FRBSF: The Economic Outlook

Eric Swanson of the San Francisco Fed with his view of the current economy and the economic outlook:

FedViews, by Eric Swanson, FRBSF: Nonfarm payroll employment fell by 4,000 jobs in August, and was revised downward in June and July after having posted steady gains for the past 3½ years. 

The details of the report were less weak than the headline numbers suggest, however—for instance, most of the fall in overall employment was due to a decline in state and local government workers, whose jobs are generally not very tightly tied to the business cycle. 

Moreover, average weekly hours per employee did not fall from its previous healthy level, and unemployment remained low at 4.6 percent.  Although this is slightly higher than a few months ago, both the unemployment rate and initial claims for unemployment insurance are at levels similar to those of the mid- to late-1990s, which was a healthy labor market.

Manufacturing production dipped slightly in August from July, but it has been expanding solidly since some weakness around the end of 2006.  The New Orders component of the ISM’s purchasing manager survey, a leading indicator for manufacturing, fell a bit in August from July, but any reading over 50 indicates expansion, so the current reading of 55.3 implies that more manufacturing industries experienced an increase in new orders in August than experienced a decrease.

Auto sales picked up in August from very weak levels in June and July.  Part of the earlier weakness and part of the uptick in August may have been attributable to fleet sales and to incentives, both of which automakers have been trying to reduce in order to enhance profitability.

The primary weakness in the U.S. economy continues to be the homebuilding sector, which contracted further in July.  Although the level of housing starts and permits is comparable to the levels of the mid-1990s, there is no sign that these series have reached their trough yet.  Indeed, with the current turmoil in mortgage-related markets and the tightening of lending standards in those markets, homebuilding may deteriorate further in the next few months.

Sales of existing homes declined again in July, which, together with the large number of homes on the market, brought the inventory of houses for sale up to about 9.2 months’ worth, a high level by historical standards.  Moreover, given the tightening of standards in mortgage markets, home sales may decline and inventories rise further in the next few months.

The high level of housing inventories should be expected to put downward pressure on house prices, and in fact there is already evidence from two indexes that this may be occurring.  The OFHEO index captures house prices across the country but only for homes purchased with conforming mortgages (at present, the maximum size of such a mortgage is $417,000).  The Case-Shiller index captures all houses, whether purchased with a conforming mortgage or not, but only in major metropolitan areas.

The increased stress in the housing market and possible spillovers to the rest of the economy have led financial markets to expect that the Federal Reserve will ease monetary policy in the near future.  While two months ago, expectations for the federal funds rate were essentially flat, the futures market currently expects the Fed to cut the federal funds rate several times before the end of the year.  Treasury yields have fallen in line with the fall in interest rate expectations.

The decline in Treasury yields has only partially passed through to private-sector interest rates, however.  Delinquency and default problems on subprime mortgages appear to have led to a loss of confidence in the underwriting and rating standards on subprime and other nonconforming (such as “no-doc” and “jumbo”) mortgage loans.  As a result, the secondary market for these loans has largely evaporated.  Since these loans cannot be securitized at present, lenders have either stopped making nonconforming mortgage loans altogether or have tightened standards for them considerably, even for prime borrowers, because those loans must be held on the lender’s own books until demand for nonconforming mortgage-backed securities revives.

The conforming mortgage market has continued to function normally, however.  Those mortgages are being securitized as usual, and interest rates have even fallen over the past six weeks, partially reflecting the decline in Treasury yields.  Perhaps surprisingly, interest rates on automobile and other consumer loans also do not seem to have been greatly affected by the troubles in the mortgage market.  Similarly, interest rates on investment-grade corporate debt have held fairly steady or even declined slightly over this period.

One of the main concerns about the turbulence in mortgage markets is that those problems could spill over to the rest of the economy.  One place where we can see such a spillover is in the commercial paper market.  Many financial institutions have been issuing short-term commercial paper to finance purchases of mortgage-backed securities, including subprime mortgage-backed securities.  As a result, the loss of confidence in subprime mortgages has spilled over into a loss of confidence in asset-backed commercial paper.  What’s more surprising is that the market’s aversion to asset-backed commercial paper seems to have spilled over even to non-asset-backed industrial commercial paper, which is used by many major corporations to fund their day-to-day and month-to-month cash needs.  Despite the dramatic fall in short-term Treasury yields, yields on A2/P2 commercial paper (which is issued by investment grade corporations and is regarded as very safe) have risen dramatically.  Yields on AA commercial paper, the highest grade, have only recently begun to ease ever so slightly.  The LIBOR interest rate, which is similar to commercial paper in that it is a common method of unsecured short-term dollar financing between large financial institutions in London, has risen about in line with commercial paper.  Note that many adjustable-rate U.S. mortgages and flexible-interest-rate C&I loans are indexed to the LIBOR rate.

In light of the problems in housing and financial markets, we have revised downward our GDP forecast going forward, but given the underlying strength and momentum in the economy outside of housing, we project that GDP will continue to grow.  Nonetheless, there are substantial downside risks to this forecast if the problems in the commercial paper and mortgage-backed securities markets do not begin to resolve themselves.

Core inflation has been moderating recently.  We project that this moderation will continue, with the core PCE price index inflation rate edging down another one- to two-tenths of a percent over the next year and a half.