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.

In the Washington Post, "Economic Growth Yet to Hit Job Market," September 5

"We've gone 10 years with zero employment growth," said David Shulman, a senior economist at the UCLA Anderson Forecast. "This has been a lost decade."

For full article see, http://www.washingtonpost.com/wp-dyn/content/article/2009/09/04/AR2009090400868_pf.html

Obama's Bad Bill Syndrome

A disturbing pattern is beginning to emerge with respect to President Obama's relationship with Congress and the American people. It seems that he prefers bad legislation to no legislation, For example he supported the stimulus bill that was weighed down with the Democratic Party's 28 year wish list, but really offered little or no near term stimulus for the economy. He could have exercised leadership, but chose not to. A similar thing happened with the cap and trade energy bill that passed the House. That bill is a long way from an ideal carbon tax and for that matter a pure cap and trade system. Instead of charging for carbon emissions, it mostly gives away licenses to pollute for favored industries and penalizes the unfavored oil refineries. Should it pass in its current form, refineries will close and the U.S. will import even more gasoline and worse it will be a bonanza for Washington lobbyists seeking to bend the permit system in their favor.

Indeed the same syndrome is playing out with the health care bill. As the CBO noted it does nothing for cost control and, in fact, it increases health care costs for both government and the economy as a whole. President Obama surely wants the glory of presiding over national health care legislation, but he fails to realize that a bad bill will soon cause most American to look back with nostalgia at the system we now have. As the good Doctor Hippocrates once said, "do no harm." Bad bills do lots of harm.

Strange Claims Data Offer Hope of Recession's End

The Labor Department (DOL) reported that new unemployment claims declined to 522k for the week ended July 11 down 47k from the prior week. These data are well below the 650k peak reported in the Spring. DOL noted that the seasonal adjustment factors could be completely out of whack because major auto lay-offs took place in April and May rather than July thereby rendering the seasonals less than accurate. In fact unadjusted claims actually increased by 86k for the week.

Nevertheless with two weeks of claims below 600k it is quite possible that on a GDP basis the recession might have ended this month. In terms of the labor market the recession is still far from over. Although layoffs might be waning, employers remain on strike with respect to hiring.

In the Washington Post, "Job Losses Dampen Hopes for Recovery," July 3

"This sprayed some Round-Up on the green shoots," said David Shulman, a senior economist at the UCLA Anderson Forecast, using a metaphor for signs of economic improvement that Federal Reserve Chairman Ben S. Bernanke popularized in the spring.
"The economy is in the process of bottoming, but that's different from saying it's recovering," Shulman said.

Full story at http://www.washingtonpost.com/wp-dyn/content/article/2009/07/02/AR2009070200354.html

No Shock in Job Numbers

The payroll number was no real surprise. The job losses occurred because there was a slowdown in the seasonal hiring college and high school graduates for summer and full-time employment. As someone who is associated with three universities, it was patently obvious to me that the normal hiring of college graduates did not take place this year. Hence when the data went through the seasonal meat grinder of the BLS it showed up as job losses. See post below.

Out of Intensive Care, UCLA Anderson Forecast, June 2009

" It's very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.” Niall Ferguson[i]

The economy is out of intensive care, but make no mistake, it is still very sick. The free fall stage of the recession appears to be over and in fact we anticipate that the economy will record positive, albeit minimal, growth as early as the third quarter. (See Figure 1) After declining by an estimated 2.9% in the current quarter we forecast that real GDP growth will be zero in the third quarter and 0.6% in the fourth quarter or 2009 and the first quarter of 2010. Thereafter we forecast growth will be in the very modest 2-3% range.

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

However, with the economy growing at such a tepid pace, the unemployment rate will continue to climb well into 2010 where we expect it to peak at a 10.4%. (See Figure 2) Job losses will likely continue for the remainder of the year and we would not be surprised to see the worst data of recession arriving with the June employment report to be released in early July. Why? The seasonal adjustment factors used by the bureau of Labor Statistics look for a large increase in college/high school graduate hiring along with a rise in vacation oriented employment. Because the economy has been so weak the hiring of new graduates has been unusually soft this year. Thus the data will likely show a large decline in seasonally adjusted employment.

Figure 2. Unemployment Rate, 2000:Q1 -2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

As bad as the U.S. Economy has been, the rest of the world has been doing much worse. As we noted last quarter, we are in a truly global slump.[ii] The 5.7% decline in U.S. output in the first quarter pales in comparison to the 25% decline in Singapore, the 22% decline in Mexico, the 15% decline in Japan and the 14% decline in Germany. These depression-like declines were caused in large part by a 30% collapse in year-over-year exports for the 15 largest economies. Because the weakness in trade was exacerbated by the lack of financing, going forward the healing of the financial system will work to mitigate the decline.

The Financial System Heals

Despite all of the controversy, the host of Federal Reserve and Treasury actions to provide liquidity and capital to a severely wounded financial system suffering from the worst crisis since the 1930s appear to be working. In the inter-bank market the three month LIBOR rate has decline from 4.85% in early October to .65% in May. The seized-up commercial paper market has reopened and sparked by a record-breaking rally high yield bond spreads have come in 800 basis points since December. (See Figure 3) Along the way we have witnessed a requitization of the major banks and the real estate investment trust industry.

Figure 3. High Yield Bonds vs. Treasuries Mar 200 – May 2009 (Daily Data)

Source: Barclays Capital


Stocks too have bounced 40% off their March lows and the VIX Index (a measure of stock market volatility) has been reduced from 85% to 30%. (See Figure 4) An improved financial sector alone does not make a recovery, but it is a precondition for recovery.

Figure 4. S&P 500, 2000-29 May 2009, Weekly Data
Source: Global Insight

Housing Bottoming, Commercial construction in Free Fall

The long agonizing decline in the housing market is in the process of ending. To be sure prices already down 31% from the peak are still falling, but the lion’s share of the decline is behind us. (See Figure 5) Indeed house prices have now returned to where they were in late 2002. We are modeling in an end to the price decline late this year or early in 2010. At the end of the day with the Housing Affordability Index improving from 100 mid-decade to 170 recently and an end to employment declines should enable house prices to put in a bottom. Nevertheless because house price bear markets tend to have “long tails” do not expect any swift rise in prices over the next several years. Indeed there are still more “shoes to drop” as a new round of Alt-A mortgage resets hits the market in 2010-11 and foreclosures rise on prime mortgages weighed down by high unemployment.




Figure 5. S&P Case-Shiller Home Price Indices, 1988-March 2009, Percent Change Year Ago.



In terms of activity housing starts likely bottomed in the current quarter at an annual rate just below 500,000, down almost 80% from the peak. (See Figure 6) The recently enacted $8,000 new home buyer credit should help over the balance of the year. Because housing activity will come off a very low base, the recovery we envisage will look steep, but in reality the 1.25 million starts we forecast for 2011 will still be 40% below the 2.07 million units recorded in 2005.

Figure 6. Housing Starts, 2000:Q1 – 2011Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

In sharp contrast to residential construction, the decline in commercial construction is only halfway through it contraction. (See Figure 7) Although the bull market in the housing market received most of the press in the mid-2000s, a parallel bull market was taking place in commercial real estate. Paced by over-generous lending standards commercial real estate prices more than doubled from 2000-07. However the onset of the credit crisis in August 2007 quickly and decisively triggered a bear market in commercial real estate. In fact, since 2006 the $250 billion/year issuance market for commercial mortgage backed securities (CMBS) market all but disappeared. It is for that reason the Fed made highly rated CMBS securities eligible collateral for the TALF program. However with rating downgrades in train, the dollar amount of eligible collateral will be severely reduced.

Figure 7.Real Commercial Construction Spending, 2000:Q1 – 2011:Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

Furthermore, commercial real estate is plagued by more than a shortage of credit. The onset of the recession brought with it huge declines in office employment and consumer spending, the leading economic drivers of commercial real estate. With that vacancies have increased and rents have fallen. All-in commercial real estate prices are estimated to be off by 30-40% and are likely to fall further.

The Shape of the Recovery

What we are perhaps most concerned about is not the timing of the recession’s end, but rather the shape of the recovery to come. We are forecasting the weakest economic recovery of the postwar era with real growth on the order of 2- 3%. Indeed the unemployment rate could very well be close to 10% by the end of 2011. Simply put, we believe that the economy will be weighed down by newly chastened consumers attempting to increase their saving rate and a wrenching structural adjustment in the financial services, automotive and retail industries. These adjustments are even before we get to energy and healthcare.

Recovery will be inhibited by the legacy of the financial excesses of 2003-07 in the form of millions of foreclosed houses and even more plagued with “underwater” mortgages”, a nationalized domestic automobile industry and a partially nationalized banking system. This legacy is in sharp contrast to the roaring 1920s boom where the economy created such productivity enhancing investments as the national electrical grid, a giant automotive industry, unit-drive motors in factories and witnessed the emergence of electronic technology in the form of radios. Similarly the late 1990s bubble bequeathed to the economy the world-wide web and the flowering of wireless communications.

The rise in savings is being caused by the need of consumers to replenish their tattered balance sheets ravaged by the bear market in housing and stocks and the new lending standards that will make it harder to borrow. For example the quaint 20th century notion of consumers saving money to make down payments on houses will come back into vogue. To be sure the saving rate recently popped to 5%, but a good part of that is a result of the decline in automobile sales. Once automobile sales start to recover the saving rate will naturally drop.

Moreover there will be downward pressure on consumer savings coming from the tax increases on high income individuals scheduled to take effect in the beginning of 2011. Nevertheless by the end of 2011 we forecast that the saving rate will be running at a sustainable 3% rate and rising; a far cry from the zero rate experience a few years ago. (See Figure 8) As a result real consumption spending will increase at a very low 1% rate in 2010 and 2011 compared to the historic 3% increases. (See Figure 9)

Figure 8. Saving Rate, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast



Figure 9. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast

Although both monetary and fiscal policy put a floor under the economy, no mean feat, it is also likely that the policies now being put into place may put a ceiling on it as well. How so? First the Fed will likely take away a good part of the monetary stimulus injected into the economy. Failure to do so would run the risk of a substantial inflation a few years out. The removal of the monetary stimulus along with modest economic growth will work to return interest rates to more normal levels. In fact this is the message of the recent run-up in 10 year U.S. Treasury yields from 3% to 3.9%.

In terms of fiscal policy the economy will be faced with trillion and near trillion dollar deficits for as far as the eye can see. With government spending(NIPA basis) estimated to peak out at a postwar record of 24.2% of GDP in 2010, the transfer of resources out of the private to the government sector will be hardly conducive the economic growth. (See Figure 10) Furthermore a new regulatory regime with respect to finance, energy, environment and healthcare will be hardly be a motivator for investment, at least, while the transition is taking place. Thus do not expect the recovery to look like those of 1991-99 and 2003-2007. But then again living without bubble-induced growth will be a new experience.



Figure 10. Government Spending as Share of GDP, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast





[i] New York Review of Books, June 11, 2009.
[ii] Shulman, David, “The Global Slump,” UCLA Anderson Forecast, March 2009.