Tuesday, September 16, 2008

Has the U.S. outlook changed between Sept. 12 and 16?

Answer: The risks of the outlook for the U.S. economy have deepened, but the fundamentals of the economy remain.

Before the collapse of Lehman and the downgrade of AIG:

  • GDP grew 3.3% annualized in Q2, but not expected to hold throughout the second half of 2008. Q4 may indeed be negative.
  • The labor market is very, very weak. Unemployment rate rose to 6.1% and total job losses since December 2007 are roughly 600k – the labor market is clearly deteriorating.
  • Real consumer spending is slowing and may soon turn negative. Real income was growing just 1.20% in July, while real consumption was up just 0.71%.
  • Housing market continues to slide, but is showing signs of stabilization (at least in sales). Home values down 16% over the year and are expected to fall further until early 2009. Existing home sales may have found a bottom, annual losses (-13%) are declining.
  • Industrials were holding rather firmly against the backdrop of an anemic auto industry. Industrial production starting to show real signs of weakness: For the first time in three months, annual growth rate is down -1.5%, driven by manufacturing, mining, and utilities.
  • Fiscal stimulus ran dry and the boost to consumer spending is now gone. Rebate checks have run dry and evidence points to consumers having saved a good portion of the checks, which was unintended.
  • A clear plus: Inflation has abated. Headline CPI fell -0.1% in August to 5.4% over the year. Core CPI (ex food and energy) also slowed to +0.2% in August, remaining at 2.5% over the year. Upside risk to inflation has subsided substantially – oil rests below $100/barrel.
  • Inflation expectations reduced significantly according to several key indicators.
  • Fed lowered its target by 325 bps since last September, but tighter lending standards have restricted the pass through of new funds to consumers and firms, but not fully.
  • Fannie Mae and Freddie Mac have been nationalized. Mortgage rates remained elevated (5.9% compared to a 2% Fed funds rate), but slid, and are expected to fall further since the U.S. Treasury has shored up the secondary mortgage market.
  • Financial firms (mostly banks and investment banks) suffered $500-$600 billion in capital losses on securitized assets to date – more expected to come.

Post collapse of Lehman and the downgrade of AIG: All of the previous bullet points above still hold…however the underlying situation in the macroeconomy will/may worsen for the following reasons:

  • The labor market will weaken further in the near term – financial services related to insurance and investments added 5k jobs over the last year. That number is expected to drop propitiously in the short-run with the collapse of Lehman Brothers and the buyout of Merrill Lynch.
  • Credit standards to the overall economy (and not just among banking institutions) may be severely restricted in the wake of recent events. For now, the extent to which the banking system freezes up is unknown, but if it does, it would have serious and negative implications for consumer spending and firm investment.
  • In spite of Fed rate cuts and low treasury yields, mortgage rates may remain relatively elevated, slowing down the stabilization of the housing sector.
    Negative wealth effects come alive.
  • Equity losses stymie consumption (saving starts to rise) and firm investment. The equity markets are historically volatile, and will likely rebound before any wealth effects arise, but the risk is real.
  • Probability of a fiscal stimulus have gone up (tax cuts or another spending program), but not until the elections have passed.

What is for sure is since September 12, the upside risks to inflation have all but dissipated, while the downside risk to growth has risen. The biggest risk is that the financial system, which has kept its losses mostly contained within its sector, will drag the U.S. economy downward.

Please leave comments. Rebecca Wilder

P.S. my friend, Alice Cook, over at UK Bubble writes a nice little piece about the aftermath of Lehman Brothers' bankruptcy.


  1. Rebecca -- Those are truly some unsettling numbers. The collapse of any financial player has to offer some grave cause for concern. As you said the short-term jobless reports will no doubt leap solely because of financials.

    A topic that I've put on the back burner for a little while now is inflation. You say "the upside risks to inflation have all but dissipated." Despite gas prices, what other risks have dissipated? Just curious...Have a good one, Tim.

  2. Love Alice's solution for the banks! If we don't take some drastic action before the election, things could get very ugly. (Obama is still being very general, too, which does not help.) I like the idea of tightening credit standards along with getting the banks sqared away like Alice said.

  3. Hi Tim,

    You are right, and as the FOMC statement reiterates, the upside risk to inflation is still in the pipeline. It is hard to say that 1-month decline out-weighs several months of record gains. But given the events over the last two days (and I am sure that you agree on this one), the upside risk to inflation is definitely on the backburner for now!