Eye on the Economy - 06/17/2009 (Plain Text Version)

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Recessionary Forces Are Weakening at Home and Abroad

U.S. economic output contracted at a rapid pace late last year and early this year as the economy was rocked by a major financial market crisis that engulfed most of the world. Real gross domestic product (GDP) in this country fell at an average annual rate of 6% during the final quarter of 2008 and the initial quarter of this year, the sharpest two-quarter reversal in more than 50 years, and global GDP fell deeply into the red as well.

Unprecedented monetary and fiscal policy responses to the financial crisis and global recession helped prevent the widely touted doomsday scenario from materializing, and a 1930s-type debacle has been avoided.

Even so, the current episode can be fairly labeled the “Great Recession,” and the world will breathe a deep sigh of relief when it finally moves behind us.

The strenuous and coordinated policy responses, together with necessary structural corrections in housing and other sectors, have laid the groundwork for recovery in economic output that should begin to take shape during the second half of the year.

The economy will be battling some formidable headwinds during the early stages of recovery, however, limiting the takeoff to historically modest proportions.

We expect U.S. real GDP to contract at a 1.2% pace in the current quarter, quite a mild setback by the standards of the two previous quarters, and to expand at an average annual rate of 1.5% during the second half of the year.

This type of below-trend growth in economic output could provoke identification of a cyclical trough before the end of the year by the Business Cycle Dating Committee at the National Bureau of Economic Research, although it’s clear that the committee focused heavily on labor market statistics when pegging the cyclical peak as December 2007.

By those standards, the “Great Recession” most likely will stretch out to two years or more, easily the longest of the entire post-war era.

Labor Market Contraction Still Has Some Distance to Run

Payroll employment in the U.S. has been falling continuously since the end of 2007 and the losses have been quite large since last fall — averaging 573,000 from October through May of this year.

The civilian unemployment rate has moved up from 6.2% to 9.4% during this period, and the government’s broadest measure of labor underutilization (U-6), including discouraged workers and those working only part time for economic reasons, climbed to a lofty 16.4% by May.

The labor market typically continues to contract while the early stages of recovery in economic output are underway as labor productivity (output per hour) rises, and this pattern undoubtedly will materialize in the second half of this year and perhaps in the early part of 2010 as well.

We expect payroll employment to stabilize by year-end at a level that’s about 7 million below the cyclical peak, and we’re expecting the unemployment rate to top out close to 10% during the first quarter of 2010 — about double the rate associated with a fully employed, low-inflation economy. [return to top]

Inflationary Forces Should Be Benign for Some Time

The projected economic recovery should not generate serious inflation issues for quite a while.

It’s true that prices for oil and other key commodities are well off their lows of early 2009, but these prices still are well below the record highs of mid-2008 and do not figure to approach those ranges in the foreseeable future. The dollar clearly is well off its early 2009 highs, delivering another inflationary impulse, but further depreciation is likely to be quite limited.

Most important for top-line and core inflation, the huge and growing degree of slack in the nation’s job market is sure to keep downward pressure on labor cost per unit of output for an extended period while the economy climbs back toward its maximum sustainable output level.

The gap between actual and potential real GDP now is huge, and it will take years of above-trend growth of at least a 3% pace to close that gap.

Recent inflation readings, including the Producer Price Index (PPI) and Consumer Price Index (CPI) for May, point toward a downward path for inflation (disinflation) without the threat of destructive deflation.

We expect both top-line and core consumer price inflation to recede over the balance of this year and in 2010. Indeed, we expect the core personal consumption expenditures (PCE) inflation measure to fall somewhat below the Federal Reserve’s long-term target range, giving our central bank a free hand to support the impending economic recovery. [return to top]

The Fed Will Not Stand Down Until Recovery Is Assured

The Federal Reserve has been a dominant force in the battle against financial chaos and the threat of depression, and Chairman Ben Bernanke has repeatedly assured the markets that the central bank “will not stand down” until these battles have been won.

In the process, the Fed has pushed conventional monetary policy to the limit, driving the federal funds rate essentially to zero and publicly committing to maintain that position for an extended period.

The Fed also has developed a range of policy innovations, including unconventional measures that employ the unlimited power of its balance sheet to maintain credit flows in sectors of the economy that need it the most — including the agency-related home mortgage market and the private asset-backed securities markets for consumer loans and commercial mortgage-backed securities.

Early signals of near-term economic stabilization have provoked speculation about a shift in Fed strategy — from an all-out war against financial market dislocations and economic weakness to a systematic march back toward monetary neutrality. Indeed, futures markets are signaling expectations of a higher federal funds rate by late this year, but the early stages of economic recovery are likely to be quite tenuous and the labor market is sure to deteriorate for some time beyond the trough in economic output.

We do not expect the Fed to raise the funds rate until the unemployment rate clearly is on a downward path, and that may not occur before the end of next year.

There’s also speculation that the Fed will have to rein in its balance sheet activities because of the inflationary consequences of its asset purchases and corresponding increases in the monetary base, the “high-powered” money. But, so far, these increases have flowed into excess reserve positions of commercial banks, with no immediate inflationary consequences.

In the event that banks come out of their shells and begin to supply ample credit to the private sector, the Fed will be able to quickly run down its balance sheet positions and extract excess reserve balances, as needed, to prevent an inflationary buildup. [return to top]

The Healing Process Is Underway in Financial Markets

Bernanke has stressed that normal functioning of financial markets is an essential precondition for sustainable economic recovery. The broad range of efforts by the Fed, combined with the financial stabilization policies enacted by Congress and the Bush and Obama Administrations, now are bearing a lot of fruit — reducing obstacles to near-term economic stabilization and recovery.

Progress on this front showed up, first of all, in interbank loan markets here and abroad followed shortly by improvements in commercial paper markets.

We’re now seeing substantial shrinkage of quality premiums in corporate bond yields, and the stock market has staged a recovery from the abysmal lows in March.

Issuance of both corporate bonds and equities is on the rise, and aggressive cost-cutting has bolstered internal corporate cash flows as well.

The Fed’s aggressive monetary policy stance helped generate a Treasury yield curve with a steep upward slope, a boon to many financial institutions and a classic forerunner of economic recovery.

At the same time, the stampede to credit quality provoked by last fall’s financial shock drove down the entire yield curve, pushing long-term Treasury rates to historic lows through the spring of this year.

But the recent brightening of the economic and financial landscapes has encouraged some risk-taking, reducing appetites for longer-term Treasuries. This development, together with investor concerns about heavy issuance of Treasury securities, potential inflation pressures and the prospects for tighter monetary policy, has put significant upward pressure on Treasury yields during the past month — other than for the very short-term instruments that are currently anchored by the rock-bottom federal funds rate.

The key issue in private credit markets, including the home mortgage market, now comes down to a tug-of-war between a rising Treasury yield curve and shrinking risk premiums above comparable-maturity Treasury yields. This actually is a healthier situation than the panic-driven credit structure that prevailed until quite recently.

For housing, the outcome should involve historically favorable prime fixed-rate mortgage yields and stabilization of mortgage lending standards — following the snap-back from absurdly lax standards that fueled the unsustainable housing boom. [return to top]

The Demand for Homes Is Firming Up

The affordability of home buying has soared as house prices have fallen in many places and mortgage rates have held in a historically favorable range. Consumers’ views of home buying conditions have strengthened in the process — according to measures produced by the University of Michigan.

First-time home buyers also have access to the $8,000 federal tax credit and a few states, including California, have enacted their own credits.

Tighter lending standards continue to be an issue, of course, but that tightening process may have run its course. Expectations of further price declines also may be a damper on demand, but prominent consumer surveys do not reveal a lot of concern on that front.

Recent indicators of home buying activity actually show that demand is firming up to some degree, despite the weakening job market and tighter credit standards. The cyclical troughs for sales of both new and existing homes apparently were hit in the first quarter, and the official sales numbers improved to some degree in April.

NAHB’s proprietary survey of large public and private home builders shows significant improvement in both gross and net home sales in May, even on a seasonally adjusted basis, following smaller gains in other recent months.

Our broad-based single-family Housing Market Index dropped by one point in June, following a series of improvements from the record low in January, as the component that measures sales expectations gave back a bit of the earlier gains. Builders presumably were reacting to a backup of mortgage rates as well as to the rising tide of foreclosures that still presents stiff competition to the new-home market. [return to top]

Housing Production Should Stabilize Soon

The housing market still is saddled with large numbers of vacant units, both for-sale and for-rent, and the foreclosure wave obviously is adding to the inventory problem facing home builders. But starts of new units recently hit record lows, particularly the for-sale components of the single-family and multifamily sectors, and the recent firming of home-buyer demand should lead to some improvement in the pace of starts.

In fact, the government’s preliminary numbers for May show a bounce-back from the record low in April, and issuance of building permits moved up as well.

We believe that total housing starts have hit bottom in the current quarter. The drag on GDP growth from the long downtrend in residential fixed investment should ease during the second half of the year and housing production should provide positive growth contributions by early next year — as long as financial conditions and support from job growth outweigh negatives for demand associated with scheduled expiration of home buyer tax credits. [return to top]

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