Fed Cuts Outlook, Keeps Chin Up

The minutes of the Fed meeting of late April were released. They show that the staff economists there had cut their economic outlooks relative to January, but are still relatively upbeat. If the three most optimistic and the three most pessimistic forecasts are excluded (what the Fed terms the Central Tendency), then the range of GDP growth forecasts for 2009 is from -2.0% to -1.3%. This marks a significant downgrade from January, when the central tendency forecasts ranged from -1.5% to -0.5%.

Considering that in the first quarter the economy fell at an annualized rate of 6.1%, even the pessimistic end of the forecasts implies that we will have a near-term recovery. Down at an 6.1% rate means that the economy has already contracted by 1.5% this year, so we would hit the -2.0% for the year if second quarter GDP were down at a 2.0% annualized rate and the second half showed 0.0% growth. Given the industrial production, retail sales and housing starts numbers for April, being down at just a 2.0% rate in the second quarter looks rather optimistic to me.

I agree that the aggressive monetary moves and the fiscal stimulus will help improve the economic outlook in the second half, but the economy still faces major headwinds, not the least of which is that the rest of the world is also in a very deep recession.  Further improvements in the Trade Deficit (net exports) seem to me to be required if we are only going to shrink 2.0% for the year as a whole.

However, a big part of the improvement we have seen so far has been because of the plunge in oil prices. Since then, oil prices have started to increase again, which should limit further gains on the trade front. A rebound in inventory investment would also help a great deal.

To be fair, those numbers came out after the Fed meeting, so they may have further revised their outlooks downward. Unemployment is expected to average between 9.2% and 9.6%, up from the previous outlook of between 8.5% and 8.8%. With Unemployment already at 8.9% in April, and new claims for unemployment insurance still above 600,000 a week, this looks extremely optimistic to me.

On the other hand, we are talking about the average for the year, not the peak level. We will probably be above the low end of that range by the time the May numbers are released, and at the high end by June. They are moving in the right direction, but in my view, they still have further to go. With the very likely bankruptcy of General Motors (GM) coming in the next few weeks, I fear unemployment could have a very significant further upward spike.

Looking out to 2010, the central tendency forecasts now range from growth of 2.0% to 3.0% for the year, down from the January outlook for growth between 2.5% and 3.3%. This would still imply slightly below-trend growth of about 3.0%. The stimulus spending and the very accommodating monetary policy will still be playing a major role, but by that point some pent up demand will start to kick in.

Spending on big ticket items like autos will start, since the current sales rate is about 3 million units per year below the scrape rate. It would be downright un-American to have the population of cars on the road actually fall significantly, well at least historically unprecedented (with the exception of WWII). Eventually, the inventory overhang in housing will get worked off, although with the next wave of foreclosures upon us, it seems unrealistic to expect it to happen by 2010. Used homes make pretty good substitutes for new homes, and there will plenty of them on the market for the foreseeable future.

As for unemployment next year, the forecasts increased to a range of between 9.0% and 9.5%, up from 8.0% to 8.3% in January. This implies a peak in unemployment sometime in the first half of 2010. That may well be the case, but I suspect it will be at a much higher level than the Fed is expecting. On the other hand, even I could be optimistic here, since in the last two recessions unemployment has continued to rise well after the end of the recession.

If we are really at the end of the official recession right now (possible given the new claims for unemployment insurance, but certainly no slam dunk either — the number will come out tomorrow morning), then it would be reasonable to expect a peak in unemployment in mid-2010. If the recession does not officially end until well into the fourth quarter, then expect a continued rise in unemployment through 2010.

Looking ahead to 2011, the outlook was also shaved, but more moderately, to a range of plus 3.5% to 4.8%, down from a 3.8% to 5.0% range in January. Significantly above-trend growth is normal coming out of a recession, and by that point, the recovery should be self-sustaining. However I still harbor doubts, given the ongoing need of the consumer to deleverage themselves. Compared to the last 30 years, a far larger percentage of any incremental income that consumers get will be going to paying down debt and building up savings.

I suspect they may be a bit optimistic here as well. They forecast unemployment to continue to decline in 2011, but remain high by the standards of the last 20 years or so. The range of expected unemployment was 7.7% to 8.5%. That is up from a range of 6.7% to 7.5%. To put that level of unemployment into perspective, the peak level of unemployment associated with the last recession was 6.3% in June 2003, 19 months after the recession officially ended.

In the recession before that, unemployment peaked at 7.8% in June 1992, 15 months past the official end of the recession in March of 1991. Thus, if we follow the pattern of the last two downturns, if the recession were to end June 1st, then we could expect a peak in unemployment between September and December 2010.

On the other hand, recessions prior to 1990 almost always saw unemployment peak right at the end of a recession. I think the change in the timing of unemployment peaks to the end of a recession is strongly related to how less significant manufacturing is to the overall employment picture now relative to the past. That trend has only continued, and would suggest that the lag could be even longer this time than it was in the 2001 recession.

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