DANGER AHEAD: THE PROSPECT OF RECESSION AGAIN CONFRONTS AMERICA
By Krishna Guha
Financial Times (London)
January 2, 2008
America has entered 2008 in greater danger of recession than at any stage since the collapse of the internet bubble in 2000-01, as the world’s largest economy struggles to maintain growth in the face of the credit squeeze, a housing slide, and high oil prices.
Fourth-quarter growth for 2007 looks likely to come in at 1 per cent or less on an annual basis, while the current three months are unlikely to be much better and could even be worse. The only question is whether the economy will struggle through this sickly period and gradually regain strength over the course of the year -- or succumb to its ailments and, with growth turning negative, fall into recession.
According to the latest NBC News/Wall Street Journal poll, more than two-thirds of Americans believe the U.S. is either in recession now or will be in 2008. Some of the country’s most famous economists -- including Alan Greenspan, the former Federal Reserve chairman, as well as Lawrence Summers, former Treasury secretary, and Martin Feldstein, president of the National Bureau of Economic Research -- put the odds of recession at close to 50-50.
This is striking, because economists say it is almost impossible to forecast recessions and, in the last quarter of a century, there have been only two brief and shallow periods of negative U.S. growth. “We have had an awful lot of bad news,” says Mr. Feldstein. “It is not a sure thing we are going to have a recession, but nor do I have great confidence that we are going to escape.”
Bill Gross, chief executive of Pimco, the world’s largest bond fund manager, goes as far as to say he -- like many ordinary Americans -- thinks a recession has already started, in December.
Ominously, the credit markets have started to price for recession, with risk spreads rising on securities that have no direct connection with the troubled housing or financial sectors. Yet the Fed and most economists still say the single most likely outcome is that the U.S. will make it through a rough patch and regain strength by the second half of 2008. In addition, while credit markets appear to be pricing in an increasingly high likelihood of recession, equity markets and the oil market -- while off their highs -- are not.
Wall Street is divided: Morgan Stanley is forecasting a recession, joining Merrill Lynch and Goldman Sachs, which are long-time bears, but JPMorgan and Lehman Brothers are noticeably less gloomy. Business leaders are split, too, with finance and housing executives much more pessimistic than their counterparts in other sectors. “If you talk to people in financial markets, they see recession as a virtual certainty,” says Martin Regalia, chief economist at the US Chamber, a business organisation. “If you talk to people in economic markets, they see positives in the economy that tend to offset the negatives, so you get slow growth rather than no growth.”
Who turns out to be right will depend on a titanic tug-of-war between the forces dragging down U.S. growth and the continued strength and resilience of key sectors of the economy. The result will be of great importance to a world that -- for all the dazzling growth of China and other emerging economies -- would struggle to absorb a full-blown U.S. recession.
At the heart of the problems is the bursting of the housing bubble that helped to power American growth since this economic cycle started six years ago. The end of the bubble has brought a brutal slide in home construction, house price falls that threaten to undermine household wealth and consumer spending, and turmoil in the credit markets that are used to finance housing.
The U.S. has endured financial crises before with little or no effect on the real economy -- for example, in 1987 and 1998. But these were autonomous financial crises with little connection to the underlying U.S. economy. This financial crisis is different. It is defined by the bursting of twin bubbles in housing and the credit markets -- bubbles that were deeply interconnected.
Easy money and the collapse of discipline in the credit markets helped push house prices to unsustainable levels. But when the residential property bubble finally burst it took the credit market bubble with it -- decimating the value of hundreds of billions of dollars of securities linked to subprime loans that were safe only as long as house prices kept going up.
Now the credit crisis poses a direct threat of its own to the U.S. economy. The secondary market for mortgage securities is dysfunctional, throttling the supply of many types of home finance and thereby putting further downward pressure on the housing market. Meanwhile, banks are being forced to take tens of billions of dollars in housing-related assets, once held in off-balance sheet vehicles, on to their books, while incurring massive writedowns on these and other securities. Mr. Greenspan says losses on subprime and related securities are likely to reach $200bn (£101bn, €136bn) to $400bn, though the final extent will not be known until house prices stabilize.
For all the supposed benefit of securitized markets in distributing risk around the world, it appears that a large share of the ultimate risk remained with big U.S. commercial and investment banks. So analysts fear that balance sheet strains will force these banks to pull back on lending both to consumers and to businesses outside the housing sector, creating a generalised credit crunch. “This is clearly happening,” says Mr. Feldstein. “Banks are shepherding their capital. As they take these investment vehicles on board and realize they have got outstanding obligations where they provided lines of credit, they are going to be more cautious about extending credit in general.”
One sector that looks particularly vulnerable to any pullback in credit is commercial property, which has boomed over the past year, helping offset the decline in residential investment and keep building workers in employment. Housing construction continues to plunge, while the rate of decline in house prices seems to be accelerating, with some experts forecasting falls of 20 per cent or more in real terms over a number of years.
As late as the third quarter -- when household wealth hit a record $58,000bn -- house price declines were offset by gains on equities and other business assets. But in a tough macroeconomic environment it seems unrealistic to rely on equity gains to offset falling house prices from now on.
Most economists think consumers will respond to falling house prices by spending less and saving more. The question is, by how much? The Fed estimates that consumer spending rises or falls by $3.75 for every $100 increase or decrease in housing wealth. But some studies suggest the effect could be much larger. Moreover, if 2007 does not turn out to have broken the record, this is likely to be the first year since the Second World War to see an outright annual decline in house prices. No one knows what sort of response actual house price falls would produce from homeowners.
“It is not all subprime,” says Jeff Frankel, a professor at Harvard. “Even without that, the magnitude of the fall in house prices itself is a prime candidate to cause a recession -- [through] what it has done to the construction industry and household finances. Then there is oil.” The high price of oil and food is putting additional strains on consumer spending, reducing disposable income and eating away at real wage gains. Richard Berner, chief economist at Morgan Stanley, says the rise in energy and food prices between June and December alone “drained about $45bn or 0.4 per cent from consumer discretionary income”.
Traditionally, economists would expect the price of oil to fall when the U.S. economy is weak, freeing up some disposable income and acting as a natural stabilizer. But strong demand in China and India plus geopolitical tensions in the Middle East are keeping oil hot -- compounding the housing and credit problems.
Given the pressure from housing, the credit squeeze, and oil, the interesting question, as Mr. Greenspan puts it, is why the probability of recession is not much higher than 50 per cent. One reason is that the U.S. had made some headway in dealing with the excesses in housing before the credit crisis erupted this summer. Home starts have already fallen from an annualized monthly rate of 2.3m units in January 2006 to 1.2m in November 2007. The construction sector has subtracted from growth for roughly a year.
Home starts may have to fall a good deal further. But the fact that the U.S. economy has already absorbed a halving in home construction greatly improves the chances of avoiding recession. If it had to begin now, recession would be all but guaranteed.
Moreover, as Mr. Greenspan pointed out in recent interviews and speeches, the business sector is quite insulated from the effect of the credit squeeze. Corporate balance sheets are unusually strong, companies have plenty of internally generated cash -- as witnessed, for example, in share buybacks -- and took advantage of low borrowing costs prior to the latest financial turmoil to lock in cheap long-term funds.
Indeed, there is still only limited evidence of the credit squeeze extending to non-housing-related sectors. Mr. Regalia at the U.S. Chamber says: “Banks across the board are tightening credit standards, but it does not imply a broad-based credit crunch for people and businesses with good credit histories and strong balance sheets.” He says surveys of small businesses show that funds are still available at decent rates.
This view is reflected inside the Fed where -- contrary to Wall Street myth -- the so-called “academics” on the board of governors have been willing to consider pre-emptive rate cuts based on forecasts of future spillovers from the credit crisis. But many regional Fed presidents -- with strong ties to local business leaders -- have been reluctant to ease too aggressively, pending more evidence of such spillovers outside housing.
The longer credit markets stay dysfunctional, the greater the likelihood these spillovers will eventually materialize. Put another way, either the credit markets will ultimately drag down the non-housing economy or the non-housing economy will ultimately drag the credit markets upward.
Indeed, the economy may be able to hang on long enough to win out. The export sector is booming, helped by the decline in the dollar over the past couple of years coupled with a slowing in U.S. growth relative to that of other big economies. Looking ahead, the contribution from net exports to growth in gross domestic product will probably decline as growth eases abroad. But exports should still contribute something between a quarter-point and a half-point to growth in the coming quarters. This will provide a buttress at a time when domestic demand is very weak.
Strong overseas earnings, flattered in conversion by the weak dollar, are also propping up the stock market, guarding against a second blow to household wealth. Business investment is muted and the latest durable goods report raises concerns that companies may be pulling in their horns. But there is little sign that investment is falling off a cliff.
Ultimately, however, the fate of the U.S. economy lies with the consumer. “The consumer so far is hanging in there but is not in great shape,” says Mr Feldstein.
Consumer confidence is weak: the latest University of Michigan survey puts sentiment only a fraction above its post-Hurricane Katrina low. Yet, for all the gloom in surveys, actual consumer spending remains quite resilient. November’s retail sales figures were much stronger than expected; the early data on December look a good deal weaker but still not disastrous.
Underpinning this is continued strong growth in nominal income in a still tight labor market, with unemployment at 4.7 per cent. If unemployment started to rise sharply and income growth slowed, the outlook for consumer spending would deteriorate sharply. But while the pace of job creation has slowed, there are few signs of a rapid deterioration in the labor market.
Moreover, there are reasons why companies may be reluctant to shed workers. Since the last recession ended in November 2001, businesses have been unusually cautious about adding employees -- leaving them still quite lean in staffing terms. Slowing productivity growth also means that for any given increase in output, companies will need more workers -- unlike in the early part of this decade when rapid productivity growth meant they could expand without adding more staff.
Fed analysis suggests that, given appropriate monetary policy, the economy can absorb falling house prices and keep growing -- particularly if the decline is not too abrupt. All analysts agree that policy actions by the Fed -- and the U.S. government, in what is a presidential election year -- could make the difference between recession and recovery.
Peter Hooper, chief economist at Deutsche Bank Securities, says the Fed’s latest move to auction loans into the money market and the administration-sponsored plan to freeze the interest rates on some subprime loans, reducing the expected number of foreclosures, made him cut his estimate of recession risk from 50 per cent to 40 per cent.
Almost all analysts’ forecasts for moderate growth, in the 2 per cent range for 2008 as a whole, assume at least one more Fed interest rate cut -- some assume three or more downward shifts. However, if upward pressure on inflation increases -- possibly from high oil prices or a weak dollar -- the Fed may not be able to cut as much as the market expects, increasing the probability of recession.
Less conventional sources of support could prove decisive. The Federal Home Loan Banks are funnelling loans into the banking system at an annualized rate of $746bn, according to Fed data for the third quarter. These loans -- against housing-related securities -- are allowing banks to continue offering mortgages, preventing a sudden stop in housing finance and, so far at least, the failure of any big lenders.
Meanwhile, sovereign wealth funds are pouring billions of dollars into the U.S. financial system in return for equity, recapitalizing banks and easing their balance sheet strains. If this happens on a large enough scale, it could ward off a generalized credit crunch.
Yet even in the most optimistic of plausible scenarios, the U.S. will skirt along the brink of recession for a number of months with very weak growth. During this period, it could easily tip over the edge.
Some, including David Rosenberg, chief economist at Merrill Lynch, see it as difficult for the economy to grow at only about 1 per cent for any sustained period without stalling and falling into recession. Others including Ben Bernanke, Fed chairman, say economies do not stall merely for lack of sufficient forward momentum. But all agree that while the U.S. works through a period of very low growth it will be particularly exposed to any additional shocks or an intensification of the existing problems in housing and the financial sector.
“The story of recessions is that unexpected adverse shocks -- or a coincidence of adverse shocks -- hit a vulnerable economy,” says Larry Meyer, chairman of Macroeconomic Advisers and a former Fed governor. “This economy is vulnerable.”
WHEN IS IT ON AND WHEN IS IT OVER? THE ARCANE ART OF CYCLE DATING
The common definition of a recession is two successive quarters of negative economic growth. However, the formal definition is more complex.
The Business Cycle Dating Committee of the National Bureau of Economic Research in the U.S. is charged with deciding when recessions begin and end. The committee is made up of top economists operating independently of the government and is chaired by Robert Hall, a professor at Stanford.
It regards growth in gross domestic product in real terms (adjusting for inflation) as the ”single best measure” of economic activity. But it does not rely exclusively on GDP statistics, for a number of reasons. The Bureau of Economic Analysis publishes GDP estimates only quarterly, while the committee works on a monthly basis. Moreover, the GDP estimates are extensively revised over a number of years.
So the Business Cycle Dating Committee uses other metrics as well. It puts “particular emphasis” on personal income (in real terms less transfer payments) and employment. In addition it looks at industrial production and wholesale and retail sales. It also weighs estimates of monthly GDP growth by private sector forecasters.
The last recession, according to the committee, began in March 2001 and ended in November of that year.
If the U.S. falls into a sharp or prolonged recession this time, the judgment will be easy. However, if output growth stalls but jobs and incomes continue to grow, the committee could face a tough decision as to whether to term the slowdown of late 2007/early 2008 a recession or not.
Do not expect an answer soon. The committee normally declares the start of a recession six to 18 months after the event. Since recessions typically last less than a year, this means a recession can be over before it has officially begun.
UNEMPLOYMENT SOUNDS WARNING ABOUT ECONOMY
By Peter S. Goodman and Michael M. Grynbaum
New York Times
January 5, 2008
The unemployment rate surged to 5 percent in December as the economy added a meager 18,000 jobs, the smallest monthly increase in four years, the Labor Department reported on Friday.
Economists viewed the report as the most powerful indication to date that the United States could well be falling into a recessionary downturn. Evidence of widening unemployment heightened anticipation that the Federal Reserve would further cut interest rates this month, perhaps by an unusually large half a percentage point, in a bid to prevent the economy from sliding into the muck.
“This is unambiguously negative,” said Mark Zandi, chief economist at Moody’s Economy.com. “The economy is on the edge of recession, if we’re not already engulfed in one.”
A recession is typically defined as an extended period of at least several months during which economic activity shrinks and unemployment rises.
The swift deterioration in the job market resonated as a warning sign that troubles once confined to real estate and construction are spilling into the broader economy, threatening the ability of American consumers to keep spending with customary abandon.
On Wall Street, the report led to a big sell-off that sent the Dow Jones industrial average plunging nearly 2 percent.
As the presidential race heated up, Democrats seized upon the bleak job numbers to indict Republican-led economic policies. “This morning’s jobs report confirms what most Americans already knew,” Nancy Pelosi, the House speaker, said in a statement. “President Bush’s economic policies have failed our country’s middle class.”
President Bush cautioned that “we can’t take economic growth for granted” and said he would work with Congress to be “more diligent” on protecting the economy. Speaking to reporters at the White House after a meeting with his economic advisers, Mr. Bush warned that “the worst thing the Congress could do is raise taxes on the American people.”
The lone consolation for investors, workers, and the public at large was that the bad news seemed severe enough to prod the Fed to push its benchmark rate below its current 4.25 percent when policy makers meet at the end of the month. Lower interest rates decrease borrowing costs and encourage banks to lend more freely, spurring spending, hiring, and investment.
The Fed has already eased rates three times since September in a bid to inject confidence into jittery markets. But analysts cautioned that central bankers may now feel constrained against further easing: inflation is growing, particularly as oil hovers near $100 a barrel. Lower interest rates, over time, can generate the seeds of inflation, and could make an already weak dollar worth less against foreign currencies.
“The Fed is trying to juggle a two-sided sword,” said Ryan Larson, senior equity trader at Voyageur Asset Management. “They’re trying to fight inflation moving higher and they’re trying to fight a slowdown in growth.”
In an effort to encourage lending, the Fed has been pumping cash through the banking system by auctioning off loans at discounted rates. On Friday, it said it would expand a pair of auctions scheduled for this month, offering $30 billion.
Some economists said the markets and other analysts were making too much of a lone jobs report that could yet be revised.
“The stock and bond markets are going into panic mode,” said Michael Darda, chief economist at MKM Partners, a research and trading firm in Greenwich, Conn. “We’re going to have a slowdown, but I don’t think we’re going to have a recession.”
While filings for jobless benefits have been rising in recent weeks, the pace has not been swift enough to justify such a sharp jump in the unemployment rate, Mr. Darda added.
For months, the economy had managed to grow vigorously despite worrying developments, from the unraveling of the housing industry to turmoil in the credit markets. Through it all, economists marveled at the resilience of the labor market, suggesting that as long as the economy kept creating jobs by the tens of thousands each month, Americans would keep spending and growth would carry on.
But the jobs report for December suggested that the negatives dogging the economy finally appear to be dragging it down.
“There’s no mystery as to why the unemployment rate went up,” said Robert A. Barbera, chief economist at the research firm ITG. “The mystery is why it took so long.”
December’s addition of 18,000 jobs to nonfarm payrolls was an abrupt drop from the 115,000 created in November -- a figure revised on Friday from an initial estimate of 94,000. It put the annual rate of job growth at its lowest since 2004.
Some areas of the economy continued to expand, according to the report. Government jobs grew, and health care added 28,000 jobs. Food services added 27,000.
But that growth was largely reversed by pain elsewhere. Retailing lost 24,000 jobs in December. Financial services lost 7,000. Construction shed another 49,000 jobs. Even commercial construction, which some have suggested could compensate for woes among home builders, lost 17,000 jobs. Over all, private sector jobs slid by 13,000.
Despite a weak dollar, which has helped compensate for disappointment at home by lifting American sales abroad, the nation shed 31,000 manufacturing jobs in December.
For the third consecutive month, wages grew slower than the pace of inflation, cutting into the real income of many workers. Among rank-and-file workers, who make up more than four-fifths of the labor force, average hourly earnings rose 3.7 percent last year, below the 4.3 percent rise in 2006.
Job growth has been slowing steadily for two years. In 2005, the economy generated 212,000 new jobs a month, according to the Labor Department. Last year, the pace dropped to 122,000.
The spike in the unemployment rate, which was 4.7 percent in November, suggested that the deterioration of the job market is now accelerating.
Last year, companies fretted about business prospects amid falling housing prices and tightening credit. Many stopped hiring, but large-scale layoffs were rare. But now, some appear to have concluded that they can no longer tough it out.
“December’s bleak jobs report represents the siren call that this business cycle is just about over,” declared Bernard Baumohl, managing director at the Economic Outlook Group, in a note to clients. “We’re about to tilt over to the other side of the economic curve and begin the downsizing.”
In Penacook, N.H., the tilt came during the Christmas season: Riverside Millwork, a supplier of windows, doors, and stair parts, laid off 43 people. That added to a wave of layoffs that has winnowed the staff from 225 to 40 since October 2005, when home building began its decline.
“We’ve cut just about everything that we can possibly cut,” said Larry Byer, the company’s human resource manager. “When you don’t have assets to sell or to keep you going, the bodies have to go.”
In calculating the rate of job growth, the Labor Department relies upon a sampling of payroll data and an extrapolation of how many jobs have been created and destroyed. An accompanying survey of households, used to calculate the unemployment rate, presented an even bleaker picture, showing that the number of Americans saying they were working plunged by 436,000 in December -- the worst number in five years.
The trend was pronounced for teenagers, blacks, and Hispanics, with unemployment among those groups jumping 0.6 percentage point, triple the increase for whites.
The household survey is notoriously volatile and treated with skepticism. But unlike the payroll data, it is not subject to revision, other than for seasonal factors, making it a better indicator when the economy is on the cusp of change, Mr. Barbera said.
Between December 2005 and December 2006, the household survey showed jobs increasing by 2.2 percent. Over the last year, jobs grew less than 0.2 percent.
“Every time we’ve gotten down to this level since 1956, there’s been a recession,” Mr. Barbera said.
The risk is that the weakening job market will swell from a symptom of malaise to a cause. As fewer jobs are created, spending power could dry up. Faced with declining business, employers could further trim payrolls. As unemployment grows, more homeowners could fall behind on mortgages, leading to more losses at banks, and more layoffs.
“The risk of a vicious cycle setting in now is very high,” Mr. Zandi said. “The job market’s operating at stall speed. Either it picks up soon or it quickly unravels.”
--Edmund L. Andrews contributed reporting.