Economic Update

Richard Hoey
Chief Economist

November 12, 2008

The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.

Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.

After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.

In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.

The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.

We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.

In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."

There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.

After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.

What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.

We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.

In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.

There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.

The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.

Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.

We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.