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		The Global Economics Team

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We do still think, however, that there is a good chance that there will be further action on the discount window to more directly address the pressures in the interbank lending market. We look for a 50bp cut in the discount rate to 4.50% and a further extension in available loan terms to 90 days from 30 days.

For the week, benchmark Treasury coupon yields rose 7-19bp, with the long end hit particularly hard, leading to a significant curve steepening. The 2-year yield rose 7bp to 3.12%, the 5-year 9bp to 3.50%, the 10-year 15bp to 4.11%, and the 30-year 19bp (a more than 3-point price plunge) to 4.585%. Just about all the steepening occurred in a big front end-led rally to start the week Monday that didn’t have any particularly obvious triggers. As these gains were sharply reversed over the rest of the week, mostly in big losses Thursday and Friday, the longer end suffered as much as the shorter end, leading to no reversal of Monday’s bull steepening as the market reversed course. Even as oil prices ended very little changed for the week (with January crude oil dipping to US$88.28 from US$88.71), TIPS performed horribly, with the benchmark 5-year inflation breakeven falling 11bp to 2.15% and the 10-year 8bp to 2.26%. The solid run of initial November data (and perhaps also a bit of optimism about the subprime reset freeze plan) led the market to significantly scale back near and medium-term Fed rate-cutting expectations, with most of the adjustment in response to the solid employment report. Looking to Tuesday’s FOMC meeting, a 3bp sell-off in the January fed funds contract to 4.185% cut the odds of a 50bp rate cut to about 25% from 40%. That still seems quite high to us after the employment report, but admittedly the Fed did surprise us and most everyone else by cutting 50bp instead of 25bp in September. Meanwhile, the February contract only lost 1bp to 3.99%, so whether it’s 50bp Tuesday and a pause or 25bp then another 25bp in January, the market made essentially no adjustment in its firm expectations for a 4% funds target after the January 29-30 FOMC meeting. The April contract lost 4bp to 3.84%, and the May contract 8bp to 3.72%. Eurodollar losses were long end-led, in line with the Treasury curve steepening, though there were also sizeable losses at the short end as the market built in current LIBOR pressures remaining worse for longer, with the Mar 08 contract losing 23.5bp to 4.405% and the Jun 08 contract 21.5bp to 3.945%. On the other hand, while the front Dec 07 contract did sell off 14bp to 4.985%, it is still building in a meaningful pullback in 3-month LIBOR in the ten days remaining before this contract settles. Looking a bit further out, the reds (Dec 08 to Sep 09) lost 16-19bp, with the low-rate Dec 08 contract closing at 3.625%.

Risk markets had a modestly positive week to extend the improvement seen since the recent lows right before Thanksgiving, continuing to leave the badly stressed interbank lending market as the major focus of current financial market worries, though trading conditions in asset-backed commercial paper have also seen a substantial recent renewed deterioration as well. The S&P 500 rose 1.6% on the week to move above 1500 for the first time in a month, having now rallied 6.2% since the pre-Thanksgiving close on November 21. In afternoon trading, the 5-year HiVol CDX index was 2bp better on the week at 200bp and the investment grade index flat at 76bp, representing 25bp and 8bp of tightening, respectively, since November 21. The high yield index was 22bp better on the week at 471bp through Thursday’s close and the index was trading narrowly either side of unchanged through the day Friday, while the leveraged loan LCDX index had improved a slight 5bp on the week to 311bp midday Friday. Although an initially very positive reaction Monday to the subprime rescue plan was quickly mostly reversed, the subprime ABX market did still continue to gradually extend its modestly improving trend off the lows hit around Thanksgiving for the week. The biggest gain was posted by the AA index (43.00 versus 39.22). The AAA index (72.81 versus 71.81) also saw modest improvement. These two highest-rated indices that have become the focus recently are still way below the mid-90s for the AAA and mid-80s for the AA where they were trading in the first part of October, but they’ve managed a decent bounce off the lows in the mid-60s and mid-30s hit around Thanksgiving. The commercial mortgage CMBX market also had a good week, with all the indices reaching their best levels since the very sharp sell-off this market experienced in the first week of November (when a period of significant contagion spillover from then ongoing ABX meltdown seemed to have started).

While the economy certainly seems to be flirting with the start of a recession — at least by the old rule of thumb of two negative GDP prints if not by the more rigorous official NBER analysis — the key round of early November data released over the past week made clear that a recession did not start last month. Employment growth was solid for a second straight month. Both ISM surveys pointed to growth, albeit slightly slower growth than in October. And consumer spending growth appears to have been surprisingly solid in November, leading us to boost our 4Q consumption forecast to +1.6% from +1.3% and our GDP forecast to +0.4% from +0.2%.

Non-farm payrolls rose a solid 94,000 in November on top of a 170,000 gain in October, though there was a significant downward revision to September (+44,000 versus +96,000). November job growth was led by retail (+24,000), government (+30,000), business services (+30,000), healthcare (+25,000), and leisure (+26,000), which offset weakness in construction (-24,000), a relatively small decline in manufacturing (-11,000), and strike-related downside in information (-6,000). Other details of the report were positive. The unemployment rate held steady at 4.7%. Average hourly earnings surged 0.5% after a couple of sluggish months. Along with a 0.1% rise in aggregate hours worked, this lifted aggregate weekly payrolls to a 0.5% gain, pointing to strong nominal personal income growth in November. The income gain will be significantly smaller in real terms, however, given what is expected to be significant upside in headline inflation caused by a surge in gasoline prices. The retail gasoline price surge topped out in mid-November, however, and has started to move slightly in the other direction the past couple weeks, pointing to support for consumer spending power going forward. Details of the employment report along with motor vehicle assembly results also pointed to a solid gain in industrial production in November.

Consumer spending appears to have been surprisingly robust in November.

Motor vehicle sales posted a slight increase to a 16.2 million annual rate from 16.1 million in October rather than the further small decline to 15.8 million we had expected. And chain store sales results were better than expected also. A weighted average composite we put together of the major companies showed overall comp store sales up 4.4% overall and 4.6% excluding drug stores. The latter was well above the +3.1% consensus. While a calendar shift to an earlier Thanksgiving boosted results and we were therefore conservative in translating them into retail sales estimates, they still pointed to better outcomes for several key discretionary components than we had previously assumed.

Incorporating the motor vehicle and chain store sales results, we raised our retail sales forecast to +1.0% overall and ex autos from our preliminary +0.5-0.8% estimate. We also boosted our forecast for the key ‘retail control’ grouping, which along with the boost to motor vehicle sales led us to raise our 4Q consumption forecast to +1.6% from +1.2%, raising our GDP forecast to +0.4% from +0.2%.

Meanwhile, both ISM surveys pointed to growth in November, though a bit slower than in October. The composite manufacturing ISM diffusion index dipped marginally to 50.8 in November from 50.9 in October. Among the key components, orders (52.6 versus 52.5) were little changed, production (51.9 versus 49.6) partially rebounded from a big drop last month, and employment (47.8 versus 52.0) hit a four-year low. The production gain suggested that last month’s weakness was likely partly related to the GM strike, while the move in the employment index below 50 left it more consistent with steady declines in factory payrolls over the past year.

Growth by industry was narrowly based, with 7 of 18 sectors reporting expansion in November, down from 9 in October. The prices paid index rose 2.5 points to 65.5, with the upside attributable to energy and energy related items. The non-manufacturing ISM survey’s headline business activity index fell to 54.1 in November, down from 55.8 in October but remaining well above the 50 boom/bust line. Ten of 18 sectors reported growth (led by information, retail, real estate and government), six contraction (including finance, strike-impacted entertainment and transportation), and two no change. Key activity measures were softer, with the orders index falling to 51.1 from 55.7 and employment to 50.8 from 51.8. The prices paid index surged to 76.5 from 63.5, with a wide range of energy and energy-related items reported up in price.

While economic data released the past week provided no real basis for a rate cut at Tuesday’s FOMC meeting, we continue to see significant downside risks going forward from the intense and worsening squeeze on the banking system, which continues to be starkly illustrated by upward pressure on term LIBOR. While the relentless move higher in 3-month and 1-month LIBOR that had run to three straight weeks of uninterrupted daily increases finally stopped over the second half of the past week, the deterioration in this market since the last FOMC meeting at the end of August remains highly disturbing — including clearly to Fed officials, given the focus placed on this development in Fed Vice Chairman Kohn’s key recent speech. At the end of the latest week, 3-month LIBOR fixed at 5.14% (pulling back just barely from the 5.15% peak hit Wednesday), up from 4.89% at the end of October, while 1-month LIBOR closed the week at 5.24% (also just marginally off Wednesday’s 5.25% high), up from 4.71% at the end of October. Of course, Fed expectations have turned much more dovish since the last end of October FOMC statement’s warning not to expect a December rate cut. The spread of 3-month LIBOR over the expected average fed funds rate over the next three months has blown out to 103bp from what was already a very high, if at the time at least improving, 43bp at the end of October. The current spreads of 3-month LIBOR over expected fed funds has moved beyond anything seen during the August/early September market turmoil.

This deterioration in interbank markets is the key risk facing the economy at this point, in our view, and, judging from the emphasis it received from Vice Chairman Kohn, it seems in the Fed’s as well, providing the basis for a rate cut Tuesday that the economic data are not really calling for at this point. The LIBOR stress is a problem in two ways. First, term LIBOR, in particular 3-month LIBOR, is in and of itself a key benchmark rate for various markets and loans. So, the upward pressure on 3-month LIBOR is a direct restraint on the economy. Second, and more important, is what the LIBOR situation is telling us about the severe and apparently significantly worsening pressure on bank balance sheets and capital, with clear and possibly severe negative repercussions for credit availability and pricing to businesses and consumers — pointing to increasing downside risks to capital spending and consumption going forward. These risks, and the signs that they are getting worse implied by the blowout in LIBOR/fed funds spreads since the last FOMC meeting, appear likely to be the key basis of downwardly revised economic forecasts that FOMC members probably discuss Tuesday and base their likely rate cut on.

Still, with the economic data not looking all that bad up to this point, we think it’s quite likely that the Fed to confine itself to a 25bp rate cut to 4.25%, bringing the cumulative reduction since September to 100bp — quite a bit of easing in anticipation of an economic downturn that in large part has not yet emerged, though it does appear clear that growth, if it’s positive at all, will be dramatically slower in 4Q than the very strong middle quarters of the year. Rather than more aggressively cut the funds target, we instead look for the Board of Governors to try to more directly address the term interbank lending squeeze through the discount window. We expect a 50bp cut in the discount rate to 4.50% from 5.00%, cutting the spread over the funds target to 25bp from 50bp currently and 100bp in normal times. We also look for the available loan terms to be extended to 90 days from 30 days currently and 1 day normally. Policymakers received some encouraging news on the potential efficacy of the discount window to tackle these problems the past week. As 1-month LIBOR blew well through the current 5% discount rate at which loans are available for a month, there was a significant amount of discount window borrowing in the latest week. This appears to have been the first meaningful such borrowing since terms were first eased in August that was based on purely economic considerations. A prior significant round of borrowing shortly after the initial adjustments were made was solely symbolic in nature, as the banks that did the borrowing clearly had cheaper funding alternatives available, since 1-month LIBOR at that point was still below the lowered discount rate.

In addition to the main focus on the Fed, a number of key data economic reports will be released in the coming week, including the trade balance and Treasury budget Wednesday, retail sales and PPI Thursday, and CPI and industrial production Friday:

* We look for the trade gap to widen a bit less than a billion dollars to US$57.3 billion after hitting a two-and-a-half-year low last month, with exports rising 0.6% and imports 0.9%. On the export side, we look for decent upside in capital goods, led by high-tech products, partly offset by some moderation in food after the incredible surge seen over the past few months and some slowing in autos in line with more sluggish assembly schedules. The import gain should be accounted for by energy products, with both petroleum products and natural gas expected to show decent upside ahead of some bigger price-related gains in coming months. On the other hand, continued sluggish activity at key West Coast ports suggests continued softness in non-energy goods imports.

* We expect the federal government to report a November budget deficit of US$95 billion in November, US$22 billion wider than a year ago. However, the bulk of this swing is attributable to calendar effects.

Specifically, roughly US$20 billion of regular payments typically made at the beginning of the month were pushed forward because December 1 fell on a weekend. We continue to see the budget deficit tracking at US$200 billion in FY 2008. Finally, note that we have long assumed a series of temporary extensions of AMT relief, so the latest Congressional action has no impact on our budget estimates.

* We forecast a 1.0% surge in November retail sales, overall and excluding autos. The chain store results were considerably stronger than expected, but came with a cautionary warning that some of the upside was attributable to calendar effects that are likely to be unwound in December. This makes it even more difficult than usual to translate the company figures into a retail sales forecast (because it is hard to identify the extent to which the seasonal adjustment factor will compensate for the calendar shift). As a result, we have tried to be conservative in extrapolating the chain store figures, but still come up with sharp gains in key categories such as general merchandise and apparel. Also, the motor vehicle unit sales point to a modest advance in the auto dealer component. And, of course, much of the elevation in November sales is still expected to come from higher gasoline prices — our estimate for sales ex autos and gas stations is +0.4%. Finally, even after shaving our assumptions for December, the changes to our November expectations take our 4Q consumption forecast to +1.6% which moves the tracking estimate for 4Q GDP from +0.2% to +0.4%.

* We expect the headline producer price index to surge 1.9% in November, matching a 30-year high due largely to an unprecedented spike in gasoline prices. Indeed, the seasonal adjustment factor this month should magnify an already sizeable jump in spot market quotes for gasoline. Meanwhile, we look for the food category to flatten out following outsized gains in both September and October. Finally, the core should rise 0.3%, a sharper advance than seen in recent months, but just about all of the anticipated upside is attributable to a likely rebound in the quirky light truck component.

* We look for the November consumer price index to rise 0.6% overall and 0.2% ex food and energy. A nearly 10% spike in gasoline prices is expected to lead to the sharpest jump in the headline CPI since May. The elevation in the energy component should more than outweigh an expected moderation in food prices, driven by some recent softening in quotes for meat and dairy items. Meanwhile, the core is expected to be right in line with the October result (+0.17% before rounding), with a rebound in hotel rates being about offset by modest outright declines in the apparel, motor vehicle, and communications categories. The core should hold at a year-on-year rate of +2.2% in November.

* We forecast a 0.4% rise in November industrial production. The employment report showed the first uptick in manufacturing hours in the past several months. So, despite a likely pullback in the utility category tied to unusually mild temperatures, headline IP is expected to post its sharpest advance since July. A rebound in motor vehicle assemblies is expected to lead the way, but solid gains are also anticipated in categories such as electrical equipment, computers and plastics. Finally, it’s worth noting that the upswing in production may prove temporary because the latest automaker assembly schedules plans point to a sharp cutbacks in output in both December and January.

Japan
Inflation Irony
December 10, 2007

By Takehiro Sato | Tokyo

The October core CPI rate returned to positive territory for the first time since last December, owing to a stronger contribution from energy-related products. An unexpected rise in the core-of-core effectively for the first time since 1999 was also important news. Going forward, we expect the November core CPI rate to surge at least to +0.3% YoY, given the higher contribution by energy-related prices. Further, it is likely to rise to +0.6-0.7% YoY during the Jan-Mar quarter next year. In short, the long-awaited inflation is now coming back. Does this mean an end to deflation? We don’t think so.

First, wages remain sluggish and the unit labor cost is dropping with a wider margin, given the virtually flat nominal employees compensation and moderate rebound of the real GDP. Second, despite the surge in some domestic demand component deflators such as capex, housing and public investment, the GDP deflator, which is another proxy of income, remains sluggish due to a higher import deflator. Third, the revised CGPI statistics have revealed that the domestic final consumer goods prices, on which we focus for correlation with the CPI, were revised down from 0% YoY to -0.7% for the Jul-Sept average. Using the new base year, domestic final consumer goods prices have been falling YoY since January 2006, highlighting the extremely slow pace of price shift to final consumer goods. Also, per our estimates, domestic final goods prices including capital goods have been down continuously YoY since December 1992.

Going forward, our concern is the squeeze of real income by higher prices. In the January-March quarter, nominal wages should display slow growth while consumer prices are likely to rise more quickly.  Thus, the extent of the drop in real disposable income should widen.  Some employment-related indices are likely to turn down, owing to deterioration in the profit margins at small to medium-sized companies, and we forecast a negative wealth effect stemming from yen appreciation and lackluster share prices.  As a result, personal consumption will probably be unspectacular in the January-March quarter.

Also, the employment situation is cause for concern. Although appetite for employment appears to be strong at large manufacturers, the employment environment seems to be deteriorating at SMEs in particular. Grass roots sentiment as indicated in the Watchers Survey has been weakening constantly in the past six months, suggesting a possible spread of bearish SME sentiment to employment. We are yet to see noticeable changes to the employment conditions of the construction industry, which is suffering from a sharp decline in construction starts; however, we think that the revised Building Standards Law could boost the number of bankruptcies at related SMEs. One of the things to watch going forward will be whether the December Tankan (due out on December 14) will reveal signs of modulation in the employment DI for SMEs.

For policy implications, with the shock waves from the subprime issue extending their reach, and time running out for the current BoJ leadership, we have to conclude that the possibility of a rate hike before the end of F3/08 has diminished substantially. Indeed, we expect the October-December GDP data due out in mid-February to point to a muted tone as a result of the amended Building Standards Law, and think that this all but rules out the prospect of a rate hike being agreed at the MPM in either February (14-15) or March (6-7). Moreover, with the Democratic Party – which effectively has the power of veto over choices at the top of the BoJ – insisting that the issue must be deferred to the next Administration after the general election, a general election taking place at around the same time as the terms run out on March 19 could have the effect of creating a vacuum – if only temporary – in the positions of governor and deputy governors. Alternatively, it is possible that the government might find itself having to deal with the situation by keeping current incumbents in place for a provisional period. If so, it seems common sense to assume that there would be no change in policy under such a provisional leadership, and that the prospect of a rate hike at the next MPMs in April (8-9, 30) and May (19-20) would be low as well.

Based on these considerations, we have put back our estimate of the timing of the next rate hike to July-September 2008 or later, though there is a risk that the slippage could be even more protracted. Alternatively, if a risk scenario were to emerge in which the US economy entered into recession and share prices fell even more steeply while the yen appreciated still more sharply, the BoJ would probably feel the need to start considering monetary easing. A rate cut is not part of our main scenario at the moment, but depending on how the market climate pans out, it is possible that the market itself would start factoring for such a scenario. Indeed, it is ironic if the BoJ has to consider the monetary accommodation in the midst of the long-awaited recovery of the CPI rate.  

 

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Global
Recession Coming
December 10, 2007

By Richard Berner & David Greenlaw | New York

Forecast at a Glance

		2007E	2008E	2009E
Real GDP		2.2%	1.1%	2.7%
Inflation (CPI)		2.8	2.6	2.4
Unit Labor Costs		3.2	2.5	0.2
After-Tax “Economic” Profits		3.5	-6.2	11.9
After-Tax “Book” Profits		3.6	-7.9	9.3

Source: Morgan Stanley Research
E = Morgan Stanley Research Estimates

 

We’re changing our calls for US growth and monetary policy.  Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth.  But the time for incremental changes is over.  A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period.  Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing. 

The prospect of real GDP growth persistently between 0-1% changes the character of and risks to the outlook.  Thus, even if the data do not immediately validate our call, we expect the Fed to insure against worse outcomes.   That process should start this week with a 25 bp reduction in the Federal funds rate, a 50 bp cut in the discount rate, and possible extensions of term open-market operations to as long as 65 business days to help ease strains in money markets.  Following that, we think officials will ease by at least another 75 bp over the next 7-9 months.  Here’s why.

First, compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available.  Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened.  Three-month dollar Libor-OIS spreads have jumped by 60 bp to 100 bp over the past month, so that Libor rates in that tenor are merely 20 bp lower than where they were in the spring.  Some of that jump in Libor rates reflects the transitory impact of year-end precautionary demands for liquidity.  But we think that some also represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008 (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007). 

Leveraged loan and credit default swap spreads over Libor, meanwhile, have been mixed: They have tightened appreciably over the past fortnight but have widened by 40 bp or more over the past month, measured by either the LCDX leveraged loan index or the S&P secondary LCD/LSTA measures.  High-yield and CMBS spreads have widened even more significantly, increasing the cost of borrowing appreciably for lower-rated borrowers, including those in commercial real estate.  As a result, the absolute cost of borrowing is higher than in June. 

Credit availability, moreover, likely has dwindled beyond where the Fed’s November Senior Loan Officer survey left it.  As delinquencies and defaults soar, lenders and investors are tightening credit for commercial, credit card and auto lending, as well as for mortgage borrowers.  Delinquency rates on all 1-4-unit residential mortgages jumped to a 19-year high of 5.59% in the third quarter, and the foreclosure start rate rose to a record 1.69%.  With home prices just now falling by some measures, credit tightening, and resets looming, more foreclosures are likely.  The new plan to freeze ARM resets for five years may be a win-win for some borrowers and lenders; foreclosures are costly for all.  However, US bank analyst Betsy Graseck estimates that the partial freeze will only be a modest positive and will not appreciably lower the expected level of bank provisioning (Subprime Rate Freeze Benefit Too Modest to Matter, Sticking with Cautious View, December 10, 2007).  In addition, it may add a risk premium to mortgage credit and further reduce its availability.  Delinquencies and net charge-offs (NCOs) for other forms of credit are still low by historical standards but they are rising.

The second new factor is coming weakness in business capital spending.  This tightening in financial conditions likely will undermine spending to some degree, but three other factors account for most of the prospective weakness in corporate capex.  Slower top-line growth itself, sagging operating rates, and a downturn in corporate profits all seem likely to promote a 1.7% contraction in real business capital outlays over the four quarters of 2008. 

At work will be the time-honored “flexible accelerator” model of investment, which implies that business investment will respond with a lag to changes in the desired stock of capital in relation to output.  As a result, a slowing in the growth of economic activity will depress the level of investment.  Managers will tend to extrapolate a slowdown in business activity into dimmer expectations of future growth, lower perceived returns from investing, and a reduced need to invest.  Until the economy re-accelerates, therefore, capital spending probably is at risk (see “Capex Recession Ahead?” Global Economic Forum, October 1, 2007).  Moreover, the coming earnings recession means internally generated cash flow that has helped to finance investment over the past six years is fading fast as earnings decline — just as lending markets have turned inhospitable (see “The Earnings Recession,” Investment Perspectives, December 6, 2007). 

The final factor behind our change in view is that while growth abroad is still strong, slowdowns in Europe and Japan are undermining it.  Our European colleagues have cut their GDP growth forecast for the euro area by 0.4 percentage point for 2008, to 1.6%, and by 0.3 pp for 2009, to 2.2%.   Eric Chaney notes the reasons: On top of spillovers from the US slowdown, a strong currency, and elevated energy prices, increased stress in money and credit markets is likely to hurt corporate spending for most of 2008.  Likewise, David Miles and Melanie Baker think tighter credit conditions and falling home prices probably will undermine UK growth. 

And in Japan, our team has just cut their 2008 forecast by a full point to 0.9%.  While Japan doesn’t face a full-blown credit crunch, Takehiro Sato believes that domestic policy blunders will combine with the US slowdown to produce serious weakness.  Changes to regulations are hurting consumer and small-to-medium business financing; revision of the Building Standards Law has led to a sharp drop in housing starts; and fear of tax hikes has further harmed consumer sentiment.  The upshot: Global growth likely will slip from 5% in 2007 to 4.2% in 2008, and the risks lie south of that still-hearty pace.  That’s because spillovers into other parts of the world may yet undermine legitimate resilience in Asia and Latin America.  And that means downside risks to growth in US exports. 

While investors are expecting that an ongoing housing downturn and threats to consumers already menace growth, it’s worth noting some lesser-plumbed features of the domestic scene.  First, we think tighter lending standards will depress housing demand further.  But even if demand stabilizes, so large is the supply-demand mismatch that builders must slash single-family housing starts by 40% from current levels to eliminate the inventory of unsold homes.  As a result, we think overall housing starts will run below one million units in each of the next two years — a level not seen in the history of the modern data since 1959.   The housing downturn will likely subtract 0.9% from growth in the next four quarters, and the housing recovery in 2009 will hardly merit the name. 

Second, while energy prices have come down from their recent peaks and may continue to slip, the rise in energy and food quotes between June and December of 2007 likely will have drained about $45 billion, or 0.4%, from consumer discretionary income.  Moreover, long-term relief is unlikely; Doug Terreson and our oil team expect that crude oil quotes (measured by WTI) will average about $83/bbl in 2008, or about $10 higher than this year (we translate that into a $7 increase for Brent to $79.40). 

Thus, consumers still face what could be a perfect storm.  Job gains have been supportive of income growth, with monthly gains in nonfarm payrolls running an average 103,000 in the past three months.  That is hardly surprising, as the economy grew at a 4.4% annual rate in the past two quarters, and employment lags GDP.  But the number of nonfarm self-employed workers fell by a monthly average 138,000 over the same period, although that job canvass is certainly less reliable than the payroll survey.  And more timely labor-market indicators such as jobless claims are weakening; the rise to 340,000 on average over the past four weeks is a two-year high.  With wages decelerating, income gains are slowing significantly.  (As an aside, revised data show that the level of wage and salary income is $45 billion lower than previously thought).  Housing prices and stock markets are both under pressure; we expect a 10% real decline in home prices over the next year, and that has just begun.  Thus, consumers will be more cautious. 

In addition, the same factors that are hitting capital spending are also depressing inventories.  Such stocks aren’t especially high in relation to sales, but slipping sales and tightening credit are pushing companies into liquidation mode, especially in motor vehicles.  Auto analyst Jonathan Steinmetz thinks that Detroit is switching from “putting money on the hood” to accepting lower sales and making production cuts.  We estimate that cuts in motor vehicle output will trim 0.3% and 0.5% from Q4 and Q1 GDP, respectively.  Moreover, slipping revenues and rising health costs are constraining state and local government budgets.  In response, some officials, like California’s Governor Schwarzenegger, are calling for sizable spending cuts.  Finally, a faltering economy will create uncertainty, which itself is the enemy of growth.   It will impair willingness to lend and dampen animal spirits. 

Those negatives sound like the recipe for a serious recession, so why do we think it will be mild?  Although it is slowing, global growth is still strong, and we expect that net exports will add about ¾ percentage point to growth through the end of 2008.  In addition, we think that corporate capital and hiring discipline in this expansion mean that there are no business-investment or labor-market excesses to unwind, adding to US economic resilience.  Finally, low inflation gives officials the latitude to respond to weakness.  But while any downturn in our view will be short and mild, the range of possible outcomes is high.

The Fed, in response to this unfolding weakness, will have more work to do.  As Fed Chairman Bernanke noted ten days ago, “[market] developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors.   Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.”   Just to keep monetary policy neutral, the Fed must ease to offset tighter financial conditions, yet we think policy ultimately will need to turn accommodative.  At a minimum, therefore, officials will want to bring the real Federal funds rate down significantly.  Inflation risks are not dead, with the dollar having weakened, import and energy prices rising, and productivity growth slowing.  But the Fed will likely judge that the downside risks to growth outweigh upside inflation risks.

A more aggressive Fed, an earnings recession, healthy growth abroad, and a scramble for liquidity all will reinforce our longstanding market calls for steeper yield curves, higher volatility, and challenges for risky assets.  While many of these themes are in the price, economic uncertainty may extend them further.   And markets are not priced for the weakness in either US capital spending or the coming deceleration in overseas growth.  As our colleagues Abhijit Chakrabortti and Stephen Jen outline in separate pieces, despite the US downturn, those factors lead to two paradoxical and out-of-consensus market conclusions: Outperformance in US stocks and a stronger US dollar (see Atonement – Navigating a US Recession and The Dollar Smiles in a Recession, December 10, 2007). 

One risk is that both our outlook and the Fed’s are too optimistic, because they pay too much attention to the economic resilience of the past, and not enough to the future effects of financial and economic headwinds and the dynamics of the downturn.  Dramatically slower growth in domestic demand leaves it vulnerable to shocks.  Insufficient Fed action could again threaten a deeper economic slowdown.  A contrasting risk is that we’re swayed by Wall Street pessimism and that things may be better on Main Street.   In our view, downside risks still dominate.

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