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More Tough Times Ahead

The economy is expected to contract, residential construction should continue to decline, and the unemployment rate is expected to reach 8.0%, S&P Economics estimates

From Standard & Poor's Equity ResearchContinued turbulence in the credit markets and the ongoing recession, which began in December 2007, means that 2009 will likely be a more difficult year than 2008, which saw its fair share of challenges.

We do think Congress and the incoming administration are committed to providing a large stimulus package, which could total as much as $500 billion. We expect the package to likely consist of several components such as rebates, similar to the 2008 checks, but aimed more at lower-income households; infrastructure spending, which will probably be the largest component, focused on highway and bridge repair; extended unemployment benefits; and housing assistance to prevent foreclosures.

Rebates were the major component of the last stimulus package. Although there is doubt in the press about their effectiveness, we think they were largely responsible for the 2.8% gross domestic product (GDP) bounce in the second quarter. It appears that about half of the checks were spent, as we had expected. A look at the retail sales data suggests that much of the money went to big-ticket items, especially consumer electronics. Unfortunately, the U.S. imports most of those goods, so many of the jobs created were not in this country.

Another round would probably lead to even less spending than with the 2008 checks, as consumers are more nervous about debt levels. Although as individuals they should be applauded for finally becoming concerned about high debt, paying off their credit cards doesn’t provide the needed economic stimulus. Despite politicians’ love for sending checks to their constituents, the rebates are likely to be a smaller component of next year’s package.

Infrastructure spending has more impact on the economy because all of the money is spent, but the problem is timing. It takes a while to get new projects going. The 2006 Highway Act didn’t boost spending significantly until late 2007, almost a year later. Because the recession is now likely to last longer than expected initially, that is less of a problem, but the surge in spending would not be likely until late 2009, when we expect the recession to be over.

Infrastructure spending does have some real advantages. Perhaps most importantly, it’s hard to import highways, so the jobs created, at least in the first round, stay in the United States. On the other hand, heavy construction is a capital-intensive process involving high-paid, union labor. Especially given government regulations on wages, the number of jobs created per dollar spent is not as high as many think. Given the recent drop-off in non-residential construction, however, the labor is more available than it was a year ago, and the idea makes more sense than it did.

It is probably better to justify this spending based on long-term needs. We need infrastructure. Bridges shouldn’t be collapsing. Mass transit systems need to be upgraded to get people out of cars to reduce energy use. There are still substantial improvements required for water supply and sewage systems. These require a long-term commitment to infrastructure, not just a short-term capital infusion. Still, if the short-term and long-term problems point in the same direction, this would be a good time to start.

Extending unemployment benefits is a certainty. With the unemployment rate now at 6.7%, it is time to increase the period for which unemployment benefits can be received. The health insurance proposals include one plan to increase COBRA rights to 30 months from the current 18, which would have no cost to the government, and one to allow tax credits for self-insurance. The latter could be seen as part of overall health care reform.

Some form of housing assistance seems likely to slow the wave of foreclosures. Mortgage rates have been brought down by the Fed’s move to buy Agency securities, but the spread of mortgage rates above the 10-year Treasury yield remains high. The Treasury is reported to be considering lowering the mortgage rate still further, and its control of Fannie Mae and Freddie Mac gives it the tools to do so. This could be done most easily by direct lending to the Agencies. After all, if the Treasury can borrow at 2.1% (10-year Treasury), for example, and lend at 4.5% to the mortgage market, it should be a profitable business as long as there aren’t too many defaults.

Preventing defaults will be the problem. Several proposals have been made to keep people in their homes, mostly involving writing down the principal to the current value of the home. Although creditors have an interest in doing this because it would be cheaper than foreclosure, legal issues make renegotiation difficult, and they also worry about moral hazard problems if the practice becomes too standard. Even households that are current on their mortgage will try to take advantage of a foreclosure-prevention bill if an attractive deal is offered. Writing down the principal becomes an attraction for borrowers, and anyone who thinks he might be underwater will try to take advantage. Given how inaccurate appraisals proved to be on the high side when people were applying for a bigger mortgage, is it hard to believe they will be just as bad when people want a low appraisal?

A major rewrite of the tax code is becoming likely, but probably not in the first two years of the new administration. No one wants to raise taxes in a recession. Once we are out of the recession, however, Washington will have to focus on financing new programs and the rise in entitlement costs, particularly for health care. Tax reform will probably be tied to health care reform, with action likely only after 2010.

The stimulus package will add to the already-enormous fiscal deficit, which is likely to approach $1.5 trillion in fiscal 2009, depending on the treatment of some of the rescue funding. In the near term, funding the deficit is cheap. The 10-year Treasury note is yielding only 2.1%, and three-month Treasury bills are yielding 5 basis points (bps). Eventually, however, rates will come back to more normal levels, and the interest payments will be a greater burden on the Treasury. The timing depends on how willing the Treasury is to lock in low long-term rates as opposed to taking advantage of nearly free short-term lending.

At the end of its two-day meeting on December 16, the Federal Open Market Committee established a target range for the federal funds rate of 0 to 0.25%, a record low. This means the Fed has reached the limit of effectiveness for federal-funds rate cuts, so it’s now looking for other ways to affect credit spreads, which are more of a problem. The Fed has begun dealing in Agency securities and has announced its intent to continue that practice. It has also been buying commercial paper. The early results have been good; mortgage rates have dropped to their lowest level of the year.

These policies are referred to generically as "quantitative easing," because they are pushing money into the system through channels other than the usual short-term money markets. The Fed has been quite creative in finding new channels, and we expect further creativity. This is a period when experimentation has to be part of policy. We know what won't work, but we aren't sure what will. The Fed will keep trying new ideas until it finds something that does work. They are prepared to ignore ideology to find a solution.

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