The Good, Bad and Ugly

Category: News & General Info

Published: Friday, December 18, 2009

Econ 101

SOME GOOD, BAD, AND UGLY

Dr. Martin Regalia                                                                                                                       Senior Vice President and Chief Economist Economic Policy                                                            U.S. Chamber of Commerce

As 2009 draws to a close, the economy is finally growing again. After almost two years of recession and four consecutive quarterly declines in GDP, GDP rebounded in the third quarter, rising at a 3.5% annual rate. Improvement was noted in all major sectors of the economy and reflects a number of factors, not the least of which was a bottoming in the housing market and policy initiatives in both monetary and fiscal policy. Marked improvement in capital markets has eased volatility and has seen elevated risk spreads drop back to prerecession levels, although lending volume still has a long way to go. Unofficially, though, it appears that the recession is finally behind us.

Not All Is Rosy

The labor market continued to deteriorate in October, and employment declined by 190,000. The pace of decline has slowed from earlier this year when we averaged monthly job losses of more than 690,000 in the first quarter, but we are still far from positive job growth. The most startling news was a jump in the unemployment rate to 10.2% from 9.8% in September—the highest rate since March 1983. Moreover, the current unemployment rate likely understates the true slack in the labor market. In addition to the unemployed, about 2.3 million people are marginally attached to the workforce. These are people who want to work but have not actively searched in the past four weeks, so they are not counted as part of the workforce or as unemployed. Also, more than 9 million people are working part time as a result of the weak economy even though they would prefer to work full time. Adding the number of marginally attached and underemployed to the unemployment rate increases the rate to 17.5%. Not only are there millions of people unemployed, but the duration of unemployment is well above what we saw during the previous recession. In other words, the job losses appear to be more permanent. While the government can help cushion the hardships from unemployment, sustained improvement in the labor market will only come through continued economic growth in excess of our long-run potential estimated to be between 2.5% and 3%. Most economists are not forecasting this level of growth. While third-quarter growth exceeded this amount, and all major sectors showed improvement, the momentum usually seen coming out of similarly steep downturns, in the mid-’70 and early ’80s, is just not there.

Outlook for Growth

Consumption increased in the third quarter at an annual rate of 3.4% after falling 0.9% in the second quarter—in contrast to prior recoveries after steep downturns when GDP growth averaged almost 7% and consumption surged by about 6.5%. In addition, third-quarter consumption was likely bolstered by the Cash for Clunkers program and the recently extended home buyers’ credit, which boosted durable goods consumption at a 22.3% annual rate. Motor vehicle consumption jumped at an astounding 56.4% annual rate after declining at an annual rate of 6.3% in the second quarter. Looking ahead, there are some reasons to think that consumption at even these paltry rates will not be sustainable. Fundamentally, consumption is driven by real income and wealth gains. Real disposable income per capita rose only 0.1% over the past year, and the latest employment and wage data suggest only modest future gains. Household net worth is recovering slowly, with home prices stabilizing and the stock market recovering. But net worth is still down over $12 trillion from the prerecession peak and consumer debt levels remain elevated. Thus, it looks like repairing household balance sheets may remaina priority for consumers into the New Year.

 Investment and Trade

One brighter spot for consumers may be an improving housing market. After several years in free fall, the housing market appears to have finally reached a bottom. After 14 consecutive quarters of decline, residential investment grew at a 23.3% annual rate, almost exactly opposite the second quarter, when it declined 23.2% at an annual rate. The $8,000 tax credit for first-time home buyers, which lured many buyers into the market, has been extended until April 30, 2010. Moreover, housing starts have stabilized, and existing home sales are at their highest levels in a year. Median prices of existing homes have fluctuated and remain about where they were in the spring. New home sales have followed a similar trend. We are currently working through existing inventories but probably won’t see any appreciable new construction until well into next year. Business investment was mixed in the third quarter. Equipment and software investment increased by 1.1% in the third quarter after declining 4.9% in the second quarter. This was the best quarterly performance in six quarters. We expect positive but weak investment until mid-2010. By contrast, investment in structures decreased at a 9.0% annual rate in the third quarter, after declining 17.3% in the second quarter. With the capacity utilization rate at 70.5%, we don’t expect much improvement. Private inventories declined by $130.8 billion in the third quarter, a modest improvement over the declines in the previous quarter. The inventory to sales ratio is still elevated, and we are not expecting any sustained rebuilding until early next year. There are a few positive signs for future investment. After five consecutive quarters of decline, industrial production finally turned positive, growing at a 5.2% annual rate in the third quarter. Corporate profits have gradually improved over the last two quarters, and the purchasing managers’ index rose 3.1 points in October to 55.7 from 52.6 in September, consistent with an improving economy. The trade deficit is down 38% since 2007 but will be hard pressed to make such gains going forward, even with a depreciating currency. With budget deficits continuing to weigh heavily on the dollar, we should see demand for imports slowing. With growth abroad picking up sooner than the domestic recovery, we should see a modest improvement in exports and in the trade deficit.

What We Can Expect Going Forward

Inflation remains low and is not currently a threat. With weak demand at home and abroad, it is unlikely that price increases will be a problem for the remainder of the year and through at least the first half of next year. As a result, short-term interest rates should remain low and stable and only begin rising slowly after the middle of next year when the Fed is expected to begin to raise rates. Long-term rates, which have leveled off recently, will likely remain benign as long as inflation remains in check. If the midterm outlook is uncertain, then the longer-run outlook is downright scary. The Fed has done a remarkable job thus far of addressing the liquidity problems in financial markets. However, it must begin at some point to draw the liquidity out of the system to avoid creating inflationary pressures. But if the Fed moves too quickly or too aggressively, rates could spike and the economy could falter. On the contrary, the economy could falter if the Fed delays too long and inflation and rates rise. The Fed’s task is made all the more difficult because it is traveling in unchartered waters with no road map to follow. Another issue for the longer run is the level of deficits and debt. This administration has proposed significant new spending at a time when the weak economy will slow revenue growth, resulting in massive and unsustainable deficits and rising levels of government debt. If these debt levels remain unaddressed, they will put downward pressure on the dollar, upward pressure on inflation, and upward pressure on interest rates—not the environment conducive to generating the needed growth rate to reemploy those displaced in the recent recession.

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