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Wednesday, July 15, 2009

Show me the Engines of Growth

by Calculated Risk on 7/15/2009 02:33:00 PM

Back in February I pointed out that I expected to see some economic rays of sunshine this year. But I never expected an immaculate recovery forecast from the FOMC.

Although I've argued repeatedly that a "Great Depression 2" was extremely unlikely, I think the other extreme - an immaculate recovery - is also unlikely.

It is probably a good time to review the usual engines of a recovery. (see Business Cycle: Temporal Order for the order in and out of a recession)

The following table shows a simplified typical temporal order for emerging from a recession.

When Recovery Typically Starts

During Recession Lags End of Recession Significantly Lags End of Recession
Residential InvestmentInvestment, Equipment & Software Investment, non-residential Structures

Housing usually leads the economy both into and out of recessions (this was true for the Great Depression too). However this time, with the huge overhang of excess inventory and high levels of distressed sales, it seems unlikely that residential investment will pick up significantly any time soon.

Note: Residential investment is mostly new home construction and home improvements.

And that leaves Personal Consumption Expenditures (PCE), and as households increase their savings rate to repair their balance sheets and work down their debt, it seems unlikely that PCE will increase significantly any time soon. Maybe there will be a pickup in auto sales from the current depressed levels, but in general a strong increase in PCE seems unlikely. So even if the economy bottoms in the 2nd half of 2009, any recovery will probably be very sluggish.

Most companies are not investing in new equipment and software - other than the normal equipment replacement purchases - because they already have too much capacity. They will not need to expand until their sales pick up significantly. So it seems unlikely that investment in equipment and software would boom until consumer spending has increased. Of course increased U.S. exports would help - but export to whom? China, and a few others ... but most of the world is also hurting.

I still think the keys are Residential Investment (RI) and PCE, and therefore I think the recovery will be sluggish. The increasingly severe slump in CRE and non-residential investment in structures will be interesting, but that is a lagging indicator for the economy.

(1) In recent recessions, unemployment significantly lagged the end of the recession. That is very likely this time too.