Pershing
We expect (1) a major U.S. recession, (2) a major G-7 recession, (3) a major global recession, (4) rising unemployment rates and falling capacity utilization worldwide, (5) global rebalancing with a drop in current account deficits in consumption-led economies and a drop in current account surpluses in export-led economies, (6) domestic rebalancing, (7) proactive monetary and fiscal stimulus worldwide, (8) an increased supply of financial liquidity from the Fed’s elastically expanding balance sheet, (9) a gradual recuperation of the financial sector as it passes through stages of disorderly deleveraging to semi-orderly deleveraging to orderly deleveraging, (10) extremely low interest rates worldwide in the coming year, (11) a rise in the U.S. budget deficit in 2009 to more than $1 trillion--7% or more of U.S. GDP, (12) a large drop in inflation worldwide with brief temporary episodes of consumer price deflation due to global recession and the sharp drop in commodity prices, (13) the avoidance over the next several years of both a sustained deflation in consumer prices and a major inflation acceleration, (14) a gradual calming of concerns about an economic depression since policymakers have a correct economic diagnosis of the risks and are taking proactive policy actions to reduce them, and (15) rising protectionist risks as global unemployment rises.
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 global recession, all of which should be among the most severe of the Postwar period. 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. We expect a sharp global decline with the most intense weakness in late 2008 and early 2009 as a global financial crisis and inventory correction are occurring simultaneously in many countries. There was a drop in payroll employment of one-and-a-quarter million jobs in the U.S. in the last three months. OECD leading indicators continue to drop sharply. Global economic activity should be quite depressed by mid-2009 by which time both the financial crisis and the inventory correction should begin to lose momentum. However, many countries will struggle to generate more than a hesitant recovery. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to recover strongly even after the U.S. recession ends.
The U.S. economy is declining sharply with pervasive weakness. With high housing inventories and little decline in mortgage rates until the last few days, housing remains weak. Commercial real estate and the state and local sector are new sources of weakness. The intensification of financial stresses following the Lehman bankruptcy and liquidation occurred just prior to the holiday spending season and the budget-planning period for corporate employment and capital spending for 2009. Multiple uncertainties about financial stresses, the economy and government policies have led many companies to suspend guidance about the 2009 outlook and to initiate reductions in their labor force and planned spending. This has coincided with a sharp weakening of expectations for economic activity abroad. The U.S., G-7 and global economies are in an intense phase of the recession, with inventory liquidation underway in most countries.
The sharp economic decline in the current quarter most closely resembles the worst part of a prior recession that was also triggered by the disruption of the credit process: the second quarter of 1980 when real GDP dropped at an 8% rate after the Carter administration limited the use of credit cards. We expect a real GDP decline in the 5% to 7% range in the current quarter and continued weakness in early 2009 with substantial declines in consumption, housing and capital spending. The result should be a rise in unemployment to above 8% during 2009. We expect further economic declines in the first half of 2009 but do expect a trough in the current U.S. recession to occur near midyear 2009, to be followed by a hesitant subpar recovery.
Current trends in consumer spending are quite weak in response to lower housing prices, lower stock prices, a weakening labor market and limited access to credit. The benefit of lower energy prices is likely to be saved not spent in this environment. We believe that U.S. consumption as a share of GDP has reached a secular peak and should drift somewhat lower over time, given the elevated debt burden and negative wealth effect impacting consumers. Cyclically, however, the pace of decline in consumer spending is so severe that it is likely to prove unsustainable, especially since we expect aggressive monetary and fiscal stimulus worldwide in 2009. We expect a weak expansion of consumer spending beginning in the second half of 2009, which should coincide with the end of inventory liquidation.
The outlook for corporate revenues is poor. U.S. nominal GDP (real growth plus inflation) is dropping and the U.S. dollar equivalent of foreign sales is also slowing due to the dollar rebound and slowing economic activity and inflation abroad. Capital spending orders weakened quickly once the capital markets froze after the Lehman bankruptcy. Corporate fears that profit weakness and excess capacity will spread beyond the housing and financial sectors appear well founded. The looming overcapacity in many industries is a global issue, not just a U.S. problem.
We expect a major global rebalancing. The global economy has been imbalanced in recent years. Consumer-led economies expanded in part by borrowing from abroad, while export-led economies (manufacturing exporters, oil exporters, materials exporters) ran large current account surpluses and lent to the consumer-led economies. The level of both current account surpluses and current account deficits became extreme. There were fears of a bond buyers’ strike from the surplus countries, but this was not the trigger for the global recession. Instead, house prices in the consumer-led countries overshot sustainable levels. When house prices dropped sharply, it triggered both the financial crisis and the recession.
The pattern of a strong debt-led consumer and housing expansion in the deficit countries has broken. This has weakened the revenues received by exporting countries due to weakness in both volume and prices. There should now be a sharp drop in current account surpluses in exporting countries due to the weakness in the volume and price of exports. There should also be a sharp drop in current account deficits in those countries where consumer imports are weak and the cost of oil imports is dropping.
The global rebalancing is likely to be accompanied by domestic rebalancing in many countries. The composition of U.S. growth is shifting from housing and consumption towards net exports and government spending. Those countries that have benefited from strong exports of materials, oil or manufacturing goods are likely to use their financial resources to stimulate their domestic economies. However, there is likely to be a lag before the full impact of such policy shifts is felt.
The U.S. recession was triggered by the bursting of a bubble in house prices and associated complex financial securities, which are not likely to recover to prior levels any time soon. The result of the bursting of the housing bubble and structured finance bubble was to reduce the net worth of a number of major financial institutions, leading to forced bank mergers, dilutive bank nationalizations and Federal support programs. The bankruptcy of a major investment bank in mid- September 2008 froze the financial system to the degree the availability of loans for refinancing and for new spending was reduced. This is only in the early stages of easing. We do expect a recuperation of the financial system, but it should be too gradual to prevent major economic weakness in late 2008 and early 2009.
Fed Chairman Ben Bernanke has given some thought to the issue of how to prevent deflation when the Federal funds rate approaches zero and there is less room to ease by cutting the Federal funds rate. For example, he addressed it in “Deflation: Making Sure It Doesn’t Happen Here” in 2002 and in “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment” in 2004. As a result of this past focus on a potential challenge that has now become quite real, Chairman Bernanke and the Fed were prepared to move quite quickly to supplement a rate cutting strategy with additional forms of liquidity support and quantitative easing. Leaving aside all the complex details, this is a policy of “whatever it takes.” This flexible response is a key reason why we believe that worse case outcomes for the next several years can be avoided despite the financial crisis and recession currently underway.
U.S. monetary policy has been easy on a gross basis in recent months, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Federal Reserve actions to supply liquidity have been aggressive, but this has occurred in a context in which the desire to hoard liquidity is strong and risk-aversion persists in the private sector. The channels of transmission of gross monetary ease have been somewhat clogged. Inflation is dropping faster than short-term rates, so real interest rates have risen. The dollar has risen rather than fallen. Prior loan commitments and intense refinancing demand have absorbed financial risk budgets. Both the supply of credit and demand for credit to finance new spending are weak. Over the last several months, the lower Fed funds rate has been accompanied by wide bond spreads, low stock prices, a higher dollar and weakening economies overseas.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGP, TOP, MMIFF, TARF) of Treasury and Fed programs to reliquify the financial system and several key programs have been extended through April 2009. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads.
Many Federal support programs have acted like backup generators when the electrical plant shuts down. They have substituted for the normal functioning of the private financial system that is only slowly being restored. The direct Federal actions to drive down mortgage rates do not fit this defensive damage control pattern, but rather are proactive steps to improve housing affordability.
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 a simultaneous recession. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened. We expect the current account deficit, as a share of GDP, will be cut in half, from a peak above 6% of GDP to about 3% of GDP. The non-oil deficit is falling due to weak imports and the oil deficit is falling due to the decline in oil prices.
Just a year after there was widespread talk about supposedly uncontrollable inflationary forces, the focus has shifted to deflation. We make a distinction between asset deflation and consumer price deflation as well as a distinction between temporary cyclical deflation in consumer prices and a sustained trend of consumer price deflation. The large decline in house prices is a form of asset deflation with two main consequences. First, it is a collateral deflation because the value of the asset used as collateral for loans has dropped. This has contributed to loan losses and the financial crisis. Second, it has generated a negative wealth effect for homeowners, contributing to weakness in their spending. Due to the aggressive government programs for housing we expect in 2009, we expect the decline in house prices to be completed by the end of 2009, with a cumulative decline of about 30% in the Case-Shiller index. However, it will be many years or decades before house prices return to their old highs.
Consumer price deflation is different than asset deflation. The real inflation-adjusted burden of debt rises when a sustained consumer price deflation occurs. Because the price of oil and other commodities has plunged in less than six months just as the global economy entered a serious recession, we expect a brief period of consumer price deflation during this phase of the economic cycle. We do not expect a sustained consumer price deflation because monetary policy will be dedicated to preventing it. We expect a trend of moderate inflation to be restored and do not expect any major upsurge in inflation in the coming years.
Fears of resurgent inflation after a cyclical phase of disinflation and deflation are based on a belief that rapid growth in reserves and money supply will trigger a major reacceleration of inflation. However, the rapid expansion of the Fed’s balance sheet is merely an attempt to counterbalance an extreme preference in the private sector to hoard financial liquidity. Velocity has been dropping as money supply has been growing. By the time risk-aversion calms and the Fed needs to start withdrawing liquidity, there will be excess capacity and high unemployment rates worldwide as well as painful memories of asset deflation. Under these conditions, central banks should be able to gradually normalize financial liquidity before any serious inflationary process begins.
Fears that asset deflation and a serious financial crisis could trigger a depression have increased in recent months. We believe that we are experiencing a severe global recession but are confident that a depression can be avoided. The reason depression occurred in the 1930s was a misdiagnosis of the economic risks and a set of counterproductive policies which resulted from that misdiagnosis. In those years, the economic doctors misdiagnosed the economic disease and prescribed medicines that made the problem worse. Today, in contrast, we believe that the economic diagnosis and the policy response are correct. Fed Chairman Bernanke, an expert on the Great Depression, recognized the risks of debt deflation spreading and has been willing to be aggressive in fighting it. On fiscal policy we expect the Obama administration to adopt a large Keynesian fiscal stimulus. We regard this as a time-shifter, eventually contributing to an end to declining economic activity at the cost of higher Federal debt service in the future. It should help limit the feedback loop between the financial crisis and the recession. Keynesian stimulus is not a cure-all. It merely increases the likelihood of preventing a serious recession from deteriorating into a depression. Critics are correct that aggressive monetary and fiscal stimulus will have some negative side effects over a period of time, but the higher priority is to prevent a worse case outcome in the near term. We do believe that a somewhat slower trend growth rate is likely in the U.S. in the coming years due to decreased immigration, greater regulation and taxation and the secular exhaustion of the strong uptrend in the use of debt. However, we strongly believe that a depression can be avoided.
The most serious economic risk in the coming years is likely to be protectionism. The unemployment rate should remain higher worldwide for an extended period of time, increasing demands for job protection from foreign competition. Actions to limit global warming are likely to be adopted at different speeds, with developed countries adding more to their cost of production than will be likely in the developing countries. There will be demands for “carbon tariffs.” While the free trade system is likely to be on the defensive over the next several years, we believe that the world can succeed in avoiding a trade war.