EconSouth (Fourth Quarter 2008)

After Rocky 2008, U.S. Consumers Seek Stable Ground in 2009

remittances graphic
U.S. consumers were besieged on a number of economic fronts in 2008. With house prices continuing their decline and unemployment rising, 2009 will see a continuation of the recession that began in December 2007.

Heading into a new year, the U.S. economy faces many of the challenges that made 2008 difficult: tight financial markets, rising foreclosure rates, and job losses. By almost any yardstick, 2009 will also present formidable challenges.

In 2008 the problems affecting the U.S. financial system took a toll on an already weak general economy. High rates of home foreclosures, declines in home prices, and, ultimately, the lack of credit availability in the economy translated into sharply lower levels of economic activity. The outlook is for further weakness through the first half of 2009, and these conditions will likely continue to dampen consumer price pressures.

Weakening intensified during 2008
EconSouth's outlook at the end of 2007 identified consumer spending and labor markets as areas of downside risk in 2008. A favorable export environment was expected to boost economic growth, and forecasters anticipated higher inflation.

As expected, consumer spending slowed in early 2008 amid declines in real estate values and the run-up in energy prices. A tax rebate stimulus temporarily boosted spending in the second quarter, but growth in consumer spending remained restrained.

Slowing economic activity led to weakening labor markets. Nonfarm payroll employment began to decline in January as firms increasingly held back on hiring, raising the unemployment rate. Layoffs were widespread, and employment in residential construction and parts of the manufacturing sector bore the brunt.

Despite the worsening jobs situation, economic activity as measured by real gross domestic product (GDP) was relatively strong in the first and second quarters, at 0.9 percent and 2.8 percent, respectively. That growth was partially buoyed by robust exports, which were spurred by strong foreign demand and a decline in the strength of the U.S. dollar relative to other currencies.

Related Links
On the Web:
NBER's procedures on dating the business cycle
Philadelphia Fed's survey of economic forecasters
U.S. Census Bureau data on new home sales
Information regarding recent Federal Rreserve actions
Macroblog entry on economic forecasts

Last half of 2008 saw faster weakening
Economic vital signs in the second half of the year were much weaker than during the first half. For example, the national unemployment rate for October was 6.5 percent, the highest level in 14 years and up from 4.9 percent in January 2008, according to the U.S. Bureau of Labor Statistics. Payroll employment declined by 650,000 from August to October compared with losses averaging 113,000 in the first quarter and 218,000 in the second quarter (see chart 1).

Financial stresses intensified dramatically in September, clearly contributing to a sharp contraction in spending and employment. Labor market conditions deteriorated further, shifting from businesses' reluctance to hire or replace staff to a marked increase in mass layoffs. The weakness has spread beyond housing industry woes and is now broad based: Employment has fallen in auto manufacturing, transportation and distribution, retail, and financial services.

Real GDP declined an estimated annualized rate of 0.5 percent in the third quarter, according to the preliminary estimate from the U.S. Bureau of Economic Analysis. At the same time, consumer spending notably weakened, declining for the first time since 1991. Data for October 2008 suggest that GDP is likely to drop steeply in the fourth quarter. For instance, auto sales plummeted in October, and anecdotal evidence, as well as record low readings from consumer confidence surveys, points to a bleak holiday season for retailers. Indicators from the manufacturing sector are similarly downbeat.

Chart 1
Payroll Employment and the Unemployment Rate
Chart of Payroll Employment and the Unemployment Rate
Note: The gray bars indicate recessions.
Source: U.S. Bureau of Labor Statistics
Chart 2
Evolution of the 2008–09 Blue Chip Consensus Forecast
Chart of Evolution of the 2008–2009 Blue Chip Consensus Forecast
Note: Dashed line represents real-time actual data.
Source: Blue Chip Economic Indicators

Inflation rears up, then settles down
Consumer price inflation accelerated through the first half of 2008, pushed up by rising oil prices that topped $140 per barrel during the summer. However, sharp drops in oil prices toward the end of 2008 have helped ease inflation pressures.

In September the headline personal consumption expenditure price index, which includes volatile food and energy costs, eased for the second consecutive month and is likely to continue to decline as lower commodity prices and weak demand restrain consumer price pressures. Over the longer term, inflation expectations influence actual inflation, and the University of Michigan's consumer survey reading for October indicates moderating inflation expectations for 2009 and beyond.

These downward pressures on prices will likely reverse the acceleration in inflation measures seen earlier in 2008. But to the extent that most of the price declines are concentrated in the goods sector, persistent price inflation in the large service component of consumption is likely to mitigate concerns about broad-based and sustained deflation.

Looking ahead to 2009
As 2008 unfolded, the deep problems relating to the housing market, consumer spending, credit conditions, and eventually wider financial stresses led economists to produce ever-bleaker forecasts. For example, in January 2008, the Blue Chip consensus forecasts, which is an average of about 50 forecasts, called for sluggish growth through the year before improving in 2009. As 2008 progressed, the outlook was revised significantly downward (see chart 2).

Most economic indicators slipped into recessionary territory during 2008, and consensus forecasts point to GDP contracting through the first half of 2009 in response to a fall in household and business spending and weakness in foreign demand for U.S. exports. The depth and duration of the decline in GDP could be mitigated by a possible expansion in fiscal stimulus in early 2009. The main risks to the outlook for the coming year center on the extent and duration of the financial market strains and problems in housing.

Chart 3
U. S. Housing Starts
Chart of U. S. Housing Starts
Note: The gray bars indicate recessions.
Source: U.S. Census Bureau

A key assumption in most forecasts for 2009 is that financial conditions will stabilize and soon begin a gradual improvement. Signs of this turnaround include a narrowing of credit spreads and an improvement in the functioning of markets. While indicators tentatively suggest that an easing of credit conditions in some markets may be under way, concerns about credit losses and financial institutions' solvency pose a plausible risk to the outlook.

Housing has fallen from historical highs to historical lows in the span of less than two years. The pace of existing home sales in the third quarter of 2008 was relatively stable, but the inventory of unsold homes remains stubbornly high. As a result, new home construction is down almost 64 percent from the historical high in January 2006 (see chart 3). Even though this falloff in home construction has been dramatic, the large inventory of unsold homes suggests that residential investment is unlikely to contribute significantly to growth in 2009.

Many forecasters expect that the U.S. economy will recover as 2009 progresses. But a return to healthy economic growth next year is unlikely. The chances for a sustained recovery depend largely on the progress of stabilization in the financial markets, making the ever-evolving outlook more uncertain than usual, with risks weighted to the downside.

This article was written by Sandra Kollen, a senior analyst in the Atlanta Fed's research department, and John Robertson, a vice president in the research department.

Financial Markets Seek Thaw in 2009

The financial turmoil of 2008 began as a continuation of the problems that surfaced in 2007: Falling home prices, rising mortgage defaults, and accelerating foreclosures led to massive losses at banks and other financial institutions. (Bloomberg News estimated that U.S. financial firms experienced $657 billion in write-downs and credit losses through Dec. 9, 2008.) The combination of financial turmoil and other factors (such as high energy prices earlier this year) slowed the U.S. economy and sharply reduced expectations for economic performance worldwide.

Related Links
On the Web:
Recent Federal Reserve actions
Macroblog entry on AMLF and MMMF
Macroblog entry on commercial paper
October 2008 Senior Loan Officer Opinion Survey
FDIC Web site on bank failures and troubled banks

Deteriorating economic conditions are further weakening the residential mortgage loan market and reducing the credit quality of many other types of loans. Market conditions are causing potential lenders to tighten their underwriting standards and demand higher interest rates, further constrict-ing financial markets and reducing expectations of near-term economic growth.

The Fed devises unprecedented responses
The Federal Reserve has taken a variety of innovative steps to alleviate strains in the financial system. A series of cuts in the fed funds rate (totaling more than 550 basis points) that began in September 2007 brought the rate down to a range of 0–0.25 percent as of December 2008. Additionally, the Fed created a variety of new liquidity and lending programs designed to accommodate the credit needs of businesses and households, bolster confidence in credit markets, and improve overall market liquidity.

Chart 1
Tightening Standards for Mortgages and Commercial and Industrial Loans
Chart of Tightening Standards for Mortgages and Commercial and Industrial Loans
Note: Chart shows responses from domestic banks.
Source: Federal Reserve Senior Loan Officer Opinion Survey

However, these programs may only alleviate banks' concerns about their ability to fund new loans; the programs are not designed to directly address the possibility that the weakening economic environment will affect borrowers' ability to repay loans. Growing concern about borrowers' financial condition has led an increasing number of banks to tighten their lending standards for various loan types, including credit cards, auto loans, mortgages, and commercial and industrial loans, according to the Federal Reserve's Senior Loan Officer Opinion Survey (see chart 1). These tighter lending standards, perhaps combined with consumers' caution about their own financial condition, led to a 3 percent reduction in consumer credit outstanding at a seasonally adjusted annual rate in August—the first decline in more than a decade.

Some of the strain in the market for short-term debt can be traced to money market funds. These funds are significant buyers of commercial paper—short-term promissory notes that large corporations and financial institutions use to finance their day-to-day operations. Significantly, money market funds link investors seeking a return with businesses looking to sell their short-term debt. Many funds suffered significant losses on their commercial paper holdings after Lehman Brothers failed in September 2008.

One of these funds, Reserve Primary Fund, could no longer maintain its per-share net asset value at $1, resulting in losses to the fund's shareholders. These losses were followed by large outflows from money market funds, whose investments in commercial paper retracted further as many funds reallocated their portfolio toward safer, more liquid Treasury securities. This pullback on buying commercial paper was a significant factor behind the sharp drop in the amount of commercial paper outstanding (see chart 2). Recovery in money market funds and commercial paper is likely to be key in restoring normalcy to credit markets and should have broader positive effects.

Chart 2
Commercial Paper Outstanding, Weekly
Chart of Commercial Paper Outstanding, Weekly
Source: Federal Reserve Board

To help stabilize the commercial paper market and money market funds, the Federal Reserve has created three new facilities. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility provides funding to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds. The Commercial Paper Funding Facility provides liquidity to U.S. issuers of commercial paper. The Money Market Investor Funding Facility supports a private-sector initiative to provide liquidity to investors in U.S. money markets.

Changes proposed to the regulatory structure
Historically, changes in the U.S. regulatory structure are almost always precipitated by significant financial upheaval. Many observers expect the current crisis to propel efforts toward a new round of restructuring. In the past, restructuring often took the form of adding new financial regulatory agencies to implement additional regulation. But some analysts believe that the confusing structure of overlapping regulatory agencies has exacerbated the current turmoil. So most of the discussion thus far about a future restructuring has focused on reducing the number of regulatory agencies, with any new powers likely being divided among the remaining agencies.

Banks respond to turmoil by consolidating
If regulatory changes come, they won't be the only changes. The financial market's composition is also evolving. Consolidation in banking and finance has increased as a number of relatively stronger financial firms have taken over weaker counterparts, and the trend is likely to continue. Nationally, 25 banks failed in 2008, and the Federal Deposit Insurance Corp. said 171 more were on its list of troubled banks as of the third quarter—before the most recent acceleration in financial market turbulence. Additionally, under the Emergency Economic Stimulus Act that President Bush signed into law in October, the U.S. Treasury has been injecting capital into banks by purchasing preferred equity. Some industry watchers believe banks may eventually use some of this capital to acquire weaker financial institutions.

Chart 3
Corporate Yield Spreads Over 10-Year Treasury Bills
Chart of Corporate Yield Spreads Over 10-Year Treasury Bills
Source: Federal Reserve Board, Merrill Lynch

Funding problems threaten business investment
Companies routinely look to the corporate bond market for financing. But the flow of funding has slowed to a trickle as investors have become increasingly concerned about the economic outlook, leading many firms to defer the issuance of new bonds. According to the Securities Industry and Financial Markets Association, investment-grade bond issuance totaled $26.5 billion in August 2008, down from the average monthly issuance of about $83 billion in 2007. Further, issuance of $400 million in high-yield bonds in August 2008 was a small fraction of the monthly issuance of $11 billion in 2007.

As a measure of investors' perception of credit risk, high-yield corporate debt spreads over Treasury bonds have risen sharply and surpassed 15 percent toward the end of October (see chart 3). The current spreads have sharply surpassed the levels seen during the past two credit cycles (after the 1990–91 and 2001 recessions) and have risen much faster. The high cost of corporate bonds is an additional source of risk to the overall economy. If rates remain high, businesses may look elsewhere for financing, postpone investment plans, or even liquidate assets to maintain their operations.

This article was written by Mike Hammill, an analyst, and Larry Wall, a research economist, both in the research department of the Atlanta Fed.