The domestic economic evidence in the U.S. has remained upbeat in early 2012, with a much better than expected employment report for January being the latest piece of good news, according to a report by IHS Global Insight.

Nigel Gault, Chief U.S. Economist for IHS, has stated that there are hints that a virtuous circle may be building where employment, incomes and consumer spending move up together. There are a few caveats. First, exceptionally mild winter weather has given temporary help to employment, construction activity, and probably auto sales, too, in December and January. Second, the economy's collapse in late 2008 and early 2009 has probably affected the standard seasonal-adjustment procedures (which are now biasing the data upwards because they are looking for extra weakness at this time of year). But these are caveats only—reasons not to get too carried away—they do not affect the underlying improvement in the economy.

Fourth-Quarter Growth Was Near 3 Percent; First-Quarter Growth Still Likely to Be SlowerIHS reports that fourth-quarter GDP growth came in at 2.8 percent, the strongest quarter of 2011 by far, up from 1.8 percent in the third quarter. Inventories were an even bigger swing factor than anticipated, adding 1.9 percentage points to GDP growth, while final sales rose just 0.8 percent. Firms prepared for the worst in the third quarter; when sales outperformed their fears, they needed to ramp up inventories again. We expect growth to slow to 2.2 percent in the first quarter, with inventories a small drag rather than a big plus. Final sales should do much better, though, rising 2.5 percent. We do not expect the fourth quarter's steep declines in defense spending and oil and gas drilling to be repeated. We now expect 2012 GDP growth of 2.1 percent (up from 2.0 percent), after 2011 growth of 1.7 percent.

Recession Risks Still Hinge on the EurozoneIHS has noted that the government has not yet extended the 2 percent payroll tax cut and emergency unemployment insurance benefits beyond the end of this month, and while there may be some drama involved, we expect the extension to be carried through for all of 2012 (possibly in stages). The key recession risk remains a threat from the eurozone, although there may be improvement. The European Central Bank's Long-Term Refinancing Operation has pumped liquidity into the system and has reduced the risks of a major banking crisis. But sovereign-debt problems have not been resolved. The only question about Greece's default is whether it will be orderly or disorderly. And markets are now beginning to anticipate a default by Portugal. But the continuing run of better domestic data, combined with reduced fears of European banking collapse, has led us to reduce our U.S. recession risk further to 25 percent, from 30 percent.

Key Deadlines Still Loom at the End of 2012Gault reports that domestic policy uncertainty will remain very high throughout 2012. As things stand, at the start of 2013, automatic spending cuts will kick in, the Bush tax cuts will expire, and, assuming that the payroll tax cut and emergency unemployment insurance benefits get a full-year extension, they too will expire. We assume that a grand bargain involving entitlement, spending cuts and tax increases, phased in over many years, will eventually be reached, but only at the last minute. The exact nature of that bargain will depend on the balance of power in Washington after the November elections, which is hard to call. Our presidential election model still sees the president as the underdog, but his prospects are improving as the unemployment rate falls.

Fed's Low-Rate Guidance ExtendedIHS has pointed that the Federal Reserve has extended its exceptionally low rates guidance through late 2014. Since our growth forecast is below the Fed's and our inflation forecast is in line with the Fed's, we have assumed no rate hike until 2015. Remember, though, that the Fed's guidance is not a cast-iron promise. If the economy improves faster than the Fed expects, the Fed can change its mind and hike sooner. Since we expect 2012 growth to undershoot the Fed's expectations, we still assume a 2012 QE III program of similar size to QE II ($600 billion), targeted mostly or entirely toward mortgage-backed securities. But the improvement in domestic data means that we're less sure than we were in 2011 that QE III will be implemented.