You call this a recession?

Standard & Poor's takes a look at the current status of the US economy.
The surprise Federal Reserve rate cut last week and the apparent agreement on a stimulus package helped brighten the outlook for the economy and financial markets, but it may be too late to avert recession. Standard & Poor's has revised its forecast to include the new stimulus package and the quicker Fed rate cut. We now expect the Fed to cut rates to 2.5% by spring. Economic releases included:

+ Sales of existing homes fell 2.2% to 5.89 million in December.

+ The Congressional Budget Office projected a $219 billion deficit for fiscal 2008. However, when the costs of Iraq (another $30 billion) and the stimulus package are added, the deficit will be near the 2004 record of $413 billion.

+ Washington has apparently agreed on a $150 billion package of tax cuts, centered on rebates paid back to taxpayers and investment tax breaks for businesses.

+ US initial jobless claims fell by 1,000 to 301,000 in the week ended January 19. Continuing claims dropped by 75,000 to 2.672 million in the week ended January 12. The insured unemployment rate ticked back down to 2.0%. The January drop could imply that labour markets are not as soft as December indicated, or could just suggest that since retailers didn't hire in December, they don't have to lay off in January.

+ Oil prices recovered to $90/bbl (West Texas) on Friday.

+ The 10-year Treasury yield rose to 3.65%, but remains well below the 4.25% reached in early December. The dollar held near $1.468/euro and 107.3 yen. Stock prices rose sharply on the Fed cut and the stimulus package.

+ The Fed cut the federal funds rate 75bp before the opening of trading on January 22, amid concerns about the declines in overseas markets Monday and Tuesday morning.

Is This A Recession?

The economic data continue to point downward, but not consistently and not drastically. Our interpretation is that we are at the beginning of a mild recession, which looks on the underlying fundamentals to be similar to the
1991-1992 downturn. The weakness in housing is spreading into commercial construction and business equipment spending. The signs of a consumer slowdown are less clear, but the evidence suggests consumers are being squeezed
by falling home prices and high gasoline costs.

The freeze in financial markets, however, is showing signs of easing. The Libor rate has dropped back down to 3.3%, below the 3.5% federal funds rate. Libor remains high relative to the three-month Treasury bill rate, with a
spread of 93bp, but that is half what it was three months ago. Moreover, much of the cause is that the T-bill rate is low relative to federal funds, as the flight to quality has cut government bond yields.

Quality spreads remain high, with speculative-grade corporate bonds trading 660bp above equivalent Treasuries. Again, this is in part due to the low Treasury yields, with the 10-year at 3.7%. But the cost of funds to
all but the highest-rated borrowers remains far above where it was the middle of last year.

Mortgage rates have dropped down to the lowest level since 2004, with the 30-year conventional rate at 5.7%. But this only applies if the borrower qualifies for a conventional loan. Jumbo mortgages, even for prime borrowers, are running one percentage point above conventional mortgages, compared with a normal spread of about 25bp. The stimulus package contains some help for the jumbo market.

Besides capital spending, the major offset to last year's housing weakness was the improvement in the trade deficit. With Europe and Japan showing weaker growth, exports are likely to slow in 2008. However, the dollar remains
weak, and we expect the deficit to continue to narrow ù just not by quite as much as in 2007.

Stimulating The Economy: The Fed

Both fiscal and monetary stimuli are being applied to the economy. The Federal Reserve unexpectedly cut the federal funds rate 75 bps Tuesday before trading opened after the Martin Luther King Jr. holiday to 3.5%. The wording in the statement suggests further rate cuts are imminent. At this time, we expect another rate cut this week followed by a March cut, bringing the federal funds rate down to 2.5%.

The problem with monetary policy is the lag. The emergency rate cut was a confession by the Fed that they are behind the curve and are trying to catch up. The timing surprised us; we had expected a 75bp cut at the meeting this week. The melt-down in world stock markets last Monday, which continued into Tuesday in Asia, convinced them to move quickly to short-circuit the collapse. The tactic appeared to work, as stock indexes recovered from overnight lows in the futures market and soared in the afternoon. (An interesting question is whether last Monday's collapse in stock prices was influenced by the unwinding of Societe Generale positions. Since we don't know exactly how big the underlying positions were, only the total loss, or what indexes they were concentrated in, it is impossible to determine how big a factor they might have been.)

But even with this earlier action, the impact on the real economy comes only after a lag of about nine months; in other words, what the Fed did this week will help the economy in October, after the recession will be over. The cuts
did help stop the stock market slide, and can make the recession shorter and shallower, but it is too late for monetary policy to prevent the recession.

Stimulating The Economy: Congress

Fiscal policy operates with a much shorter lag. The usual problem with fiscal policy is that by the time the government is aware there is a problem, proposes action, and then gets a program through Congress, the recession is
usually over. Historically, fiscal policy has usually been counterproductive, because the stimulus gets applied only while the economy is already in a strong recovery mode. The major exception was 2001, where the stimulus was
largely accidental as a result of the 2001 tax cuts, but hit during the summer, when it was most needed.

This time, we may actually get it done fast enough. The House leadership and the Administration have agreed quickly on a $150 billion package of tax cuts, including roughly $100 billion in tax rebates and $50 billion in investment incentives for businesses. The core would be a replay of the tax rebate checks sent out in 2001, but somewhat more focused on below-median incomes, since the rebates will be phased out for incomes over $75,000 ($150,000 per couple). The extra $300 child allowance pushes the rebates more towards people with children. Unless the Senate delays the passage, we would expect this to get through by mid-February.

Even so, checks are not likely to get written until May at the earliest, given Treasury delays. We assume the rebates will be split between the second and third quarters, with the bulk of the additional spending coming in the third
quarter. There is obviously a possibility that the spending could come more quickly if the checks make it out earlier, but we are being deliberately conservative.

We would expect this to have an impact similar to the 2001 rebates, when about 60% of the money was spent within 60 days. We have toned down the expectations slightly here, on the assumption that spending may be deferred because some people will need the money to pay the mortgage. But insofar as that happens, it should help moderate the problems in the housing market, which also helps the economy. We think we are being conservative in this assumption. We see no evidence that people are less willing to spend than they were seven years ago; indeed the savings rate is much lower today than going into the 2001 recession. We expect consumer spending to rise 2.1% in the second quarter and 4.1% in the third (in constant dollars); without the rebate, spending would have been nearly flat.

Some commentators have suggested that this time people will save the money. Apparently they believe Americans have all converted into savers instead of spenders. We may be a little more rational and save more money than we did in 2001, but the evidence so far is against that expectation. My assumption is that these commentators have never lived with an American consumer.

The impact of the business tax cuts is less clear, in part because the tax cuts themselves haven't been fleshed out completely. We assume these will be accelerated depreciation, which actually gives a bigger "bang for the buck"
than rebates, because the extra tax allowances provided for this year will be partially recouped in subsequent years.

However, business decisions take longer than the consumer grabbing his rebate check and heading off to Best Buy. Most of the additional spending is likely to come in the fourth quarter, assuming that, as in the past, the equipment
has to be in place by year end to get the incentive. Moreover, much of the incentive will go for purchases that would have been made anyway.

Because the business taxes will impact spending later, most of the budget effect of the business tax cuts will be seen in fiscal 2009 rather than fiscal 2008. This moderates the impact on the fiscal 2008 deficit, which we now expect to come in near the record $413 billion deficit of fiscal 2004.

The plan also temporarily raises the limit on mortgages for loans made by Fannie Mae and Freddie Mac to the lesser of $725,000 or 125% of regional median home price. Exact details remain to be worked out. This should make it
easier to refinance large mortgages, although that market has calmed down a bit anyway. The help is most needed in the high-priced markets, such as Los Angeles, San Francisco and New York.

The Economic Result

Our forecast for 2008 now begins with a slightly negative first quarter, with the economy then bouncing higher in the second and third quarters (growth of 1.2% and 1.9%, respectively). The fourth quarter turns negative, because the rebates have already been spent by then. The business investment increases are not sufficient to offset the drop-off in consumer spending power. The year looks much like 2007, with weakness in the first and last quarters and strength in the middle û just more so.

The Federal Reserve continues to lower interest rates, bringing the federal funds rate down to 2.5% by the April meeting. Bond yields gradually rise from their current level, as fear of a deep recession wanes, but the 10-year yield
remains under 4% through year end. The stock market recovers to close the year near 1,540 points (S&P 500).

Whether this will count as a recession depends on the decision of the National Bureau of Economic Research Business Cycle Dating committee. The period looks a lot like 2001, however, which they did call a recession. My guess is that this will also be called one.

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