The Current Economic Outlook
FedViews December 11, 2008
- Corresponding charts (PDF - 163KB)
Simon Kwan, vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:
- Recent economic indicators were weaker than expected on balance, and in some cases by a wide margin. Financial markets remain severely stressed and vulnerable to shocks; both implied and realized volatilities continue to be elevated.
- Real consumer spending declined for the fifth consecutive month since June; the decline was pretty much across-the-board except for Walmart Stores. Sales of light vehicles plummeted again in November, to a level not seen since the early 1980s. Going forward, consumption is likely to remain very weak, given the massive amount of job losses, the limited availability of credit, and the sharp fall in asset prices.
- Business spending retrenched significantly. Both orders and shipments of core capital goods fell more than expected in October. This is hardly surprising given the large degree of economic uncertainty, limited credit availability, and the very high cost of capital that many businesses face.
- The manufacturing sector continued to weaken. Although the decline in industrial production was exacerbated by the effects of the hurricanes and the Boeing strike, after excluding these special factors, manufacturing output still was estimated to have fallen by about two-thirds of a percent in both September and October. With auto makers slashing production and with the sharp drop in orders including exports, the manufacturing fundamentals point to weakness well into next year.
- The slump in the housing sector shows little sign of abating. Forward-looking housing construction indicators continue to decline sharply. House prices continue to fall, and the pace of decline had intensified even before the financial meltdown in October. Housing inventory remains very elevated, despite some signs of stability in home sales activity; a good fraction of current existing home sales were foreclosure sales.
- In the labor market, nonfarm payroll employment fell by 533,000 jobs in the month of November. Job losses were broad-based across both the service- and goods-producing industries, with the largest declines in manufacturing, construction, retail trade, and temporary help services. Moreover, the number of job losses in both October and September was revised up substantially. In sum, the economy has lost 1.9 million jobs since the beginning of this year, and the pace has been accelerating, as two-thirds, or about 1.25 million of those jobs were lost over just the last three months. The unemployment rate climbed by two-tenths of a percentage point to 6.7 percent and is expected to move higher.
- Financial conditions have tightened on balance. Broad stock market indexes have fallen by over 40 percent from their peak, and volatility skyrocketed. However, the collapse in stock prices reflected plummeting corporate earnings, rather than a collapse in valuation. The S&P 500 P/E ratio retraced relatively little from its recent peak. To the extent that there was no large run-up in valuations, as in the last stock market bubble, stock prices could rebound relatively quickly once corporate earnings start to recover. Other more sophisticated measures of stock market valuation, such as the spread between the forward-earnings yield over real bond yield, also point to a relatively large equity premium.
- In the corporate bond market, yields on below-investment-grade corporate bonds have reached record high levels. Yields on Baa-rated investment-grade bonds also have risen substantially, despite the large decline in Treasury yields. While some of the widening of the credit spreads in corporate bonds reflected rising risk of default amid worsening economic fundamentals, the compensation required by investors to bear that risk likely also has risen.
- Evidence of very tight financial conditions can also be found in the Asset-Backed Securities (ABS) market. Yield spreads of AAA-rated ABS-backed by credit card receivables, auto loans, and student loans skyrocketed when investors became either very reluctant to take on risk or unable to do so due to deleveraging and balance sheet constraints. As a result, credit availability to consumers has been curtailed when the originators cannot securitize even their good loans. Many consumer loan originators, including banks, are capital-constrained and do not have much capacity to expand their loan portfolios. The Federal Reserve in November announced the creation of the Term Asset-Backed Securities Loan Facility (TALF) under which the New York Fed will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Treasury will provide $20 billion of TARP money to fund this operation, and the Treasury's claim will be junior to the Fed's.
- In addition, two other new programs announced by the Federal Reserve aim to support the mortgage market. While conforming mortgage rates have declined recently, their spreads over Treasury yields remain stubbornly high and rising. The elevated mortgage spread is perhaps due to the impairment of the Mortgage-Backed Securities (MBS) market, despite the fact that the two housing GSEs are in conservatorship and thus, in theory, have the backing of the U.S. government. It appears that investors have some doubts about the implicit government guarantee and demand a premium for holding the agency debt and agency MBS. These risk premiums are eventually passed onto the primary market. In an attempt to improve the functioning of the agency debt and the MBS markets, the Fed announced that it will purchase up to $100 billion in agency debt and up to $500 billion in agency MBS.
- In the money market, rates on high-grade commercial paper fell following the Federal Reserve's introduction of three facilities to support that market's functioning. However, rates on A2-P2 commercial paper, which are not eligible for the Fed's facilities, remain very elevated. The term interbank borrowing rates also remain very elevated after moving down from their extraordinary peaks, and they show signs of firming as the year-end approaches. Note that the last few TAF auctions were all undersubscribed, indicating that the recent demand for TAF funds was met completely.
- With a large number of programs in place, the Federal Reserve has both changed the composition of and expanded its balance sheet significantly. The three new programs announced in November will expand the Fed's balance sheet further.
- Despite the Federal Reserve's direct intervention in credit markets, it will take some time for financial market functioning to return to normal. The current economic downturn is shaping up to be one of the worst in terms of duration, job loss, and contraction in economic activity in the post-war period. Even if some form of reasonably sized fiscal stimulus is enacted rather quickly in early 2009, the economy may not begin to expand again until the second half of next year. With the slack in the economy growing, and with sharp declines in the prices of energy and other commodities, inflation is expected to moderate rather quickly in the foreseeable future.
The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle of the month. The next FedViews is scheduled to be released on or before January 12, 2009.