Recession!

 

The U.S. economy, which has been weathering a Katrina-like onslaught of building intensity for over two years, appears to have finally succumbed and entered a recession. While the folks at the National Bureau of Economic Research (NBER) are yet to officially call the downturn, we believe that the unwinding of the housing bubble, severe problems in the financial markets, oil price spikes last summer, sharp declines in equity prices, and, most recently, a virtual freeze-up in the credit markets have sapped the economy's last bit of resilience. What is truly surprising is not so much that economic growth ultimately stopped, but, rather, that the economy withstood this pummeling as long as it did. The questions now are: How bad will it get and how long will it last?

 

Aided by the economic stimulus package passed earlier this year, the economy grew at a 1.8% annual rate in the first half of this year, shaking off a drop in GDP at the end of 2007. We are projecting growth to drop to less than 0.5% in the third quarter before turning negative in the fourth quarter of 2008 and the first quarter of 2009 (see chart 1). The consumer will likely be the "last domino to fall" as the economy enters its slide. Consumption grew in the second quarter at a paltry 1.2% annual rate despite a considerable boost to disposable income from the tax rebates. Without continued help from Uncle Sam and with job losses mounting, the stock market in free fall, and energy and food prices still high, consumption growth will flag. Consumers are unlikely to borrow to maintain past spending patterns even if banks were willing to lend (see chart 2).

 

The unwinding of the housing bubble continues to drag down GDP growth. Housing starts are still falling, albeit at a less steep rate, and are currently at levels not seen since the early 1990s. Home prices and sales have fluctuated recently but do not yet appear to have bottomed out. With lower interest rates and lower home prices, housing affordability has risen noticeably, but we don't foresee a turnaround until the backlog of unsold housing inventory is substantially reduced. With consumer confidence shaky and job worries growing, it may be some time before this sector starts to contribute to economic growth-perhaps toward the middle of next year.

 

Business investment, which has been lackluster for a number of quarters, has slipped another notch of late. Equipment and software investment declined at an annual rate of 5.0% in the second quarter on top of a very small drop in the first quarter (see chart 3). Factory orders in August (the latest available data) were down 4.0%, signaling continued decline in business investment. Even the bump in investment in structures in the second quarter isn't expected to continue in the face of capacity utilization rates below 80%.

 

International trade has been the only bright spot for the U.S. economy as the trade deficit has fallen 22% since 2007. Imports decreased at an annual rate of 7.3% in the second quarter, and exports increased a whopping 12.3%. In the second quarter, the growth in net exports accounted for virtually all real GDP growth. However, with the dollar stabilizing a bit of late and growth abroad weakening, we expect trade to offer less support to GDP for the rest of the year.

 

With growth slowing, the labor markets have continued to slacken. The economy has lost 760,000 jobs in 2008 and has lost 299,000 jobs in the third quarter alone. Not surprisingly, housing and manufacturing are the two biggest contributors to job declines. Employment in the construction industry fell by 340,000 jobs this year, and manufacturing lost 392,000.

 

The unemployment rate remained unchanged in September at 6.1%, following a rapid increase of 0.4% in August (see chart 4). This rate has risen from 4.9% in January 2008, and we expect it to reach 7.0% before the economy bottoms out. Initial claims for unemployment have also been trending up for the past few months and are currently at 474,000 on a four-week moving average.

Overall inflation declined slightly in August after trending up for several months. Core inflation (net of food and energy components) has also moderated in the most recent data, but it remains at the upper bound of the Federal Reserve Board's comfort zone. Market expectations of inflation have declined sharply as the economy has deteriorated. The recent moderation in inflation is a welcome development and made it easier for the Fed to cut interest rates.

 

On October 8, 2008, the Fed lowered the federal funds rate by 50 basis points to 1.50% in response to negative developments in financial and credit markets. The Fed's action was an important signal because it rarely acts in between its regularly scheduled meetings. Prior to the rate cut, the Fed had left rates unchanged since its April meeting, when it cut rates to 2.0%. This most recent action has been one part of a broader response to the recent turmoil in credit and financial markets. The Fed has pumped hundreds of billions of dollars into the financial system in an attempt to increase liquidity and stabilize credit markets.

 

As I write this, the credit markets are still uncertain, and we are continuing to see a flight to safety. Yields on 3-month Treasury notes are right around 0.5%, which is incredibly low by historical standards. Measures of risk spreads are elevated, and we have seen a severe contraction of interbank lending and sharp declines in the amount of commercial paper outstanding.

 

On October 3, 2008, the president signed the Emergency Economic Stabilization Act of 2008 that will, among other things, allow Treasury to purchase up to $700 billion of distressed mortgage paper, establish an asset insurance program, and increase deposit insurance to $250,000. This was a necessary first step in reliquefying financial markets stemming the growing panic, but it is not a panacea. One must guard against overzealous expectations; it is going to take some time to work, and it is not intended to solve all the economy's current woes.

 

Earlier in the year, we reviewed the four primary indicators that the NBER uses to time business cycles-nonfarm employment, industrial production, manufacturing and trades sales, and real personal income minus transfer payments. At the time the levels were weak but did not necessarily point to recession. Unfortunately, the significant worsening of problems in credit markets provided the tipping point and likely signals the onset of recession. If the Treasury plan works, and we see some improvement in credit flows and catch a break in the housing markets, we could be out of the decline by next summer. If not, it could be a long steep drop.