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Four Economic Questions

The following is excerpted from "Critical Current Issues Facing the U.S. Economy in 2008," by Mickey D. Levy and Peter K. Kretzmer, published by Bank of America, January 2, 2008, and "Fed 'finishes' what it started with funds rate cut to 3 percent," by Peter K. Kretzmer, published by Bank of America, January 30, 2008.

What were the surprises in 2007?

While our year-ago macroeconomic forecasts for 2007 proved close to the mark—real GDP grew an estimated 2.6 percent Q4/Q4, with softer domestic demand offset by a healthy boost from the net-export sector, and core inflation declined in the second half of the year—the magnitude of the continued declines in housing activity and prices were larger than expected, and the jarring repricing of subprime mortgage debt, which triggered the unanticipated seizing up in the short-term funding markets and financial crisis, were the most glaring and unpleasant surprises of the year.

The major lesson of 2007 stems from trends in housing and mortgage finance: Beyond the valuable adage that "unsustainable trends will not continue," it is critically important to acknowledge that such trends would not have been carried to such extremes without the numerous government policies that subsidize and encourage homeownership and without the misguided incentives in the financial industry that fueled over-reliance on subprime mortgages and the distribution of their risks in the form of structured-credit products. All aspects of government economic and regulatory policies that influence housing and housing finance, as well as private-sector risk management, must be addressed. In the meantime, the reverberations resulting from the financial turmoil will provide yet another test of the resilience of the U.S. economic and financial systems, and another challenge to the Federal Reserve, which must reconcile short-term crisis management with its long-run objective of maintaining low inflation as the best foundation for sustained healthy economic expansion.

Traditionally, our economic forecast is based on an assessment of long-term fundamentals and cyclical fluctuations around trendline, driven largely by monetary policy. Key variables, like profits and credit quality, tend to be directly linked to economic performance. What is atypical of the current situation?

Current conditions reflect some normal cyclical characteristics, but in many ways they are very atypical. Most glaringly, large credit losses and the sustained financial market turbulence have occurred amid healthy economic expansion and low unemployment; typically, credit deteriorates following an economic downturn and increase in unemployment. This credit deterioration, of course, stems from the collapse of the subprime mortgage market and structured-credit products based on it and the uncertainty about the true value of impaired assets. This atypical pattern raises the question of what may happen to overall credit quality if economic performance slumps and the unemployment rate rises materially.

As 2008 unfolds, many are forecasting recession, but in key respects, current conditions do not resemble typical expansion peaks. Most recessions are initiated when excessive monetary restrictiveness generates a slump in aggregate demand. Businesses continue to increase production, employment, and investment, not knowing whether the slowdown in demand is temporary or permanent. As a result, expansion peaks tend to be characterized by overhangs in inventories, too many employees, and excess capital stock relative to output. Accordingly, most of the decline in real GDP during recessions tends to be inventory liquidation (involving reduced production and employment) and large declines in capital investment.

Currently, outside of the housing sector, business inventories are low (auto inventories are being reduced and should subtract from GDP in 2008Q1), employment has been modest, and business investment has been weak, so the capital stock net of depreciation has been declining relative to output. Perhaps most striking, the Fed's monetary policy, which was mildly restrictive in early 2007, has been eased and now is consistent with sustained growth in demand. We believe that the combined 125-basis-point Fed funds rate cut of the last two weeks reflects a clear change in the Committee's view of the degree of risk to the economy, informed in part by feedback from financial markets and in part by weaker economic releases for December. Nevertheless, despite the lack of large imbalances in much of the non financial sector, and monetary policy, which is moving toward accommodative, the possibility of a "credit crunch" that inhibits the flow of capital to non-financial businesses certainly raises uncertainties—and places economic risks to the downside.

What is the economic outlook, and what are the largest risks and uncertainties?

Real GDP grew 0.6 percent in 2007Q4, down from 4.9 percent in the prior three months. GDP is expected to expand at a 1.5 percent pace in the first half of 2008 and then pick up in the second half. With a declining trade deficit boosting domestic production, this implies only slight growth in domestic demand in the first half of 2008, and recession-type conditions in some industries. Presently, uncertainties are larger than normal, and the risks facing the economy are to the downside, particularly through mid-2008. We see about a one-in-three risk of mild recession.

Residential investment is projected to decline and subtract from GDP throughout 2008 but at a lesser pace than in 2007 (-8.7 percent versus -17.8 percent, measured Q4/Q4), while a continuing decline in the trade deficit will provide a boost to domestic production. Consumption is projected to grow 1.9 percent annualized in the first half, a marked slowdown from recent years, but pick up to 2.7 percent in the second half. Business fixed investment is expected to grow very modestly, while businesses will keep inventories low.

The longer-term outlook is decidedly more favorable: The drag from declining residential construction eventually will run its course, and the Fed's monetary easing will stimulate growth, beginning in the second half of 2008. Accordingly, real GDP is projected to grow above 3 percent in 2009.

Uncertainties abound: a) how much will housing activity and home prices continue to fall? b) how does the current rocky financial environment affect non-financial business hiring and employment and capital spending? c) how are the large capital losses and balance sheet constraints on large banks affecting overall bank lending to non-financial businesses? d) will the turmoil lead households to reduce consumption? and e) how will the unfolding slowdown in U.S. growth affect overseas economies?

These uncertainties suggest a wide range of possible economic and financial outcomes. In response to the downside risks, we have lowered our baseline forecast for 2008. However, because the Fed is easing monetary policy, and given the general lack of imbalances in business operations outside of housing, if any recession were to unfold, it likely would be shallow in terms of declines in output, employment, and personal income, and it would be followed by economic rebound.

Through what channels would the financial crisis affect the economy?

Financial markets affect economic performance primarily through the availability and costs of capital. Presently, the concern is that the financial crisis is driving up the costs of capital, tightening credit standards, and slowing the flow of credit to businesses and households. Indeed, a sharp deterioration in these factors would be sufficient to generate recession. Our assessment is that the impacts of the financial turmoil are fairly complex, and to date, while they certainly add downside risks to the economic outlook, they do not necessarily involve a severe "credit crunch" that points decidedly to recession. But the situation requires close scrutiny.

The Federal Reserve's Flow of Funds data confirm that total debt in the economy has risen dramatically, both in absolute terms and as a percent of GDP (debt has risen from 192 percent of GDP in 2000 to 233 percent in 2007Q3), but all of that increase has occurred in home mortgages and the heightened liabilities of financial institutions that have increased leverage to finance mortgage-related activities, while outstanding consumer credit card debt and debt in non-financial businesses have not increased materially relative to GDP. The deleveraging process has already started. At issue is whether the unwinding of the debt buildup—and the associated capital losses—occurs primarily in the mortgage-related "problem areas" or spills over materially to the rest of the economy.

The financial turmoil and sizeable capital losses have involved deleveraging of the earlier run-up in mortgage debt, large write-offs, and higher costs of capital for the housing and banking industries, but they have not materially affected the flow of capital to most non-financial businesses and most prime households. Lines of credit and leverage in hedge funds and venture capital funds have been pared, which has been associated with a contraction of short-term commercial paper outstanding. Similarly, write-offs of structured-credit products have been mirrored by a shrinkage of asset-backed commercial paper outstanding. Banks have reduced lines of credit to mortgage brokers, adding to their cutbacks and tighter credit standards they apply to building contractors and elsewhere in the housing sector. Losses incurred by the largest banks, largely in the form of write-offs of structured-credit products, have constrained their balance sheets and lowered their capital. So far, this has forced a significant adjustment in portfolios and a wave of capital raising.

A crucial issue is whether these trends have impaired bank lending to the wide array of non-financial businesses sufficiently to call for recession. So far, the answer is no. The largest banks seem to have "tightened lending standards" by applying more rigorously existing standards rather than cutting off lines of credit to their myriad non-financial business clients. Moreover, the vast majority of banks outside of the nation's largest banks have not been materially involved in the subprime mortgage-related mess, and they are still making loans. Bank commercial and industrial loans have not diminished, although to some extent outstanding C&I loans may capture the absorption onto the balance sheets of the largest banks some of the illiquid, impaired debt securities that are symptomatic of the financial turbulence. A survey conducted by the National Federation of Independent Business suggests that availability of credit is not a major concern.

The real costs of credit have increased, but the rise has not been material for most non-financial businesses. While corporate bond spreads have widened significantly to Treasury yields, a portion of that widening reflects declines in Treasury yields. New corporate bond issuance remains healthy, although costs have increased modestly in after-tax terms.

Similarly, borrowing costs for households have risen, but the increase in rates has been more selective than widespread. Reflecting bottlenecks in the secondary mortgage markets, mortgage rates have risen, and ARM resets will raise debt service costs materially for a relatively small subset of mortgagors. This dampens home purchases and presumably lowers house prices. However, while lending standards to prime customers for credit cards and other lines of credit may be tighter on the margin, the costs of credit have not risen materially.

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