June 22, 2009

 The economy, while still in recession, still seems to be on track for a recovery sometime around the end of the year.  The stock market continues to climb.  Consumers are feeling better and spending a bit more.  Businesses are laying off fewer people now than they were a few months ago.  The employment declines have been trimmed from 650 thousand per month in the spring to about 350 thousand in May — but employment is still declining, and output is still falling.  Thus, the economy remains in recession, but it is clearly on the mend.

 So what next?  What might this recovery look like?  Typically, following a deep recession the economy bounces back sharply and produces what is sometimes called a V-shaped recovery.  Economists frequently say that this time it will be different, and it rarely is.  But maybe this time it really will be different.

 Those of you who took Econ 101 will remember that the entire economy, or GDP, consists of four categories — consumption, capital spending, government spending, and trade.   That’s it.  So where will rapid growth come from?  Let’s talk about the consumer this week because it is the largest category of spending, accounting for more than two-thirds of the overall economy.  Then, we will focus on the outlook for capital spending in two weeks, and the other, smaller categories of spending in future articles.

 Consumer spending has leveled off the past couple of months as evidenced by changes in retail sales.  But it is hard to imagine robust spending in the months ahead for a variety of reasons.

  1.  Employment.  The unemployment rate was 9.4% in May and employment is still declining.  The unemployment rate is almost certain to hit 10% by yearend.  This is not the time for a spending binge.  If you lose your job, you may not quickly find another one.  It is smart to save as much as possible and, indeed, the savings rate for April climbed to 5.7%, a 15-year high.
  2. Debt.  The consumer remains saddled with debt.  The ratio of debt to income late last year was the highest since the Great Depression.  This column addressed this issue back in March.  While the ratio has come down slightly since then, this debt burden will significantly limit consumers’ ability to spend for years to come.
  3. Home prices have fallen sharply from their peak.  In the late 1990’s and early part of this decade, home prices rose rapidly.  Consumers tapped that equity by re-financing and used it to supplement their spending frenzy.  But home prices have fallen 20% from their peak value three years ago.   Whatever equity existed previously, it is far less now and, in many cases, has been completely wiped out.  The take-out equity, re-financing game has ended.
  4.  Credit.  Even if the consumer were ready and willing to borrow, his ability to borrow has been sharply curtailed by the reduced availability of credit.  Banks continue to tighten their lending standards and require both higher credit scores and bigger down payments.
  5. Mortgage rates.  30-year mortgage rates have risen from a low of 4.75% in the spring, to 5.75% currently.  This will probably not nip the incipient housing recovery, but it will put a damper on activity.
  6. Gasoline prices have quietly backed up to $2.60 per gallon from $1.59 at the end of last year.   That represents an increase of 63 per cent.  To the extent that consumers must pay more to fill their car’s tank with gas, they will have less money left over to spend on other goods and services.

 Against this backdrop it is hard to imagine a hearty recovery in consumer spending and, given its importance, the same applies to the overall economy.  As we will see in two weeks, the outlook for capital spending is equally subdued.  Why are markets so worried about inflation, as evidenced by the recent rise in long-term interest rates?   They are looking at the explosion of the Fed’s balance sheet, and while that is a legitimate concern  it is a longer term concern.  The market’s fear of inflation and resulting backup in mortgage rates, will take the steam out of any recovery.