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Economic Readings

Fed sees hopeful signs but downgrades '09 forecast The Federal Reserve expects the economy to improve in coming months, even as policymakers have downgraded their outlook for all of 2009. Fed Chairman Ben Bernanke and his colleagues believe business sales and factory production will begin to gradually recover later this year as President Barack Obama's stimulus package and the Fed's aggressive efforts to end the recession take hold. In new Fed documents, they also pointed to signs that the recession's grip was easing in the current quarter. The Fed now expects the economy will shrink this year between 1.3 and 2 percent. The old forecast called for a contraction between 0.5 and 1.3 percent. The unemployment rate may hit nearly 10 percent, up from 8.8 percent in the old forecast.

• Housing Starts at Record Low in April
• Quarterly Housing Starts and New Home Sales
• Fed: Delinquency Rates Surged in Q1 2009
• WSJ: Small Banks Face $100 Billion in CRE Losses

FedViews for May09 The economy shows many signs of continued weakness. That said, several indicators suggest that the pace of contraction is slowing. This does not mean that economic activity is increasing, but that it might bottom out in coming months. Historically, such indicators have signaled a turning point in the business cycle and the onset of a recovery. Given current circumstances though, we expect the subsequent recovery to be very slow compared to previous ones. Continued weakness is particularly evident in the recent labor market data. Nonfarm payroll employment declined by a substantial 539,000 jobs in April, as firms, operating in a weak and uncertain sales environment, continued to cut costs. The very thin silver lining is that the April job decline was significantly smaller than those in the previous three months. However, the unemployment rate has increased to 8.9 percent. The main drag on economic activity has been investment. This consists of four main components: housing construction; commercial construction (offices, industrial buildings, retail space, and other commercial real estate); purchases of equipment and software; and changes in inventories. The commercial real estate market is going through a correction very similar to that of the housing market. Prices of commercial real estate almost doubled between 2000 and 2007 and have since declined by more than 20 percent. Vacancy rates have increased, the delinquency rate on commercial mortgages has risen, and the pace of construction has slowed to a crawl. Starting in June, commercial-mortgage-backed securities (CMBS), which are an important source of financing in the commercial real estate market, will be eligible collateral under the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF). Almost no CMBS have been issued in the U.S. since the summer of 2008. The current technology-sector slowdown is of the same order of magnitude as the tech bust of 2001. However, in this downturn, the inventory levels in the tech sector are much lower than in 2001. This suggests that production might pick up relatively quickly when demand strengthens and inventories are replenished. We expect such inventory replenishments to extend well beyond the tech sector and emerge as one of the sources of GDP growth in the second half of the year. These developments suggest a deceleration of the adverse feedback loop that is at the heart of the current economic downturn. This loop is a cycle in which losses by banks and other lenders lead to a tightening of credit, which in turn reduces spending by households and businesses. The resulting drop in demand drags down the housing sector and the broader economy, contributing to greater loan losses and tighter credit. This slowdown of the adverse feedback loop, as well as the easing of the pace of job losses, have contributed to a jump in consumer confidence. In sum, we expect GDP growth to turn positive by the fourth quarter of this year. However, we envision a much slower recovery than those of the past four recessions. In fact, we only expect GDP growth to return to its trend level by the end of 2010. The result is a gap between GDP and potential GDP in excess of 6 percent. We expect this persistent slack in the economy will result in a peak unemployment rate of around 9.5 percent and a very slow decline in the rate during 2010 and 2011. Finally, in light of the large degree of economic slack we are forecasting over the next two years, we expect inflation to remain relatively low.

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World Economies Plummet Steep declines in the economies of three of the U.S.'s biggest trading partners -- Mexico, Japan and Germany -- underscored the severity of the global recession and put pressure on major industrialized nations to revive moribund global trade talks. On Wednesday, Mexico became the latest country to report a plunge in output. The country's gross domestic product fell at an annualized rate of 21.5% in the first quarter, the worst performance since the 1995 peso crisis led to an International Monetary Fund and U.S. Treasury financial rescue. This time, Mexico has insulated itself somewhat by arranging a $47 billion IMF credit line in advance. Mexico's decline followed by a day Japan's report that its economy contracted in the first quarter at a 15.2% clip, its worst performance since 1955. Last week, Germany said its first quarter decline in GDP, an annualized 14.4%, was the worst since 1970. All three countries depend on exports to the U.S. But they have nose-dived as U.S. consumers cut back purchases of autos, electronics and other goods mass produced abroad. For the first three months of 2009, U.S. merchandise imports declined about 30% to $352.5 billion compared with the same period a year earlier. Mexico's ties to the U.S. are particularly strong because of the North American Free Trade Agreement, and Mexican auto production in the first quarter fell 41% from the year before.

Policy and Structural Change

Obama's Auto Plan Is Capitalism at Work Contrary to what many pundits claim, the Obama administration's approach to the auto industry is not anticapitalist. Without a drastic restructuring neither Chrysler nor GM would have a chance for long-term success. Not only would thousands of workers lose their jobs, but the government would lose tens of billions of taxpayers' dollars. So rather than simply writing a check to the auto industry -- the policy of the previous administration -- the Obama team is focused on fundamentally restructuring these two businesses. So far, the auto task force has done an admirable job of refusing to rubber stamp the industry's proposals. It's used rigorous analysis to make tough decisions. These decisions include "right sizing" industry capacity by cutting many union and white-collar jobs and closing numerous manufacturing plants and dealerships; making the unions accept lower wages and benefits so that these companies can compete; and cutting the debt crushing these companies by forcing many of the stakeholders -- workers, retirees and creditors (including the government) -- to take equity rather than cash for their obligations. And yet the Obama administration has been strongly criticized for not adequately respecting the rights of creditors. That charge is false. Not a single creditor right has been altered during this process. The banks had the same choice they always face in similar situations: accept a modification in their loans or take over the struggling companies. A substantial majority of the banks initially accepted the government's offer as fair. They recognized that Chrysler could not survive without enormous additional funding and realized that the value they would receive in liquidation would likely be less than what the government offered. They understood that the billions of dollars Chrysler desperately needed wouldn't materialize without a dramatic restructuring. All debtholders have now agreed to the government's plan.The creditors are also reasonable and sophisticated capitalists who clearly recognized the risks they were taking when they purchased these Chrysler loans. Many probably bought these loans at prices below the 29 cents on the dollar that the government is offering since this debt often traded below that level. While these creditors were hopeful that the Obama administration might bless them with an enormous windfall -- a reasonable thought given the actions of the last administration -- they certainly knew that these loans were incredibly risky and that Chrysler survived only by the grace of taxpayer financing.

• Geithner Calls for `Very Substantial' Change in Wall Street Pay Practices

Credit-Card Law May Reduce U.S. Consumers' Purchasing Power by $90 Billion  excessive fees and last-minute contract changes. It also may prompt banks to slash available credit by as much as $90 billion to avoid risk, said Robert Hammer, chief executive officer of R.K. Hammer Investment Bankers, an adviser to card companies. That reduction could choke off a consumer-led recovery and hurt retailers struggling amid the longest recession since the 1930s, said Andrew Caplin, an economics professor at New York University. Consumer spending accounts for 70 percent of the U.S. economy. “When people walk into stores with credit cards instead of cash, 90 percent of them spend more,” Britt Beemer, founder of America’s Research Group, said in an interview. “Apparel, which is in the dumpster already, is going to be hurt the most. Nonessential, big-ticket items like TVs and electronics could certainly be impacted a lot.”  Available consumer credit contracted by a record $11.1 billion in March, according to a May 7 Federal Reserve report. The drop was equivalent to a 5.2 percent annual rate, the biggest since 1990. Reckless lending -- and the attendant defaults -- led to the reductions in credit, said Josh Frank, senior researcher at the Center for Responsible Lending in Durham, North Carolina."The impact on available credit has been greatly overstated as an industry tactic to scare people to be against the bill,” said Frank, who supported the legislation. Credit-card companies will still be able to price according to risk, said Gail Hillebrand, a San Francisco-based attorney for Consumers Union. The legislation will ensure that the cost of borrowing money is disclosed at the outset instead of luring risky borrowers with a low introductory rate, she said. The interest will be too high for some -- and in other cases, banks simply won’t issue cards, said Hammer. He estimated that as much as 10 percent of the $934 billion in U.S. card loans would disappear.

Wall Street's Crisis Wipes Out Jobs and Pay on Main Street The biggest Wall Street crisis since the Great Depression isn’t just a setback for New York or bankers. The finance industry’s contraction may wipe out $185 billion in wages and profits, or $600 for every man, woman and child in the U.S., according to Thomas Philippon, a finance professor at New York University’s Stern School of Business. The trail of reduced income affects car mechanics, waiters, sports teams, hair stylists, jewelers, housecleaners and watch repair shops. “We’re seeing lots of lives derailed,” said Simon Johnson, professor of entrepreneurship at the Massachusetts Institute of Technology. Irace, who worked at Bear Stearns for 19 years and is now a teacher in Uniondale, New York, is one of 255,441 people who’ve lost U.S. finance jobs since January 2008, according to data compiled by Bloomberg. Thousands more have seen cutbacks in pay. In New York City alone, bonuses fell to $18.4 billion last year from $32.9 billion in 2007, the largest absolute drop ever, according to the state comptroller’s office. The consumer discretionary and industrial sectors -- dependent on people who buy refrigerators, restaurant meals or cars -- are the only areas that have shrunk more than finance, with 383,340 and 270,278 job losses, according to the data. For each finance post eliminated, 3.3 in other industries will vanish, the comptroller’s office estimated.

Strategic Consequences

Is Nouriel Roubini lucky or just good? Roubini is widely seen as an incorrigible pessimist, and, in the years leading up to the crisis, this nose for doom pitted him against his more cautious colleagues in the academy and the regulatory agencies, as well as the ebullient in-house economists at banks and hedge funds. Even those who predicted a downturn didn't recognize the extent of the problem. They homed in only on certain pet indicators--trade imbalances, say--and saw a temporary, contained recession in the works. Roubini, on the other hand, saw something else entirely. Like a good mechanic or internist, he understood the wiring. Some economists--strict academics mostly--have long considered Roubini a quack. They sneer at his approach, which is wide, deep, and deeply unconventional. When he travels, for instance, he says his research includes talking to "everyone from the airport cab driver all the way to the finance minister. What sets Roubini apart from his fellow economists (and what occasionally gets him in trouble) is his willingness to intuit broad patterns and connect the dots, something that became apparent early in his career. While others spent years refining one econometric model or drilling down on one microsubject, Roubini gorged on a range of diverse topics that, to him, were all related: Japanese public debt, tax evasion, liquidity and exchange rates, monetary policy in the newly formed European Union, the effect of political cycles on industrial economies. Robert Shiller, who also worked with him at Yale and was one of the first people to warn of a housing bust, isn't surprised that Roubini, of all the great minds staring down our financial future, emerged as the one to piece it together. "A financial crisis needs general thinking, and a team of specialists will have difficulty understanding the whole thing," he says. "Nouriel's approach has always been worldwide, which is not rewarded in academia. There's an element of luck in everything, but it's not random who he is." He's been thinking a lot not just about the way down but the way out. With the help of the Obama administration's policies (not great, he says, but better than nothing), he sees "a light at the end of the tunnel." To actually get to the end of it, though, the United States will have to get used to consuming less, which means China, Germany, and Japan will have to get used to producing less, which means that all the intermediaries--Chile, Australia, Brazil--will have to scale back and turn inward like everyone else. The world may curve and warp a bit, and it will be difficult, but Roubini sees good in this. Given the right changes, perhaps the United States can develop with the productive long view in mind, and maybe its human talent can be spread more equitably.

The economic impact of increased US savings Two forces that until recently turbo-charged US consumer spending—growing household debt and a falling savings rate—have gone into reverse. In late 2008, as households started reducing their indebtedness and saving more, consumption tumbled. New research from the McKinsey Global Institute shows that the economic impact of further US consumer deleveraging will depend on income growth. Without it, each percentage point increase in the savings rate would reduce spending by more than $100 billion—a serious drag on any recovery. Relatively healthy income growth, on the other hand, would help households reduce their debt burden without trimming consumption as much. The significance of any fall in consumption could be profound. US consumers have accounted for more than three-quarters of US GDP growth since 2000 and for more than one-third of global growth in private consumption since 1990. These different scenarios have serious implications for the US and global economies because, holding incomes constant, each percentage point increase in the savings rate translates into roughly $100 billion less in consumer spending¬. A 5 percent savings rate would mean $530 billion less in spending each year if US incomes fail to rise; if they rose by 2 percent a year, a 2.3 percent savings rate would mean $250 billion less spending, all else being equal. In short, the importance of income growth is difficult to overstate. With it, households can simultaneously reduce their debt burden, rebuild savings, and boost consumption. But without significant income gains, deleveraging could undermine consumption and the global economy for years to come. One implication: policy choices that favor productivity and employment growth—critical determinants of income growth—will make deleveraging less painful. Efficiency breakthroughs in sectors, such as health care and government, that employ large numbers of people—but that have not enjoyed productivity revolutions similar to those experienced in industries like retailing and wholesaling—would make a dramatic difference.