Purdue: Ag Econ: Programs & Pubs: Prices: U.S. Economy

The expansion that began in December 2001 may be over. Perhaps a recession has begun. GDP growth slowed to one percent or less in the most recent three quarters. It’s grown just 1.8% over the past year. The unemployment rate is up a full point in the past year, to 5.7%. Rising oil prices have increased the inflation rate to its highest level since 1990, at 5.5%. The core rate, not counting energy and food, is also rising, but is still moderate at 2.5%. The Fed has reduced the federal funds rate from 5.25% to 2% over the past year. Both short and long term Treasury rates have fallen too. Housing is the main problem. Home prices have fallen, housing construction is off, and this has contributed to financial market problems and consumer cutbacks. Trade is the main bright spot. The falling value of the dollar has helped exports grow rapidly. Imports are falling—in real terms—though spending on imports has increased.

Gross Domestic Product
Real GDP grew only 1.8% from the second quarter of 2007 to the second quarter of 2008. Most of that growth came with a 4.8% increase the third quarter of 2007 (measured as an annual rate). Since then the economy has seen quarterly growth rates of -0.2%, 0.8% and 1.9%, in the fourth, first and second quarters, respectively. The fourth quarter decline was the first negative growth quarter since 2001. Real GDP growth has been slow.

The principle drag on growth was residential investment—housing construction—which fell 22% over the past year, almost 16% in the most recent quarter. The decline in residential investment has continued now for two-and-a-half years. The peak was in the fourth quarter, 2005. In the past year, though, consumer durable consumption has declined, and in the past quarter, business equipment investment has fallen.

Curiously, the decline in investment spending wasn’t general. Investment in business structures was the most rapidly growing component of GDP. The other big contributors to growth have been trade, with exports growing and imports declining (in real terms, anyway), Federal spending, and spending on consumer non-durable goods. Consumer spending got a boost in the second quarter from the tax rebates.

The tax rebate provided a one-time boost to consumer spending. Consumer spending rose at an annual rate of 1.5% in the second quarter, but averaged only 0.9% over the previous two quarters. Unless Congress decides to authorize another, the effects of the rebate are over. Consumers are very pessimistic, according to the University of Michigan’s index of consumer sentiment. The index was lower in June than at any time since the 1980 recession. Home prices are likely to continue to fall for another year, and this will be a drag on consumers as well. So will high expenditures on imported oil. Consumer spending will probably grow very little over the next year.

Investment in housing has been plummeting, but there are reasons to think that it has hit bottom (see below). While no growth is to be expected, the change from decline to no change eliminates a major drag on GDP growth for 2009.

Equipment investment has also been dropping. Slow consumer spending growth is unlikely to encourage firm expansion, so equipment investment growth is likely to remain sluggish. Capital goods orders are a leading indicator of equipment investment. They’ve been up and down. As of June they’re no higher than they were in 2006—but no lower either. Continued small declines in equipment investment might be expected.

Investment in business structures has been growing rapidly—12.9% over the past year. This seems unlikely to continue. Why invest in new strip-malls, for example, when consumers are spending less?

Overall, investment growth will be less of a negative in GDP growth in 2009, because housing is not likely to decline. Other investment, however, is unlikely to grow substantially.

Federal government purchases have been growing, defense at 5.9% over the past year, non-defense purchases at 2.4%. State and local purchases have been growing more slowly, 1.2% over the past year.

Defense spending depends in part on the course of the wars in Iraq and Afghanistan—beyond the expertise of an economic forecaster. Budget deficits and revenue shortfalls might restrain Federal non-defense purchases, and definitely will restrain state and local purchases. Slower growth in government purchases overall seems likely.

The falling value of the dollar makes U.S. exports cheaper and imports more expensive. The U.S. is selling more goods and services overseas. Exports grew 10.2% over the past year. And the U.S. is buying fewer goods and services from other countries. Imports fell 1.7% this past year. Measured after adjustment for inflation, the trade deficit got smaller. Measured in nominal terms, as a share of GDP, however, the trade deficit got bigger. The response of imports to price changes apparently has been inelastic—price has increased more than quantity has fallen. Import spending has increased.

The U.S. trade deficit is still enormous, which usually calls for a further drop in the value of the dollar. A falling dollar may not shrink the deficit in the short run, if imports respond inelastically. A smaller trade deficit is more likely in the long run, especially as consumers and businesses adjust their consumption to high oil prices.
The Fed is unlikely to reduce interest rates further, while central banks in other developed countries may. This should reduce the demand for other currencies, which could stabilize the dollar’s value.
China may see a need to stimulate its economy, and so may lessen the rate the yuan is appreciating. The dollar has been falling against the yuan more rapidly than usual in the past year.

Perhaps, then, the value of the dollar will continue to fall, but more slowly than in the past few years.

Economies in the rest of the world are expected to slow. This could reduce U.S. export growth. But a slowing U.S. economy should also reduce imports further.

Overall, it seems likely that exports will grow more slowly in 2009 than they did in 2008. Imports should continue to decline. Trade will provide a boost to the overall economy, but not as big a boost as in the past year.

Consumer spending will grow slowly. Residential investment may not be quite the drag on the economy as it has been, but equipment and business structure investment is likely to fall or grow slowly. State and local purchases will grow slowly, and trade won’t make as big a contribution as it has this past year. Expect real GDP to grow 2% from the second quarter of 2008 to the second quarter of 2009. This would be the third straight year of growth at 2% or less, but may not be slow enough to declare an “official” recession.

Housing
Home prices are falling. Standard and Poors’ Case-Shiller Index of prices in ten major markets has fallen 17% over the past year. The index peaked in June 2006 and has fallen every month since. The rate of decrease may be slowing, however. The index fell 2.8% in February, 2.4% in March, 1.5% in April and 1.0% in May, the most recent month with data.

How far do prices have to fall? One way to guess is to look at the ratio of the home price index to an index of rents. This is a kind of price-earnings ratio for housing, or more simply an index of real home prices, deflated with a housing-related price index. This ratio began rising in 1997. It accelerated in 2002, and peaked in 2006, having increased 60% in four years. The index has now given back more than half of that gain. At the rate it has been falling, it will be back to its early 2002 level within the next year.

Prices fall so homes can find buyers. There is evidence that new home sales have stopped falling. They peaked in July 2005 at 1.39 million (annual rate), then fell to 513 thousand in March 2008. That’s a 63% drop in 32 months. But new home sales were slightly above their March level in the next three months. Sales may have hit bottom.

If prices keep dropping, sales may begin to rise. If so, home builders may be encouraged to increase construction. That hasn’t happened yet, but it appears that construction activity has stopped falling. Single-family housing starts peaked in January 2006 at 2.27 million, then fell to one million in December 2007 (at an annual rate). That’s an average decrease of 3.5% per month. Since then starts have stabilized, averaging just over one million a month so far in 2008.

Likewise, building permits have stopped falling. They peaked in September 2005 and fell rapidly through March 2008. They’ve stopped falling since then.

It’s possible that housing construction has hit bottom. Home prices are likely to keep falling for another year, but this should encourage sales and may encourage the beginnings of an increase in construction activity. It’s unlikely that we’ll see another 22% decline in residential construction during 2008-2009.

Credit Crunch
Another year of falling home values is likely to mean continued problems in financial markets. Falling home values mean more defaults and foreclosures. Lenders with portfolios full of mortgage loans are likely to suffer losses.

Housing problems have caused a credit crunch. The spread between the three month commercial interest rate and the three month Treasury rate is a good measure. If lenders are skittish about prospects in the private economy, they’ll lend to the Federal government instead. Commercial interest rates rise or fall slowly, Treasury interest rates fall rapidly, and the spread between them gets big. This indicator shows the credit crunches during the savings and loan crisis of the early 1990s, and during the Long Term Capital Management crisis of October 1998.

This private-public spread leapt upward in August 2007 and has remained high since, by historic standards. The spread peaked in December 2007 and has been falling in fits and starts since then. Perhaps lenders are becoming marginally more confident, but private sector loans remain relatively hard to come by. The continued fall in home prices may mean that the crunch will continue for another year.

Unemployment and Inflation
The unemployment rate was 5.7% in July, down from 4.7% a year earlier. The unemployment rate has been rising sporadically. It saw two sizable three-tenth jumps in December 2007 and March 2008, and the biggest one-month jump in two decades—half a point—in May. Yet, in other months, the rate has held steady or even declined

Historically, a real GDP growth rate of about 3.4% is needed to hold the unemployment rate steady. With GDP growing only 1.8% over the past year, it’s no mystery that the unemployment rate increased. If GDP grows only 2% in 2008-2009, the unemployment rate will continue to rise. Expect the unemployment rate to rise to 6.2% by this time next year.

The inflation rate was 5.5% from July 2007 to July 2008. This is the highest 12-month rate since January 1991. The core rate, excluding energy and food prices, was only 2.5%. This is an increase from 2.1% at this time last year. Still, the huge jump in inflation is clearly due to rising energy prices.

Long term trends of expanding demand from China and India, stagnant supplies and potential supply disruptions in oil producing nations will maintain upward pressure on oil prices. A large price drop seems unlikely.
Slow growth or decline in many of the world’s economies should reduce demand for oil, moderating price increases.
The U.S. Energy Information Administration projects the price of crude oil to be $123 per barrel in 2009, and the price of gasoline to be $3.82. These are small increases from expected 2008 average values.

Oil and gasoline prices may rise some from current levels, but it seems unlikely that we’ll see another huge price jump, as we saw in 2007-08. Since inflation is a measure of price change, this will reduce the inflation rate.

The core rate of inflation should moderate, because of the slowing economy. There is no clear evidence yet that energy prices have lapped over into prices of other consumer goods and services. The Federal Reserve may increase interest rates to slow the economy further, should inflation show signs of increasing.

The inflation rate should drop considerably from its current 5.5% rate, towards the core rate. Expect the inflation rate to be 2.1% over the next year.

Monetary Policy and Interest Rates
The Federal Reserve reduced its federal funds interest rate from 5.25% in August 2007 to 2% in May 2008. It has remained at 2% since then. The Fed’s latest press release, on August 5, said “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.” It seems unlikely that the Fed will reduce interest rates further anytime soon. Inflation is too high for that. Big energy price drops might ease the Fed’s inflation concerns. More likely the Fed will stand pat, or possibly increase the federal funds rate during the next year.

The “Taylor Rule” equation, which relates the federal funds rate to the unemployment and inflation rates, predicts a 2% rate at the predicted levels of unemployment and inflation.

The economy is slowing. Interest rates usually fall in times of slow growth or recession, because loan demand drops.
The Fed may not cut or raise its interest rates much in 2009. This implies little change in interest rates generally.
Lenders are pessimistic, and further financial crises are possible. This implies higher risk premiums on private loans.

Inflation is up. Lenders must raise rates to compensate. Short term rates were below the inflation rate in July.

The three month Treasury rate was 1.6% in July. It usually rises and falls with the federal funds rate, at a level a few tenths below the federal funds rate. With inflation as high as it is, the gap between these rates seems likely to narrow. Expect a three-month Treasury rate of 1.8% by this time next year.