Three developments have altered the US economic and financial climate this year. They have been powerful enough to compel an almost unprecedented policy response by both the Federal Reserve and the US Government.
First is a distinct tightening of credit terms by US banks that jeopardizes formerly sturdy sectors of the US economy, especially commercial real estate.
Second is a sudden slide in confidence, evident in a flock of gloomy consumer and business sentiment surveys as well as in a frequently volatile stock market.
Third are emerging signs that theUS labor market, which had held up surprisingly well last year despite the problems in housing and mortgage securities, is softening.
The implications became obvious to almost everyone at the Fed, the White House and the US Congress: A business recession can be averted only by forceful countermeasures, including monetary policy easing and significant fiscal stimulus.
Two questions remain: Will the package work? What will it mean for the financial markets?
Will it work? The answer is yes, but probably not soon enough to avoid a near-miss with recession. The situation could have been worse. Fortunately, the Fed started to ease monetary policy back in September 2007, mainly because of last summer's financial dislocations and well before the recession dangers started to multiply. While the Fed didn't follow through decisively for a while, its truly dramatic actions last month signified a clear shift in priorities.
For its part, the Bush administration came to realize that easier monetary policy wouldn't be enough. It needed to be buttressed with substantial fiscal stimulus. Despite the partisan distrust in Washington, the White House and the Congress, with the public support of Fed Chairman Bernanke, are well along in crafting a compromise fiscal program to inject $168 billion of spending power into the economy.
We estimate that the combined monetary and fiscal stimulus will keep the economy expanding this year but only by about one percent and with at least one negative quarter for GDP. Next year will be better, but not thrilling. The overhang of unsold homes and the continued decline in home prices will keep consumers nervous, and a rise in unemployment will deter consumption. Tighter credit conditions will impair non-residential construction and dampen capital spending by US corporations. Weak real estate markets will hurt state and local tax collections, forcing many to postpone infrastructure projects. GDP Growth of no better than 2% in 2009 will remain below the economy's potential.
What will it mean for financial markets? For most of last year, equity investors underestimated the severity of the economic and financial problems that were unfolding. Then they took for granted that an easier Fed monetary policy would be sufficient to keep corporate earnings from declining. But after US stock market indexes peaked last October, the mood has progressively darkened. Prices have fallen by more than 10% since then. The near-term outlook is not good. More disappointment for the stock market is probable, especially since it will take more than a year before the combination of monetary and fiscal stimulus will start to rekindle trend-like US growth.
In contrast to equity investors, participants in the bond markets have long believed that theUS economy was in trouble and that monetary policy was too restrictive. Even after the Fed has cut its key lending rate to 3% from 5.25%, bond investors still feel that theUS central bank must do more. That is probably correct. Fiscal stimulus won't have much effect until summer, and leading financial institutions are coming under more and more strain. The federal funds rate could be pushed down to 2% by mid-year.
What's unclear is how the foreign exchange markets will respond. The dollar weakened considerably against the Japanese yen and European currencies in 2007, but the latest currency developments are diverging. The dollar has actually improved against the euro and the pound sterling, while staying weak against the yen. Many traders suspect that Europe will be hurt sooner or later by the USslowdown. But the most interesting explanation I've heard is that a weaker euro and pound reflects deleveraging. Speculators appear to be unwinding asset positions in Europe that they had financed by borrowing either dollars or yen. They are buying dollars and yen in the currency markets, while selling euro and sterling.
The main uncertainty is how quickly big banks and other important financial institutions hobbled by their excessive involvement in the securitization business will be able to get back to normal, or close to normal. No one knows, least of all the institutions themselves. Until the financial crisis that started last summer is seen to be over, confidence in the equity and credit markets—and financial leadership—will remain fragile.