What Can Go Worse—or Better?
To quote the great Yogi Berra, "Forecasting is difficult, especially about the future."
We expect the fiscal stimulus package that President Bush signed and the Federal Reserve's quick moves to lower interest rates will put a fairly swift end to the mild recession we’re expecting.
Although the underlying problems of the U.S. economy seem to reflect the 1991 to 1992 recession (which saw gross domestic product, or GDP, fall 1.2% from peak to trough), we think the aforementioned moves will keep this recession closer to the 2001 downturn (when real GDP dipped only 0.4%).
We believe the latest expansion’s cyclical peak will be dated November 2007, and the trough is likely to come in July 2008, when the last of the tax rebates are paid out. Thus, the eight-month recession would be shorter than the 50-year average of 10.7 months.
We're forecasting negative GDP growth for the first two quarters of 2008 for a total decline of 0.4%. We think the tax rebates will provide a strong boost, to 3.2%, for GDP growth in the third quarter. Then we expect the economy to slow to an average of 2.6% growth over the next three quarters, after the boost from the rebates fades. The business tax credits should prop up the economy in the fourth quarter, preventing a double-dip recession.
We expect a 20% drop in the S&P 500 index—less than the historical average decline during a recession—to be completed this spring.
The Fed has moved more quickly than we expected, or than it has typically done in the past. It chopped the Federal funds rate to 3% from 5.25% in September. We expect another half-point cut this month. Long-term interest rates have dropped 70 basis points from their peak of 4.5% in the summer of 2007.
However, the cost of funds to private companies and individuals has fallen much less and has even gone up for poor-credit-quality borrowers. About two-thirds of the fiscal stimulus package, which will transfer more than $160 billion into the economy beginning in May, will take place in fiscal 2008 (ending September). We expect that to bring this fiscal year's federal deficit close to the 2004 record of $413 billion. In terms of consumer spending, the stimulus is likely to be felt primarily in the third quarter. The business components will see the most impact in the fourth quarter.
The Downside Case
In our deep recession scenario, oil prices rise instead of fall, as they do in the base case, to peak at $115 a barrel in the spring of 2009. Financial markets remain frozen, and foreign investors become scared of a falling dollar and bond defaults. As a result, bond yields have to rise to attract the funds needed to balance the trade deficit. The dollar declines steeply, adding to the Fed's fear of inflation but helping exports in the long run.
After a brief third-quarter rebound, fueled by the tax rebates, the United States slides back into a recession in the fourth quarter of 2008 after consumers spend their rebates, and businesses respond less actively than hoped for to the investment incentives.
Real GDP declines 2.2% from its fourth-quarter peak to its first-quarter 2009 trough. The downturn would be about the same length (16 months) as the 1975 and 1982 recessions, but would remain somewhat milder because of the tax rebates. This would still, however, be the third-worst recession in postwar history. The unemployment rate peaks at 7.4% in late 2009, compared with a top of 5.9% in our baseline scenario.
The slumping economy and higher federal benefit costs hit the budget deficit, which jumps to a new record high of $429 billion in fiscal 2008, only to break the record in each of the two subsequent years, peaking at $554 billion in fiscal 2010. Weaker revenues, rather than higher expenditures, cause most of the widening.
The Upside Case
A recession is by no means certain. Lower oil prices and a more rapid calming of financial markets could still avert a downturn. At the same time, a revival of productivity increases could keep inflation under control despite stronger economic growth. The stimulus plan may have a greater impact on both consumer spending and business investment.
This scenario is our optimistic projection. Oil prices drop more sharply than in our baseline, falling to $65/barrel this summer compared with $75. Bond yields fall in response to the lower inflation and the increased confidence in the U.S. economy, which attracts more foreign inflows. Unemployment holds near its current 4.9% rate, as real GDP growth is steady. Inflation rates drop because of a stronger dollar and more rapid productivity growth. The consumer price index (CPI) rises only 1.2% in 2009, helped also by lower oil prices. But even the core CPI is up just 1.7%, compared with 2.2% this year.
More robust growth helps control the budget deficit. After rising to $385 billion in fiscal 2008 (compared with $411 billion in our baseline), the deficit falls back to $137 billion by fiscal 2011, less than half the level of our baseline projection.
This scenario is optimistic, but not unreasonably so. In fact, it's near the expectations we had at this time last year.