Mortgage Bankers Association Economic Commentary (July 2010)

Slower Growth Ahead


Incoming data over the past month or two have made for sobering reading. Data from the housing industry have revealed huge declines in housing sales and starts, building permits, and applications for loans to purchase homes. While some post tax credit slump was to be expected, more was borrowed from the future than had been bargained for. The manufacturing industry, which earlier had been growing rapidly, is cooling off—the ISM index for that industry fell in June. Consumers have lost confidence, and car sales have tailed off. Reports from abroad indicate a slowdown in the rate of growth in industrial activity.

Signs of slowing growth at home were confirmed by the employment report for June. Growth in private payroll employment averaged 200 thousand a month in March and April, but then subsided to an average of 58 thousand in May and June. While the manufacturing sector added a small number of jobs in June, the average length of the work week fell by one-half an hour. Declines of that magnitude are quite unusual, typically seen only in recessions.

There seems little doubt that real GDP growth is decelerating significantly, probably to a second half pace of around 2-1/2%, following increases of 2.7% at an annual rate in the first quarter and an expected rise of close to 3% in the second. Slowdowns in the course of an economic recovery at not at all uncommon. To cite a few examples: economic growth during the recovery from the 1953-54 recession was unusually erratic—there were three quarters when real GDP showed an outright decline during the course of the expansion. During the recovery from the recession of 1973-75, there was one quarter of negative growth and five quarters in which real GDP rose by less than 2% at an annual rate. The recovery from the 2001 recession started slowly and finally gained momentum, but there were four quarters of growth below 2% before more robust growth kicked in.

There are reasons to suspect that growth might run into headwinds as the year goes on. Rising inventory investment, always a temporary source of stimulus, accounted for more than half of the growth in real GDP during the first three quarters of recovery. Support for growth from this sector is bound to wane at some point. Similarly, the impact of the fiscal stimulus package passed last year is widely expected to wane in the latter half of 2010. Credit availability to small businesses and consumers remains constrained, impeding full recovery. The European debt crisis is likely to take a toll on the U.S. economy—markets for exports have been affected negatively; stock prices have declined, and credit spreads have widened. Inflows of capital to the U.S. stemming from the European debt crisis have pushed down Treasury rates considerably, and that has led to lower mortgage rates. But the benefits of lower long-term Treasury rates are not flowing through as they usually do to other private credit costs.

The apparent slowing of real growth has raised anew concerns that the economy might be headed for a double-dip recession. While such a development cannot be ruled out, the probability of its occurrence still seems relatively low. The more likely outcome is that a period of subdued growth will be followed by resumption of somewhat stronger expansion next year. The U.S. economy has repeatedly demonstrated its resiliency to shocks. Reflecting large productivity gains, corporate profits have risen sharply since the end of 2008. That should help to bolster stock prices as the year goes on. Businesses have been investing aggressively in equipment and software, and data on new orders and order backlogs suggest continuation of that trend. The air pocket in housing caused by the tax credit will surely be behind us by year end, if not earlier, and housing activity will then resume a moderate pace of expansion. Inflation remains exceptionally low, a favorable factor for economic growth. Still, there are probably more downside than upside risks to a forecast of about 2-1/2% growth in the second half of this year, followed by slight improvement thereafter.

The drop in weekly earnings in the June report was another disconcerting reminder of just how weak this job market remains. Moreover, non-financial corporations have stockpiled nearly two trillion in cash, funds that could have been used to invest in new productive capacity, or to hire new workers. Business executives cite significant uncertainties. Increasing regulatory burdens, forceful but unpredictable government actions, and a slowing economy all make it difficult for businesses to plan and spend for the future.

What can be done if the worst happens? The first line of defense against economic weakness has typically been a monetary policy action in the form of a reduction in the federal funds rate. That rate, however, is for practical purposes already at the zero bound. The Fed could, of course, reactivate its asset purchase program, a step that Fed officials would be very reluctant to take absent clear signs of an economic downturn that threatened to get worse. Whether use of that policy instrument would be sufficient to stem a downward spiral is debatable. The yield on the 10-year Treasury has already fallen to levels not seen since the 1950s, and whether further declines generated by Fed purchases of long-term Treasuries would pass through to rates on corporate debt is uncertain. Purchases of agency debt or mortgage-backed securities might push mortgage rates somewhat lower, but the bang for the buck would certainly be a lot less than it was the first time around—since the spread between the 10-year Treasury rate and the conforming mortgage rate, around 250 basis points at the time, was far above the longer run average of about 170 basis points. Today, the spread is well below the long-term average.

Activist fiscal policy, i.e., yet another round of stimulus, could be used again if the Congress were willing to support an increase in the deficit, an unlikely outcome in the current political climate. A permanent, across the board, income tax cut of substantial magnitude would help to invigorate spending by consumers and businesses, but it would reduce the future tax base at a time when long-run projections of federal outlays and receipts point strongly to the need both to cut expenditures and raise additional revenues. A temporary tax cut, for example, extending the Bush tax cuts for another year or two, would be beneficial, but would have far less effect on aggregate demand than tax cuts perceived to be permanent, since the beneficiaries would expect their taxes to increase again and would therefore be reluctant to make major changes in their spending habits. Another round of expenditure increases by the federal government funded by additional borrowing could increase aggregate demand. Unless long-term interest rates rose in response to the larger outlays, an unlikely event in a weakly growing, low-inflation economy with short-term interest rates pegged at near zero levels, increased governmental outlays would lead to higher output and stronger job creation. But the mood of the public is so strongly opposed to any deficit-widening measures that Congress would be understandably reluctant to go in that direction.