Prices & Outlook: U.S. Economy
Larry DeBoer
August 21, 2009
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The past year saw the worst financial panic since the Great Depression, the highest unemployment rate since the early 1980’s, the most rapid two-quarter drop in output in fifty years, and the most aggressive policy actions by the Federal Reserve in its entire 96-year existence. Mercifully, the next year should be much less exciting. But it will be hard on almost everyone.
Consumer spending dropped in 2008-09, the first decline in seventeen years. Consumer confidence is not recovering; households are saving more and spending less. Consumer spending will probably grow a little over the next year. But since consumption is more than 70% of gross domestic product, the economy cannot grow rapidly without bigger purchases by households.
Investment spending will not take up the slack. The housing market appears to have bottomed out. Real home prices are back down to where they were in 2000, before the boom. Building permits, new home sales and new single family home starts have stopped declining. Business orders for new equipment have stopped declining too. Investment spending probably won’t decline over the next year—a big improvement over the last year—but it won’t grow much, either.
The rest of the world may be recovering a bit faster than the U.S. Exports may edge upward. The value of the dollar rose against the euro during the Fall panic, as Europeans bought U.S. Treasury bonds as a safe haven for their money. The dollar’s value is back down again, and this should also help exports begin to grow.
Government spending on defense and non-defense purchases grew substantially during 2008-09, and this should continue. State and local government spending is likely to fall, as revenues continue to drop. Adding it all up, expect gross domestic product to grow 2.1% above inflation over the next year.
That’s not enough to bring the unemployment rate down. The rate appears to have leveled off in the past three months, and stands at 9.4% as of July. Slow GDP growth will cause the unemployment rate to drift upward over the next year, as not quite enough jobs are created for the expanding labor force. Expect the unemployment rate to be 9.8% by July 2010.
The consumer price index dropped over the past year—1.9% deflation—due to falling energy prices. Energy prices will recover modestly, which should cause the CPI to register inflation during 2009-10. The core rate of inflation, which excludes food and energy, fell from 2.5% to 1.6% over the past year. With unemployment so high, this rate should continue to fall. Expect an inflation rate of 1% over the next twelve months.
The Federal Reserve is unlikely to raise interest rates with unemployment so high and inflation so low. This will keep the three-month Treasury interest rate near 0.7%, and the ten-year Treasury interest rate near 3.7%, by July 2010.
So, will it be recovery or more misery? The answer: both. The recession may be over, but the first day of recovery is a lot like the last day of recession. The economy has fallen into a deep hole. It will take years to climb out. The climb will start—slowly—in the coming year.
Last August’s forecast was particularly inaccurate. The forecast was made on August 22. Three weeks later, on September 14, 2008, the Lehman Brothers investment bank went bankrupt, and the world financial panic was on. The result was the worst recession since the early 1980’s, maybe since the Great Depression. Needless to say, this was unanticipated.
The year 2008 will likely be studied by economists for decades to come. The worst financial panic since the Great Depression led to the deepest recession since the early 1980’s. Real GDP fell 3.9% from the second quarter of 2008 to the second quarter of 2009. The unemployment rate jumped from 5.8% in July 2008 to 9.4% in July 2009. Inflation had been measured at 5.4% in the twelve months to July 2008, due to the huge run-up in energy prices. With the crash of energy prices since then, inflation has become deflation. The price level fell 1.9% from July 2008 to July 2009. International money rushed to the U.S. Treasury as a safe haven, driving the three-month Treasury rate to near zero in December. It remains very low, at 0.2%. The ten-year Treasury rate hit a 55 year low at 2.4% in December, before recovering to 3.6% by July. The Federal Reserve responded to these events with the most aggressive policies in its history, led by a cut in the federal funds rate effectively to zero.
Things could hardly get worse, and they’re not. The Conference Board’s index of leading indicators began to turn upward in April. The spread between the short and long term Treasury securities, another leading indicator, puts the odds of a new recession in the next year at near zero. Real GDP fell “only” one percent in the second quarter, after consecutive five- and six-point declines the previous two quarters. The financial panic has abated; the housing market may have hit bottom; the unemployment rate has stopped leaping upward. The recession that began in December 2007 may well be marked as ending in June, July or August of 2009.
Remember, though, the first day of recovery looks a lot like the last day of recession. The economy has dug itself a deep hole. It will be several years before it climbs all the way out.
Gross Domestic Product. GDP, adjusted for inflation, has dropped in five of the past six quarters. The decreases in the fourth quarter of 2008 and the first quarter of 2009, 5.4% and 6.4% respectively (at annual rates), were the largest consecutive quarter declines in fifty years. The second quarter decline of one percent was a relief by comparison.
Consumption. Consumer spending, adjusted for inflation, increased every quarter for seventeen years, until the first quarter of 2008. U.S. consumers were a large part of the engine of growth for both the U.S. and the world as a whole. Big drops in consumer spending in the third and fourth quarters helped produce the severe recession. As usual in a recession, durable goods spending has dropped the most, by 9.2% over the past year. When incomes are down and employment uncertain, consumers postpone purchases of cars, appliances and furniture. Purchases of non-durables fell as well, and service spending was flat.
Consumers are saving more out of their reduced incomes. The personal savings rate dipped below 1% in April 2008, but rose to more than 6% in May 2009. It was 4.6% in June.
Consumer spending makes up 71% of gross domestic product. Without a recovery in consumption, there can be no overall recovery. Unfortunately, the University of Michigan’s Index of Consumer Sentiment has fallen during the past two months. Manufacturer’s orders of consumer goods rose in June, but are still lower than they were in March. These two leading indicators of consumer spending do not point to vigorous growth in the near future. And that means a sluggish recovery over the next year.
Investment. Investment spending collapsed in 2008. Housing construction (residential structures investment) had been declining since 2006. Investment in equipment and business structures began falling at the end of 2007, and really dropped starting in the fourth quarter, 2008. In fact, in the first quarter of 2009 investment spending fell 16% in one quarter—an annual rate of over 50%.
The contraction in housing construction may have finally hit bottom. Building permits for single family homes reached its lowest level in at least fifty years in April, then increased in May and June before falling slightly in July. Housing starts and new home sales also appear to have turned upward since Spring.
The Case-Shiller index of housing prices actually edged upward in May (the most recent month available), after falling every month from July 2006. The ratio of home prices to rents—also known as the real price of housing—is now down to its level as of December 2000. That was before the housing price boom. Perhaps housing prices have fallen about as far as they’re going to fall. That would be further good news for the housing market, since an expectation of falling home prices discourages home buying. And it would be good news for consumer spending overall, since declining housing wealth discourages spending.
Manufacturer’s new orders of capital goods is a leading indicator of business investment. It dropped 27% from June 2008 to January 2009, but has increased 6% since then. Business structure investment is not showing much evidence of recovery either. There is no business investment boom in the offing, but the rapid declines appear to be over.
Exports and Imports. Exports fell almost 16% over the past year, a clear sign that the recession is global. Our trading partners don’t have the incomes to buy our goods. Imports fell almost 19% over the past year. We haven’t got the incomes to buy goods from our trading partners. The trade deficit as a share of GDP has fallen dramatically, from 6.1% at the end of 2005, to 2.5% now. 
The economies of Japan and Europe performed better than the U.S. economy in the second quarter. Output in Germany and France rose slightly; output in Europe as a whole and Japan fell slightly, but less than output fell in the U.S. The Conference Board’s leading indicators indexes are up for Europe, Japan, Korea and Mexico. China is growing rapidly. The World Bank projects 7.2% output growth for China in 2009, and 7.7% in 2010.
The value of the dollar in European euros jumped during the financial panic, as international investors raced to put their money in the safe haven of Treasury bonds. As the panic has subsided, so has the value of the dollar. The value of the dollar in Japanese yen has been falling since mid-2007. These relatively low exchange rates should help U.S. exports grow, once recovery gets underway in the rest of the world.
Government Purchases. Federal defense and non-defense purchases have been growing rapidly. The administration’s increased military effort in Afghanistan, and the beginnings of stimulus spending, are reflected in a 7.5% rise in defense purchases and a 3.9% rise in non-defense purchases over the past year. State and local governments must balance their budgets, and so are more restricted in their ability to spend. State and local purchases are down slightly from last year.
Federal purchases are likely to rise at least as fast during 2009-10, due to the increased deployment in Afghanistan and the spending of the bulk of the stimulus funds. State and local spending, however, is likely to decline. Indiana’s budget is in better shape than most, but its recently passed two-year budget includes annual operating spending increases of only 0.3%, not adjusted for inflation. We can expect declines in state and local purchases as a whole over the next year.
Gross Domestic Product. Suppose consumption grows just 1% above inflation over the next year, and investment doesn’t grow at all. Inventories continue to drop, but by only $50 billion. Those would be dismal readings in an ordinary year, but they’re improvements over 2008-09. Let exports grow 2%, assuming the economies of our trading partners are recovering a bit faster than ours. Imports grow like consumption, 1%. State and local purchases fall 2%. Federal defense spending continues to grow by 8%, and non-defense spending gets a boost from the stimulus program, and grows 8% too. These add up to real GDP growth of 2.1% over the next year.
Inflation. As of July 2008, the 12-month inflation rate was 5.5%, the highest it had been in almost two decades. Inflation was a problem. One year later the rate was -1.9%—1.9 percent deflation—the first annual deflation rate since the 1950’s. Deflation was a problem. Clearly, the wild changes in energy prices have distorted the Consumer Price Index as a measure of the general price level.
The core rate of inflation, which excludes food and energy prices, is the better measure of general inflation. The 12-month rate stands at 1.6% as of July 2009. A year ago it was 2.5%. The inflation rate is falling, but it’s still an inflation rate.
The average price of gasoline was $2.53 per gallon in July 2009. The Energy Information Administration projects the price to rise to $2.73 by July 2010. As this happens the all items deflation rate will turn back towards inflation, and approach the core rate.
But with the unemployment rate above 9% during the coming year, the core inflation rate should fall. Over the past year, the core rate fell nearly a percentage point as the unemployment rate averaged 8%. It will continue to fall in the coming year, by perhaps another half-point. So, expect the all-items inflation rate to be 1.0% over the July 2009-July 2010 period.
Unemployment Rate. The unemployment rate increased by four-tenths or five tenths of a percent every month from December 2008 to May 2009. During the last recession, it did not increase by that much in even one month. In June and July, however, the unemployment rate stopped rising—in July it fell by one-tenth.
Initial claims for unemployment insurance peaked at the end of March, and are down about 17% since then. The 574,000 new claims as of the first week of August , though, is still higher than at any time during the last recession.
During the past two recessions a rapid increase in the unemployment rate was followed by more than a year of slower increases. At the end of the 1990-91 recession, in March 1991, the unemployment rate was 6.8%. It peaked at 7.8% in June 1992. At the end of the 2000 recession, in November 2000, the unemployment rate was 5.5%. It peaked at 6.3% in June 2003. The rapid increases in unemployment may have stopped as of May. But it is unlikely that the unemployment rate will actually fall until the second half of 2010.
The reason is that real GDP must grow by 3% to 3.5% in order to hold the unemployment rate steady. The labor force rises by more than a million people in a normal year. Jobs must be created for these new workers, and that requires economic growth. If too few jobs are created because output is growing too slowly, the unemployment rate will rise.
The forecast for the next year is for real GDP to grow by 2.1%. That’s not enough to hold the unemployment rate steady. Expect the unemployment rate to rise to 9.8% by this time next year.
Monetary Policy and Interest Rates. The Federal Reserve was more aggressive in 2008-09 than at any time in its 96 year history. The federal funds rate, which is the overnight bank lending rate and the Fed’s main policy tool, was cut to 0-0.25% by November 2008. That’s effectively zero: it can’t go lower. The Fed began purchasing assets other than Treasury bonds, and began lending directly to institutions other than banks. The monetary base—which is the sum of bank reserves and currency in circulation—more than doubled.
The financial panic had dramatic effects on interest rates. It caused investors to demand Treasury bonds as a safe haven for their money. Treasury security interest rates dropped. The ten-year Treasury rate fell to 2.4% in December, its lowest rate since 1954. This meant that few funds were available for private lending, so commercial and corporate rates went up. The BAA corporate bond rate jumped from 7.3% in September to 9.2% in November.
The glut of money available for Treasury borrowing drove the Treasury bill rate down to 0.7% in October and 0.03% in December (yes, three-hundreds of a percent). The commercial paper rate peaked at 3.2% in October. The spread between the two is a measure of financial panic. It peaked in October at 2.5%, a very large spread.
Financial markets have calmed considerably since the Fall of 2008. The demand for Treasury bonds as a safe haven has subsided, and the ten-year bond rate has returned to 3.6%. The three month Treasury bill rate remains very low, at 0.2%, but now the commercial paper rate has followed, at 0.3%. The spread is in its normal one to two tenth range.
This interest rate spread usually is a leading indicator of the economy. Sure enough, it began rising in August 2007, four months before the recession is marked as starting. The fact that the spread is back down may mean that the worst is over, for financial markets and the economy.
With the unemployment rate remaining above 9% for the next year, it is unlikely that the Fed will increase the federal funds rate above its current near-zero level. That means the three-month Treasury rate will remain low as well. Barring another panic, the ten-year Treasury rate should also remain stable. Expect a three-month Treasury rate near 0.7%, and a ten-year Treasury rate near 3.7%, by this time next year.
Problems for the Future I: Inflation
Many people have expressed concern that inflation will result from the huge increase in bank reserves and currency in circulation created by the Federal Reserve over the past year. Fed Chair Bernanke himself has cited this as a danger.
We can make a rough estimate how much additional inflation might be on the horizon by applying two old macroeconomic ideas: the money multiplier and the equation of exchange.
The money multiplier is the ratio between the money supply and the monetary base. The base is bank reserves and currency in circulation. The “M1” definition of money supply is bank checking deposits and currency in circulation. The difference between the two is bank lending. Banks lend a fraction of their reserves, which are re-deposited in the banking system, so that a fraction can be lent again. This “multiple expansion of bank deposits” means that the money supply is determined both by the Federal Reserve (how much money the Fed creates) and bank behavior (how much of this money is reserved and how much is lent). The more money banks lend, the bigger is the money multiplier, and the bigger is the money supply.
The Fed more than doubled the monetary base between 2008 and 2009, shown in the table, in its effort to rescue financial markets, keep interest rates low and stimulate the economy. But banks greatly reduced their lending in 2008 and 2009. The money multiplier dropped from around 1.6 to slightly less than one. As a result, the money supply increased only 16.3% from 2008 to 2009, much less than the increase in the monetary base.
The equation of exchange says that the money supply, multiplied by velocity (the number of times a dollar is used each year), equals the price level times the real output of goods and services. In equation form, that’s MV = PQ. If the money supply increases, and velocity and output are unchanged, the price level must rise. That’s the relationship between the money supply and inflation: too much money chasing too few goods produces inflation.
Of course, velocity and output don’t remain unchanged. Output fell 3.9% from 2008 to 2009. Velocity fell too, by 16.1%. The average checking or currency dollar was used 10.45 times in 2008, but only 8.77 times in 2009. People are cautious during a recession. They spend less, and leave more in their checking accounts each month. So dollars are used less frequently for transactions, and velocity falls.
Why hasn’t the Fed’s enormous increase in the monetary base created inflation? Because banks aren’t lending and people aren’t spending. Much of that new money is sitting in bank reserves and bank accounts, so it isn’t out there chasing goods and pushing up prices.
Eventually, though, banks will start lending and people will start spending. Suppose the money multiplier returns to its 2007 level, 1.62. Then all that money the Fed has created will increase the money supply by an added 78.7%. Suppose velocity returns to its 2007 level, 10.17, and suppose output recovers from recession (at 3% per year from its 2007 level). The increase in the money supply—because banks are lending—plus the increase in velocity—because people are spending—produces a price index 90.8% higher than it is now. Over five years (to pick a number), that would be inflation of almost 14% per year.
That’s double digit inflation like we had in the worst years of the 1970s and early 1980s. It is not hyperinflation, though. Hyperinflation is triple-, quadruple-, even septuple-digit inflation, millions of percent a year, like Zimbabwe recently experienced. The Fed has not created nearly enough money for hyperinflation in the United States.
This is not a prediction of double digit inflation in the next decade, however. The Fed can create money, but it can also destroy it. The Fed’s task over the next several years will be to withdraw bank reserves and currency in circulation, at a pace fast enough to prevent inflation, but not so fast as to bring on a double-dip recession.
Chairman Bernanke summed it up in a February 18 speech: “. . . by carefully monitoring our balance sheet and developing tools to drain bank reserves as needed, we will ensure that policy accommodation can be reversed at the appropriate time to avoid risks of future inflation.” The Fed will try to reduce reserves to prevent inflation.
It will be a tricky business, and a lot rides on the Fed’s success.
Problem for the Future II: The Budget Deficit
The Federal government’s budget deficit became very large in fiscal 2009 (which ends on September 30). In June the Congressional Budget Office estimated that the government would spend $1.7 billion more than it received in revenue. The Federal government will spend about $3.9 billion in 2009, which means it is paying for less than 60% of its spending with taxes. It’s borrowing the rest.
A better measure of the size of the deficit is as a percentage of GDP. GDP represents the nation’s ability to pay interest on debt, so a larger GDP can support a larger annual deficit. The chart shows the deficit percents since 1980, and the CBO’s projections through 2019. The largest previous deficit percentage over this period was 6% in 1983. In 2009, according to the CBO’s baseline projection, the percentage will be double that, at 12%. This is the biggest budget deficit percentage since World War II.
Government budget deficits can be problems for the economy because government borrowing may “crowd out” private borrowing. If the government is first in line with lenders, private borrowers may not be able to obtain funds for home construction, business expansion or technological development. Over many years, reduced private investment in plant and equipment would produce slower growth in output. With fewer, lower tech tools to work with, workers produce fewer goods and services than they could have.
Crowding out is not a problem now. Banks are not lending, and businesses are not borrowing. The government is borrowing and spending money that otherwise would be sitting idle in bank reserves. Deficits are the appropriate Federal government response to recessions, and a deep recession requires a big deficit. The added spending and lower tax collections will help end the recession sooner, and speed the recovery.
Crowding out is a danger during expansions, though. The CBO projects that the deficit will drop dramatically from 2009 to 2012, as tax revenues grow with recovery and the temporary stimulus measures expire. After 2012, however, the deficit does not improve. The baseline projection remains near 2%, and the analysis of the President’s budget proposals has the deficit growing back to 6% of GDP by 2019.
The deficits in the President’s proposal exceed the baseline because of income tax reductions, most of which are extensions of the tax cuts from earlier in this decade. These are allowed to expire in the baseline estimates. The President’s tax proposals also include indexing the alternative minimum tax to inflation, and expanding earned income and child tax credits. On the spending side, differences include added education grants, increases in physician payments under Medicare, and rising debt service payments that result from the accumulated larger debt. The CBO’s June projections did not include changes in health care policy.
There is evidence that crowding out occurred in the 1980s during the years of big deficits. Private investment fell as a share of GDP during most of that decade, a rare occurrence during an expansion. The 6% annual deficits projected for the next decade are as large as any during the 1980s. They likely would create crowding out of private investment, and result—over many years—in slower output growth.
Federal budget deficits are not a problem now. They’re just what we need during a recession. In the expansion to come, however, the continued deficits could ultimately slow long run growth.
