December 22, 2008

Thirteen Months into a Deepening Recession

Data released in recent weeks reflect an economy in a deepening recession, confirmed by the National Bureau of Economic Research on Dec. 1 when it declared that the current recession began in December 2007.  The economic outlook deteriorated again in November.  Recent employment reports have been abysmal, and real growth in the fourth quarter is expected to contract significantly. Meanwhile, the credit market has shown some signs of improvement, and inflation is quickly moderating.

Further GDP Contraction Likely
In third quarter 2008, real gross domestic product (GDP) declined by a revised 0.5 percent, as consumption, business investment, and residential investment all fell substantially from the second quarter.  Strong increases in government spending and inventory investment contributed positively to GDP in addition to net exports, which had buoyed the economy in previous quarters. While both imports and exports growth declined due to the bleak economic outlook, exports growth was hit harder due to an appreciated dollar.

Personal consumption expenditures fell 0.5 percent in October, following a decline of 0.4 percent in September. If consumption continues to decline at a similar pace through November and December, its drag on fourth-quarter GDP will be even greater than its already substantially negative contribution in the third quarter.  With consumer confidence at record-low levels, the personal savings rate jumped from 1.0 percent in September to 2.4 percent in October.  Business investment contracted as well. New orders for durable goods plunged 6.9 percent in October, the largest monthly decline since 2000, with all segments of the manufacturing sector contracting except communications equipment. In November, retail sales declined for the fifth straight month, and industrial production fell an additional 0.7 percent.  The steep decline in the Institute for Supply Management’s indexes, which reflect severe contraction in both the management and services sectors, confirms the deteriorated state of the economy. In particular, the drop in the ISM nonmanufacturing composite index (service sector) does not bode well for fourth-quarter real GDP (Chart 1).

The economic outlook has worsened significantly. The Conference Board’s index of leading economic indicators declined again in November, despite large increases in the money supply, showing an acceleration in the rate of decline in the past six months that surpassed the index’s decline of the 2001 recession and may soon surpass that of the early 1990s recession (Chart 2). Looking forward, the December Blue Chip survey reported downwardly revised forecasts of near-term real GDP growth, predicting a contraction of 4.1 percent for fourth quarter 2008.  The growth forecasts for every quarter of 2009 were also revised down, predicting the economy will contract through the second quarter of next year.

Largest Employment Drop Since 1974
Labor market conditions are steeply worsening. Employment reports in the past two months have been abysmal, and the unemployment rate—currently at 6.7 percent—is likely to climb higher.  Nonfarm payroll employment fell by 533,000 jobs in November, the largest one-month drop since December 1974. Job losses in September and October were also considerably revised, adding another 199,000 jobs to earlier losses. Declines in payroll employment were widespread, as all major sectors posted sizable losses. To date, the labor market has lost 1.9 million jobs since peaking in December 2007, the start of the recession. Initial claims for unemployment insurance recently reached 575,000, a level not seen since November 1982, the trough of the early 1980s recession (Chart 3).

Some Signs of Credit Market Improvement
Conditions in short-term funding markets have improved somewhat over the past weeks, with Libor[1] spreads falling notably since the beginning of November. Since the second half of October, commercial paper volumes have bounced back, and commercial paper spreads over Treasuries have retreated (Chart 4).  However, conditions in the longer-term credit markets have improved very little. Investment-grade corporate bond yields and mortgage rates have declined since the second half of October, yet their spreads over Treasuries have widened significantly, reflecting market participants’ uncertainty about the economy, the ongoing housing market correction and the overall tenuousness of financial markets.

Housing Permits and Sales Continue Declining
Housing market conditions remain exceptionally weak. The housing sector has continued to suffer the effects of compromised mortgage quality that caused the current flood of homes on the market. Overall housing permits and starts dropped again in November by 15.6 and 18.9 percent, respectively, hitting their lowest levels since at least 1960.  Single-family building permits are now down 77.1 percent since they peaked in September 2005 and are down 42.3 percent since the start of the recession. While the downturn in residential investment has exceeded the worst historical scenario in terms of depth, it has yet to exceed it in terms of duration (Chart 5).

New home sales continued to slide in October, down by 5.3 percent from September to 0.43 million annualized units, and inventories edged up to 11.1 times the current monthly sales pace.  Existing home sales also fell, declining 3.1 percent to 4.98 million annualized units, with the median existing-home price down an additional 3.3 percent since October and down 11 percent from a year ago.

Inflation Quickly Moderating
As expected, both headline and core inflation dropped substantially since September. The sharp deterioration in the outlook for global economic growth has further depressed prices for oil and other commodities. As a result, headline PCE and CPI inflation decreased at 5.3 and 10.9 percent annualized rates in October, respectively, with CPI decreasing more rapidly in November at an 18.4 percent annualized rate. Year-over-year, core CPI inflation was 2.0 percent in November. In addition, the economic slowdown and appreciation of the dollar have lowered the inflation projection considerably. Since November, the Blue Chip survey’s forecast for headline CPI inflation in the fourth quarter was revised from a -2.1 to a -5.7 percent annualized rate. The December survey also forecasts headline CPI inflation to be mildly deflationary through the first quarter of 2009 (Chart 6).

—Jessica J. Renier

About the Author Renier is a research analyst in the Research Department at the Federal Reserve Bank of Dallas. Note London interbank offered rate