Dr. Martin Regalia

As I mentioned last month, it is evident that the U.S. economy is in a recession. Moreover, the incoming data suggest that the downturn will be steeper and more prolonged than either of the last two, perhaps rivaling the double-dip decline of the early 1980s. One reason for such pessimism is the global nature of the current downturn. Most of our major trading partners were caught up in the recent credit problems and are experiencing slower growth.

International Outlook—In the third quarter, economic growth in the United Kingdom decreased 0.5% from the second quarter of 2008. The banking system in the United Kingdom was affected shortly after our own problems started. In September 2007, Northern Rock received liquidity from the Bank of England. When that did not stem problems, the bank was nationalized in February 2008.

France and Germany, as well as other European countries, are experiencing weakness. Both countries experienced similar declines in the third quarter, and conditions are expected to deteriorate further. The problems in Western Europe were recognized later than they were in the United States, and the European Central Bank (ECB) actually increased rates by 25 basis points this past July in response to rising risks of inflation. Now that their economies are clearly deteriorating, the ECB has eased rates and will likely continue to do so.

Canada, one of our most important trading partners, grew slightly in the second quarter, but monthly GDP data indicate that the third quarter will turn negative. Iceland is still in the midst of a major financial crisis after its three major banks ran into trouble refinancing their short-term debt. The banks are now in receivership, but there remains considerable uncertainty and the situation could deteriorate further. Finally, there are signs that the financial crisis has now spread to emerging markets as well. China's growth, while still rapid by our standards, has started to slow, and its government has implemented a massive stimulus plan to keep the economy going.

These developments are especially troubling for the U.S. economy because international trade has been the only steady source of growth for the past year. The trade deficit has fallen 28% since 2007 (see chart 1). Imports decreased at an annual rate of 1.9% in the third quarter, and exports increased a healthy 5.9%. However, with the dollar stabilizing a bit of late and growth abroad weakening, we expect trade to offer less support to GDP for the rest of the year and next year.

Problems in Financial and Credit Markets—
A more pressing problem for the U.S. economy is the current financial market crisis and credit crunch. To deal with these problems, Congress passed, and the president signed, the Emergency Economic Stabilization Act of 2008 (ESSA). This legislation authorized Treasury to buy up to $700 billion in troubled assets from the financial markets and gave Treasury a broad array of powers to deal with the financial crisis.

While implementation of the rescue is still in its infancy, Treasury has designated up to $250 billion to purchase equity shares in troubled financial institutions. This approach allows Treasury to inject money into the financial system much more quickly than through the purchase of troubled assets, and by providing additional capital, the stock purchase allows financial firms to leverage up their lending. As of this writing, Treasury is considering expanding this approach to include nonfinancial firms.

Since the passage of this act, financial markets have stabilized a bit. One common measure of risk is the so-called TED spread. This measures the difference between interest rates on interbank loans (the three-month London Interbank Offer Rate) and three-month Treasury bills. The TED spread began a rapid upward climb in September and reached an all-time high on October 10, 2008, of more than 450 basis points. The spread has since narrowed to just over 200 basis points. Historically, the spread between the two series should be less than 50 basis points, so we still have a while before markets approach normal levels.

Other measures of financial stress are not as positive. The Fed has flooded the banking system with liquidity, hoping to break the lending logjam. However, banks have hoarded much of the infusion from the Fed as can be seen in their reserve holdings. For the two weeks ending September 10, 2008, total reserves held by commercial banks were $47.1 billion, and required reserves stood at $44.9 billion, leaving excess reserves of nearly $2.3 billion. That situation has changed dramatically. For the two weeks ending November 5, 2008, total reserves swelled to $415.9 billion, with $52.3 billion in required reserves and $363.6 billion in excess reserves.

U.S. Economic Outlook—In addition to continued problems in financial and credit markets, the real economy is weak and getting worse. Aided by the economic stimulus package passed earlier this year, the economy shook off a drop in GDP at the end of last year and grew at a 1.8% annual rate in the first half of this year. However, third quarter GDP declined by 0.3%, and we expect further declines over the next three quarters (see chart 2). The weak growth number was the result of declines in consumption, and both business and residential investment and the remaining sectors were weak.

Consumption in the third quarter declined by 3.1%. Without continued help from Uncle Sam, and with job losses mounting, significant losses in the stock market, and food prices still high, consumption growth will remain depressed. Consumers are unlikely to borrow to maintain past spending patterns even if banks were willing to lend.

Available monthly data also point to continued weakness. Retail sales declined in October by 2.8% from the previous month and have been on a downward trend since June. Another measure of consumption, chain store sales, declined in October by the most since 1991. With consumer sentiment at rock-bottom levels and declines in real disposable personal income, consumption will be a drag on the economy through the first half of 2009.

The housing market has been a persistent drag on the economy since 2006, when residential investment first turned negative. Since then, most aspects of the housing market have been in free fall. Recent home price declines have slowed somewhat, and sales have shown some signs of stabilizing, offering a glimmer of hope. It is still far too early to call this a bottom in the market.

With growth slowing, the labor markets have continued to slacken. The economy lost 240,000 jobs in October and almost 1.2 million thus far in 2008. Not surprisingly, housing and manufacturing are the two biggest contributors to the job declines. Employment in the construction industry has fallen by 396,000 jobs this year and manufacturing has lost 492,000.

The unemployment rate jumped 0.4% in October to 6.5%. This rate has risen from 4.9% in January of this year, and we expect it to exceed 7.5% by the middle of next year. Initial claims for unemployment have also been trending up for the past few months and are currently at 477,000 on a four-week moving average.

Inflation, both overall and core (net of food and energy components), has moderated in the most recent data. Market expectations of inflation have declined sharply as the economy has deteriorated. The recent moderation in inflation is a welcome development and made it easier for the Fed to cut interest rates at the end of October when it dropped the Federal Funds rate to 1%. This last cut followed a surprise intra-meeting cut of 50 basis points in early October. The Fed has cut rates by 425 basis points since the middle of last year.

As of this writing, Congress is expected to meet in mid-November to discuss a second stimulus plan. While the details at this point are not known, Democrats have pushed for extensions of unemployment benefits as well as infrastructure spending, but they have downplayed tax cuts. House Republicans have indicated a willingness to work on a stimulus bill, but they support tax cuts and generally oppose more spending. All are waiting for the administration, which has remained relatively silent on the issue. President-elect Obama has called for another stimulus and said that if it were not accomplished in a lame-duck session, it would be the first order of business for his administration.