October 8, 2009

Optimism Amid Uncertainty

As we enter the final quarter of 2009, a number of important indicators are beginning to show expansion, suggesting that the trough of the current contraction may have come in the second quarter of this year. However, not all incoming information has been positive. Some data suggest that any optimism should be tempered, that this fledgling recovery has a long way to go before the economy achieves stability, and that the key word moving forward is “uncertainty.”  

Manufacturing Up, but Job Losses Give Reason for Pause
An example of recent growth is the Institute for Supply Management’s Purchasing Managers Index for Manufacturing. In August, this indicator crossed the critical threshold of 50 for the first time since January 2008. And it remained above 50 during September with a value of 52.6. This typically signals expansion in the manufacturing sector. The ISM’s nonmanufacturing indicator also rose into expansion territory for the first time in a year, to a value of 50.9 (Chart 1).

Conversely, the job picture in September is no cause for excitement. During the month, the economy shed 263,000 jobs, and the unemployment rate rose to 9.8 percent (Chart 2). The story becomes somewhat more worrisome when looking at only private-sector jobs. As of September, the number of nongovernment jobs was just below that seen in June 1999, leaving the impression that 10 years of private sector progress has been lost through 21 months of labor market downturn.

There is some optimism to be found in the job market, however. Job losses in housing-related industries are now tapering off at about the same pace as in nonhousing-related activities, suggesting that the structural adjustment that this sector has been undergoing since roughly 2005 may be coming to an end.

Housing Market Hints at Steps Toward Normalcy
Taken together, existing-home sales and new housing starts give the impression that the housing market may have finally bottomed out (Chart 3). It’s possible that the apparent stabilization has been artificially induced, in part, by the temporary tax credit for first-time homebuyers, something that will become clearer when the tax credit expires in December. Even so, the improvement in housing market conditions is apparent in the flattening of home prices during the three months of second quarter 2009—the first time in six quarters that prices have declined by less than 3 percent. Unfortunately, this too could give way to additional price declines once the large foreclosure inventory on banks’ balance sheets hits the market.

Perhaps the most persuasive evidence that the housing downturn has halted comes from the indicator of five-month-moving-average, single-family housing permits, which we use in gauging the housing cycle. According to this indicator, the housing downturn that started in December 2005 may have ended in April of this year, making it the deepest in magnitude and the third-longest on record (Chart 4).

Consumer Fears Ease and Prices Remain Subdued
The pervading unease that has typified consumer spending seems to be gradually lifting as well. Headline retail sales climbed 2.7 percent in August, the biggest monthly advance since January 2006. The monthly gain remained solid—1.1 percent—even after excluding products benefiting from the cash-for-clunkers program. In addition, the University of Michigan’s indexed consumer confidence indicator has risen 15 points since the end of last year, when it hit low levels comparable with those seen in the first- to third-quarter 1980 downturn.

Finally, changes in prices have remained relatively subdued. In both July and August, year-over-year CPI inflation was between –1.4 and –1.9 percent, while core CPI inflation remained about one point below its average over the past decade. Long-term inflation expectations, as implied by forward rates, similarly remain close to historical levels.

Financial Indicators Provide Market Optimism
On the financial side, a host of indicators used to assess the stress of credit and securities markets are returning to historical levels, reinforcing the view that markets are beginning to heal. That is certainly the message coming from the three-month LIBOR–OIS spread. After a period of uncharacteristic elevation, the spread is quickly approaching levels seen well before the current downturn started (Chart 5).

Judging from the lower fraction of banks tightening credit standards on consumer and mortgage loans—on average, 20 percent fewer banks report tightening—financial intermediaries are feeling more comfortable about their current level of scrutiny toward borrowers (Chart 6). 

Unfortunately, troubles in the financial intermediation industry seem to have shifted from nonconventional credit markets to the traditional banking sector. However, the number of bank failures is still moderate by historical standards. In fact, the number of recently failed banks is comparable with the number coming out of the 1980–81 recession (Chart 7). A similar message comes from the size of failed banks, which, measured by the sum of their nominal assets as a percentage of gross domestic product (GDP), is still within the range observed in the mid-1980s when the U.S. economy was expanding.

Uncharted Waters
All in all, an examination of the usual indicators seems to suggest that the worst of the recession is over and that sufficient conditions for growth may finally be in place.

However, the speed of an eventual recovery is the subject of a wide range of opinions. The disparity in views can be traced in part to an unusual feature of this contraction: Despite sharp declines in employment and GDP, the overall efficiency of the economy (based on total factor productivity) appears to have remained intact throughout the downturn.

Deep contractions, both in the U.S. and internationally, are typically accompanied by large declines in the efficiency of the economy. The departure from this standard makes it particularly difficult to assess the characteristics of an eventual recovery.

Typically, more-severe-than-average contractions are followed by stronger-than-average recoveries. But the very presence of this productivity anomaly suggests that the U.S. economy is not living through normal times. As a result, policymakers will still be navigating uncharted waters in the months to come.

—Max Lichtenstein and Jessica Renier

About the Author Lichtenstein is a research assistant and Renier is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.