Research Facts & Figures > Economic Forecasts & Updates > Q4 2009 Quarterly Forecast > The Nation

The Long Goodbye¹

Recession Over, But Recovery Very Sluggish

David Shulman
Senior Economist
UCLA Anderson Forecast

Although the worst recession in seven decades likely ended in the current quarter, its negative effects will linger well into the next decade. As we noted previously, the recession had its origins not so much in imbalances in the real economy, but rather in the over-indebtedness of consumers and businesses that will take time to cure. Simply put it was a balance sheet recession.

That said, after four quarters of decline, economic growth is resuming. A lion’s share of near-term growth will come from a dramatic reversal in inventories. After plunging at a revised annual rate of $159 billion in the second quarter, real inventories are forecast to increase by $12 billion in the fourth quarter accounting for almost 1 1/2% of real GDP. However, once the big swing in inventories is spent, growth will remain very modest for most of 2010. Two other important swing factors are the recovery in exports and the long awaited rebound in residential construction.

And so, if our view of sluggish overall growth is close to the mark, the unemployment rate will be above 10% well into next year. Also adding to the subdued recovery is our belief that after a two decade consumer spending binge based initially on rising stock prices and then on rising home prices fueled by extraordinarily easy credit has ended. Now consumers seeking to accumulate assets will have to do it the old fashioned way, by directly increasing savings through a reduction in consumption.

Fiscal Collateral Damage

Starting with the Bush Administration’s $168 billion stimulus package in 2008 and ending with the Obama Administration’s $787 billion package in 2009, the federal government has gone all out in attempting to mitigate the effects of the recession and to engender economic recovery. Whether or not the programs work as intended will take time to sort out, but it appears that the increase in spending and tax cuts may have put a floor under last winter’s decidedly weak economy.

However, the stimulus spending along with an increase in baseline spending and the effects of the recession have caused a decided worsening in the long-term fiscal outlook. The administration is now projecting cumulative federal deficits of $9 trillion over the next 10 years. To call this collateral damage is to put it mildly; it looks more like a fiscal train wreck that international holders of large dollar balances might seek to avoid thereby triggering a significant devaluation of the currency. Given the fiscal outlook, sooner or later President Obama is going to have to give-up on a host of domestic programs and/or go against his campaign pledge not to increase taxes on households earning less than $250,000 a year.

Whither the Fed?

Now that Federal Reserve Chairman Ben Bernanke has been re-nominated, the focus will return to the substance of Fed policy. As difficult as it might have been for both the Fed and the Treasury to engage in their unprecedented interventions in the economy, the hard part is now ahead of them. It is one thing to intervene with the goal of saving the economy and restoring growth, it is quite another to take back the monetary stimulus to fight an incipient inflation in an environment of high unemployment. Market participants know full well that there is more than enough liquidity in the system to ignite a persistent inflation; not today but perhaps within a few years.

In order to deal with this threat we believe that the Fed will gradually shrink its balance sheet and begin to slowly move away from its zero interest rate policy in the third quarter of 2010. To be sure unemployment will still be around 10%, but the economy will have been growing, albeit slowly, for about a year by then. The argument for modest rate hikes will be that the financial emergency is over and that modest rate increases would have a minimal effect on the economy. In fact it could be viewed as a sign of strength in light of the fact the financial markets by that time would have returned to normal.

Bottom line: despite the weak outlook, we are no longer looking into an abyss.

[1] With apologies to Raymond Chandler.

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