PRINTMarket Update -- Economic Comment
January 16, 2008
The liquidity crisis appears to be resolved. LIBOR rates have plunged and are now below the 4.25% federal funds rate, and the Fed's latest auction of 28-day term funds revealed a 3.95% interest rate, also well below the federal funds rate. Unfortunately, financial markets have a new bugbear to worry about: the economy.
Two economic indicators released during the first week of January caused economists and investors to rethink their 2008 economic forecasts. The first, the ISM manufacturing index for January, fell 3.1 points to 47.7, a level that spells trouble for the manufacturing sector. The second, the unemployment rate, jumped 0.3 percentage points in December to 5%. This outsized jump, coupled with the fact that the unemployment rate had already risen 0.3 percentage points in the previous two quarters, clearly forewarns a recession. While both of these economic indicators may show improvement in the next release, these data cannot be dismissed as outliers.
In reaction to these data and other economic data that support our thesis that a recession is at hand, we raised our odds for a recession from 60% as seen in November to 90% following the labor market report. We also lowered our full year GDP growth forecast to 1% from 1.5% and cut our quarterly forecasts to show three quarters of negative growth in 2008. We cannot claim a high level of conviction in our quarterly GDP forecasts, though, because recessionary environments have a way of taking on a life of their own that makes forecasting particularly difficult.
Economic recessions, while defined by economic statistics, are characterized by profound changes in consumer and business manager behavior. Thus, you have to forecast behavioral changes in order to predict the magnitude and duration of a recession. In a recessionary environment, consumers might choose to spend less even if they have the means to maintain their spending habits due to concerns about the future. Similarly, business managers might choose to reduce hiring and spending due to concerns about a potential softening in domestic demand. The danger is that a feedback loop will form, whereby slower activity perpetuates itself. Breaking this cycle is the key to turning the economy around. Fiscal and monetary stimuli have worked in the past, but the economy's reaction to stimuli varies from cycle to cycle.
The good news is that the Federal Reserve and Congress are now recognizing the need for stimuli. Let's hope it can be applied in a timely and efficient manner.
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