HISTORICAL ECONOMIC COMMENTARY

Week of October 3rd, 2008

The turmoil in the financial markets and the political shenanigans surrounding the infamous $700 billion "bailout" bill are overshadowing what is shaping up to be a painful adjustment for the U.S. economy - transitioning from a sputtering expansion to a deepening recession. True, the broadest measure of the economy's performance -GDP - has yet to verify that transition. But the 2.8 percent growth rate registered in the second quarter can only be viewed at this point as an historical signpost, not a yardstick of where we are now. For that, it is necessary to look at more recent hard data, as well as anecdotal evidence.

The latter is revealed in a litany of surveys that describe a growing level of anxiety among households and businesses. Much of that anxiety stems from the ongoing, and still escalating, woes in the housing market, where household wealth is being destroyed by plunging prices, neighborhoods tarnished by surging foreclosures and state and local services being slashed by falling property tax revenues. Businesses, meanwhile, are worried that their customers will zipper up their wallets for all of the above reasons, leading to more cautious budgeting and expansion plans. Their fears of weaker demand are being compounded by the growing scarcity of credit, leading many smaller companies to turn to nontraditional commercial lenders and paying exorbitant rates as high as 30 percent for funds.

For some time now, the polls have indicated that households believe the nation is in a recession, a perception scoffed at by statisticians whose numbers showed otherwise. But increasingly, the hard data coming out of the statistical mills are supporting the anecdotal evidence. The job market, of course, has followed a recessionary course for some time, and the latest monthly employment report released on Friday confirms that trend. But in recent weeks, just about every other key indicator has been consistent with an economy that is firmly mired in a cyclical downturn. Take consumer spending, which accounts for 70 percent of total economic activity. In the second quarter, the $100 billion of tax rebates dispensed to households overcame the powerful headwinds of surging gasoline prices, the housing meltdown and mounting job losses. During the period, real outlays on goods and services rose by 1.2 percent, skimpy by historical standards, but enough to keep the GDP growth rate in positive territory.

But that was then. With the rebate boost having run its course, households are now retrenching with a vengeance. The auto industry, of course, has been under siege for some time, reeling from the hit to sales coming from climbing prices at the pump. But car buyers are now staying away from dealer showrooms for a variety of other reason, including budgetary constraints and, most importantly, the difficulty in getting car loans. In September, sales of autos and SUVs, fell below 1 million for the first time since 1993, and the fall-off would have been deeper if not for sizeable price discounts offered by General Motors. That experience just about assures an awful September for overall consumer spending, but it's not necessary to wait for the corroborating numbers to come out late this month. The retrenchment in July and August has been bad enough.

Indeed, real outlays on goods and services have either declined or remained unchanged for three consecutive months going back to June, when the rebates were presumably still lifting spending. If there was any doubt that households would reduce spending for an entire quarter for the first time since 1991, it should be soundly extinguished. Following the summer retrenchment, the average level of real outlays for July and August stood almost 1 percent below the second quarter average. With retailers reporting tepid back-to-school sales and the dismal auto readings already noted, there is only a remote possibility that September will stage any rebound. In short, the third quarter will show a negative reading for personal consumption for the first time in nearly eighteen years, which will likely lead to a contraction in overall GDP for the period. The only swing factor is inventories. If the consumer retrenchment results in a corresponding build-up in inventories, which adds to GDP, the net effect could be neutral. But an involuntary stockpiling of inventories of that magnitude only means that businesses will be slashing orders and production in the fourth quarter.

In fact, the timeline going forward is abundantly clear. Whether GDP records an outright contraction in the third quarter or not, the economy has slipped into a recession that will be hitting its stride in the fourth quarter and the opening three months of 2009. Just how deep the downturn turns out to be is still up in the air. The International Monetary Fund recently conducted a study of 122 recessions in 60 countries going back to 1960. What it discovered is that the recessions tended to last considerably longer and experienced steeper contractions when caused by a credit crisis or housing collapse. Both catalysts were present at the start of the current cycle, which does not portend a brief or soft landing for the U.S. economy. To be sure, policymakers, despite their failings, have learned some lessons from the experiences over the past 50 years, which we assume will facilitate better decisions that foster a quicker recovery than otherwise.

But the financial turmoil that is engulfing the U.S. economy - and rapidly spreading on a global scale - is something that hasn't been seen since the Great Depression, and the policy fixes seem almost to be improvised. The $700 billion bailout bill that was thankfully passed by the House on Friday is hardly the answer to what ails the economy, albeit its passage was undeniably necessary if only to restore a semblance of confidence in the financial system. The "real" effects of the bill on the economy, however, remain to be seen. Taking illiquid assets off the books of financial institutions, the main objective of the bill, will free up some funds that can be used for lending to businesses and consumers. However, it's doubtful that the liberated assets will translate into new loans on a dollar for dollar basis. More than likely, lenders will be focusing on repairing their tarnished balance sheets, raising much-needed capital at the expense of expanding assets for the foreseeable future.

Still, investors needed a confidence boost, and the bailout legislation at least stopped the bleeding pouring out of deeply wounded financial market. Now the task is to follow up by providing the necessary liquidity that is essential to nourish business and consumer spending. Indeed, cash-starved companies have been brought to the precipice of not being able to finance day-to-day operations. In recent weeks, the commercial paper market has virtually dried up, closing off a vital source of operating funds to a broad swath of businesses. Banks, meanwhile, are turning away borrowers, not only to avoid taking on risky loans but because they themselves have been shut out of the interbank loan market, where daily funding requirements are met. The spread between Libor (the rate banks charge each other on overnight loans) and Treasury bill rates surged to record highs this week. Only the massive infusion of liquidity by the Fed and foreign central banks has kept the global banking system functioning at all in recent days.

Had the seizing up of the credit markets continued, it would be only a question of time before companies could not access enough funds to meet their payrolls, resulting in layoffs big enough to evoke images of the Great Depression. No one expects conditions to deteriorate that badly, but the credit squeeze and housing meltdown are taking an ever-larger toll on the job market. As noted earlier, this morning's employment report was a huge disappointment to the handful of optimists who felt the economic slowdown would morph into a mild and brief recession at worst. That expectation, however, is looking more unrealistic with each passing week. Even before the current credit squeeze tightened its vise in recent weeks, workers were losing jobs at an accelerating pace. In September, nonfarm payrolls plunged by 159 thousand, far more than the 90 - 100 thousand expected by analysts and the largest monthly fall in 5-1/2 years.

The September job losses marked the ninth consecutive month of payroll cutbacks, bringing the cumulative decline to 760 thousand since last December. What's more, the losses are no longer confined to industries linked to the moribund housing sector. Except for government, education and health care, the payroll reductions are widespread, with factories, retailers, business service firms, financial institutions, transportation and leisure and hospitality payrolls all experiencing cutbacks. It's possible that some layoffs occurred because of Hurricanes that hit towards the end of the survey period, as there was a spike in the number of people who did not show up for work due to weather-related reasons. More than likely, though, the weak job market is rooted in fundamental economic weakness.

Nor is it particularly encouraging that the unemployment rate, which is derived from a separate survey of households, remained unchanged in September at the elevated 6.1 percent level reached in August. There is little question that people are having a harder time finding a job. The duration of unemployment for idled workers is rising and those who have jobs are seeing their hours cut. In fact, the total number of hours worked fell by another 0.5 percent in September, lowering the average for the third quarter by 2 percent below the second quarter average. Assuming a modest 1-1.5 percent gain in productivity, that indicates the economy contracted by ½-1 percent during the period, putting the economy squarely in the midst of a recession, which we feel will extend through at least the first quarter of 2009.

Given that prospect, the policymakers will probably have no choice but to step up its pump-priming efforts in the weeks and months ahead. Nothing will happen on the fiscal front until the next administration assumes office. But the Fed has been working overtime to keep the credit markets functioning, injecting huge amounts of liquidity into banks and other financial institutions, taking illiquid assets from these institutions onto its own balance sheets, and brokering whenever necessary the takeover of failing institutions by stronger ones. We suspect that the next shoe to drop will be the federal funds rate, which could well occur before the next scheduled policy meeting on October 29. At this juncture, a cut in short-term rates would do less to help the economy than would an increase in the availability of credit. But it’s another weapon in the Fed’s arsenal, and the central bank may have to unleash as much ammunition as it has to prevent the economy from spiraling into an ever-deepening recession.