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Thread: Recession Looms for the U.S. Economy in 2007 (pdf)

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    Mar 2006
    Boston, Mass.

    Default Recession Looms for the U.S. Economy in 2007 (pdf)

    Recession Looms for the U.S. Economy in 2007 (pdf)
    November 2006 (Dean Baker) Center for Economic and Policy Research

    The recovery that began in November of 2001 is likely to come to an end in 2007. The main factor pushing the economy into recession will be weakness in the housing market. The housing market had been the primary fuel for the recovery until the last year, as there was an unprecedented run-up in house prices since 1997. With prices now headed downward, construction and home sales have dropped off by almost 20 percent against year ago levels. Even more importantly, borrowing against home equity, which had been the main factor fueling consumption growth, will plummet as many homeowners lack any further equity to borrow against. The result will be a downturn in consumption spending, which together with plunging housing investment, will likely push the economy into recession. The economy will see a substantial net loss of jobs, with nominal wage growth slowing as the labor market weakens over the course of the year.

    AntiSpin: The folks over at CEPR, and Dean Daker in particular, have been realists throughout the tech stock and housing bubbles. This analysis is as compelling as any they have produced, and of course I agree with the prediction of a recession in 2007. This excellent analysis raises a few questions.

    Let's summarize the main points and address them:
    • This recovery has been fueled to a very large extent by a housing bubble.
    The housing bubble and federal government spending.
    • Based on past patterns, it is reasonable to expect a drop in output in the housing sector from its 2005 peaks of at least 40 percent.
    40% sounds like as good a number as any. Expect a downside over-shoot as the housing market reverts to the mean.
    • It should reach this bottom by the end of 2007 or early 2008 at the latest.
    The iTulip Jan. 2005 housing correction analysis predicts a 10 year correction starting from the peak of Q3 June 2005. It's possible that most of the price declines happen as quickly as projected by CEPR, and bottom three years into the down cycle, and take another seven or more years to get back to where they were in 2005 by, say, 2015.
    • The wealth effect created by the housing bubble fueled an extraordinary surge in consumption over the last five years, as savings actually turned negative. The run-up in prices created $5 trillion in excess housing wealth. Conventional estimates of the size of the housing wealth effect imply that this wealth would have generated an additional $200-$300 billion of consumption (1.6-2.3 percent of GDP). This home equity-fueled consumption will be sharply curtailed in the near future.
    With $50 of consumption generated per $1,000 of housing wealth on the way up, assume optimistically a reduction of, say, half or $25 per $1,000 on the way down over a year. That represents an approximate $100-$150B decline in consumption by the end of 2008.
    • Homeowners will also be hit by the resetting of more than $2 trillion in adjustable rate mortgages in 2006 and 2007. There also will be an increase in default rates, as many homeowners will be unable to meet mortgage payments and unable or unwilling to sell their homes.
    This will also tend to be concentrated in California and other areas where ARMs and other products were heavily sold at the top of the housing bubble.
    • The savings rate is no longer declining. It is likely to begin rising in the near future, and will almost certainly have moved into positive territory by early 2007. This means that consumption growth will be trailing income growth.
    Indeed consumers are cutting back on revolving credit as a proportion of income–in other words, they are starting to save. Blame Suze Orman and Ben Stein.
    • Investment spending has weakened in recent months, following the slower growth in consumption.
    Firms have been cautious throughout this so-called recovery and will get considerably more careful as signs of recession start to crop up.
    • The slowdown in the U.S. economy should lead to a modest improvement in the trade deficit, assuming that there are no major adjustments in currency prices and that oil stays near its current price.
    "No major adjustments in currency prices and that oil stays near its current price" are two big asks in this prediction.
    • Government spending is likely to make somewhat more of a contribution to GDP growth in 2007, primarily due to the relatively rapid growth of state and local spending.
    Government spending will certainly contribute more relative to private industry due to the end of the housing bubble that has represented the bulk of private employment growth since 2001.
    • The growth of federal spending is likely to slow due to pressures to limit the size of the deficit and possibly some reduction in the size of the forces o ccupying Iraq. Federal spending will grow at a 0.7 percent rate in 2007, with real defense spending increasing by 0.2 percent and non-defense spending rising at a 1.8 percent rate. This will lead to an overall increase in government spending of 2.2 percent.
    This is the big wild card. History shows that, paradoxically, a new Democratic Congress tends to try to prove how fiscally conservative it is, to buck its reputation for over-spending.
    • The decline in GDP will lead to a substantial drop in tax revenues. As result, the deficit in fiscal year 2007 will be $370 billion. It will rise to $460 billion in fiscal year 2008.
    This, combined with a resolution–one way or the other–to the Afghanistan and Iraq War will have a considerable impact on interest rates and the dollar.
    • The rate of job growth has slowed sharply over the course of 2006. The economy was creating jobs at a healthy rate of 230,000 per month in 2005. As consumption growth falls off, there will be reduction in employment growth in other sectors. This downturn is already visible in manufacturing, which has lost 55,000 jobs from July to October. Retail trade has also been shedding jobs, with employment down by 63,000 year over year. Much of this job decline is attributable to consolidation within the industry, but it is likely that slower demand growth will lead to continuing job losses even as the impact of the consolidation diminishes. Slower consumption growth will likely also curtail the growth in employment in restaurants, a sector that added 292,000 jobs over the last year. The health care sector, which added 300,000 jobs in the last year, is likely to sustain a healthy pace of job growth, as is the government sector, which added 230,000 jobs.
    Again, if we end 2008 with many of us in the States working for the State or Federal government, some corporation that depends on government spending such as General Dynamics, or some pharma company or hospital, what does that mean for the bonar and interest rates?
    • Over the course of the year, the economy will shed 1.2 million jobs. The greatest job loss will be the housing related sectors, construction, real estate, and mortgage banking, but most sectors are likely to be affected by the drop in output.
    No doubt. A lot of these folks came out of the technology industry after the bust. Whither the 1999 dot com product manager post housing bubble?
    • There will be important forces pushing inflation in opposite directions in 2007. The higher unemployment rate and resulting downward pressure on wage growth will help to ameliorate inflation. Similarly, the oversupply of housing and the record high vacancy rates will lead to downward pressure on rents. The rental components account for more than 30 percent of the overall consumer price index and almost 40 percent of the core index, so a slower rate of rental inflation will have a substantial impact on the overall index.
    The pushme-pullyou of inflation will have less to do with rents than mortgage costs, and that will be a function of foreign demand for US financial assets.
    • On the other side, productivity growth has slowed sharply over the last year. Productivity rose by just 1.3 percent from the third quarter of 2005 through the third quarter of 2006. This is down from a growth rate of more than three percent in 2001-2004. This number will be revised down by approximately 0.2 percentage points after the benchmark revision to the establishment survey. In addition to slower productivity growth, import prices are likely to stay on an upward path in 2007.
    Increased federal and state government employment as a proportion of total employment does not bode well for improvements in productivity.
    • Non-oil import prices had been falling earlier in this cycle. However, with most other economies growing rapidly and the dollar falling at least modestly against other currencies, we are likely to see some further increase in the inflation rate in non-oil imports.
    And likely oil imports as well, depending on how things work out in Afghanistan and Iraq.
    • On net, the inflation rate is likely to moderate slightly in 2007 as the impact of slower wage growth and rental inflation more than offsets the impact of slower productivity growth and higher inflation in import prices. The core and overall CPI inflation rate should both average 2.6 percent over the year, with both easing downward from their current rates over the course of the year. Rental inflation is likely to end the year at just over 2.0 percent, driven down by the record high vacancy rate.
    It's possible that inflation will net out this way, but lower productivity, a higher dependence on government for employment, and a falling dollar will create a strong inflationary bias.
    • The Fed will be torn between the desire to slow inflation, which will remain slightly above its target range, and the need to boost the economy.
    Managing interest rates and the economy through stagflation is a bitch.
    • With the economy's weakness becoming evident by the end of the year, the Fed is likely to begin lowering rates no later than its first meeting in January. However, just as raising the Federal Funds rate had little impact on the 10-year treasury rate, lowering the Federal Funds rate is likely to have little effect in lowering rates, especially in a context in which the bond market seems to have already anticipated a drop in interest rates.
    The last bond bull market, as Bill Gross has warned.
    • By the end of the year, the Fed will likely have lowered the Federal Funds rate to close to 4.0 percent. However, investors are likely to be more concerned about the prospects of a falling dollar as rising interest rates in Europe, Japan and elsewhere make foreign currencies more attractive. For this reason, the short-term and long-term rates will move in opposite directions. The 10-year treasury rate is likely to end the year close to 5.2 percent, which would still be relatively low by historical standards in both nominal and real terms.
    The bonar will be the headline issue all next year as the US goes into recession and the its trading partners react.
    • Both the euro and the yen will appreciate modestly against the dollar, with the dollar worth 0.77 euros and 105 yen by the end of the year. This analysis assumes only modest appreciation of the yuan (about 2 percent) against the dollar. If the Chinese government allows for more rapid appreciation, then long-term interest rates in the United States could be considerably higher.
    The Chinese government will not allow for more rapid appreciation but the euro may rise until the EU needs to prints euros to buy dollars, in which case gold ends 2007 over $800.
    • The ability of the economy to recover from the 2007 recession will depend both on how quickly the imbalances are corrected (the housing bubble and the over-valued dollar) and the direction of the policy response. The Federal Reserve Board will have to choose whether to fight the risk of inflation associated with a declining dollar (which is essential for correcting the trade imbalance) or whether to provide stimulus to counterattack the slump brought on by the collapse of the housing bubble. Since there may be no consensus for either path, it is very possible that it will end up in an intermediate position where it lowers interest rates modestly, but does not act to aggressively counteract the slump.
    Again, I do not envy the Fed next year. 2007 will be the year when all the policies of the last ten years or so finally produce undeniable stagflation. A high rate of unemployment with stable prices or more modest unemployment less modest inflation? Tough choice going into an election.
    • Fiscal policy could be subject to a similar paralysis. It would be reasonable for Congress to enact a stimulus package including tax cuts and/or spending measures to counteract the slump; however, concern over the size of the deficit could prevent effective action. If political factors prevent effective monetary and fiscal measures, then a slump caused by the collapse of the housing bubble could be prolonged considerably.
    The Dems will be overly conservative, and will not act until the economic pain becomes quite palpable. The pain will come relatively slowly, as declining housing bubbles are slow compared to collapsing stock market bubbles. I don't expect any action from Congress until Q3 2007 at the earliest.

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    Last edited by FRED; 12-12-06 at 07:31 AM.



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