A Recession That's Mild But Long?

It might be deeper than the downturns of 1990 and 2001 but still gentler than the postwar averagethanks to bold policy actions, falling inflation, and early inventory adjustments

The financial crisis is rapidly moving beyond Wall Street. Frozen credit markets pose a serious threat to the welfare of consumers and businesses—and not just in the U.S. The crisis is now officially global, as evidenced by the unprecedented coordination by major central banks on Oct. 8 to cut interest rates by a half-point. In the U.S., recent reports suggest the economy hit an air pocket last month: Job losses accelerated to a five-year high, and the nation's purchasing managers said manufacturing activity plunged to a seven-year low. Many economists believe a recession of some depth and duration is unavoidable in the wake of the latest sharp tightening of credit conditions. Worried investors are frozen by one key question: How bad will it get?

Start with past recessions as reference points. On average, the 10 downturns since World War II lasted 10.4 months, and real gross domestic product declined 2% from peak to trough. The last two episodes were relatively mild, each lasting only eight months, with real GDP falling 1.3% in the 1990-91 recession and a mere 0.4% in the 2001 downturn. The average rise in the unemployment rate, from its low point to its peak, was three percentage points.

Against that baseline, there are several reasons to believe the recession now shaping up will be on the mild side of average, but with the risk that it could be more severe than either of the last two. That's because the financial headwinds facing the economy are without precedent since the 1930s.

The response by Washington policymakers, however, has been equally unprecedented in its magnitude and willingness to break through old policy structures. Congress has ventured outside the free-market mold, committing $1 trillion this year alone to shoring up the economy and wobbly banks. The Federal Reserve is putting up another $1 trillion to boost credit-market liquidity via its innovative lending facilities and other means.

The Fed isn't finished. Its latest precedent-busting move is to buy unsecured commercial paper in an effort to thaw the markets for short-term lending, which is crucial to day-to-day business operations. And the Fed's half-point cut in its target rate on Oct. 8, to 1.5%, is likely not its last. Rate cuts will lower banks' cost of funds and over time help to rebuild capital.

The improving inflation outlook gives the Fed leeway to cut further. Market measures of expected inflation have plummeted to levels not seen since the deflation scare earlier this decade. Oil prices are down some 40% since July, and inflation outside of energy and food has declined in every postwar recession, as labor markets weaken and wage growth slows. The average rise during recession in the unemployment rate, currently at 6.1%, would put peak joblessness at 7.4%.

Another factor that should soften the recession's impact is information technology, which has greatly damped down the inventory cycle. In the 10 previous recessions, efforts to cut excessive inventories have accounted for about 70%, on average, of the drop in real GDP. But new systems have created faster adjustments, especially in this cycle. So businesses already began to liquidate stockpiles in the third quarter of last year. Last quarter's reduction was the second-largest on record.

What may not be so mild about this recession is its length. All four of the monthly indicators used by the National Bureau of Economic Research to date the onset of a downturn began falling between last October and January. Economists are betting the NBER will deem the start date to have been December 2007. That would mean the slump would have to run through April 2009—or 16 months—to tie the severe 1973-75 and 1981-82 recessions for the longest in postwar history. At this point many forecasters think that's not out of the question.

Beyond the current rough patch, history shows recoveries are born of a combination of policy efforts and the economy's built-in recuperative powers. This time should be no different, but that's next year's story.

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