The economy's return to growth after a year and a half of recession marks a major turn, and it looks like more than a flash in the pan. It seems to me that the economy has entered a sustained period of expansion.
All the same, I am not going to paint an entirely rosy picture for you. The strength and durability of the expansion is in question. Some of the rebound is due to temporary government programs and a swing in inventory investment that will not provide an ongoing source of growth. Financial conditions have improved markedly in some respects, but many financial institutions are still hobbled with bad loans.Â
The outlook for consumer spending is in doubt, because households remain burdened with debt, and they have taken enormous hits to their wealth from declines in house and stock prices in recent years. And it's particularly sobering that labor markets continue to deteriorate badly, leaving many millions of our fellow Americans unable to find jobs. On top of this, we found out that the unemployment rate passed 10% in October. The 10.2% jobless rate is the highest since 1983.
Against this backdrop, the nation's third-quarter return to growth was a great relief. Real gross domestic product – which is the economy's total output of goods and services – increased at a solid annual rate of 3.5%. The recession hasn't officially been declared over, but a wide array of data suggests that the country's economy has turned the corner.
In the third quarter, residential investment – which was at the center of the downturn – rose at nearly a 25% annual rate, albeit from a very low level. Home sales, prices, and housing starts are, once again, climbing. Meanwhile, manufacturing is also beginning to show signs of strength. This was helped by a rebound in motor vehicle production, boosted by the government's temporary Cash for Clunkers program. Our exports surged, as growth abroad picked up. And, importantly, consumer spending finally is growing.
To me, the explanation for this turnaround is clear: Massive and concerted responses by governments and central banks around the world rescued the financial system, brought down interest rates, provided emergency support and broke the economy's downward spiral.Â
On the monetary policy side, the Fed has pushed its traditional interest rate lever – the federal funds rate – close to zero. And, in order to provide additional stimulus, we put in place an array of unconventional programs to spur the flow of credit to households and businesses. These measures provided funding to banks and restored liquidity to a range of markets.Â
We've increased the flow of credit for securities backed by small business loans, consumer loans and other assets. Our large-scale purchases of Fannie Mae and Freddie Mac debt and mortgage-backed securities (MBS) helped lower mortgage rates and bolstered the housing market. We've also bought longer-term U.S. Treasury debt to help bring private borrowing rates down.
These initiatives appear to have eased financial conditions. Clearly, the financial system is not yet back to normal, but it has bounced back notably. The stock market has soared since its low in the winter. That rally has helped households recover some of their lost wealth and provided a much-needed psychological boost.Â
Investors perceive that economic risks are not as dire as they once seemed to be. Interest rates on corporate bonds – especially for less-than-prime firms – have dropped sharply, and issuance has been brisk. And the markets that financial institutions and corporations rely on for short-term funding are functioning reasonably well again, due in part to Fed intervention.
The big issue is how strong the upturn will be. With such enormous reservoirs of slack in the form of high unemployment and idle productive capacity, we need a strong rebound to put unemployed people back to work and get underutilized factories, offices, and stores humming again. Unfortunately, my own forecast envisions a less-than-robust recovery for several reasons. As the impetus from government programs and inventories diminishes in the quarters ahead, private final demand will have to fill the breach. The danger is that demand may grow at too anemic a pace to support vigorous expansion.
First, it may take quite a while for financial institutions to heal to the point that normal credit flows are restored. The credit crunch hasn't entirely gone away. In the face of massive loan losses, banks have clamped down on underwriting and credit terms for both businesses and consumers.
Second, households have been pummeled, and prospects for consumer spending are cloudy. Consumers have surprised us in the past with their free-spending ways, and it's not out of the question that they will do so again. But I wouldn't count on them leading a strong recovery.
It may be that we are witnessing the start of a new era for consumers following the harsh financial blows they have endured. We often hear the word "deleveraging" used to describe the push by financial institutions to scale back debt and build equity.Â Households, too, have now begun to pay down debt and rebuild their savings.
I'd like to take a close look at real estate markets – both residential and commercial. You may be getting weary of my "on-the-one-hand, on-the-other-hand" message, but I'm afraid I have more of that to offer when it comes to housing. To put it bluntly, the outlook for the residential market is uncertain. And uncertain is much better than the prospects for commercial real estate, which clearly are weak.
Let me begin with housing. We have gone through many boom-and-bust cycles, but none in the past half-century has had such far-reaching effects as did the wild ride of residential real estate during this decade. House prices soared from 2002 through 2005, moving dramatically out of line with fundamentals. By one measure, house prices on average peaked more than 50% above the level that could be supported by underlying rental values.
Since the market top three years ago, the nation has experienced roughly a 30% collapse in average house prices, depending on the index used. That's a terrible plunge, but there's some good news in it for the future: Prices are approaching a range where valuations are more in line with fundamentals. Such an adjustment is essential for a sustained revival of housing activity.Â Â Â
Indeed, there are indications that the sickening market plunge has ended, with prices beginning to edge up. At the same time, home sale volumes are advancing briskly. The supply of new houses on the market has been brought down from over 12 months to about 7.5 months. That's still well above the four-month supply that was typical in the period right before the bust, but the adjustment seems to have been enough to kick some life back into construction.
In the third quarter, real residential investment surged, though from an admittedly low level. For the first time in more than three years, housing construction actually added to GDP growth.Â Â
In the face of high and rising unemployment, mortgage delinquency and foreclosure rates are still increasing in the area. The share of mortgage loans in foreclosure or 60 days or more past due is nearly three times the national median. And this is, by no means, largely a subprime problem. Prime borrowers now account for the lion's share of new foreclosures.
Meanwhile, developers and their creditors have been caught with excess raw land, lots that are partially completed, or completed but still vacant. Values for finished but vacant lots across the country are reported to be off about 50% from their peak, with some hard-hit regions in the West down even more. Over the past year and a half, developers and their bankers have been working through this inventory and recognizing the associated losses. As write-offs on these loans flow through community and regional banks, we can expect more failures.
The bottom line is that the outlook for housing has turned up in response to favorable mortgage rates, lower house prices and a lower overhang of unsold houses. Growth in this sector should contribute to the overall economic recovery. These developments represent real gains, but it's important not to get carried away.
Some of the advance reflects temporary government support in the form of tax credits for first-time home buyers, and the impact of loan modification programs and foreclosure moratoriums that reduced the pace of distressed sales. Moreover, foreclosure notices surged earlier this year, and distressed property sales may rise once again in the months ahead. If so, we could see renewed pressure on house prices.Â
Of course, continuing high unemployment will also fuel additional foreclosures, and the supply of credit for nonconforming mortgages remains extremely tight. Financial institutions are reluctant to place them on their books when they are trying to reduce leverage, and we have yet to see any revival of the market for private mortgage-backed securities.
When we turn to commercial real estate, the prospects are worrisome. Commercial property didn't turn down until well after housing did. The sector's problems appear to stem, in large part, from the effects of the recession and the credit crunch, rather than the type of building boom and lax underwriting standards that tripped up housing.
Still, there are some parallels between the two sectors. As in the residential market, commercial real estate values posted enormous price gains, with office values roughly doubling from the end of the 2001 recession to the peak. Since then, values have plunged an estimated 35% to 40%, and vacancy rates are rising for office, retail, warehouse and other income-producing properties.
Credit market conditions are weighing heavily on this sector. Risk premiums on commercial real estate financing remain elevated, although they're down a bit from the peak of the financial crisis. Average commercial real estate capitalization rates have seen risk spreads more than double over the past two years to more than four percentage points over 10-year Treasury securities.
The market for commercial mortgage-backed securities (CMBS) remains deeply distressed, and issuance is meager, despite support from the Fed's Term Asset-Backed Securities Loan Facility (TALF) and the Treasury's Public-Private Investment Program. Banks and thrifts, which account for more than half of commercial real estate financing, have significantly raised rates and tightened credit terms. That, combined with higher investor demands for returns and weakening operating income, points to further downward pressure on property values.
Commercial real estate borrowers are increasingly hard-pressed to stay current on their loans. CMBS delinquency rates rose from about half a percent in August 2008 to over 3% this July. Weakening loan quality is particularly damaging in Arizona, where commercial real estate accounts for a much larger share of the average bank loan portfolio than in the nation.
A large volume of commercial real estate loans and securities are coming up for renewal over the next several years. This will prompt lenders and investors to review terms for continued extension of credit. In many instances, banks are asking borrowers to either repay loans, provide more equity, or agree to modified terms and conditions. These adverse trends recently prompted federal regulators to issue guidance on commercial real estate to banks and thrifts, with a focus on sound practices for loan workouts.
Nationwide, the commercial real estate downturn has been a drag on economic growth, subtracting about 1% at an annual rate over the first three quarters of this year, compared with a roughly neutral effect in 2008. All indications are that commercial real estate will continue weighing down the recovery going forward.Â
When the weakness of the commercial property market is combined with the muted outlook for housing and consumer spending, you can see why I believe that the overall economic recovery is likely to be gradual and remain vulnerable to shocks.Â
It's popular to pick a letter of the alphabet to describe the likely course of the economy. The letter I would choose doesn't exist in our alphabet, but if I were to describe it, it would look something like an "L" with a gradual upward tilt of the base. With such a slow rebound, unemployment could well stay high for several years to come. In other words, our recovery is likely to feel like something well short of good times.
Janet L. Yellen is president and CEO of the Federal Reserve Bank of San Francisco. This article is adapted from a speech delivered on Nov. 10 at the Phoenix Chapter of Lambda Alpha International.