U.S. Macro Outlook: With a Little Bit of Luck

View the Moody's Economy.com U.S. Macro Forecast. Listen to a podcast with Mark Zandi discussing the U.S. outlook.

• After the longest, broadest and most severe economic contraction since the 1930s, growth is expected to resume this quarter.

• The fiscal stimulus is fueling sales at home and abroad, and layoffs are moderating.

• However, weak hiring and mounting foreclosures could prevent an economic expansion from gaining traction.

• It is still too early to tell, but the economy may need another boost from the government next year.

The Great Recession is giving way to recovery. The downturn that began in December 2007 will go into the record books as the longest, broadest and most severe contraction since the 1930s. It will have lasted more than twice as long as the average U.S. recession, dragging down nearly every industry and every region of the country. Unemployment will have risen more and the decline in real GDP will be greater than during any other contraction since the Great Depression.

GDP growth is expected to resume this quarter. Some heavy weights are lifting, including in housing construction. Homebuilders have cut housing starts, to levels last seen in the midst of World War II, and although a rebound is hard to fathom, given the severity of the housing crash, builders may soon begin to put up a few more homes. There is a surfeit of vacant, existing homes for sale and rent, but inventories of new homes are becoming lean in a number of markets.

Retailers and manufacturers have also worked hard to reduce bloated stocks of goods. The plunge in inventories in the second quarter was the largest on record and followed a year of destocking. Stocks are now so thin that production will have to pick up quickly. Otherwise, any increase in sales will leave businesses without sufficient goods on their shelves.

And the fiscal stimulus is fueling more sales. Lower payroll tax withholding rates, checks to Social Security recipients, and extra benefits for unemployed workers are buoying household income. The cash for clunkers program has juiced up vehicle sales, and the housing tax credit has boosted home sales. It is no coincidence that the recession is ending just as the stimulus provides its maximum benefit.

Sales to overseas customers are also reviving. Exports, in free fall just a few months ago, are expanding again as the global economy stabilizes. Massive monetary and fiscal stimulus measures have quickly turned the Chinese economy around, which in turn is lifting much of the rest of Asia. Even the European downturn appears to be winding down. Growth has resumed in the region's biggest economies, Germany and France.

Self-sustaining expansion

For the stimulus-supported recovery to evolve into a self-sustaining expansion, businesses soon must respond to improving sales by making fewer cutbacks. The economic boost from the fiscal stimulus will wane in early 2010 and turn into a measurable drag on the economy by the end of next year. Unless firms are hiring and expanding by then, the recovery will fizzle.

So far, so good, however. Job losses are moderating from an average of 700,000 per month earlier this year to less than half that level, and investment spending is no longer in free fall. It seems likely, given the inventory and sales situation, that the massive layoffs in manufacturing, construction and retail will soon abate. Together, these industries have accounted for nearly two-thirds of the jobs lost during the recession.

But fewer layoffs won't be enough. Hiring must resume, and there is no indication that businesses are ready to expand their payrolls. Just before the recession, firms were hiring more than 5.5 million workers each month. As of June (the latest month for which Bureau of Labor Statistics data are available), hiring had fallen to an abysmal level—less than 4 million per month—and was still dropping. Hiring is expected to improve as businesses grow more confident about sales, pricing, and their ability to borrow again, but the proverbial coast is far from clear.

Economic threats

The main threat is the foreclosure crisis, which shows no sign of letting up. Nearly 1 million mortgage loans were in default—the first step in the foreclosure process—at the end of June, according to data from the credit bureau Equifax. This was over four times the default rate that prevailed in the middle of the decade, when the housing market was at its most robust. Many more defaults are coming. Nearly 1.5 million additional loans are more than 90 days delinquent. More foreclosures eventually means lower house prices, which will further undermine household wealth and the tentative stability of the financial system. The expansion will not gain traction so long as foreclosures are rising and house price are falling.

Hundreds of billions of dollars in commercial mortgage loan defaults also threaten to upend hundreds of banks with large loan portfolios relative to their capital bases. With absorption of commercial space still falling and vacancy rates rising, rents and property prices are under severe pressure. More disconcerting is that even property owners with solid tenants and cash flow are unable to refinance their mortgages. The commercial mortgage-backed securities market remains closed, and traditional portfolio lenders such as banks, insurance companies and pension funds seek to reduce their exposure to commercial real estate.

Credit remains severely impaired. The securitization markets are frozen, and banks are anxious about the prospect of both more loan losses and regulatory reform. The credit crunch isn't getting worse, but it isn't getting better, as underwriting standards remain tight. According to Equifax credit file data, household debt outstanding declined by over $250 billion in the second quarter, a stunning amount. Credit card, auto, consumer finance and mortgage debt are all declining. Some of this decline reflects consumers' desire to reduce their debt loads, but most of it stems from lenders' unwillingness to lend. Until credit flows more freely, the economy will struggle.

California has finally settled on a budget, but several other states have not, and nearly all states will need to fill what are sure to be gaping budget holes next year. Rainy-day funds are depleted, and investors are demanding very high interest rates to buy municipal bonds. Even if Washington comes forward with more help, state and local governments will be forced to raise taxes or cut spending, or both. The drag on the economy by this time next year could be substantial.

More policy help

It is still too soon to know for sure, but odds are high that the economy will need another boost from policymakers next year to ensure the expansion takes root. More help to state and local governments makes sense, as does another expansion of benefits to the long-term unemployed. Nothing is scarier than being without a job and a safety net. Extending and expanding the housing tax credit would also lift home sales. Significant federal subsidies to allow mortgage loan modifications that include principal write-downs would go a long way toward easing the foreclosure crisis.

Businesses could also use another round of incentives to persuade them to shift from cost-cutting to expansion. The current stimulus provides business tax benefits via accelerated depreciation for big firms and expensing and a net operating loss carryback, or NOL, for small firms. Although such incentives generally don't make particularly effective stimulus measures—they don't induce much extra near-term investment—they aren't very costly to taxpayers and would arguably be more potent in today's environment. Extending the current investment incentives and expanding the NOL to benefit all businesses would be helpful.

The Bush tax cuts, set to expire at the start of 2011, must also be addressed. Policymakers are sure to make permanent the current tax rates for those making less than $250,000 per year, but it also seems appropriate to phase in or even postpone the scheduled tax increases for those with higher incomes as well. Though the deadline is more than a year away, the economy is unlikely to be healthy enough to gracefully digest these higher tax rates all at once.

A U-shaped outlook

The worst is clearly over, but it is far from clear when the economy will be back in full swing. The Moody's Economy.com baseline economic outlook—the middle of the distribution of possible economic outcomes—is for a U-shaped recovery. In this scenario, the economy comes back from the Great Recession, but it doesn't come roaring back. There are too many impediments to growth. Yet, with some deft policymaking and a bit of luck, these impediments are slowly overcome and the economy returns to a stronger path of growth. Real GDP in the baseline is projected to decline 2.8% this year, to grow at a weak 1.8% in 2010, and expand by a more robust 4% to 5% in 2011-2012. Trend economic growth consistent with stable unemployment is estimated to be 2.5% throughout this period. Employment is expected to hit bottom next spring, with the unemployment rate peaking in the double digits. Not until late 2013 is full employment—a 5.5% unemployment rate— restored.

For the first time since the financial crisis struck over two years ago, risks to the outlook appear about equally balanced. A more optimistic V-shaped outlook hinges on a quicker rehabilitation of the collective psyche. Consumer, business and investor confidence remains extraordinarily fragile—but confidence is fickle. If it improves quickly, a more robust recovery could ensue. A more pessimistic W- or L-shaped outlook seems likely if policymakers fail to provide more help to the economy and financial system. The incipient recovery will likely need another boost from policymakers to turn into a self-sustaining expansion. Without the necessary policy help, the recovery could flag.