Hitting Bottom Is Inevitable, Subsequent Pace of Growth Is the Real Concern

Given the length and depth of the current recession, it is natural for analysts to start looking for a bottom. In such an environment, bad news will be ignored while the seemingly good news is overblown. For example, the most recent initial unemployment claims report indicates that labor markets continue to deteriorate; we have yet to see a turning point consistent with improved conditions. Likewise, the durable goods report was heralded as a positive sign, but the jump in this volatile series needs to be taken in context of the severe drop the previous month. The chart (click to enlarge) of nonair/nondefense new orders is not particularly encouraging:

That said, things will eventually get less worse, if only because some sectors, such as new residential housing, will hit a bottom. And that bottom is not likely to be zero, and, I suspect, that bottom will be late this year or, at worst, early next year. That should not, however, be confused with an optimistic outlook, as the durability and strength of the eventual recovery is in doubt. I am confident that the economy will not spiral downward endlessly; I am more worried that the we will be left at a suboptimal equilibrium chiefly characterized by low growth and persistently high unemployment.

San Francisco President Janet Yellen outlined the "optimistic" case in a speech Wednesday:

However, I am well aware that my views are strikingly more optimistic than those I hear from the vast majority of my business contacts. They tend to see conditions as dire and getting worse. In fact, many of them can’t believe I would even suggest what they see as such a patently rosy scenario! So why is it that so many of us who prepare forecasts seem to be more optimistic than many others? I think there are several reasons. First, as forecasters, we distinguish between growth rates and levels....Second, it takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today’s very low levels—not a robust performance at all—a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point...

The key point, often lost to the general public, is that data patterns can quickly reverse when the economy hits bottom. Still, job growth can remain largely nonexistent, similar to the 2001-2003 period. Next:

Third, policies are in place that could jump-start the economy, including the fiscal stimulus package, the Administration’s housing program, and a growing list of Federal Reserve and Treasury credit programs that aim to improve financial market function and the flow of credit.

A significant amount of stimulus will be flowing into the economy, and while it is not enough to fill the output and credit gaps, it is not negligible. Finally:

Finally, at some point, negative feedback loops can turn positive. For example, if federal government and Federal Reserve policies were to jump-start the economy, credit losses of financial institutions could diminish and lenders might increase the supply of credit available to finance spending. More credit, and better consumer and business confidence, could further boost the economy and employment, which would feed back positively on credit conditions. In other words, the negative feedback loop that is currently in play could be replaced by self-reinforcing positive dynamics.

I am less optimistic that negative feedback loops will soon turn positive. Again, while the amount of stimulus flowing into the economy is significant, credit worthiness looks to be deteriorating at a faster rate. As noted early, the employment picture is not yet turning rosier (Yellen expects unemployment to rise into 2010), households are already choking on debt, and, as reported in the Wall Street Journal, commercial real estate loan delinquencies are rising. I suspect that Richmond Fed President Jeffrey Lacker is close to the mark when he said yesterday:

One popular notion is that the credit market disruptions we have seen over the last year or so impede the financial sector's ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending. But causation can flow in the opposite direction as well. When overall economic activity seems poised to contract, the outlook for household income and business revenues deteriorates as well, and borrowers become less creditworthy, all else constant. Moreover, consumer and business demand for lending declines when they cut back on discretionary outlays. My reading of current conditions is that the economy is holding back credit markets much more than credit markets are holding back the economy.

The lack of creditworthy borrowers, especially considering more reasonable underwriting standards, strikes me as a significant impediment to the Fed's plans for restarting securitization markets via TALF. (Lacker also looks for positive signs, notably the recent retail sales data, and appears more optimistic, but like Yellen highlights downside risks). That said, the willingness of monetary and fiscal authorities to pump massive amounts of money into the financial sector has staved off a collapse - and thus created another sort of bottom.

Still, despite the prospects for bottoming, the key in my mind remains the subsequent path of activity. On that Yellen says:

...for some time to come, disinflation, and even deflation, will represent greater risks than inflation. With economic activity weakening, economic slack is likely to be substantial for several more years. We need to be sure that we avoid the kind of deflation that Japan experienced during its lost decade. While I don’t think such an outcome is likely, it should be on our list of concerns.

Likewise, I am not optimistic on the longer term. The US economy is suffering the aftereffects of a credit bubble, and this will have lingering effects on the growth path. This is especially the case given the depth and breath of the global downturn; indeed, few others are pursuing stimulus as aggressively as the US, promising to prolong US weakness with continued pressure on exports.

In short, analysts should be looking for the bottom, and it would not be a surprise to get a strong bounce in the data soon after hitting the bottom. But I think sustaining that bounce will be difficult. Expectations of a rapid return to sustainable, high growth path are likely to be met with disappointment. Hitting the bottom is inevitable. It is the subsequent pace of growth that should be the focus of concern.

Comments

[William Cowie:]

Something that may put a damper on the recovery: many consumers are deliberately scaling back their debt-driven consumption. That's a lifestyle or cultural shift, going much deeper than just waiting for some money to go on a shopping spree again. Several analysts have observed that a reason banks aren't lending more is people aren't applying for loans like before.

Mar 27 08:58 AM

[Carlos Lam:]

Tim, excellent article, but you seemingly ignore a big factor: the purchasing power of the U.S. dollar.

FACT: The Fed has expanded its balance sheet and and -- with the TALF -- is monetizing the debt

FACT: The federal government's debtload is now $11 trillion (not including the liabilities for Social Security & Medicare)

FACT: U.S. household debt as a % of GDP is just under 100%

These facts and more have to weigh on the dollar's value. The more the dollar's value drops, the more dollars it takes to buy given commodities, be they gold, oil, or coffee. I see the possibility of "stagflation" returning. Growth will be slow and yet -- due to a declining dollar -- one's cost of living will rise.

Mar 27 11:00 AM

[Larry House:]

Thanks for your good analysis. Cetin, what do you know that the rest of us don't know?

Mar 27 11:55 AM

[CJJ:]

Where do you see all this good news and people ignoring bad news? I'd say things are much closer to the exact opposite of that statement.

I'm unsure how someone writes and article with a statement like that. Consumer confidence, CEO confidence, Manufacturer confidence levels are all at ALL TIME LOWS.

What the heck am I missing? You want to resubmit your article without that ridiculous statement.

Sorry that people aren't all miserable like you and try to see some positives. But come on, overall the news is BAD BAD BAD.

Mar 27 01:44 PM

[@TexasER:]

I don't believe the all of the bad news was priced in at the most recent low. The fundamentals are unbelievable bad across the board. The problem is that they are so unbelievable...well people don't believe them.

Pilots are trained that their first step when an engine fails is to suspend their disbelief. It is a universal and natural human reaction.

Mar 27 03:24 PM

[Adrienne Go...:]

Janet Yellen has no idea what she is talking about.

Lacker and Plosser are the only ones over there with their heads screwed on straight and even they take an overwhelmingly moronic stance now and then - and certainly one dissenting vote can't stop Ben Bernanke from dropping the WMDs on the dollar.

But I agree with previous comments... buck up, kiddo! Things aren't THAT bad! Unless we continue to operate as we have (blindly, ignoring inflation, blah blah blah), in which case... buckle up, it's going to be a bumpy ride!

Mar 27 05:12 PM

[Mayascribe:]

Wakeup: The family relationships you speak of that are being eroded were probably family relationships that were weak to begin with. I see young adults, just out of college, moving home to save money. I see my family communicating now more than ever. I see tough times actually making the family unit stronger and more important than the good times enjoyed just a few years ago. In general, tough times bring people closer together. That is, perhaps, one of the single most positve impacts this screwed up economy is giving us.

Mar 28 04:16 PM

[GaryCamaril...:]

I see all that Mayascribe says mirrored exactly in family profoundly and I had been completely overlooking this wonderful dynamic.Gary Camarillokie

Mar 28 04:49 PM

[Carlos Lam:]

On Mar 28 04:16 PM Mayascribe wrote:
> I see my family communicating now more than ever. I see tough times
> actually making the family unit stronger and more important than
> the good times enjoyed just a few years ago. In general, tough times
> bring people closer together. That is, perhaps, one of the single
> most positve impacts this screwed up economy is giving us.

You make an excellent point. When times are tough, family members tend to rely on one another to muddle through. It's a form of "economic stabilizer" that most central planners (i.e. bureaucrats, Fed policymakers) totally ignore. The current economic problems may be decimating financial capital but are certainly creating a lot of SOCIAL capital. My brother-in-law, for example, has lived with us since the fall, paying only $200/month room and board and doing the occasional babysitting. County clerks have noted that divorce filings have fallen due to the bad economy; it will be interesting to see if divorce filings are permanently affected.

Mar 29 07:41 AM