2008 Review Part 2

2008 FORECASTS –RESULTS YEAR TO DATE |

Overview

Table 1 shows the range of opinion that prevailed at the beginning of 2008 and the year-to-date results. Actual results through the October-November timeframe reflect a severe and troublesome deterioration in the performance of the U.S. and global economies coincident with the violent upheaval that swept over global financial markets beginning in mid-September. Indeed, virtually all optimism has evaporated and fears of the potential consequences of the rapidly escalating global recession abound.

The pessimistic view presented in Table 1 at the beginning of 2008 was actually not the worst view at the beginning of the year but one that reflected a mild recession scenario.

At the outset of the year I mentioned that the risks of a more severe recession developing during the year were higher than normal. I stated that factors that could lead to that outcome included a progressively worsening credit crunch, a more rapid decline in housing prices and further erosion in consumer confidence which collectively would lead to substantial pull back in consumer spending. Unfortunately, not only have all of these risks now become reality, the situation appears to be worsening by the day. Evidence is emerging that the U.S. and global economies may have fallen into a “Liquidity Trap”, an economic condition in which credit markets break down and monetary policy becomes ineffective. The last time this occurred was during the Great Depression of the 1930’s.

As I have expected since the beginning of the year, the National Bureau of Economic Research finally dated the onset of recession in the U.S. as December 2007. Initially, deterioration was gradual during the spring and early summer which emboldened the optimists.

We can now, with the benefit of knowing what has happened, say without doubt that this optimism was illusion, wishful thinking and based on precious limited critical thinking. This kind of herd mentality and bias for “feel-good” talk seems to be a natural collective human tendency. Because of this tendency we rarely attempt to study with any degree of rigor how today’s policies and decisions could lead to problems and consequences in the future. We want to believe that markets work … in recent years this belief has bordered on being religious dogma. Because we believe, we become lazy critical thinkers and collectively become blind to imbalances that are developing and may potentially induce negative outcomes. Also, because we believe, we don’t engage in any kind of contingency planning. Then, when the deluge comes, the tsunami engulfs us, we don’t have a clear understanding of why it is happening and therefore policy responses are late and often are only partially effective or ineffective because they do not target the right problems. When the history of the last few months is written there will be much to say about the failures of policy making leading up to the crisis and also how some of the ad hoc solutions in the early stages of the unraveling process were ineffective and may even have contributed, in some instances, to deepening and accelerating the process of collapse.

But, let me start, as I customarily do, with a recap of what has happened in the U.S. economy so far during 2008 by reviewing key economic indicators listed in Table 1. These data, since they are averages for all of 2008, no longer paint a very accurate picture of the severe recession we are now in. Third quarter GDP growth was revised to -0.5%, which brought the annual rate of growth over the first nine months of 2008 to 1.0%. Q4 is shaping up to be an extraordinarily negative growth quarter. Current estimates range between -4 and – 7%, which would be the worst quarterly contraction since the second quarter of 1980 when the Carter Administration’s ill-fated experiment with credit controls decimated the economy. This would reduce GDP growth to 1.0%, as conventionally measured, and to -0.8% when measured from the fourth quarter of 2007 through the fourth quarter of 2008. If that is what occurs, then my view at the beginning of 2008, while seemingly quite pessimistic, at the time will prove to optimistic. (Note: 2008 GDP forecasts in Table 1 are not measured in the conventional fashion of year over year but rather from the fourth quarter to fourth quarter, which is the method I use in my econometric model [see Table 2 below] to derive a 2008 GDP growth estimate of -0.3%., considerably worse than my forecast in Table 1 of 0.0 to 0.5% growth. On a year over year basis my model’s real GDP growth estimate converts to +1.0%. However, my model’s estimate for Q4 while pessimistic, as it projects -3.9% growth, now appears to be at the optimistic end of the emerging forecast range.)

Inflation

Core PCE inflation for 2008 should average about 1.8%, only slightly above my beginning of the year forecast. For a while it appeared that my forecast that core inflation would fall during the year was far too optimistic because I did not anticipate the short-lived but powerful commodity price bubble which totally overwhelmed gathering disinflationary forces during the first half of the year. Over the first nine months of 2008 core PCE inflation increased at an annual rate of 2.4%. However, the crash in commodity prices since mid-summer and the swoon in consumer spending since mid-September seem poised to drive core inflation to zero during the fourth quarter and annual inflation for all of 2008 to 1.8%.

Total PCE inflation peaked in July at 4.5% and declined to 3.2% in October. Because of the collapse in commodity prices and the dramatic decline in consumer spending, the descent in total PCE inflation will accelerate over the remainder of 2008 and could end the year as low as 0.0%.

Employment

Payroll employment during the first eleven months of 2008 declined an average of 178,000 per month. This far exceeds the pessimistic view, and is worse than my even more negative view of -100,000 per month. November’s payroll loss was a staggering 533,000 on top of revised losses of 403,000 to September and 320,000 in October, bringing total job losses since the onset of recession in December 2007 to 1.9 million. The continuing and enormous escalation in initial unemployment claims in recent weeks makes negative revisions to October’s and November’s payroll data highly likely and implies a loss of 300,000 or more jobs in December.

Real Consumer Income and Spending

Consumer income and spending data were distorted earlier in the year by the fiscal stimulus program. While hopes were high that the stimulus would serve to prevent recession or keep one very mild, based on subsequent events, the fiscal stimulus either had very little lasting impact or its benefits were entirely swamped by high energy and food prices followed by the stock market crash after Labor Day. Through October, real consumer income rose just 0.5% (annual rate of 0.6%) and real consumer spending actually fell 1.5% (annual rate of -1.8%). Both results are considerably worse than my forecast and the pessimistic forecast.

In November retail sales fell 1.8% from the October level and are down 6.7% from a year ago. Both of these data points are in nominal terms. This means that the collapse in retail sales is far worse when adjusted for inflation.

Given what is happening in labor markets and the extreme loss of real estate and financial asset wealth, growth in real consumer spending for all of 2008 will be extremely negative. Growth in real consumer income will be near zero and could even be slightly negative.

Saving

The saving rate averaged 1.4% during the first ten months of 2008. It averaged 0.6% during 2007. The saving rate always rises during recessions and it is following this traditional progression in the current recession. I expect the saving rate will average 1.5 to 1.6% for all of 2008, slightly lower than my forecast of 1.8%. The saving rate was 2.4% in October, so there is a reasonable chance that my end of year forecast of 2.3% could be close to the mark.

Housing prices

Based on January-September data from Case-Shiller’s 20-city housing price index, housing prices fell -12.7%, or at an annualized rate of -16.5%. The 12- month rate of decline has worsened steadily throughout the year from -10.7% in January to -17.4% in September. Prices are now down -21.8% from the July 2006 peak. The monthly Federal Housing Finance Agency (FHFA) housing purchaseonly price index has declined 7.0% over the 12 months through September 2008. The FHFA index covers only homes with prime mortgages less than $417,000. Regardless of index, the rate of housing price decline accelerated from October 2007 through September 2008. For the second year running, all forecasts of home price declines are likely to end up being too optimistic. Most analysts expect prices to fall an additional 10 to 15%.

Housing Starts

Starts fell to 791,000 in October, bringing the year-to-date average to .97 million. Starts are now down 65.2% from the January 2006 peak and are near levels that marked bottoms in previous housing recessions. However, a variety of housing data implies that starts will need to fall further before the housing market can stabilize.

Dollar

The trade-weighted value of the dollar rose 12.3% over the first ten months of 2008, or 13.4% at an annual rate. None of the beginning of the year forecasts is on the mark. The optimistic scenario with a forecast for no change in the value of the dollar is closest, but for the wrong reasons. Through the first seven months of the year the value of the dollar declined, as forecast. The reversal over the last three months has been a direct consequence of the global financial markets crisis. Until the enormous U.S. trade deficit shrinks substantially the value of the U.S. dollar will be under relentless downward pressure. This fundamental force is still very much in play but has been overwhelmed temporarily by the global financial crisis. As global deleveraging has accelerated there are only two currencies investors wish to hold – the dollar and the yen. Both currencies have appreciated against all other currencies over the last three months. Given the severity of the crisis and the fact that deleveraging still has a long way to go, it seems likely that the U.S. dollar will remain a preferred currency for the foreseeable future. This is a very unhealthy development for U.S. businesses and for U.S. exports. Since peaking in July, through October U.S. exports of goods were down 13.3%. During the same timeframe, imports of goods were down 11.3%.

Interest Rates – Short-Term Rates – Federal Funds Rate

After much talk during the middle of the year that the Fed was done cutting interest rates and would soon need to raise them to stanch the threat of inflation, the meltdown in financial markets in September forced the Fed to lower the Fed Funds rate target to 1.0%. This is the level I forecast at the beginning of the year. Increasingly, it appears that the Fed will cut this rate to 0.50% or even 0.25% at the FOMC meeting on December 17th. Already the evidence indicates that the Fed has shifted to quantitative easing. The effective Fed Funds rate has considerably below the target of 1.0% for weeks.

Interest Rates – Long-Term Rates – 10-Year Treasury Rate

Long-term Treasury rates finally dropped precipitously in the last month in one of the greatest rallies of all time. I expected the rate to average 3.4% for the year and then end the month of December at approximately 3.0%. Through November this rate averaged 3.78% and looks likely to average about 3.7% for the year. However, the December average rate should be close to 2.7%.

The commodity price bubble and inflation scare during the first half of the year delayed the decline I and others expected in long-term rates that usually occurs in the early stages of a recession. After falling below 3.5% in March during the Bear Stearn’s crisis, long-term rates rose above 4.0% during the inflation scare. Now that the inflation scare is history and the severity of the global economic downturn has been recognized, the 10-year Treasury rate has fallen precipitously. As of December 12th, the rate was 2.57%, which is 95 basis points below the November average and 125 basis points below the October average of 3.82%.

This is part 2 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

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