WORD ON THE STREET: In the third quarter of 2009, the U.S. economy began to emerge from the deepest recession of the post-World War II period – one that had been precipitated by a severe financial crisis. Economic history teaches that such downturns typically are deeper, and that the pace of their subsequent recoveries is more moderate than is the case for business cycles not associated with financial crises. Certainly, that has been the U.S. experience for the past year and a half: Real economic activity has been steadily recovering overall, but the speed and strength of the rebound have been restrained by significant financial headwinds.
Consumer spending, which rose at only a modest rate in the first year of the recovery, has strengthened in recent months. Personal consumption expenditures (PCE), adjusted for inflation, increased at an annual rate of 3.75% between June and November, with sales increasing across a relatively broad range of consumer goods and services. The pickup included an increase in purchases of autos and light trucks that, in turn, prompted automakers to increase their assembly schedules for early this year. And while we don't have December data yet, initial reports of holiday spending have been strong.
Nonetheless, even with the recent pickup, consumer spending has not provided its usual cyclical boost to the recovery, as households have been restrained by the substantial loss of wealth they sustained during the financial crisis, persistently high unemployment and reduced availability of credit. The good news is that some of these restraints have been easing: Rising stock prices have been helping rebuild household wealth, the ratio of debt to income has come down, and delinquency rates on consumer loans have been falling. The supply of consumer credit has also improved somewhat over the past year, although the terms and conditions for some types of consumer loans are still tight relative to historical norms.
One area of continued stress is housing. After what looked to be a gradual recovery in new home building during 2009 and early 2010, new single-family starts slumped again during the summer and have remained depressed in recent months. Sales of new and existing homes are still at very low levels, and inventory remains high compared with the monthly pace of sales. House prices – even apart from sales of bank-owned properties – have been falling again, and many households appear to have lost confidence that prices will turn up anytime soon.
Disturbing reports of foreclosure improprieties have heightened concerns about mortgage loan servicing and mortgage modifications and have created uncertainty about the pace and volume of foreclosure sales yet to come. Delinquency and default rates on existing mortgages seem to have peaked, but they remain at historically high rates. And while low mortgage interest rates have contributed to strong refinancing activity, many households are still unable to qualify for the loans with the most favorable terms due to depressed home values, reduced income or weaker credit scores.
The commercial real estate market is also still quite anemic. Even after almost three years of declining investment in office and commercial structures, vacancy rates are still elevated, and property prices remain weak. Financing conditions for commercial real estate remain tight, and delinquency rates deteriorated further during the third quarter of 2010.
That said, some modest signs of improvement have surfaced: After having declined for two years, prices of commercial real estate, although still volatile, have changed little, on net, since the spring, and the number of property sale transactions has increased recently. Also, issuance of commercial mortgage-backed securities has turned up, albeit from a low level.
State and local governments also continue to struggle. The federal fiscal stimulus of the past two years helped shore up this sector but did not prevent significant cutbacks in services and employment that were associated with the steep decline in revenues sustained during the recession. In the second half of 2010, with some pickup in retail spending and moderate gains in taxable income, revenues began to firm, and outlays by state and local governments appeared to stabilize. Nonetheless, these jurisdictions will continue to face significant pressures to satisfy balanced budget requirements and to rebuild their depleted reserve funds at the same time that federal stimulus grants are winding down.
With the recovery proceeding at a moderate rate and the margin of economic slack quite wide, the underlying rate of inflation has been trending lower despite upward pressure from rising costs of energy, other commodities and imported goods. In the 12 months ending in November, overall inflation in PCE prices was 1%, and the 12-month change in core PCE inflation, which excludes more-volatile food and energy costs, was just 0.8%. Both measures show that inflation has drifted lower over the preceding year and that slowing appears to have been broadly based.
Indeed, even after reviewing a number of measures of the underlying trend in inflation, I find it difficult to identify a single measure that doesn't show that inflation has drifted steadily lower. At the same time, longer-run inflation expectations still appear to be stable.
Although the recovery continues to be uneven across sectors, recent economic and financial developments are broadly consistent with my forecast that the economic recovery will gain even more momentum and that the expansion will become sufficiently strong to gradually bring down the unemployment rate. Key elements of my forecast include a further strengthening in consumer spending and business investment in equipment and software, both of which will receive additional support from the recently enacted tax package. Given the currently high level of resource slack and my projection for only a gradual reduction in unemployment, I expect that inflation will remain subdued.
My forecast for continued growth in consumer spending is predicated on an assumption of ongoing recovery in wage and salary income that should accompany an expected pickup in hiring. In addition, household balance sheets should gradually strengthen as asset prices firm and continued deleveraging reduces household debt.
As the recovery continues, businesses should become more confident about expanding – by both upgrading facilities and adding workers. To date, larger firms have contributed importantly to the recovery in business spending, and they seem well positioned for further investment. Over time, small businesses, which have been held back by the slow recovery in demand and greater difficulties in obtaining credit, should also be better able to increase their spending and expand their operations.
My outlook for the housing market and for commercial real estate is more cautious. A sustained recovery in income and jobs will be an important prerequisite for a recovery in the housing industry. But until the overhang of vacant homes is reduced significantly and home values begin to firm, new residential construction is likely to remain at low levels. Similarly, time will be required to absorb the currently large amount of vacant office and commercial space before construction in that sector begins to turn up noticeably.
One important element of the outlook is my expectation that financial market functioning and lending conditions will continue to improve, providing additional support for a further pickup in consumer and business spending. During the financial crisis, banks reported on our quarterly survey an extraordinary tightening of their lending standards. To date, only a small part of that tightening appears to have been reversed. As banks continue to repair their balance sheets and develop greater confidence in the economic outlook, I anticipate that standards will improve further over coming quarters.
Nonetheless, I expect loan volumes, especially real estate loan volumes, to recover only slowly as both borrowers and lenders proceed cautiously.
One notable exception to my forecast for gradual improvement in financial markets is my expectation that residential mortgage markets could take a number of years to repair as policymakers and market participants grapple with the role of government in housing finance, adapt to changing regulation, and look for ways to better manage and price the risks associated with mortgage lending and servicing. Whatever the structure of housing finance is to become, the large overhang of problem loans and weak housing markets will necessitate a gradual transition.
Elizabeth A. Duke is a governor of the Federal Reserve Board. This article is an edited adaptation of a speech presented at the Maryland Bankers Association First Friday Economic Outlook Forum in Baltimore on Jan 7. The complete speech is available here.
