U.S. Macro Outlook: Training Wheels Still Needed

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

• Real GDP is projected to grow just under 3% during the second half of 2009 but by 2% or less during 2010.
• Aggressive Fed policy is making it easier for businesses and households to obtain credit.
• Consumers remain cautious but no longer seem panicked, despite rising unemployment.
• Expansion depends on when businesses increase hiring, which they show no signs of doing soon.
• Policymakers' failure to provide more help in the coming year is the most serious threat to the outlook.

An economic recovery is under way, but it remains tentative and fragile. Real GDP is expanding again, but growth is inconsistent and insufficient for businesses to resume hiring. Employment thus continues to decline, and the unemployment rate will soon reach double digits. The Federal Reserve and fiscal policymakers likely will need to provide further support to ensure the economy doesn't stall or fall back into recession next year.

Growth drivers

We estimate that real GDP expanded close to 3% at an annualized rate in the third quarter and is on track to grow a bit less than that in the fourth quarter. Supporting this newfound growth are an unprecedented monetary and fiscal stimulus and a significant manufacturing inventory swing.

The Federal Reserve's aggressive efforts have succeeded in lowering borrowing costs and easing the credit crunch. Fixed mortgage rates are a full percentage point lower than we estimate they would be if not for the near-zero fed funds rate and the Fed's purchases of Treasury debt and Fannie Mae and Freddie Mac securities. Without the Fed's actions, Freddie's 30-year conforming loan rate would be closer to 6% than its actual 5%

It remains difficult for businesses and households to obtain credit, but steadily less so. Corporate borrowers with solid financials are raising record amounts of cash in the bond market thanks to low investment-grade corporate bond yields. Riskier corporate borrowers have been able to issue bonds at reasonably attractive interest rates. Households are getting new loans more easily, in large part because the federal government has stepped into the void left by nervous and capital-short private lenders. Only commercial mortgage borrowers are still largely shut out of new credit.

The fiscal stimulus has succeeded in firming up consumer spending. Expanded unemployment insurance benefits, tax cuts, cash for clunkers, and the first-time homebuyer tax credit have created just enough incentive for households to resume shopping. Consumers remain cautious spenders, but they no longer seem panicked, despite a continuing loss of jobs and high unemployment.

GDP is also receiving a boost from a sharp turnaround in industrial production, powered by a massive inventory swing. Firms have shifted from drawing down stocks to replenishing them, most dramatically in the auto industry. The GM and Chrysler bankruptcies, combined with cash for clunkers, pushed the days' supply of vehicles on dealers' lots to record lows. Automakers have responded by sharply increasing current production. The inventory swing has yet to kick in across the entire manufacturing base, but it will in coming months.

Repairing balance sheets

The economy's move from recession to recovery is supported more fundamentally by the progress that financial institutions, businesses and households have made in repairing tattered balance sheets. Much work remains before they are on solid financial ground, but they are on their way.

The nation's largest bank holding companies—those 19 institutions forced to undergo stress tests this past spring—are now arguably overcapitalized. These institutions have raised sufficient capital to withstand losses that would occur only if the economy were to slide back into a deep recession. Once it is clear that the economy will not suffer such a fate—when unemployment peaks and house prices definitively stop falling—the banks will be able to extend much more credit. On the other hand, hundreds of small banks have not been as successful shedding troubled assets or raising capital. Many of these will fail, but the FDIC is working through these problem institutions quickly. Already this year the government agency has resolved some 100 such institutions.

Larger nonfinancial firms have also been feverishly restructuring their balance sheets, even though these were in fairly good condition (at least in the aggregate) prior to the financial crisis. Despite a sharp slide in profits and cash flow, these businesses' interest coverage ratio—the share of cash flow devoted to servicing debt—is manageable. With businesses now reducing outstanding debt or refinancing to lock in low interest rates, the coverage ratio should decline soon. In a less favorable position are smaller firms that rely on troubled banks for credit. Corporate bankruptcies are thus rising, but with sales and profitability now stabilizing, these pressures should peak soon.

Excessively indebted households were at the heart of the financial crisis and recession, but they, too, are now deleveraging rapidly. Total household liabilities have fallen by an astounding nearly $450 billion (equal to 4% of liabilities) from their mid-2008 peak through this past September, according to data based on Equifax credit files. Mortgage, auto and credit card debt are all declining quickly. This reflects surging defaults, but it also stems from a decline in the number of new loans and households paying down existing debts. A sharply falling number of loans are in an early stage of delinquency—30 and 60 days late. Lower-income households in particular remain under substantial stress, but the worst is over.

How gracefully the nascent recovery evolves into a self-sustaining economic expansion depends on whether businesses respond to firmer sales and better profitability by hiring and investing more actively. To date, there isn't much evidence that they are. At best, businesses are curtailing layoffs and no longer cutting back on orders for equipment and software.

No help wanted

Businesses' reluctance to expand is clearest with respect to jobs. More than 250,000 jobs were lost on net again in September, bringing total losses to nearly 8 million since employment peaked nearly two years ago (after accounting for upcoming revisions to the employment estimates). For context, the peak-to-trough decline in employment during and after the 2001 recession was about 2 million jobs.

Job losses have moderated since the beginning of the year, when they averaged closer to 700,000 per month, but this is entirely due to fewer layoffs; hiring continues to weaken. Unless hiring revives, job growth will not resume and unemployment will continue to rise, depressing wages and ultimately short-circuiting consumer spending and the recovery itself.

It is possible that firms will resume hiring soon. There is historically a lag between when production picks up and businesses hire. But in the past, during the gap between increased production and increased full-time hiring, businesses increased working hours and brought on more temporary employees. None of this has happened so far; hours worked remain stuck at a record low, and temp jobs are declining.

A more worrisome possibility is that firms are so shell-shocked that they won't resume hiring. Smaller businesses are struggling to obtain credit, and larger businesses are nervous about navigating the coming changes to healthcare, financial regulation and energy policy. Businesses may also wonder whether demand for their products will soon fade, given that the recent improvement is supported by the monetary and fiscal stimulus and an inventory swing, all of which are temporary.

More life support

Indeed, if monetary and fiscal policymakers do nothing more to support the economy, the stimulus effect will soon wane and by mid-2010 turn into a drag on the economy. Policymakers are expected to do more to ensure the recovery remains intact and that a self-sustaining expansion takes root by this time next year.

For the Federal Reserve, this may mean increasing its commitment to purchase Fannie and Freddie mortgage securities. The central bank's current commitment will end next March, but this seems premature given the rising number of foreclosures and the chance that many houses will be dumped onto the market next spring, forcing prices lower again. Without more Fed buying, mortgage rates are likely to rise at just the wrong time for the housing market and the broader economy.

For fiscal policymakers, this means at least extending provisions of the current fiscal stimulus package, such as expanded unemployment insurance benefits, higher conforming loan limits in higher-priced housing markets, accelerated depreciation and net loss carryback provisions for small businesses, and even perhaps the homebuyer tax credit. It may even mean another fiscal stimulus—although it won't be called that for political reasons—including help for state governments whose fiscal 2011 budgets will be even more troubled than this year's.

In coming months, Congress will also very likely pass three other pieces of legislation with far-reaching economic implications: healthcare reform, financial regulatory reform, and a bill addressing the expiration of the Bush tax cuts. Policymakers will need to be wary when fashioning this legislation lest they derail the economy's fragile recovery.

A slog through 2010

The Great Recession is over, but the current economic recovery will be a difficult slog through much of next year. Real GDP is projected to grow just under 3% annualized during the second half of 2009 but by no more than 2% during all of 2010. Weighing on the recovery will be high unemployment and weak wage growth, the ongoing foreclosure crisis, rising commercial mortgage loan defaults and resulting small bank failures, budget problems at state and local governments, and dysfunctional structured-finance markets that will limit credit to consumers and small businesses.

Policymakers are expected to provide just enough support to the economy to ensure the economy does not slide back into recession next year. This is the most serious threat to the outlook, as political pressure to not respond aggressively will be intense.

There are upside risks to the outlook as well. The main potential positives include a much stronger global economy than anticipated, due to the massive stimulus in many parts of the world and thus strong export growth, and a quicker revival in optimism among businesses and consumers than currently anticipated.

The outlook brightens for 2011 and 2012, when growth is expected to accelerate to between 4% and 5%. This will generate enough job growth to bring down unemployment, although it will be 2013 at the earliest before the economy returns to full employment.