March 26, 2008

Recession Averted by Policy Responses

U.S. economic growth slowed markedly in the fourth quarter of last year, with the economy expanding at just a 0.6% annual rate. In 2008 the economy continues to be challenged by deteriorating conditions in credit markets, increases in energy prices, the ongoing housing correction and weakening of consumer confidence. As a result of these forces of restraint and data pointing to continued sluggish growth, we marked down our forecast for near-term growth, but still expect that a sustained decline in GDP will be narrowly avoided. Real GDP growth is expected to be between 0% and 1% in the first quarter of this year, but improve to 1.7% in the second quarter and 5.2% in the third quarter with the aid of the fiscal stimulus package.¹ Because the fiscal boost to growth will be temporary, the forecast shows GDP growth slowing quickly to 1.8% in the fourth quarter before transitioning back to roughly trend-like growth of 2.9% during 2009. Anemic GDP growth contributes to further softening in labor markets for the next few quarters. Non-farm employment is projected to be roughly flat through the third quarter at close to the January level, before solid growth in output produces solid employment gains this fall and throughout 2009. The unemployment rate is projected to rise to 5.3% by the third quarter of 2008 and remain at that level through the end of next year. While not "recessionary" at that level, it would imply some modest slack in labor markets that should help keep inflation in check.

Consumer price inflation rose sharply at the end of last year -- with the December to December change in the Consumer Price Index (CPI) reaching 4.1%, the highest pace since 1990 -- boosted by spiking food and energy prices. But core consumer price inflation (excludes food and energy prices) has also been elevated of late, but is expected to moderate. The core CPI increased 2.4% in 2007 (December over December) a reading outside what we gauge to be a range acceptable to the Federal Reserve of 1¼% to 2¼%. Emerging slack in labor markets resulting from a period of below-trend growth, combined with a temporary firming of the dollar, and an end to the sharp rise in energy prices, underpins our forecast that core inflation will moderate over the next few quarters.

The biggest news on the economy of late has been the continued turmoil on Wall Street and what it might mean for Main Street and dramatic actions by the Federal Reserve as well as related financial market developments have taken center stage since we completed this forecast. Over the past several weeks, stock prices tumbled, spreads of corporate bond yields over similarly-dated U.S. Treasury notes widened, and indications of intensifying stress in the credit markets continued to surface. Fear that large losses on holdings of certain securities (e.g. lower rated mortgage-backed securities) could have made some large financial institutions insolvent leading to a pull-back in short-term lending to those institutions as other banks, investment banks or other financial institutions, became unwilling to bear the counter-party risk. This inability to obtain needed funds, or a lack of liquidity, would normally have been circumvented by selling securities or pledging securities as collateral. However, the near complete lack of trading in some more complex and thus opaque securities, and lack of investor interest in lower-rated mortgage-backed securities left some firms with fewer and fewer items they could sell or pledge. This was the problem faced by Bear Stearns in mid March. Unable to obtain the liquidity it needed, it turned to the Federal Reserve. But, because Bear Stearns was not a commercial bank with borrowing rights, it did not directly have the ability to borrow from the Fed. So, the Fed used the giant JPMorgan as a conduit through which to funnel a $30 billion short-term loan to Bear. However, even this proved insufficient.

On Sunday March 16 the Fed announced a series of steps aimed at providing needed liquidity to major investment banks and forestalling widening financial crisis, and the next day JPMorgan announced the acquisition of Bear for a mere $2 per share, down from $65 just a few months earlier. This was followed on Tuesday, March 18 by a 75 basis-point (¾ of a percentage point) cut in the federal funds rate target (the rate targeted by the Fed that commercial banks charge each other for overnight loans). These policy steps capped an extraordinary couple of weeks in which the Fed initiated or expanded a number of policies aimed at addressing financial market stress. Together, the aggressive use of these "liquidity tools" and the steep cuts in the federal funds rate imply that the Fed sees the financial stress as posing considerable economic risks and is addressing those risks on a number of fronts.

Subsequently, the Office of Federal Housing Enterprise Oversight (OFHEO) decided to allow mortgage agencies Fannie Mae and Freddie Mac to expand their holdings of mortgages and mortgage-backed securities. These actions all had decidedly salutary effects on equity prices (up), and mortgage rates and corporate bond yields (down). Broad equity indexes were also boosted by the possibility that the weight of historically high commodity prices on the global economy might finally be lifting as oil, gold, and other commodity prices turned down sharply. It remains to be seen whether a wider financial crisis has been averted, but the bold actions by the Fed seem to be offering a large glimmer of hope that the worst may be behind us.

This forecast presumes that the Federal Reserve will lower the federal funds rate another ½ percentage point at its next policy meeting on April 30. With these recent rate cuts, policy will have moved into outright accommodation, so at some point, easings will have to be reversed. We expect the Fed will begin to reverse course next March, with the funds rate reaching 3¼% by late 2009.

¹ Unless otherwise noted, all quarterly growth rates are expressed as compound annual rates, all expenditure components of GDP are chained 2000 dollars, and all annual growth rates are stated as fourth-quarter over fourth-quarter.