Monday, January 04, 2010

Fed's Duke on Economic Outlook

by Bill McBride on 1/04/2010 01:09:00 PM

From Fed Governor Elizabeth Duke: The Economic Outlook

In my view, the outlook for economic activity depends importantly on our ability to build on the progress to date in improving the operation of financial markets and restoring the flow of credit to households and businesses.

Although household wealth has received a boost from the gains in the stock market over the last nine months and from the stabilization in house prices, household balance sheets remain weak. In 2009, household income received some temporary support from the tax cuts and transfer payments enacted with the fiscal stimulus package and from the extensions of unemployment insurance. Over the coming year, households should begin to see gains in income associated with an improvement in the labor market, and the drag on spending from past declines in real net worth should ease. As their income and balance sheets improve, consumers should have better access to credit. Favorable trends in income and employment should also bolster consumer confidence, although one risk I see to the outlook for household spending is the possibility of a rise in the personal saving rate as consumers choose to shore up their balance sheets rather than spend. While good in the long run, increased saving means consumers are providing less of a short-run boost to the economy.

The outlook for homebuilding will depend critically on the continuation of the uptrend in the demand for housing that began in early 2009. I anticipate that low mortgage rates and house prices that are still very low compared with the recent past will continue to provide important support for demand. And a shift in expectations from falling house prices to modest appreciation should encourage buyers to invest in houses. That said, the headwinds in housing and mortgage markets remain relatively strong and are likely to restrain the pace at which the residential construction sector recovers. Many of the existing homeowners who face payment problems are having trouble restructuring their loans, and the large backlog of foreclosed properties will likely take several years to resolve. Tighter standards for government-backed loans and still-restrictive credit conditions in private loan markets are also likely to slow the housing recovery. Nevertheless, with the inventory of new homes having been worked down to a relatively low level, even a gradual strengthening of demand should lead to an upturn in homebuilding.

Prospects for a recovery in business investment are getting better as we move into 2010. Typically, business confidence builds as firms see a sustained increase in sales and output. Various indicators of business sentiment rebounded over the second half of 2009 as economic activity accelerated, and the latest surveys of capital spending plans have been more positive. That said, the amount of unused capacity in the business sector is substantial, which implies that the recovery in spending on equipment and software will likely be more gradual than typically occurs during a cyclical recovery.
Unfortunately, the outlook for commercial real estate is much less favorable. Hit hard by the loss of businesses and employment, a good deal of retail, office, and industrial space is standing vacant. In addition, many businesses have cut expenses by renegotiating existing leases. The combination of reduced cash flows and higher rates of return required by investors leads to lower valuations, and many existing buildings are selling at a loss. As a result, credit conditions in this market are particularly strained. Commercial mortgage delinquency rates have soared. ...

In this environment, a turnaround in CRE is likely to lag the improvement in overall economic activity. However, compared with the situation in the early 1990s, the problems in this sector now appear to be due largely to poor business fundamentals rather than widespread overbuilding, suggesting that the performance of the CRE sector will gradually begin to improve as the economy continues to strengthen.

An important element of a sustained economic recovery will be an improvement in labor market conditions. Employment gains typically lag the recovery in sales and production in the early months of an economic upturn. In many cycles, the lag occurs because businesses need to restore productivity and are reluctant to hire until they are more confident that any pickup in sales will be maintained. In this cycle, the reductions in jobs and hours of work have been so deep, and the pressure to cut costs has been so strong, that businesses in the aggregate have already realized solid gains in productivity. As a result, I expect that businesses will begin to add jobs this year, but I anticipate that they will do so cautiously in order to hang on to their cost savings and efficiency gains.

Even as the unemployment rate begins to decline later this year, it likely will remain high by historical standards. Based on the experience of the last two economic recoveries, net gains of roughly 100,000 payroll jobs each month are needed to reduce the jobless rate by 0.1 percentage point. ...
emphasis added
I think Ms. Duke is somewhat too optimistic on housing and employment. It might take more payroll jobs to lower the unemployment rate this time because the Labor Force Participation Rate has declined so sharply; the BLS reported the participation rate as 65.0% in November (the percentage of the working age population in the labor force). This is the lowest level since the mid-80s, and I expect a number of people will rejoin the labor force at the first sign of an employment recovery, putting upward pressure on the unemployment rate.