U.S. Economy: Gauging the Risks
Beyond the projection of gross domestic product (GDP) and inflation, we include outlooks for other major economic categories, such as home and auto sales, employment, and oil prices in our monthly economic forecast. We call this forecast our baseline scenario.
However, we realize that financial market participants also want to know how we think things could go worse — or better — than what our baseline scenario calls for. So we have instituted a quarterly feature called Risks to the Forecast, in which we project two additional scenarios, one worse than the baseline and one better, both of which have an estimated 20% chance of occurring (in the sense that reality will look more like them than like the baseline).
The downside case can then be used to estimate the credit impact of a worse economic outlook. Note that these alternative forecasts wouldn’t apply equally to all industries. For example, our downside case assumes higher oil prices. That’s not good if you’re running an airline or a car company, but it is good if you’re an oil producer.
BASELINE CASE: A LONG BUT MILD RECESSION
The July baseline forecast is for the recession to be mild but long. The stimulus payments came out earlier than expected, and appear to have been spent more quickly than expected, which has helped the economy through mid-2008.
However, higher oil prices have further squeezed consumers, and financial markets remain tighter than anticipated. We now think the recession will arrive a bit later than we thought.
Although the underlying problems that led to the recession seem to be similar to those of the 1991-1992 recession (during which the GDP fell 1.2% from peak to trough), we think that the stimulus package will lead to a recession that more closely mirrors the 2001 downturn (when real GDP dipped only 0.3%). We believe that the cyclical peak of the latest expansion was reached in December 2007 and the trough is likely to come in March 2009. This 15-month recession would be longer than the 50-year average of 10.7 months.
We’re forecasting negative GDP growth for the fourth quarter of 2008 and first quarter of 2009, with a total decline of 0.7%. The tax rebates should result in GDP growth near 2% in the second and third quarters of 2008. However, after the impetus from the rebates has abated, the economy will likely deteriorate. The business tax credits will provide a boost to the fourth quarter, but that should only worsen the decline in the first quarter.
The S&P 500 index of stock prices has already dropped 20%, reaching the usual definition of a bear market. However, the historical average decline in the market during a recession is 36%. Stock prices normally lead the economy by three to six months and should hit bottom in the third or fourth quarter. However, past performance is no guarantee of future results.
We expect the Fed to stay on hold until the recession is over, and raise rates in the second quarter of 2009.
THE DOWNSIDE CASE: SLIPPING ON OIL
In our deep recession scenario, oil prices rise to peak above $200 a barrel early next year. The financial markets remain frozen, and foreign investors’ worries about a falling dollar and bond defaults intensify. As a result, bond yields have to rise to attract the funds needed to balance the trade deficit.
The dollar falls steeply, adding to inflation but helping exports in the long run. Consumers spend less of their rebates than assumed in the baseline. Consumer spending drops more sharply in the third quarter, as households try to rebuild the wealth that has been lost to weaker home and stock prices. Real GDP declines 3.1% from its fourth-quarter 2007 peak to its second-quarter 2009 trough. The downturn would be slightly longer (18 months) than the 1975 and 1982 recessions and match 1975 as the worst recession in postwar history (based on the drop in real GDP).
The unemployment rate tops out at 8.4% in early 2010 compared with a peak of 6.2% in our baseline scenario. In this scenario, housing and oil are the major negative factors for the economy.
THE UPSIDE CASE: OIL’S RIGHT WITH THE WORLD
A recession is not yet certain, despite the six consecutive employment declines recorded in the first half of the year. 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. And the stimulus plan could have a greater impact on consumer spending than we are expecting.
In our optimistic projection, oil prices drop more sharply than in our baseline, falling to $100 a barrel by year-end (compared with a rise to $157/barrel in the baseline) and to $75 a barrel in late 2009, where they remain through 2010.
Bond yields fall in response to the lower inflation and the increased confidence in the U.S. economy, which attracts more foreign inflows. Unemployment drops to about 5.0% next year from its current 5.5% rate, as real GDP growth recovers to 2.6%, though under its 3.3% trend.
Inflation rates drop because of more rapid productivity growth and a slightly stronger dollar. The CPI rises only 0.6% in 2009, further helped by lower oil prices. But even the core CPI slows to 1.7% compared with 2.4% currently.
Housing recovers more quickly than in the baseline scenario because of lower mortgage rates and a stronger economy. Mortgage rates drop to 5.2% in 2009 versus 6.6% in the baseline. Residential construction rises 4.6% in 2009 compared with an 11.5% drop in the baseline. Starts fall to 990,000 in 2008 but improve to 1.29 million in 2009 and 1.67 million, near their trend level, in 2010.
Consumers spend more freely because of stronger employment and a more rapid increase in purchasing power. Consumer spending rises 2.2% in 2008 and 2.6% in 2009 compared with 1.7% and 0.3%, respectively, in our baseline.
This scenario is optimistic, but not unreasonably so. In fact, it’s near what our expectations were at this time last year.