The U.S. Economy in 2009: “Toto, We’re Not In Kansas Anymore”

by Beth Ann Bovino

This was a record-breaking year, though there was almost no good news. As it came to a close, most welcomed its departure. Unfortunately, we expect more tough times ahead in 2009, with no turn around likely until later next year. The current financial crisis has deeply frightened consumers and businesses, and in response they have sharply pulled back spending, making the recession even more severe. Moreover, the usual recovery tools used by governments, monetary and fiscal stimuli, are relatively ineffective given the circumstances. The economy won’t likely reach bottom till spring of next year, with risk of an even bigger recession more pronounced.

The National Bureau of Economic Research officially declared that the U.S. has been in recession since last December, only surprising those living at the North Pole. The downturn is expected to approach the slump of 1981-82 and be even longer, bottoming out in the spring of next year, which would make this the longest postwar recession. After a strong rebate-check related second quarter, four consecutive quarters of negative growth is expected through the second quarter of 2009, with risk that the fourth quarter will be down 6% based on current data. Employment dropped for the eleventh consecutive month in November, with 2.1 million jobs lost over last year, the biggest 12-month job loss since the 1982 recession. Financial markets remain in distress. Housing is still in recession, with November housing starts falling to the lowest pace since World War II. Not surprisingly, both business and consumer confidence remain weak.

The spendthrift habits of American consumers are a likely casualty of the crisis. Consumers and banks are becoming more cautious, and we expect household debt to decline from record levels, relative to income and to assets. The household saving rate is likely to increase, how much will help determine how quickly the economy revives.

In the long run, Americans would be better off saving more both individually and as a nation. But the short-run transition to a higher saving rate can be difficult, especially in a period of low interest rates and weak demand for capital spending. Insufficient demand can keep the economy weak. This was one of the complications that kept the Japanese economy soft through the 1990s.

Among businesses, nonfinancial corporate debt to net worth is at its lowest level since the junk-bond explosion of the mid-1980s, with cash balances near-record highs, despite share buybacks. However, smaller firms remain more dependent on debt to finance expansion, and that is where the pinch will be felt. We expect to see declining capital spending, which could result in lower employment growth and weaker productivity. The drop in employment and resulting lower incomes will further constrain consumer spending. This comes with commercial construction at a near halt because of the combination of tight credit and weak employment growth.

The only bright spot for consumers and businesses (excluding energy companies) is the decline in energy prices. Oil has fallen to less than one-third of the July record level, and gasoline prices are back under $2/gallon ($1.70/gallon for my boyfriend’s last fill-up). If prices remain relatively low, it will help household purchasing power. But even that isn’t as good a present as it was last summer, when energy prices were high.

Continued financial turmoil and the weak economy forced the Fed to establish a target range for the federal funds rate of zero to 25 basis points on December 16, with an explicit guarantee that it will keep rates low. Congress will continue to play Santa Claus as well, trying to boost the economy out of recession. They haven’t yet chosen the exact wrapping paper for the package, but the contents will likely include major infrastructure spending, an extension of unemployment benefits, and perhaps some more rebates and help for the housing market. The cost is unknown, but it will be huge, perhaps as much as $500 billion added to the $1 trillion deficit already expected for fiscal 2009. However, it will fit within the government’s credit card limit.

Though the U.S. economy has proved more resilient than we first feared, we think the recession had only been delayed, in part because of the temporary boost from the stimulus package, and that the worst of the downturn is ahead of us. We expect the economy to fall 1.2% in 2009 after a modest 1.2% increase in 2008. The unemployment rate will rise from the current 6.7% level to 8.3% by late 2009.

However, we are outside the range of historical data in terms of the freeze in credit markets. Projections are even more uncertain than usual in this environment, and the risks have increased. We still believe this will be an average recession, but the downside risks are larger than usual. It could be longer and deeper if oil prices rebound sharply or the financial turmoil drags on. Our best guess is that this will be a moderate but prolonged recession, with a sluggish recovery. It could still turn into a mega-recession with bad luck in energy or credit markets.

Another big risk is that the U.S. financial markets echo the experience of Japan in the 1990s. Like the U.S., the Bank of Japan shoved interest rates down to zero, but heavy loan losses impaired the capital position of the banks, thus the money didn’t get out to customers. The result was a decade of stagnation in the Japanese economy, as investment waned because of lack of funds, slowing productivity growth. Home prices are still down around 25% from their peak, and the Nikkei stock index is only at about a third of its level of 20 years ago.

Hope you had a happier holiday than this forecast!

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