Months Nouriel Roubini and Christian Menegatti, 07.16.09 The U.S. economic outlook remains very weak.

Months
Nouriel Roubini and Christian Menegatti, 07.16.09
The U.S. economic outlook remains very weak.


The United States is in the twentieth month of a recession that has been by far the longest and most severe of the postwar period. While comparisons with the Great Depression are frequent and appropriate (especially if we look at the pace of contraction in industrial production), the aggressiveness of policy measures has significantly reduced the probability of a near-depression. Economic activity fell off a cliff in Q4 2008 and Q1 2009, with two consecutive quarters of sharp contraction--by 6.3% and 5.5% respectively--in line with our previous forecasts. The general consensus is that this recession will end sometime in the second half of 2009. While we expect more quarters of negative real GDP growth in 2009, we also expect the pace of contraction of economic activity to slow significantly. We forecast negative real GDP growth in Q2 2009 and Q3 2009, and for real GDP to remain flat in Q4. After the sharp contraction in economic activity in 2009, growth will reenter positive territory only in 2010, and then at a very sluggish rate, well below potential.

Even if economic activity stops contracting by the end of 2009, that might not mark the official end of this recession. Recessions are not measured exclusively by GDP contractions. Unemployment, industrial production, real manufacturing, wholesale trade sales and real personal income (less transfer) are all considered when it is time for the National Bureau of Economic Research (NBER) to put dates around recession periods. As reported by the NBER, this recession started in December 2007, and all the above indicators peaked between November 2007 and June 2008. U.S. real GDP will stop contracting at the end of 2009, but it is likely that many of the above indicators will not bottom out (or peak, in the case of unemployment) before mid-2010.

Improvements in real economic activity are present and visible in the reduction of the pace of job losses, in the improvement in indicators of manufacturing activity, in the stabilization of housing starts and in the improvement of financial conditions. However, we do not yet see signs of a strong and sustainable recovery.

Labor market conditions are still quite dire. More than 3.4 million jobs have been lost in 2009, and about 6.5 million have been lost since the beginning of the recession. Compare this with the 2.5 million jobs lost in the recession of 2001, 1.5 million lost in the recession of the early 1990s, 3 million in the one of the early 1980s and 2.2 million in the one of the 1970s. The pace of job losses has fallen from the 600,000-plus per month registered between December 2008 and March 2009 to about 350,000 in May and 467,000 in June; the average of monthly job losses in this recession is now at about 360,000. While the recent slowing of losses is a positive development, we have to put this in perspective: In previous postwar recessions, average monthly job losses ranged between 150,000 and 260,000. Moreover, average weekly hours in private non-farm payrolls are at the lowest since 1964, as employers have cut employees' hours. Job openings and turnover openings continue to fall and are at the lowest levels since 2000, indicating continued weakness in the economy.

The U.S. consumer is still the engine of U.S. growth and contributes over 70% of aggregate demand. While saving rates are headed for the high single digits and high oil prices together with long-term rates keep putting a dent in personal consumption, the over-leveraged consumer is finding some support in the tax breaks of the fiscal stimulus package. Yet the over-indebted U.S. consumer--whose deleveraging process has yet to start--will likely continue to put the brakes on consumption, while the savings rate continues to creep up. While this will encourage a rebalancing in the U.S. and global economy, in the medium-term it isn't likely to support strong U.S. and global growth.

Housing starts appear to have stabilized and will likely move sideways for quite some time. However, housing demand is not yet improving at a pace that can guarantee that the lingering inventory overhang will dissipate. This implies that home prices will continue to fall. We expect home prices to continue to fall through mid-2010.

U.S. industrial production has been contracting for 17 months in a row--with a short break in October 2008. Industrial production usually finds a bottom shortly after the ISM manufacturing index does. While the index probably found its bottom back in December 2008--at depression levels of 32.9--industrial production remains in a mode of contraction that started in January 2008.

Financial conditions are showing some improvement. Banks are borrowing at zero interest rates, and higher net interest margin can definitely help rebuild capital. Regulatory forbearance, changes in FASB (Financial Accounting Standards Board) rules and under-provisioning might enable banks to post better-than-expected results for a few quarters. However, relaxation of mark-to-market rules reduces the banks' incentives to participate in the Public-Private Investment Program (PPIP) and therefore reduces the likelihood that the program will succeed in clearing toxic assets from banks' balance sheets. The "muddle through" approach might be successful in a scenario in which the U.S. and global economy recover soon and go back to potential growth during 2010, but according to our forecasts, this is highly unlikely. While we might have positive surprises coming from the banking system in the next couple of quarters, the situation could turn around again after that, jarring confidence in financial markets in a way that would spill into the real economy. Increases in the unemployment rate, well beyond the rates envisioned by the adverse scenario of the recent bank stress tests, imply that recapitalization needs are larger than what the too-lenient stress test prescribed. The U.S financial system--in spite of the massive policy backstop--thus remains severely damaged, and the credit crunch remains unlikely to ease very fast.

A sharp rise in public debt burden--the U.S. Congressional Budget Office estimates that the public-debt-to-GDP ratio will rise from 40% to 80% (in the next decade), or about $9 trillion--will also put a dent in growth. If long-term rates were to increase to 5%, the resulting increase in the interest rate bill alone would be about $450 billion, or 3% of GDP. The implication is that the fiscal primary surplus will have to be permanently increased by 3% of GDP, which could constitute further pressure on the disposable income of the U.S. consumer.

Not only does the U.S. economy face downward risks to growth in the medium term, but potential growth might fall as well. The U.S. population is aging. With employment still falling--and another jobless recovery on the horizon--the rate of human capital accumulation will fall. Moreover, workers who remain unemployed for a long period of time lose skills, while young workers that enter the workforce, but don't find a job, don't acquire on-the-job skills. Reduced investments in worker training and education, coupled with lower capital expenditure, are a recipe for lower productivity ahead.

Deflationary pressures are still present in the U.S. economy. Demand is falling relative to supply, and excess capacity is still promoting slack in the goods markets. Moreover, the rising slack in labor markets, which is pushing down wages and labor costs, implies that deflationary pressures are going to be dominant this year and next year. This suggests that the Fed will keep monetary policy loose for a while longer. However, discussion of an exit strategy has to start now as investors' concerns about the Fed's ballooning balance sheet and expectations of inflation both mount.

There are also signs that a double-dip recession could materialize toward the second half of next year, or in 2011. If oil prices rise too much, too fast and too soon, that's going to have a negative effect in terms of trade and real disposable income in oil-importing countries. Also, concerns about unsustainable budget deficits are high and are pushing long-term interest rates higher. If these budget deficits are going to continue to be monetized, eventually, toward the end of next year, there is a risk of a sharp increase in expected inflation that could push interest rates even higher. Together with higher oil prices, driven up in part by this wall of liquidity rather than fundamentals alone, this could be a double whammy that would push the economy into a double-dip or W-shaped recession by late 2010 or 2011.

In conclusion, the outlook for the U.S. economy remains very weak. The recent rally in global equities, commodities and credit may soon fizzle out as worse-than-expected earnings and financial news take their toll on this rally, which has gotten ahead of improvements in actual macroeconomic data.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics (RGE), is a weekly columnist for Forbes. Read more of his columns here.Christian Menegatti is head of global economic research at RGEMonitor.com.