employed labor resources. And the trend has been our friend with a continued low pace of initial claims for jobless benefits and a firm run rate of monthly average job growth around 200,000.

On the latter, the downside risks to inflation have risen and the Fed will need to gauge those risks as having eased before raising rates. International developments have sent the trade-weighted dollar (TWDI) to a twelve-year high and sent energy prices tumbling to new lows (Exhibit 3 & Exhibit 4). The Fed will need to gauge that the trade-weighted dollar is leveling out, and energy prices have stabilized.

Exhibit 3: Autumn Outlook Baseline Points to Exhibit 4: Further USD Appreciation Expected to Stable But Lower Oil Prices vs Spring Outlook Come at A Slower Pace

Source: Morgan Stanley Research Source: Morgan Stanley Research 4 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Moreover, market-based measures of inflation compensation have dropped sharply. The Fed's modeled 5-year/5-year forward TIPS breakeven was at 1.89% as of August 26, down from 2.05% at the July FOMC. Our TIPS strategist believes lower energy prices are weighing on inflation risk premiums, but lower breakevens may also in part reflect lower near-term inflation expectations as the stronger dollar continues to weigh on core goods prices. Monetary policy theory would inform policymakers that you do not raise rates in the face of falling inflation expectations lest you risk embedding expectations permanently lower, so these mixed signals are likely to be met with some trepidation.

That said, measures of inflation compensation may recover should stability in the dollar and energy prices emerge. If market volatility calms and global growth scares come off high boil, the Fed is likely to feel more confident in its projections that inflation will move up toward its 2% goal over the medium term. We think the Fed's confidence returns in time for it to move at the December meeting.

Domestic vs External

Throughout this Autumn Outlook is the common thread of domestic strength versus external headwinds. This holds whether discussing the outlook for growth or inflation. On the inflation front, domestic services prices in core PCE are caught in crosswinds between rising costs for housing and lower healthcare inflation, while the rising dollar has contributed to continued downward pressure on import prices and a deep decline in core goods prices (Exhibit 6).

Exhibit 5: After Hitting 1.2% in July, Core PCE Exhibit 6: Strength in Domestic Services Prices vs Begins Slowly Rising in 3Q15 Downward Pressure on Core Goods

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Morgan Stanley Research Morgan Stanley Research

For now, the downside pressure from externally driven prices is winning the tug of war and core PCE prices on a year-over-year basis have fallen further away from the Fed's goal, hitting 1.2% in July. In our forecast 1.2% is the monthly low point for core PCE, then it begins to rise slowly and gets back to just below the Fed's 2% goal at year-end 2017 (Exhibit 5).

The growing wedge between core PCE and core CPI has been a focal point as methodological, compositional, and structural differences between these two data series continue to drive a wide gap over our forecast horizon (see US Economics & Strategy Insights: Inflation: The CPI-PCE Wedge, 25 Jun 2015). By the end of 2017, we expect the wedge will stand at 0.5pp, with core PCE at 1.9% and core CPI at 2.4%, something our strategists believe investors in 30-year TIPS should bear in mind.

5 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH F ed Exit: Reinvestments Revisited

The timing of when the Fed will see fit to begin tapering its reinvestments will depend on how "economic and financial conditions and the economic outlook evolve", but the latest guidance from President Dudley provides a useful framework. We now assume that the Fed will begin tapering MBS reinvestments in 4Q16.

With the Fed on the cusp of a rate hike cycle, the lack of discussion around the balance sheet in recent meetings was perplexing. But minutes of the July meeting of the FOMC indicated that those discussions have begun anew. Though the method for raising interest rates was formalized in the Fed's “Policy Normalization Principles and Plans”, with detailed discussion among policymakers proffered as further guidance, plans for the balance sheet have been more ambiguous.

What we know: "The Committee expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate." "The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities..."

In our Spring Outlook, we argued that the Fed's goal is to get back to a pre-crisis normal balance sheet, only big enough on the asset side to support on the liability side required reserves and currency outstanding plus a minor amount of excess reserves—and consisting only of Treasuries (see Spring US Economic Outlook: The Beginning of the End, April 12, 2015). To be sure, policymakers have yet to decide a course of action in regards to reinvestments, but the most recent round of comments appear to support our view that the FOMC will concentrate on MBS when it begins tapering. From the July FOMC minutes:

"Participants indicated a range of views on various issues specific to agency mortgage-backed securities (MBS) and Treasury markets. Using the same strategy for both agency MBS and Treasury maturities was viewed as simpler to communicate, but a number of market-specific considerations might suggest employing different strategies for each asset class. No decisions regarding the Committee's strategy for ceasing or phasing out reinvestments were made at this meeting."

With only informal guidance on when the Fed would entertain tapering its reinvestments of MBS, we have moved out our expectation to 4Q16 from 2Q16, effectively removing 25bps in equivalent monetary policy tightening in 2016 compared with the balance sheet assumptions in our Spring Outlook. We essentially split the difference between the desire of Fed officials to start scaling back MBS and Treasury reinvestments soon after the exit process has begun—in order to start scaling back the flood of excess reserves the ON RRP facility soaks up—and recent comments by President Dudley. Dudley's own view "is that I’d like to get short term rates to a reasonable level so I felt that I was off the zero lower bound by a reasonable amount, but how far that it is—whether it's 1% or 1.5%—I or the Fed haven’t really reached a conclusion, but it seems to me you’d like to have a little room before you start ending the reinvestment, because ending the reinvestment is a tightening of monetary policy ."[ 1 ]

6 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 7: Fed's MBS Reinvestments Have Averaged $26 Billion Per Month Over the Past Year

Source: Federal Reserve, Morgan Stanley Research

In the past year, monthly purchases of MBS to reinvest agency and MBS maturities and prepayments have ranged from $20 billion to $40 billion and averaged $26 billion (Exhibit 7). At that pace, ending reinvestments would effectively amount to about $250 billion in “reverse QE” per year. Fed officials and researchers have suggested that the impact of a $600 billion QE program is about the equivalent of a 75 basis point fed funds rate cut.[ 2 ] [ 3 ] So a $250 billion annual rundown of the MBS portfolio could be considered (and we expect will in part be framed as) the equivalent of about a 25bp per year rate hike.

We anticipate in our baseline that MBS reinvestments will be reduced by half starting in December 2016 and then ended in June 2017.

Exhibit 8: Fed's Balance Sheet: Forecast After Tapering MBS Reinvestments

Source: Federal Reserve, Morgan Stanley Research

L ong-Term Rate Outlook

The longer-term outlook for Fed policy beyond the first rate hike is anchored to questions on the potential growth rate of the economy and uncertainty about the equilibrium interest rate. In the following section, we work through our assumptions around the moving parts of potential output and examine the longer-run implications for the Fed.

7 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Potential Growth

There's a basic accounting identity on the supply side of the economy that output growth is determined by growth in labor productivity and the working age population, and changes in the unemployment rate, labor force participation rate and average hours per worker (Exhibit 9).

Based on our outlook, we peg potential GDP growth at 1.5%Y. This estimate takes into account a sobering view of these supply side dynamics that assumes only a gradual climb in productivity to around 1%Y and very slow growth in the labor force of around 0.5%Y.

Rule of Thumb: Growth in Labor Productivity + Growth in the Labor Force = Potential GDP Growth

Exhibit 9: Supply Side Components of Real GDP Growth: Historical Averages and Forecast

O utput identity follow s Gordon (2014): Y = (Yb/Ab) * (Ab/Eb) * (E/L) * (L/N) * N *[(Q /Ep)/(Q b/Eb)] * (Ep/E), w here real GDP (Y) is equal to labor productivity (Y/H), aggregate hours per employee (A/E), the employment rate (E/L), the labor force participation rate (L/N) and the w orking age population (N), a "mix effect," and a "bridge term." The "mix effect" is the ratio of output per payroll employee in the total economy to output per employee in the nonfarm private business sector, and the "bridge term" converts BLS payroll survey hours to hours from the household survey. Superscript "B" denotes nonfarm private business sector. " Ep" denotes employment in the payroll survey, w hile "E" is total employment in the household survey. Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Morgan Stanley Research

Since the post-financial-crisis recovery began, growth in real GDP has averaged 2.1%, in line with the FOMC's estimate of the economy's longer-run potential. Okun's Law, a widely held theory that describes the relationship between the level of unemployment and the growth rate of the real economy, would inform us that a steady rate of unemployment is associated with an economy growing at its potential. Yet over that same time the unemployment rate has declined by more than 4 percentage points. By that measure, it's clear the economy's growth potential is much lower. Indeed, potential output appears to have hit a brick wall after the financial crisis. And the cumulative loss in aggregate supply is enormous (Exhibit 10 ).[ 4 ]

8 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 10: Real GDP Relative to Trend: Pre- and Post-Financial Crisis

Note: Pre-crisis trend calculated 1985 to 2007. Post-crisis trend calculated 2009-present. Source: Bureau of Economic Analysis, Morgan Stanley Research

Put another way, in light of the minimal productivity growth, most of the sluggish GDP growth trend in the past six years simply reflects elevated growth in labor input as the unemployment rate fell sharply. That obviously can't be repeated in the next five years. We'll need a much larger improvement in labor productivity than the past five-year trend (much larger even than what we forecast ) to get close to a sustainable 2% GDP trend with labor force growth at 0.5% and the unemployment rate nearing sustainable full employment.

Staff at the Federal Reserve are looking at the economy through a similar lens, based on the accidental leak of their projections.[ 5 ] Forecasts prepared for the June meeting of the FOMC showed the staff estimating potential GDP growth at 1.6% this year. Since then, the annual benchmark revisions to GDP led the staff to further trim its "projected rates of productivity gains and potential output growth" over the medium term in the updated outlook presented at the July FOMC meeting.

In this Autumn Outlook, our GDP growth forecasts undercut those of the consensus among private forecasters, and the Fed's central tendency estimates shown in the June FOMC Summary of Economic Projections (SEP) (Exhibit 11 ). For those lofty estimates to prove true, something extraordinary in the economy needs to change the course of labor productivity and labor force participation.[ 6 ]

Exhibit 11: Real GDP (% 4Q/4Q): Morgan Stanley Forecasts vs Consensus and the Fed

Morgan Stanley Blue Chip Consensus (Aug 2015) June FOMC Projections 2015 2.0 2.1 1.8 to 2.0 2016 1.8 2.7 2.4 to 2.7 2017 1.8 - 2.1 to 2.5

Source: Blue Chip Economic Indicators, Federal Reserve, Morgan Stanley Research

9 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH P roductivity

Growth in labor productivity can be decomposed into three parts: 1. Growth in multifactor productivity—or the change in output after accounting for both capital and labor inputs, reflecting technological change, efficiency improvements, returns to scale, and reallocation of resources; 2. The contribution of capital deepening; and, 3. The contribution of labor quality change.

Exhibit 12: Contributions to Annualized Growth in Labor Productivity Over Time

Contribution from capital deepening equals capital services per hour multiplied by capital's share of current dollar costs. Labor quality is the ratio of labor input to hours, and the contribution from labor quality change equals labor quality multiplied by labor's share of current dollar costs. Multifactor productivity is output per combined units of labor input and capital services, capturing effects of technological change, efficiency improvements, returns to scale, reallocation of resources, and other factors impacting grow th. Note: Components may not sum to total due to rounding. Source: Bureau of Labor Statistics, Morgan Stanley Research

The annual benchmark revisions to GDP confirmed a weak and, moreover, worsening trend in labor productivity growth. Annualized growth in the six years since the recession ended is now 1.0%, and only 0.4% in the past five years, 0.3% in the past three years, and 0.0% in the past year and a half (Exhibit 13 ).

The deterioration in labor productivity in recent years has importantly owed to a shallowing out of the capital stock (lack of capital deepening) that has led to an unprecedented decline in capital intensity (less services from capital). Multifactor productivity (MFP), has also slowed substantially. MFP largely reflects productivity- enhancing technological change, and despite some potentially positive developments in the tech sector, we're not seeing much of that in the data at this point. But as we discuss in our Outlook for Aggregate Demand, R&D spending has accelerated and we expect that may portend stronger MFP growth over the next few years.

For the capital deepening part, the ratio of capital services per hour worked fell in 2011, 2012, 2013, and 2014, the only run of four consecutive declines on record (Exhibit 14 ). Furthermore, it's falling at an accelerating pace this year, with payrolls averaging around 200,000 per month, while net nonresidential investment fell at a 9.1% annual rate in 1H15. It will take a much better pace of investment over a sustained period of time for capital deepening to support an improving labor productivity trend.

10 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Over the forecast horizon we expect moderate improvement in productivity to around 1% in 2016, lower than the historical average but certainly better than the more recent trend around 0%. This moderate improvement owes importantly to our expectation for better sustained growth in investment. After no net growth in the first half of this year, we are looking for nonresidential investment to grow at an average annualized pace of 3.8% in 2H15, then settle in around a 3.0% growth rate over the remainder of the forecast horizon.

Exhibit 13: A Weak and Worsening Trend in Exhibit 14: Lack of Capital Deepening Contributes Productivity Growth to Weak Productivity Growth

Source: Bureau of Labor Statistics, Morgan Stanley Research Source: Bureau of Labor Statistics, Morgan Stanley Research

Exhibit 15: Net Nonresidential Investment Fell at Exhibit 16: It Will Take a Much Better Pace of Net a 9.1% Annual Rate in 1H15 Investment to Support Productivity

Source: Bureau of Economic Analysis, Morgan Stanley Research Source: Bureau of Economic Analysis, Morgan Stanley Research

L abor Force

Underlying demographic trends point to labor force growth slowing to 0.5% in coming years, as the participation rate eventually moves back into a 0.2-0.3pp annual decline in the demographic trend and the working age population grows a bit less than 1% a year.

11 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH In the past few years, population growth has slowed and labor force participation is on a secular downtrend. Simply put, there are fewer workers applying the resources available to produce—the civilian labor force participation rate has shed 3.5 percentage points in the past seven years (Exhibit 17 ).

Cyclically adjusted, the moving estimate of the trend of the labor force participation rate dipped into negative territory and has moved lower since 2004 (Exhibit 18 ). This moving estimate predicts a decline in the participation rate of about 0.3 percentage points per year.

Exhibit 17: Labor Force Participation is on a Exhibit 18: Estimated Trend Predicts ~0.3pp per Downtrend and Has Shed 3.5pp Since 2007 Year Decline in the Participation Rate

Source: Bureau of Labor Statistics, Morgan Stanley Research Source: Bureau of Labor Statistics, Morgan Stanley Research

More recently, labor force participation appears to have flattened out as a small cyclical rebound in prime working-aged groups has counteracted structural effects such as an aging population. In our forecast this dynamic doesn’t last and participation renews its downward trend in 2016, falling to 62.35% by end-2017 compared with 62.6% as of July this year.

A pickup in the rate of productivity to around 1%, coupled with a steady participation rate in 2016, would suggest average monthly payroll gains of about 175,000 compared with 200,000 in 2015. But as the downtrend in participation resumes, we expect average job gains to slow to just 50,000 per month toward the end of 2017—that’s enough to hold the unemployment rate about steady.

On this backdrop the unemployment rate continues to decline, albeit more slowly, and ends 2015 a touch below NAIRU, which we currently peg at 5%.[ 7 ] NAIRU continues to trend lower and the unemployment rate chases it throughout the forecast horizon. Diminishing labor market slack has had an upward, though muted, effect on wages thus far, and this relationship is likely to continue as the unemployment rate and NAIRU remain closely matched. E quilibrium and the Path for Rate Hikes

A lower longer-run growth rate implies a lower equilibrium short-term real interest rate. We peg the longer-run neutral real rate to be around 1% compared with the Fed's implied median of 1.75% in its June SEP.

Janet Yellen's "persistent headwinds" appear to be more persistent, and the current policy setting really isn't all that easy relative to a Taylor rule prescription. Therefore, we expect the path of rate hikes to be somewhat more gradual compared with our Spring Outlook.

12 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH In an important speech on March 27, Chair Yellen lauded improvements in the labor market and broader economy, but reminded us those gains had required an environment of "extraordinary monetary accommodation" and that the economy's potential growth remained "quite weak" by historical standards.[ 8 ] To that end, the real equilibrium funds rate can also be considered a measure of the economy's potential. In February, New York Fed President Dudley suggested that the neutral longer-run rate would likely be lower than in the past because of slow growth in the labor force and labor productivity.[ 9 ]

In March, Yellen's specification of the Taylor rule pegged the current neutral real rate at "close to zero" and underscored that the Committee's assessment for the nominal federal funds rate to rise gradually is predicated on a gradual rise in the neutral real rate as persistent headwinds fade.[ 10 ]

With lower trend growth and a weak productivity trend improving only slowly, we expect the path of rate hikes to be somewhat more gradual compared with our Spring forecast. Our baseline assumes the Fed first hikes rates by 25 basis points in December this year and follows it up with 25bp hikes once every quarter. This lowers our end-2016 expected midpoint of the target range to 1.375% compared with 1.625% in our Spring baseline. And it puts the target range at 2.375% by end-2017 (Exhibit 19). These results are largely in line with a Taylor rule specification around our outlook, where:

* Rt = r + πt + 0.5(πt -2) + 0.5Yt r* = estimated equilibrium real rate

πt = core inflation rate Yt = output gap measured as the difference between the unemployment rate and NAIRU

Exhibit 19: Contributions to Changes in the Taylor Rule Prescribed Policy Rate Over Forecast Horizon

Source: Morgan Stanley Research

Applying the same Taylor rule framework to the median estimate from the Fed's June outlook coincidentally falls closely in line with the median path for rates laid out in the dot plot. Our projected path for rates is lower than the Fed's, but higher than the market. Judging from Fed funds futures, the market has cast its vote that the economy's longer-run growth potential and the associated equilibrium rate is substantially lower than the Fed's and our estimate (Exhibit 20 ).

13 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 20: Outlook for Fed Policy: Morgan Stanley Projections vs FOMC Projections & Market Pricing

Note: Dots represent an individual FO MC participant's expectations for the midpoint of the target Fed funds rate at year-end. Source: Federal Reserve, Morgan Stanley Research

Chair Yellen has said she finds the market's expectation for a very low path of rates "sobering,” with low levels of bond yields and low inflation breakevens suggesting “investors place considerable odds on adverse scenarios that would necessitate a lower and flatter trajectory of the federal funds rate than envisioned in participants’ modal SEP projections.”

Yellen has made clear "the FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the funds rate target range...Rather, the actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation." For now, monetary policy theory informs the FOMC that the equilibrium real federal funds rate is ultra low, will rise slowly over time, and the Fed will aim to align policy with that gradual climb.

Based on our underlying assumptions and outlook, a gradual pace of tightening not too far below what the Fed envisioned at its June meeting is appropriate—and something will have to go fantastically right, or horribly wrong, to alter that course.

14 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Outlook for Aggregate Demand

C onsumer

We expect record levels of liquidity funded by income versus debt, along with further strengthening driven by the improved buying power of the dollar and additional energy savings, to continue to drive consumer activity.

After an early year lull driven largely by transitory factors, the US consumer began spending down the surge in disposable income, with real consumer spending coming in at a 3.1% annualized pace in 2Q. We are tracking a similar pace of growth for spending in 3Q. Throughout the forecast horizon, much of the domestic momentum is driven by the US consumer, though growth in real disposable income is expected to slow alongside a slowing pace of jobs gains that is only partially mitigated by improved wage trends. Still, these dynamics are enough to support a moderate pace of spending throughout the forecast horizon. Finally, while the early recovery from the financial crisis predominantly benefitted wealthy households, we are seeing some improvement in the broader base.

Driven primarily by growth in aggregate wages and salaries, Morgan Stanley's Consumer Liquidity Index (MSLQD) rose again in 2Q15, suggesting household liquidity has reached its highest level since 2006 (Exhibit 21, see MSLQD: Steady As She Goes, August 14, 2015).

Moreover, while the decline in energy prices and the appreciation of the trade weighted value of the US dollar place an exogenous drag on inflation and economic growth, on net these factors should benefit the US consumer. Lower oil prices, and in particular lower gas prices, serve as an effective tax break freeing up consumer discretionary income, and dollar strength provides a net benefit to the US consumer in the form of an increase in buying power.

Exhibit 21: With Steady Growth, Consumer Liquidity Reaches Highest Level Since 2006

Source: Bureau of Economic Analysis, Federal Reserve Board, Bureau of Labor Statistics, Federal Home Loan Mortgage Corporation, Centers for Medicare & Medicaid Services, Morgan Stanley Research

15 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH We expect solid job growth to continue through 2016, though over the coming years growth in the working age population will slow, the downtrend in labor force participation will resume and underlying demographic trends will drive lower the pace of job gains, climb in aggregate income, and consequently consumer liquidity gains, by 2017. After a record-breaking year in 2014, average monthly changes in nonfarm employment have already come off that high and we expect further moderation as the economy nears sustainable full employment (Exhibit 22).

The moderate improvement we look for in labor productivity should lead to comparable wage gains. Indeed, a basic tenet of economics is that productivity growth is the source of growth in real per capital income for the average worker, and over the long run real wage and productivity growth generally move in tandem. [ 11 ] As a result, in line with our expectations for a modest improvement in productivity from 0% to around 1% in 2016 as well as a continued decline in the unemployment rate to a touch below NAIRU, we expect roughly 1%Y average inflation-adjusted wage growth over the forecast period (Exhibit 23).

Exhibit 22: Employment Growth Slows Materially Exhibit 23: Close Link Between Growth in Labor By 2017 (Historical Averages and Forecast) Productivity and Real Wages

Source: Bureau of Labor Statistics, Morgan Stanley Research Source: Bureau of Labor Statistics, Morgan Stanley Research Note: Compensation includes employee wages and salaries plus employers' contributions for social insurance and private benefit plans, adjusted for changes in the CPI-U.

Since the financial crisis, household wealth has grown by roughly $19 trillion, concentrated in financial assets. But the majority of Americans who have assets own real estate, and housing equity, though growing, remains below its previous peak, underscoring that a substantial amount of negative equity remains (Exhibit 24). While wealthy households have benefitted from the outstanding performance in the stock market over the past several years, middle and lower income wealth creation lingers as a headwind.

That headwind fades throughout the forecast horizon. Our housing strategists look for home price growth to average around 4% over the next several years, which will continue to whittle away at negative equity. Moreover, with the labor market growing ever tighter there is scope for relative gains in labor income to outpace relative gains in market income, which we expect to continue to support low-to-middle income discretionary spending relative to high-end discretionary.

16 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 24: Growth in Shareholder Equity Exhibit 25: Low Consumer Leverage Ratio Continues to Outstrip Housing Equity Gains Persists

Source: Federal Reserve Board, Morgan Stanley Research Source: Bureau of Economic Analysis, Federal Reserve Board, Morgan Stanley Research

Prudent balance sheet management as well as constrained access to credit has kept debt levels low compared to precrisis averages. Credit expansion has not yet emerged as a dominant driver of liquidity in the post-financial-crisis era and growth thus far has been restricted to the borrowers with the highest credit quality. Credit restrictions and cautious credit usage have helped bring households' debt-to-disposable-income ratio down to 1.07—the lowest consumer leverage ratio since 2002 (Exhibit 25).[ 12 ]

Headwinds remain, and stock market volatility may hold back segments of high-end discretionary spending if it persists, while middle- and low-end discretionary spending continues to be affected by sluggish wage growth and negative equity in housing. But while the former is always a source of uncertainty, the latter two are on an improving trend. Indeed, the kids are all right. I nvestment

Lower potential growth implies a lower equilibrium rate of investment. We are looking for a modest pace of growth in business investment over the forecast horizon as the drag from energy investment diminishes, and commercial building and R&D activity expand. Residential investment remains a bright spot, supported by strengthening fundamentals that are somewhat tempered by slow improvement in credit.

Nonresidential

Excluding the effects of energy, many areas of business investment are poised to continue along a moderate growth trend, including commercial construction and investments in technology-related products (Exhibit 26). After no net growth in the first half of this year, we are looking for nonresidential investment to grow at an average annualized pace of 3.8% in 2H15, then settle in around a 3% growth rate over the remainder of the forecast horizon.

17 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH Exhibit 26: The Investment Gap in Nonresidential Structures & Technology Is Slowly Closing

Trend calculated from 1990-2007. Source: Bureau of Economic Analysis, Morgan Stanley Research

Nonresidential structures investment has picked up after heavy drag from cuts to oil & gas drilling earlier this year. Equipment spending is looking better going into 2H15 after what’s been a poor trend. Weakness in core capital goods orders since mid-2014 has been most pronounced in machinery; plummeting oil and gas drilling equipment demand has been a big contributor to that, but orders for construction equipment and industrial machinery have also been soft—tied to weak global growth (Exhibit 27).

One potential bright spot within capex trends is the recent acceleration in R&D spending that could help to provide some offset to capital shallowing and boost productivity growth. Multifactor productivity largely reflects productivity-enhancing technological change, and despite some potentially positive developments in the tech sector, we're not seeing much of that in the data at this point. But real R&D investment (a component of the intellectual property products part of business investment) was up 12.2% annualized in 2Q15 and 7.9% in the past year—the best year-over-year growth since 2007. As a share of GDP, private R&D investment was up to a record high 1.8% in the first half this year—that ratio has trended gradually higher over many decades but had stalled at 1.6% from 2007 to 2011 before starting to move higher again in recent years ( Exhibit 28).

Exhibit 27: Equipment Spending is Looking Better Exhibit 28: Strong R&D Cycle May Help Improve for 2H15 After Weakness Since Mid-2014 Multifactor Productivity In Coming Years

Source: Census Bureau, Morgan Stanley Research Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Morgan Stanley Research

18 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH We see this R&D expansion as a positive leading indicator that may portend increases in productivity over the next few years. Accelerating R&D spending may help boost multifactor productivity in particular, as newly developed technologies proliferate through the broader economy when firms upgrade their existing capital stock and incorporate more recent innovations.[ 13 ]

Keep in mind, though, that global growth concerns remain the biggest risk to business investment, as a stronger dollar continues to irk manufacturers and suggests an historically subdued pace of investment is to be expected. Moreover, equity market volatility, or a higher equity risk premium resulting from weak global growth can weigh on business investment by raising the cost of capital for businesses.

Residential

Residential investment has held its momentum and continues to be a bright spot in our outlook (see Housing Market Insights: Why Are We Positive on US Housing?). Household formation rates have finally moved back above the historically normal 1 million mark (Exhibit 29). Declining rates of foreclosure and credit delinquencies, as well as rising income have supported demand for new and existing homes, but demographic trends and slow to improve credit conditions continue to drive a wave of those formations toward multi-family (apartment) living vs single-family (Exhibit 30).

Exhibit 29: Household Formation Rates Have Exhibit 30: New Formations Going Mostly In Finally Moved Back Above 1 Million Multi-Family Apartments vs Single Family

Source: Census Bureau, Morgan Stanley Research Source: Census Bureau, Morgan Stanley Research

19 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH We expect housing starts to average 1173K this year, 1434K in 2016 and 1497K in 2017, while growth in residential investment climbs to 9.5%Y this year, and hits a high-note at 10.9%Y in 2016 before slowing to 5.1%Y in 2017. That pace of growth would put residential investment on track to make an above- average contribution to GDP growth through most of the forecast horizon, as we expect new construction to pick up to meet the backlog of demand that built up after multiple years of subdued household formations (Exhibit 31). We expect new housing activity to moderate in 2017 only once that pent-up demand is absorbed.

Exhibit 31: Residential Investment on Track to Make An Above-Average Contribution to Growth

Source: Bureau of Economic Analysis, Morgan Stanley Research

20 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Risks to the Outlook

B ear Case: US Recession

Our bear case sees a mild US recession within the next 12 months. On a leap of faith, the Fed hikes rates in September, but after only one hike, it is apparent the Fed has moved too soon. GDP growth slows, but a cautiously optimistic Fed points to external drags as the culprit and remains focused on domestic momentum. Signs of a more material weakening appear, the Fed backs out the only rate hike it had executed, but a short- lived recession in 2H16 is already locked in. B ull Case: A More Normal Normal

In our bull case, households pick up the pace of spending more than expected. Seeing the sustained pickup in demand and expecting more, business investment accelerates and cyclically depressed productivity rebounds closer to historical norms. An optimal control policy informs the Fed to embark on a path of tightening that is cautious at first, then plays catch-up with the Fed’s target, reaching 3.625% by end-2017.

Exhibit 32: US Economic Outlook: Bull and Bear Cases

2015 2016 2017 (Year over Year) Base Bear Base Bull Bear Base Bull Real GDP 2.4 0.6 1.9 2.5 0.5 1.8 2.7 Final Sales 2.2 1.0 2.3 2.9 0.5 1.9 2.6 Final Domestic Demand 2.8 1.4 2.4 3.1 0.7 2.0 2.7 PCE 3.0 1.6 2.3 2.7 0.9 2.0 2.4 Business Fixed Investment 3.2 -1.3 3.1 5.4 -1.6 3.0 6.2 Residential Fixed Investment 9.5 6.9 10.9 11.8 4.8 5.1 4.7 Exports 1.7 -2.1 2.5 5.3 0.4 3.2 6.0 Imports 5.5 1.1 3.9 6.0 2.0 4.1 6.3 Government 0.7 1.1 1.1 1.1 0.9 0.7 0.7 CPI 0.1 1.4 1.5 2.0 2.0 2.2 2.7 Core PCE Price Index 1.3 1.1 1.6 1.8 1.3 1.8 2.2 Unemployment Rate (EOP) 5.1 5.6 4.8 4.8 5.6 4.8 4.7

Source: Morgan Stanley Research

21 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Full Forecast Table

22 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Exhibit 33:

Year over Year 4th Qtr/4th Qtr from Prior Quarter* 2014A 2015E 2016E 2017E 2014A 2015E 2016E 2017E 1Q15A 2Q15A 3Q15E 4Q15E 1Q16E 2Q16E 3Q16E 4Q16E 1Q17E 2Q17E 3Q17E 4Q17E Real GDP 2.4 2.4 1.9 1.8 2.5 2.0 1.8 1.8 0.6 3.7 2.0 1.7 1.9 1.8 1.8 1.9 1.8 1.8 1.8 1.7 Final Sales 2.4 2.2 2.3 1.9 2.6 2.1 2.0 1.8 -0.2 3.5 2.8 2.4 2.1 1.9 1.9 2.0 1.8 1.8 1.8 1.7 Final Domestic Demand 2.5 2.8 2.4 2.0 3.0 2.6 2.2 1.9 1.7 3.2 3.1 2.6 2.2 2.2 2.2 2.3 1.9 1.9 1.9 1.7 Personal Consumption Expenditures 2.7 3.0 2.3 2.0 3.2 2.5 2.0 2.0 1.8 3.1 2.9 2.4 2.0 2.0 1.9 2.1 1.9 2.0 2.0 1.9 Business Fixed Investment 6.2 3.2 3.1 3.0 5.5 3.1 3.1 2.6 1.6 3.2 4.4 3.2 2.0 2.9 3.7 3.7 2.9 2.5 2.5 2.3 – Structures 8.1 -0.9 2.1 3.3 5.0 -1.1 3.2 2.8 -7.4 3.2 -2.4 2.7 1.6 2.9 4.0 4.3 3.0 2.9 2.9 2.5 – Equipment 5.8 2.7 2.1 2.4 5.1 2.5 2.0 2.0 2.3 -0.4 5.8 2.5 0.4 1.6 3.1 3.1 2.7 1.9 1.8 1.7 – IPP 5.2 6.8 4.9 3.7 6.5 6.5 4.5 3.2 7.4 8.6 5.0 5.0 4.5 4.5 4.5 4.5 3.3 3.2 3.1 3.0 Residential Investment 1.8 9.5 10.9 5.1 5.1 11.3 8.9 3.5 10.1 7.8 13.9 13.5 13.2 8.6 7.3 6.7 4.3 4.4 3.0 2.1 Exports 3.4 1.7 2.5 3.2 2.4 1.1 2.2 3.8 -6.0 5.2 1.9 3.5 2.1 2.0 2.2 2.5 3.4 3.7 4.2 4.0 Imports 3.8 5.5 3.9 4.1 5.4 4.6 3.9 4.1 7.1 2.8 4.2 4.3 3.2 3.9 4.3 4.3 3.9 4.2 4.4 3.9 Government -0.6 0.7 1.1 0.7 0.4 1.1 1.1 0.6 -0.1 2.6 1.0 0.9 1.0 1.1 1.1 1.1 0.6 0.6 0.6 0.6 – Federal Government -2.4 -0.5 0.2 0.4 -0.8 0.1 0.4 0.4 1.1 0.0 -0.9 0.2 0.3 0.5 0.5 0.4 0.3 0.3 0.4 0.4 – State Local Government 0.6 1.5 1.7 1.0 1.1 1.8 1.4 0.7 -0.8 4.3 2.2 1.4 1.5 1.5 1.4 1.4 0.7 0.7 0.7 0.7 Business Indicators Real Net Exports (Bil.) -442.5 -546.1 -595.2 -640.5 -541.2 -532.6 -550.1 -560.4 -570.6 -586.3 -604.0 -619.9 -628.7 -637.4 -645.3 -650.7 Current Account as a % of GDP -2.2 -2.1 -1.8 -2.0 Surplus / Deficit as % of GDP (FY) -2.8 -2.5 -3.0 -3.1 Housing Starts (Thous) 1001 1173 1434 1497 978 1144 1236 1334 1390 1425 1450 1472 1483 1491 1500 1513 Light Vehicle Sales (Millions) 16.4 17.2 17.4 17.3 16.6 17.1 17.7 17.4 17.4 17.4 17.4 17.3 17.3 17.3 17.3 17.2 Industrial Production 3.7 1.8 1.7 1.7 3.7 1.8 1.7 1.7 -0.2 -1.7 3.1 1.8 1.9 1.8 1.5 1.8 1.6 1.7 1.7 1.6 Civilian Unemployment Rate # 5.7 5.1 4.8 4.8 5.6 5.4 5.1 5.1 5.0 4.9 4.8 4.8 4.8 4.8 4.8 4.8 After-tax corporate profits ** -0.6 -0.9 1.7 4.4 Real Disposable Personal Income 2.7 3.5 2.4 2.0 3.6 3.4 1.9 1.9 3.8 1.5 5.9 2.3 2.1 1.1 1.9 2.3 2.4 1.5 1.8 2.0 Personal Saving Rate (Pct) 4.8 5.2 5.3 5.2 5.2 4.8 5.5 5.5 5.5 5.3 5.3 5.3 5.4 5.2 5.1 5.1 Productivity (Nonfarm Business)*** 0.7 0.3 0.9 1.3 0.0 0.4 0.9 1.5 Inflation^ Consumer Price Index 1.6 0.1 1.5 2.2 1.2 0.3 1.9 2.4 -0.1 0.0 0.2 0.3 1.3 1.3 1.4 1.9 2.2 2.2 2.2 2.4 CPI ex Food Energy 1.7 1.8 2.0 2.2 1.7 2.0 2.1 2.4 1.7 1.8 1.9 2.0 2.1 2.0 2.1 2.1 2.1 2.1 2.2 2.4 PCE Price Index 1.4 0.4 1.4 1.8 1.1 0.6 1.6 2.0 0.2 0.2 0.4 0.6 1.3 1.4 1.3 1.6 1.7 1.7 1.8 2.0 PCEPI ex Food Energy 1.5 1.3 1.6 1.8 1.4 1.4 1.6 1.9 1.3 1.3 1.3 1.4 1.6 1.6 1.6 1.6 1.7 1.7 1.8 1.9 M onetary Policy Fed funds target (midpoint of range, EO P) 0.125 0.125 0.125 0.375 0.625 0.875 1.125 1.375 1.625 1.875 2.125 2.375

E= Morgan Stanley Estimates, A= Actual *Annualized percent change from prior period, unless noted **Including inventory valuation & capital consumption adjustments ***O utput per hour w orked ^Q uarterly figures denote year-over-year change #Annual figures denote end of period Source: Morgan Stanley Research, Forecast as of August 31, 2015

23 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

Endnotes

1 See Dudley's Q&A following prepared remarks in early June: https://www.marketnews.com/content/feds-dudley-qa-markets-should-not-be-surprised-liftoff 2 Dudley (2010): “$500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point. But this estimate is sensitive to how long market participants expected the Fed to hold on to these assets.” 3 Bernanke (2011): “the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points (…) roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the federal funds rate.” 4 At a 2013 IMF conference, Fed researchers found a hit to the level of aggregate supply of comparable magnitude. Reifschneider, Dave, William Wascher, and David Wilcox. Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy. Federal Reserve Board, 2013. 5 Projections that were posted publicly when the leak was recognized. 6 In a 2014 NBER paper, Robert Gordon reminds us that aggregate supply determines the growth rate of the real economy through the "output identity." Real GDP growth is related primarily to labor productivity, the unemployment rate, and the labor force participation rate. "The output identity is like an iron vise, because it is true by definition. For output to grow that much faster than the 2.1 percentage point average of the last five years, something radical has to happen." http://www.nber.org/papers/w20423 7 The minutes of the July meeting of the FOMC also made note that the staff “lowered slightly its estimate of the longer-run natural rate of unemployment,” perhaps bringing it more in line with our own estimate. In June the staff had estimated NAIRU at 5.2% through 2020, which looks high compared with our estimate of 5.0% now and declining slightly on a trend basis in coming years. 8 Chair Janet L. Yellen, Normalizing Monetary Policy: Prospects and Perspectives, at the "The New Normal Monetary Policy," a research conference sponsored by the Federal Reserve Bank of San Francisco, San Francisco, California, March 27, 2015. 9 Remarks at the 2015 U.S. Monetary Policy Forum, New York City, February 27, 2015. 10 For the original exposition of the Taylor rule, see John B. Taylor (1993), "Discretion Versus Policy Rules in Practice." For a broader discussion on policy rules, see John B. Taylor and John C. Williams (2010), "Simple and Robust Rules for Monetary Policy." 11 Trends can diverge in the short term caused by imbalances in income distribution, for example. Where Did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income, NBER Working Paper, December 2005 12 Note that the debt-to-income ratio briefly hit 1.07 in 4Q 2012 but increased to 1.1 in the following quarter. 13 For an example of this theory, see Cummins and Violante (2002), "Investment-Specific Technical Change in the United States (1947-2000): Measurement and Macroeconomic Consequences," discussing the "technological gap" between the newest and most productive innovations and the average quality of the current capital stock. A wider technological gap indicates that there are ample opportunities for firms to integrate new technologies into existing capital.

24 US Economic Autumn Outlook | August 31, 2015 MORGAN STANLEY RESEARCH

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