Economic Trends and Risks

Grossest Growth in 26 Years

The government estimated fourth quarter GDP at a -3.8% decline a month ago as actual December data has left a revised plunge of -6.2% -- the largest decline since the -6.4% dive in early 1982.  The downward revision was very broad based with the only lift in housing investment (but from -24% to -22%), nothing to cheer about.

Moreover, large declines were seen in all the major components excluding inventories (stock left on the shelves) and government spending (a preview of whats ahead).  Consumer spending topped the large Q3 decline as business investment simply collapsed falling -21% after the tame -2% Q3 decline.  Equipment spending plunged -32% as foreshadowed by the plunge in capital goods orders.  The decline in residential investment was larger than the prior two quarters as the global trade flow (net exports) showed the first negative contribution in two years. 

And that growth composition is important.  With 70% weight in GDP, personal spending isn't going to rebound quickly even with the massive government aid.  Consumer confidence is at a record low as the halving in equity prices and sharp fall in home prices have cut household net worth a stunning $7 bln since the peak in Q3 2007.

Business investment nearly matched the plunge in consumer spending as the lack of capital investment leaves closing factories and a continued reduction in payrolls which feeds back in to reducing consumer spending.   Business investment and household spending and investment show the crucial part of the domestic economy outside the effects of the global trade, government spending and unintended inventories swings.  This is private domestic demand which fell over -7% in Q4.

Early expectations for the current quarter are running slightly stronger that the dive in Q4, but that's really only based on an expected January rise in consumer spending (to be released Monday).   January payroll declines continue to grow larger (and initial claims for unemployment reached a staggering 667,000 in mid February) as January industrial production fell -1.8% and home sales continued lower.

Fed's Bernanke: Outlook given Key Presumption

The Federal Reserve Chairman presented his semi-annual testimony to Senate regarding monetary policy and the economy.  It was long on what actions have been taken and light on further actions that may be needed but provided an outlook given the key presumption (and its a big one) that financial stability is restored.  See the full document on the Fed's web site. 

Bernanke noted the severe contraction in the domestic economy and the first decline in global economic growth in over a quarter century.  He sited the principal cause as the collapse of the global credit boom and the ensuing financial crisis. 

In reviewing the curative practices taken by the Fed, the nearly flat policy rate (0% - 0.25% targeted range) and the numerous initiatives to address the financial strains which have inflated the Fed's balance sheet.  These added Fed assets sum to over $1.3 trillion since the start of 2008 (see the weekly listing of Fed assets for a listing and the size of each).

Bernanke also reviewed the recent announcement from the Treasury secretary for further actions including new bank capital assistance, the public-private investment fund, TALF -- the fund intended to restart securitization markets to support consumer and small business credit extension and the plan to prevent home foreclosures.

The Congressional testimony stated (bold face added) that "If actions taken by the Administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability -- and only if that is the case, in my view -- there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery".

The Fed's outlook presented in the table below calls for negative growth in 2009 given a significant contraction in the first half and an anticipated gradual resumption of positive growth over the second half of the year.  Downward growth risks are predominant given the global nature of the slowdown and reinforcing downward effects of the economic and financial conditions.  Unemployment is expected to peak just below 9% as inflation concerns have disappeared given the drop in commodity prices (chiefly energy prices ) and the slack in the economy and the resulting lack of pricing power.

                                                   Federal Reserve's Central Estimate Range

                                                        2009                  2010                2011

   Change in real GDP                 -1.3% - -0.5%       2.5% - 3.3%       3.8% - 5.0%   

   Unemployment rate                 8.5% - 8.8%        8.0% - 8.3%       6.7% - 7.5%

   PCE Inflation                            0.3% - 1.0%        1.0% - 1.5%       0.9% - 1.7%

   Core PCE Inflation                    0.9% - 1.1%        0.8% - 1.5%       0.7% - 1.5%

Housing Aid

President Obama's efforts to aid homeowners under the threat of foreclosure is long overdue.  Yeah, its a effort estimated at a very large $275 bln following the record $787 bln economic stimulus but the housing recession hasn't yet shown any clear signs of stabilizing given the self feeding downward spiral of home prices and resulting foreclosures -- see a Nov 25 post titled Self Sustained Downward Spiral.

The plan takes effect in two weeks -- March 4 -- and would pay incentives to mortgage lenders to make changes in loan terms to increase borrower affordability.  The plan also addresses the problems of high lending rates and higher mortgage loan to value ratios as home prices fall. It also would increase credit availability which has all but dried up over the last few years.

The questions that have stalled any action to date remain -- the costs of bad lending isn't offset by those who did it and errors (intentional or not) in reported income to secure the mortgages won't be penalized.  But the plan does intend to exclude speculators and second home owners. 

In normal times this type of assistance after frighteningly shoddy lending would be condemned.  But these aren't normal times.  January housing starts were the weakest on record as the -20% to -25% drop in home prices increase foreclosures to leave over a year of available supply further dragging new construction and pricing.  Housing starts have fallen 80% since its peak and have halved in just the last six months.

 

A similar episode is seen in manufacturing.  January's industrial production is -10% lower than a year ago given an annualized -21% plunge in manufacturing over the last six months.  Autos are a big piece as January's -23% nosedive adds to the -11% annual decline in ex-vehicle manufacturing output. 

The requested financing from the auto companies draws even larger criticism given the source of the errors in the executive offices.  GM, the nation's largest automaker, requested another $12 bln of government loans to add to the $18 bln already approved.  In the U.S. failing companies typically go bankrupt but the weight/extent of the auto sector is providing added pressure.  

The government loans/giveaways continue to mount as autos add to the fiscal economic stimulus plan, the Treasury assistance to the banking sector (with the latest Public-Private Investment Fund) and the president's promise to troubled homeowners.   The costs will be huge but the effects without them would be far more damaging.

The Stimulus Plan and Recovery

After posting a survey of economic growth on Friday I'm embarrassed having not noted that the outlook for economic recovery over the second half of this year is drawing increased  question.

The Fed's policy statement noted that "the Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant."   Moreover, the lack of clarity on solutions to the racked financial markets also provides worry that the big turnaround will not meet the expectations.  Granted, the American Recovery and Reinvestment Bill of 2009 is the largest stimulus plan in U.S. history at $787 bln but even its weight may prove unable to redirect the economy by year end. 

The stimulus package wasn't front loaded with the intent of quickly ending the current recession.  You can choose whether the politicians were partly focused on a longer lasting recovery, the laundry list of democratic objectives or the 2010 mid-term congressional elections.  The bi-partisan Congressional Budget Office (CBO) expects it to drag the 2009 budget deficit by $185 bln as more than twice that hit estimated at $400 bln arrives in 2010. 

A third of the package is tax relief with the remaining two thirds composed of government spending.  The tax relief promised during the elections has been thinned to $400/yr for individuals which nets out to only about $13 (yeah, thirteen dollars) of added weekly take home pay this year and just $8 next year.  That small boost won't provide much of an economic lift given the trade off to save or pay down debt.

The government spending includes infrastructure which will create jobs with the heaviest effect on construction which has suffered under the housing recession.  But the spending will be slower in coming and could delay what many are hoping to be the end of this ugly recession which continues to worsen.  The CBO estimates less than 1/5 of the proposed spending on energy and water would occur by the start of 2011 -- no help for the current problems.

Forecasters' View Ahead

The week ends with some modestly encouraging news from the Philadelphia Fed's Survey of Professional Forecasters -- 43 economic forecasters including the skills at Goldman Sachs, Bank of America, Economy.com and others. 

Despite downward revisions from last quarters estimates and another sharp GDP decline expected near -5% in the current quarter an economic recovery is expected in the third quarter with GDP returning to positive growth.   Longer term estimates show 2.56% average GDP growth over the next ten years.

Short Term Expectations

                  Real GDP    Unemployment   CPI Inflation   CPI core

2009 Q1       -5.2%                7.8%               -2.7%           0.6%

         Q2       -1.8                   8.3                   0.8              1.2

         Q3        1.0                   8.7                   1.7              1.3

         Q4        1.8                   8.9                   1.8              1.3

2010 Q1         2.4                   9.0                   2.0              1.5

Long Term Forecasts (10-year)

    Real GDP                                 2.56 %

    Consumer inflation                    2.4 %

    Stock returns (S&P 500)            6.50 %      

    Bond returns (10-yr Treas)         4.85 %

However, the near term outlook also sees a worsening in unemployment to a 9% rate in early 2010 when the labor market recovery is expected to take shape.  Inflation currently shows the effects of the plunge in oil prices and the lack of pricing power given the recession.  After a year, when the energy price declines are washed from the calculation, annual inflation growth is expected to return to a more comfortable 2% as the core (the less volatile ex food and energy component) rises to 1.5% from deflation suggesting levels in the current quarter.

90% of the surveyed forecasters reflect the new fiscal stimulus package and expect it to affect real GDP growth in the second quarter of 2009.  The package is expected to lift real GDP growth 0.9% this year, 1.1% in 2010 and 0.4% in 2011. 

The longer ten year forecasts were lowered slightly from last quarter's estimates with longer term trend like gains lead by a 6.5% average in stock returns as 10 year Treasury bonds are expected to rebound and average 4.85%. 

I posted my 2009 Outlook on December 26.

Global Trade Tanks

The trade deficit plunged in November with a follow up dip in December leaving over a 30% decline over the final two months of 2008.  December's -$39.9 bln deficit is the smallest in five years but still larger that the Q4 GDP estimates assumed.  The larger than expected deficit will provide a downward revision to GDP near 0.5%.

The key causes of the massive pullback are the cooling of global trade given the recessions gripping much of the world and the price declines (and dollar trade declines) in petroleum (read oil) products. 

The global recession turned the trade figures in August after record sized exports and imports in July.  Both have only seen monthly declines since as exports have plunged 20% over the last five months, topped by the24% drop in imports influenced by petroleum prices.

Filtering out trade in petroleum products from the trade deficit shows the steady improvement in non petroleum U.S. trade.  That measure has almost halved over the last two years but the improvement was hidden by the volatility in oil flows. 

Oil's recent price plunge adds to the reduced volume of petroleum trading given the weakened economy which leaves the effect more than halving its effect over the last half year.  

While petroleum products carry heavy influence, the near term influences argue that the weak global economy will continue to provide a smaller trade deficit -- a welcome event but under the ugliest of circumstances.  

 

Evolution of the Economic Mess

January payrolls fell by a new cyclical high of -598K as the unemployment rate jumped to 7.6%.  Yesterday's weekly reports on unemployment benefits rose to new highs for both the newly unemployed and those on the line for the longer haul leaving even darker news quite likely for February.  There isn't any indications of troughs or bottoms in the key economic indicators.  The summation below serves as a thumbnail review of how we got in to this economic mess.  

 

The downswing started back in 2005 as home sales fell off after the powerful lift during give-away borrowing in earlier years.  Home prices began to fall and start the housing recession.  Housing starts and new home sales are now -76% below their peaks as new home prices have fallen 21%.

 

Banks came to realize the risk in low quality mortgage borrowing, its effect on mortgage backed securities and the carry over to other asset-backed securities.  Market liquidity froze up.  Investment banks collapsed in the wake as policy remedies will probably add to the $700 bln TARP financing.  The Treasury secretary speaks Monday.

 

Hesitant banks tightened lending standards as Fed easing took shape in forms other than traditional overnight policy rates.  The policy rate is now in a 0% to 0.25% target range.

 

The housing and financial crises carried in to lower equity prices as consumer confidence faded quickly with the addition of extremely high energy prices (prior to July).

 

Lower home and equity prices significantly reduced household wealth as lower confidence added to the slowing consumer spending now -7% (annualized) over the last half year.

 

The recession turned the tables on inflation as fears of deflation rise with the rapid downturn in energy prices and the lack of pricing power.

 

The reduced demand from declining spending, recessionary housing and tighter lending standards provided a lift to the unemployment rate which accelerates the downturn in spending and the lack of demand.  Payroll layoffs continue to show larger declines.  Layoffs lower income growth with a self perpetuating downward effect on spending and the economy.

 

Business investment turned sharply negative as weak demand and lower profits leave manufacturing in to a recessionary state.  Foreign demand for capital goods faded with the global economy.

 

The economic recession and an assured stimulus package should leave a budget deficit just under $2 Trillion in FY09 as tax payers pay the cost.  

Inflation and Deflation

Over the last year the world economy has treated us to the textbook sources of inflation. 

"Cost-push" inflation peaked at mid-year as commodity prices (read energy prices) left consumer prices (CPI) at a 17 year high.  Currently given the recession based lack of "demand-pull" inflation the CPI is nearly flat from a year ago and about to enter in to deflation readings (i.e.  when prices are falling).

 

The current lack of pricing power has had a far smaller effect on core CPI which excludes the volatile food and energy prices.  Core CPI is now 1.8% higher than a year ago from a 2.5% yoy gain in July and stronger growth in prior years.  But despite the Fed's attention on these core prices, overall price deflation and deflation fears are the new buzzwords.  Well, at least until the plunge in energy prices falls out of the annual calculation by this time next year.

Over the long term inflation is always a monetary phenomenon.  Through the provision of liquidity to grease the wheels in the financial markets the Fed has put M2 money growth on at full spigot.  Annual growth will reach the late 2001 10%+ pace in early 2009. 

However, non-bank market-based liabilities (e.g. Repos, commercial paper) also provide funds, but outside the M2 definition.  Reduced non-bank assets leaves room for the Fed to be a bit more generous in reserve provision.

 

The Fed's key objective is to keep inflation at a low, positive level.  The unstated goal for core inflation is between 1% and 2% annual growth.  The Fed will have to be quick to pull back on the increased funding once the economy and financial markets are back on their feet.  Despite all the talk of deflation your likely to hear over the coming year you should have faith (and I know that's asking a lot these days) that the Fed is addressing the risks of deflation as well as inflation.   See an earlier post (Nov 18) on the early signs of oncoming deflation.