Ascending from the Undergloom
Part I: Update on the Economy
Having plumbed the depths of Americans’ confidence in the potential for recovery, the pace of contraction in the economy has begun to ease. However uneven, tangible signs of firming have materialized in key areas of activity, including the housing market. Policy makers have seized on this evidence. In its August 12 monetary policy statement, the Federal Open Market Committee’s cautious optimism is reflected in its decision to taper its purchases of Treasury securities over the next two months. The Fed’s balance sheet has bloated since last September, rising above $2 trillion on Wednesday, August 13. By projecting its intention to step back, the Fed has signaled a surprisingly sanguine outlook.Eluding the 9th CircleThe FOMC’s more confident posture has been buttressed by an array of market gauges. Amongst the most comprehensive, the Bureau of Economic Analysis (BEA) released advance estimates of second quarter gross domestic product (GDP) [ PDF] last Friday morning. According to the early approximation, the economy contracted at an annual rate of 1.0 percent in the second quarter. Economists had expected the report to show a contraction of 1.5 percent. Supported by contributions from federal, state, and local government, as well as a shifting net export position, the estimate represents a substantial improvement from the first quarter’s revised 6.4 percent contraction. In anticipation of a smaller drop off in activity, the FOMC revised its projections for GDP growth at its June meeting. The Fed’s central tendency has pegged 2009 GDP change between -1.5 percent and -1.0 percent. Real Estate Econometrics is more conservative in its outlook, projecting 2009 GDP change of -1.6 percent.Consumer activity, business investment, and housing remain drags on growth. With jobs losses and wage-income declines expected to persist, constraints on consumer spending will temper the recovery. For now, the government has sought to suffuse the void. Offsetting the diminution in the private economy, government spending was the sole top-line category registering growth in the second quarter. Federal spending increased by 10.9 percent, largely on account of increases in defense spending. Non-defense spending increased by 6.0 percent. While state and local budgetary challenges will require deep spending and payroll cuts in the upcoming fiscal year, non-federal spending increased by 2.4 percent in the quarter, buoyed by transfers from Washington that offset declines in local tax revenues.Alongside the better-than-expected GDP estimate, the most recent new home sales and Case-Shiller reports added to evidence that housing market conditions are moderating. While no index can fully-capture the nuance of the markets it gauges, the Case-Shiller Index conveys that repeat-sale prices have leveled in a growing count of markets. While prices have fallen by 32.0 percent from their peaks across the 20 market composite, the month-to-month decline in May eased to just 0.2 percent. Prices fell in 12 of 20 markets, down from 16 of 20 in April.Job losses have eased, as well. According to the Bureau of Labor Statistics’ August 7 employment report for July [ PDF], payrolls shrank by 247,000 jobs over the last month. The national unemployment rate fell from 9.5 percent to 9.4 percent. Both of the labor market’s headline measures bested economists’ expectations. The consensus estimate anticipated a July payroll contraction of 300,000 jobs and a rise in the unemployment rate, to 9.7 percent. Investors welcomed the positive signal from the job market; by day’s end on August 7, the Dow Jones Industrial Average had jumped 1.2 percent. Using a broader measure, the total market capitalization of the United States increased by roughly $155 billion over the course of the day. From Inferno, En Route to PurgatorioThe labor market’s July performance was not unambiguously positive. The decline in the unemployment rate, for example, was not the result of a net increase in jobs. Rather, it resulted principally from a drop in the number of people looking for work. 422,000 people exited the labor force in July, reducing the number in search of employment – the “unemployed” component of the unemployment rate – by 267,000. Corresponding with this decline, the nation’s labor participation rate fell from 65.7 percent in June to 65.5 percent in July. The share of the population that is employed now stands at 59.4 percent, down from 59.5 percent in June and from a peak of 63.4 percent in 2006.Even as slack in the labor market and capacity utilization increase, consumers remain concerned about the potential for rising prices. They are at odds with the most recent consumer price index report, released just this morning, that shows that prices are relatively stable to-date. The most recent Reuters/Michigan consumer sentiment survey reaffirms consumers’ expectations that medium and long-term inflation will rise above policy makers’ target range.Higher inflation implies a rise in interest rates that will prove unequivocally problematic for the modification and refinancing of commercial mortgages. While the Fed does not view inflation as an immediate concern, we consider it imprudent to discount completely consumers’ expectations. Chairman Bernanke has clarified the reasoning himself in saying that “the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”+ Coinciding with the challenge from unanchored consumer expectations, the Fed’s persistent monetization of the debt holds the potential to foment price instability, as well. How Long in Limbo?President Obama stated week before last that, “we won’t have a recovery as long as we keep losing jobs.” By this standard, a national recovery is unlikely to take hold before late 2010. In the intervening period, the economy and housing market recovery will remain vulnerable. First and foremost, shrinking payrolls will constrain aggregate household consumption. A sustained and robust resumption of growth cannot emerge without the support of consumer spending. Even now, with consumers holding back, personal consumption expenditures represent 70.6 percent of gross domestic product. At the same time, housing demand and the capacity of households to meet mortgage principal and interest obligations will remain under pressure as long as jobs are being lost and family incomes undercut. Next Week | Part II: The Implications for Commercial Real Estate and the Policy Response Thus Far + Bernanke, B.S., Inflation Expectations and Inflation Forecasting, Address at the Monetary Economics Workshop of the National Bureau of Economic Research Summer Institute, Cambridge, Massachusetts, July 10, 2007. Note: The titles of this post and its sections are borrowed from Durante “Dante” degli Alighieri.