The major components of domestic final demand contracted rapidly in the fourth quarter, including consumer spending, nonresidential fixed investment and residential investment. Indeed, housing production contracted at a 23.6% annual rate and subtracted 0.85 percentage point from the overall GDP growth rate (that’s a lot).

Two surprises limited the fourth-quarter GDP contraction in the face of the retrenchment of domestic final demand.

First, business inventory investment added 1.3 percentage points to the change in GDP and, second, net exports were a neutral force rather than a drag on growth.

Both performances were unsustainable, and the inventory buildup definitely has negative implications for the early part of this year.

The buildup obviously was unintended, and firms undoubtedly will make strong efforts to cut stocks in the near term.

We’re currently projecting a 5.2% annualized rate of contraction in real GDP for the first quarter of 2009, the sharpest setback since the second quarter of 1982. We expect most major components of GDP to contribute to this decline, including inventories and trade, and the contraction in housing production will once again be a big part of the story.

Downward economic momentum most likely will extend into the second quarter of this year ― we expect a 1.5% decline in real GDP ― even though an impressive combination of economic policies should be coming together by then..

We expect policy support to gain sway during the second half of 2009, pushing GDP growth modestly positive and paving the way for stronger growth in 2010.
 

Half that loss occurred during the last three months alone, and the January loss of 598,000 jobs was the worst since December 1974. Furthermore, the job losses have been broad-based, including large ongoing losses in residential construction ― 61,000 in January.

Only education and health care have shown recent gains.

The unemployment rate naturally has been moving up as employment has fallen, rising by 2.8 percentage points since the beginning of the recession to a level of 7.6% in January. The unemployment rate has literally shot up since last September, registering a 1.4 percentage point increase over the course of four months — the type of increase not seen since the 1980 recession.

The Labor Department’s most comprehensive measure of underemployment, including so-called discouraged workers and those working part time who would rather be working full time, shows an even dire picture than the standard unemployment rate.

This rate (U6) has now risen to 13.9% and is up by 5 percentage points over the past year, driven mainly by increases in involuntary part-time work.

The near-term outlook for the labor market is quite serious, and job losses similar to recent months are in the cards for at least a few more months. Indeed, net job losses are likely to persist throughout the year, even if GDP growth picks up in the second half. The unemployment rate may very well rise into the early part of 2010, approaching 9% in the process.

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But little or no success has been seen in the banking system, despite large injections of capital under the Troubled Asset Relief Plan (TARP) as well as massive injections of reserves by the Federal Reserve. Banks are leaning hard on many outstanding loans and are severely restricting the supply of credit for new loans.

The Fed’s most recent quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices, conducted in January, documented continuation of the tightening process that began in earnest early last year. The Fed report noted that “the net fractions of respondents that reported having tightened their lending policies on all major loan categories over the previous three months stayed very elevated.”

The tightening process continued to show up in the mortgage lending arena, where about half the banks had tightened their lending standards on both prime and “nontraditional” mortgages — on top of even broader rounds of tightening in previous quarters.

Only a few banks reported making any subprime mortgages late last year.

The tightening of bank lending policies now is hitting the markets for land acquisition, land development and construction loans (the AD&C credit markets) very hard. Nearly 80% of banks in the Fed survey had tightened standards for such loans during the final quarter of 2008, and no bank had eased standards.

Tightening in the AD&C market has most commonly taken the form of lower loan sizes, lower loan-to-value ratios, higher debt-service coverage ratios and wider spreads of loan rates over banks’ cost of funds. Interest rate floors in floating-rate contracts also have proliferated. [return to top]
 

The national Housing Affordability Index produced by the National Association of Realtors® hit a record high in December ― the series goes back to 1971. Furthermore, NAHB’s Housing Opportunity Index surged in the final quarter of 2008 following a systematic rise from the cyclical low in mid-2006.

But housing demand has been weakening rather than strengthening, particularly in the new-home market and the owner-occupied portion of the existing-home market (abstracting from foreclosure-related sales to investors).

In fact, NAHB’s single-family Housing Market Index hit a record low in January and preliminary tabulations suggest little change in February.

The disconnect between affordability measures and housing demand points to the inherent deficiencies of the affordability measures as forecasting devices.

In the current circumstances, improvements in these measures are being overwhelmed by tightening mortgage lending standards, expectations of further house price declines and consumer concerns about the darkening economic environment.

The restoration of measured affordability bodes well for housing down the line, but it’s obvious that special measures now are needed to spur home buying and arrest the downward spiral in house prices.

A temporary incentive, such as the home buyer tax credit in the Senate’s version of fiscal stimulus, would be just what the doctor ordered. [return to top]
 

The homeowner vacancy rate moved up to a record-high 2.9% in the final quarter of 2008, equivalent to the rate in the first quarter of the year, and the rental vacancy rate moved up to 10.1% in the fourth quarter — also equaling its first-quarter high.

There were about 6.4 million vacant year-round housing units on the market (for-rent or for-sale) at the end of 2008, nearly 5% of the total housing stock. Furthermore, an unusually large number of vacant units were held off the market, suggesting that the “shadow” inventory still is running high.

Excessive housing vacancies are putting persistent downward pressure on house prices, wiping out household wealth and further weakening mortgage credit quality.

Policy measures to spur home buyer demand and limit foreclosures are urgently needed to stimulate demand, limit supply and stabilize prices, and policymakers are now on the job. [return to top]
 

The Fed has also developed a second set of policy tools which involve the provision of liquidity directly to borrowers and investors in key credit markets, including the high-grade commercial paper market.

A third set of tools involves the purchase of longer-term securities for the Fed’s portfolio, including the debt and guaranteed mortgage-backed securities of the housing government sponsored enterprises (GSEs).

The Fed has additional measures under consideration or on the drawing board, and hopefully these will be implemented in the immediate future.

A new Term Asset-Backed Securities Lending Facility (TALF) has been promised for some time, and a beefed-up version is part of the Treasury’s Financial Stability Plan that has just been unveiled by Treasury Secretary Tim Geithner.

This facility will be capitalized by the Treasury and the Fed will lend to investors against high-grade asset-backed securities collateralized by various consumer and small-business loans and possibly commercial as well as private-label residential mortgage-backed securities.

The Fed also has been talking about buying more aggressively into the long end of the Treasury yield curve, in effect “pegging” long-term Treasury rates at some desired level.

The Fed should stand ready to implement this policy as the prospect of burgeoning Treasury issues and the possibility of falling demand from overseas combine to raise Treasury rates and drag up associated long-term private interest rates (such as home mortgage rates) in the process. [return to top]
 

The negative reactions apparently were provoked partly by a glaring lack of concrete details behind a series of complicated concepts contained in a Treasury “Fact Sheet.” The markets were looking for quick and decisive government support to the credit system but came away with major uncertainties about the structure and feasibility of the plan outlined by Secretary Geithner.

The markets also appeared to be concerned about heavy emphasis on the need for private capital, and comparatively light emphasis on the potential need for more public funding to “cleanse” the balance sheets of stressed financial institutions.

In general, the package was far less bank-friendly than the markets had hoped for.

The Financial Stability Plan promised that a comprehensive plan for “Housing Support and Foreclosure Prevention” would be developed “soon”.

The broad outline mentioned expansion of Federal Reserve efforts to drive down mortgage rates and use of $50 billion of the remaining TARP funds “to prevent avoidable foreclosures of owner-occupied middle-class homes.” But no further details were presented on the foreclosure relief front.

Perhaps the Financial Stability Plan just wasn’t quite ready for prime time, and implementation of a fleshed-out plan might turn out to be quite constructive.

But the announcement was a stunning downer for the markets and there’s a lot of skepticism about the eventual success of the plan outlined by the Treasury Secretary — not exactly what the markets and the economy need at this juncture. [return to top]
 

The absolute sizes of the House and Senate bills are quite close ― at $819 billion and $838 billion, respectively. However, there are some glaring compositional differences that set the stage for potentially contentious negotiations before the final bill is sent to the President — hopefully by the President’s Day “deadline.”

The Senate bill contains a $15,000 tax credit available to all buyers of principal residences for up to one year after date of enactment. The credit would not have to be repaid to the Treasury — unlike the $7,500 credit now available to first-time buyers ― and, although the Senate version is not refundable, buyers could claim it against both their 2008 and 2009 tax bills.

The House version simply removes the obligation to repay from the $7,500 credit now in effect for first-time home buyers.

There’s no doubt that the final stimulus bill will provide substantial support to housing and the economy, particularly if a sizeable home buyer tax credit makes its way through. However, it’s obvious that the overall package will not be heavily front-loaded, particularly if the House version holds sway, limiting the short-term stimulus effects just when they’re needed the most. [return to top]
 

The three legs are fiscal stimulus, financial stability and foreclosure relief, and these measures should be coupled with maximum complementary efforts by the Federal Reserve.

At this point, fiscal stimulus is moving well in Congress but the Treasury’s Financial Stability Plan is getting stern reviews from the markets and there’s no concrete plan in view to deal with the daunting foreclosure issue.

On the Fed front, our central bank is out of traditional monetary policy ammunition and is attempting to improve credit flows via use of its practically unlimited balance sheet capacity — unconventional measures with uncertain impacts.

This all adds up to substantial uncertainty about the economic outlook.

It seems likely that economic growth will be able to solidify by the second half of this year and that the labor market will start to recover early next year — that’s our forecast.

But even this pattern would leave a huge gap between actual and potential output as well as a tremendous degree slack in labor markets.

This scenario brings outright price deflation onto the radar screen, a potentially destructive condition that would create daunting challenges for policymakers here and abroad. Stay tuned. [return to top]