Thursday, September 17, 2009

The Long Good-Bye, UCLA Anderson Forecast, September 2009

“But the world is not in a run-of-the mill recession. The turnaround will not be simple. The crisis has left deep scars, which will affect both supply and demand for many years to come.”[i]

Olivier Blanchard, Director, International Monetary Fund Research Department

Although the worst recession in seven decades likely ended in the current quarter, its negative effects will linger well into the next decade. As we noted previously the recession had its origins not so much in imbalances in the real economy, but rather in the over-indebtedness of consumers and businesses that will take time to cure. Simply put it was a balance sheet recession.[ii]

As a result both consumption and investment will be weighed down by the process of deleveraging the balance sheets of consumers, businesses and financial institutions. Not only will financial institutions be less willing to lend, but consumers and businesses will be less willing to borrow. This process differs from normal recoveries where there is a natural inclination to borrow and spend after a period of Fed tightening that induced recession in the first place. Remember the Fed was easing well before the start of the current recession. That is why that even after an extended period of zero official interest rates the economy is only now showing hopeful signs of recovery.

That said, after four quarters of decline, economic growth is resuming. We forecast that real GDP will increase at an annual rate of 2.1% in the current quarter and 2.3% in the fourth quarter. For all of 2010 we forecast quarterly growth to average 2% with noticeable improvement at the end of the year. (See Figure 1) A lion’s share of near-term growth will come from a dramatic reversal in inventories. After plunging at a revised annual rate of $159 billion in the second quarter, real inventories are forecast to increase by $12 billion in the fourth quarter accounting for almost 1 1/2% of real GDP. (See Figure 2) However, once the big swing in inventories is spent, growth will remain very modest for most of 2010. Two other important swing factors are the recovery in exports and the long awaited rebound in residential construction. Exports are being helped along by the rebound in production that is taking place in Germany, France, Japan, China and Southeast Asia. Nonetheless, if our view of sluggish overall growth is close to the mark, the unemployment rate will be above 10% well into next year. (See Figure 3)

Figure 1. Real GDP Growth, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 2. Change in Real Inventories, 2000:Q1 – 2011:Q4, SAAR
Source: Global Insight and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2000:Q1 – 2011Q4F
Source: Global Insight and UCLA Anderson Forecast

Our cautious view of growth rests on the belief that after a two decade consumer spending binge based initially on rising stock prices and then on rising home prices fueled by extraordinarily easy credit has ended. (See Figure 4) Instead of increasing their nest eggs by deferring consumption, households took advantage of the ebullient asset markets to buttress their balance sheets and to over-consume housing and automobiles. Now consumers seeking to accumulate assets will have to do it the old fashioned way, by directly increasing savings through a reduction in consumption. (See Figure 5) Simply put, credit impaired lower income consumers can’t spend the way they used to and wealth impaired affluent consumers won’t. To be sure the stock market has rallied 50% off its March lows and housing prices apparently have made a bottom, but both of these asset classes are trading well below their highs of only two years ago.

Figure 4. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast.

Figure 5. Saving Rate, 2000 – 2011F, Quarterly Data
Source: Global Insight and UCLA Anderson Forecast.

Fiscal Collateral Damage

Starting with the Bush Administration’s $168 billion stimulus package in 2008 and ending with the Obama Administration’s $787 billion package in 2009, the federal government has gone all out in attempting to mitigate the effects of the recession and to engender economic recovery. Whether or not the programs work as intended will take time to sort out, but it appears that the increase in spending and tax cuts may have put a floor under last winter’s decidedly weak economy. However the stimulus spending along with an increase in baseline spending and the effects of the recession has caused a decided worsening in the long term fiscal outlook. The administration is now projecting cumulative federal deficits of $9 trillion over the next 10 years. (See Figure 6) To call this collateral damage is to put it mildly; it looks more like a fiscal train wreck that international holders of large dollar balances might seek to avoid thereby triggering a significant devaluation of the currency.

Figure 6. Federal Deficit, Unified Budget, FY 2000 – 2019F
Source: Global Insight and UCLA Anderson Forecast

Programmed deficits averaging $900 billion a year over the next decade are a recipe for higher taxes above the increases already scheduled to take place. For example the $180 billion a year hike in income taxes on high earning households will kick in 2011. Given the fiscal outlook this tax increase looks like a drop in the bucket so sooner or later President Obama is going to have give-up on a host of domestic programs and/or go against his campaign pledge not to increase taxes on households earning less than $250,000 a year. Make no mistake, tax increases on the broad middle class are becoming more likely and that will put more stress on consumption spending later in the decade. The arithmetic is simple. The federal government financing itself, in part, with near zero teaser rates interest cost on the debt is running at approximately $250 billion a year. Add $9 trillion dollars in debt and assume a 4% interest rate, interest costs sky rocket to $800 billion a year, nearly 40% of current receipts.

One modest fiscal effort in terms of dollars that caught the public’s attention and not in the original Obama stimulus package was the so called “cash for clunkers” program where the federal government paid consumers $3500-$4500 a car to trade-in and scrap their older vehicles for new ones. Ostensibly the purposes of the program were to get older low mileage vehicles off the road and to replace them with more fuel efficient vehicles and to explicitly subsidize the automobile industry.

This tiny, by federal standards, $3 billion program accounted for the sale of 700,000 vehicles ($14 billion at $20,000/car) in August thereby increasing the estimated automobile sales rate in the third quarter to 11.8 million units compared to 9.6 million units in the second quarter. Of course it will take time to estimate how many of those cars would have been sold absent the program and how many represent the pulling forward of demand from subsequent quarters. Because we believe that much of the sales represented the pulling forward of demand we have modeled in a drop-off in automobile sales over the next few quarters. (See Figure 7)

Figure 7. Motor Vehicle Sales, 2005:Q1 – 2011:Q4
Source: Global Insight and UCLA Anderson Forecast

We did, however, learn an important lesson from the “cash for clunkers” program. It met the threefold test of being temporary, timely and targeted and it did not require a huge spending program to have a big short term impact. The program mopped-up excess automobile inventories triggering increased production and employment for that beleaguered industry. As mentioned above we don’t know whether or not the program will have long term effects outside of reducing the capital stock of automobiles, but in the short run the real psychological effects on the economy were certainly welcome.

Whither the Fed?

Now that Federal Reserve Chairman Ben Bernanke has been re-nominated the focus will return to the substance of Fed policy. The Bernanke central bank has been perhaps the most activist Fed in its nearly 100 year history. Once the financial crisis was in train, the Fed launched a host of very aggressive and in many cases first time measures to relieve the most seized up lending environment since the 1931-3 Great Depression crisis. Bernanke also dusted off Section 13 of the Federal Reserve Act to directly lend to nonbanks in “unusual and exigent circumstances,” a power not used in over 75 years.

Furthermore the Fed took monetary policy to its zero interest rate bound by targeting the Federal Funds rate at between zero and 25 basis points, again reminiscent of the Great Depression and more recently of the Japanese deflation.
Along the way the Fed for a time tripled the size of its balance sheet. Simply put, in Bernanke’s words, the policy was “whatever it takes.”[iii]

As difficult as it might have been for both the Fed and the Treasury to engage in their unprecedented interventions in the economy, the hard part is now ahead of them. It is one thing to intervene with the goal of saving the economy and restoring growth, it is quite another to take back the monetary stimulus to fight an incipient inflation in an environment of high unemployment. Market participants know full well that there is more than enough liquidity in the system to ignite a persistent inflation; not today but perhaps within a few years.

In order to deal with this threat we believe that the Fed will gradually shrink its balance sheet and begin to slowly move away from its zero interest rate policy in the third quarter of 2010. To be sure unemployment will still be around 10%, but the economy will have been growing, albeit slowly, for about a year by then. The argument for modest rate hikes will be that the financial emergency is over and that modest rate increases would have a minimal effect on the economy. In fact it could be viewed as a sign of strength in light of the fact the financial markets by that time would have returned to normal.

Indeed in late August the Israeli Central Bank became the first official authority to raise rates after two years of declines. We do note that the Governor of the Bank of Israel is Stanley Fischer, Bernanke’s thesis advisor at M.I.T. Remember that if the Fed doesn’t act, the bond market has the potential to make life very unpleasant for the central bank. (See Figure 8)

Figure 8. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2000:Q1 – 2011:Q4F
Sources: Global Insight and UCLA Anderson Forecast

The H1N1 Wild Card

We would be remiss not to note a potential risk posed by the 2009 version of the H1N1 flu, a lineal descendant of the historic 1918-19 pandemic.[iv] Public health authorities have warned that the 2009 version has the potential to infect half the U.S. population, hospitalize 1.8 million and kill 90,000 people.[v] Although this might be viewed as a worst case estimate, these data indicate that we facing something far worse than the garden variety flu season we face every year where about 36,000 people die.

Obviously if the upcoming flu season is anywhere close to the public health prediction economic activity could suffer from plant and office closings as well as sharp reductions in business and leisure travel, further battering the already hard hit transportation and hospitality industries. We have not modeled in a severe flu season, so we would we would warn that it represents a downside risk to the forecast.

[i] Blanchard, Olivier, “Sustaining a Global Recovery,” F&D Magazine, International Monetary Fund, August 2009.
[ii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008 and Koo, Richard, “The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession,” (Singapore: John Wiley and Sons, 2008)
[iii] Wessel, David, “In Fed we Trust,” (New York; Crown Business, 2009) p.7
[iv] For the best history of the 1918-19 pandemic see, Barry, John M., “The Great Influenza,” (New York: Penquin Group, 2005)
[v] Randall, Tom, Alex Nussbaum, “Swine Flu May Cause 90,000 U.S. Deaths, Report Says,” Bloomberg, August 24, 2009.

No comments:

Post a Comment