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Tuesday, November 10, 2009

Fed's Yellen on the Economic Outlook

by Calculated Risk on 11/10/2009 10:53:00 AM

Lately I’ve been leaning against the view of a “V shaped” recovery. I think that growth will be decent in the second half of 2009, but growth will be sluggish in 2010.

San Francisco Fed President Dr. Yellen has a similar view – from her speech this morning: The Outlook for the Economy and Real Estate

The big issue is how strong the upturn will be. With such enormous reservoirs of slack in the form of high unemployment and idle productive capacity, we need a strong rebound to put unemployed people back to work and get underutilized factories, offices, and stores humming again. Unfortunately, my own forecast envisions a less-than-robust recovery for several reasons. As the impetus from government programs and inventories diminishes in the quarters ahead, private final demand will have to fill the breach. The danger is that demand may grow at too anemic a pace to support vigorous expansion.

First, it may take quite a while for financial institutions to heal to the point that normal credit flows are restored. The credit crunch hasn’t entirely gone away. In the face of massive loan losses, banks have clamped down on underwriting and credit terms for both businesses and consumers. Smaller businesses without direct access to capital markets are particularly feeling the pinch. Lenders have had to run hard just to stay in place: Rising unemployment, business failures, and delinquencies in real estate markets have fed additional credit losses and made it more difficult for financial institutions to get their balance sheets in good order.

Second, households have been pummeled and prospects for consumer spending are cloudy. Consumers have surprised us in the past with their free-spending ways and it’s not out of the question that they will do so again. But I wouldn’t count on them leading a strong recovery. They face high and rising unemployment, stagnant wages, and heavy debt burdens. Their nest eggs have shrunk dramatically as house and stock prices have fallen, and their access to credit has been squeezed.

It may be that we are witnessing the start of a new era for consumers following the harsh financial blows they have endured. ...

Weakness in the labor market is another factor that may keep the recovery sluggish for quite some time. Payroll employment has been plummeting for more than a year and a half, and, even though the pace of the decline has slowed, unemployment now stands at its highest level since 1983. In addition, many workers have seen their hours cut or are experiencing involuntary furloughs. ... my business contacts say they will be reluctant to hire again until they see clear evidence of a sustained recovery. High unemployment, weak job growth, and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery.

... the outlook for housing has turned up in response to favorable mortgage rates, lower house prices, and a lower overhang of unsold houses. And growth in this sector should contribute to the overall economic recovery. These developments represent real gains, but it’s important not to get carried away. Some of the advance reflects temporary government support in the form of tax credits for first-time home buyers, and the impact of loan modification programs and foreclosure moratoriums that reduced the pace of distressed sales. Moreover, foreclosure notices surged earlier this year and distressed property sales may rise once again in the months ahead. If so, we could see renewed pressure on house prices. Of course, continuing high unemployment will also fuel additional foreclosures. And the supply of credit for nonconforming mortgages remains extremely tight. Financial institutions are reluctant to place them on their books when they are trying to reduce leverage and we have yet to see any revival of the market for private mortgage-backed securities.

When we turn to commercial real estate, the prospects are worrisome. ...

When the weakness of the commercial property market is combined with the muted outlook for housing and consumer spending, you can see why I believe that the overall economic recovery is likely to be gradual and remain vulnerable to shocks. It’s popular to pick a letter of the alphabet to describe the likely course of the economy. The letter I would choose doesn’t exist in our alphabet, but if I were to describe it, it would look something like an “L” with a gradual upward tilt of the base. With such a slow rebound, unemployment could well stay high for several years to come. In other words, our recovery is likely to feel like something well short of good times.
emphasis added