August 30, 2010
• The economy grew only 1.6 percent in the second quarter
• 23 percent of homeowners are underwater with their mortgages • Orders for business equipment plunged 8 percent in July
The past few months have revealed a lot that is going wrong in this economic recovery: Bank lending is still constrained, consumer spending is tepid, home sales are plunging, and businesses remain hesitant to hire. The economy’s engine just can’t seem to get going, despite more than $800 billion in federal stimulus programs and some of the lowest interest rates on record. After a promising start, with GDP growth averaging 3.4 percent in the three quarters through this year’s first quarter, the upturn appears to have stalled.
All this has been a wake-up call for the Federal Reserve, which only two months ago anticipated the economy would grow between 3 percent and 3.5 percent this year. The Commerce Dept.’s downward revision to second-quarter GDP growth on Friday, to 1.6 percent from the originally reported 2.4 percent, along with disappointing data at the start of the third quarter, makes that forecast a pipe dream. To achieve it, the economy would have to average 3.4 percent growth in the second half, a pace almost no one now expects, given that overall demand is too weak to provide that kind of thrust.
Despite the downgraded outlook, Fed Chairman Ben Bernanke appears to believe there is enough going right in the recovery to keep the economy growing at a “relatively modest pace” without the need for more policy stimulus. Speaking in Jackson Hole, Wyo., Friday, Bernanke said the Fed stands ready to push borrowing costs even lower, most likely with additional purchases of long-term government securities, “if the outlook were to deteriorate significantly.” However, his generally sanguine remarks on prospects for the economy, along with his expectations of a pickup in growth in 2011, appeared to set a high bar for more Fed action.
One trend headed in the right direction, Bernanke says, is bank lending. He noted that banks are improving their balance sheets and trying harder to attract customers. After three years of sharply tighter lending standards, banks are starting to ease their terms and conditions on loans to both large and small businesses, according to the Fed’s latest survey of senior loan officers. Standards for consumer borrowing remain tight, but they, too, have eased somewhat, including those for prime mortgages. “If, as is typical, bank lending picks up following the easing of standards, it would provide important support to growth and employment,” says UBS economist Samuel Coffin. That would be especially true among credit-constrained small businesses and in the housing market.
But cheap and ready financing is no cure-all. The Fed’s bigger problem in kick-starting bank lending is weak loan demand, especially among consumers trying to shed mortgage and installment debt, not take more on. The good news, Bernanke noted, is that consumers are rebuilding their finances much faster than expected. With ultra-low interest rates and modest gains in income, economists at Morgan Stanley estimate that households have cut their debt service — interest and principal payments on their debt — to 12.4 percent of after-tax income in the second quarter, the lowest level in a decade. “In our view, the headwind to consumer spending from deleveraging is now a smaller risk to the outlook, as consumers can spend more of their incomes,” says Morgan Stanley economist Richard Berner.
Stronger household finances also help support the housing market. Bernanke believes that housing will ultimately benefit from record-low mortgage rates and cheaper home prices. The expiration of the tax credit for home buyers who signed contracts by April 30 sent home sales plunging this summer, following the artificial boost to demand earlier. That reversal was widely expected, as is some associated weakness in home prices in coming months. After plunging in June, mortgage applications to buy a home have begun to stabilize in recent weeks, according to the Mortgage Bankers Association, suggesting that the downdraft from the credit’s expiration is about over.
Still, housing remains one of the biggest risks in the outlook, especially with little support from the job market. In the second quarter, 23 percent of homeowners were underwater, with homes worth less than the balance on their mortgage, according to CoreLogic. Many are simply walking away from their mortgages, adding to the stock of foreclosures and bank charge-offs, which put pressure on banks’ capital and their capacity to lend.
One thing low mortgage rates have accomplished is to set off a refinancing boom. The average rate for a 30-year loan slipped to another record low of 4.36 percent last week, according to Freddie Mac. Refi activity is up 26 percent in the past four weeks, to the highest level since May 2009, and accounted for about 80 percent of new mortgage applications in recent weeks, according to the Mortgage Bankers Association. Homeowners who are able to refinance have extra cash for paying off existing debts, spending, or saving.
Perhaps the chief risk the Fed faces is the loss of business confidence in the future. So far, the business sector has returned to profitability with surprising speed, giving companies the ability to expand as demand picks up. Increases in spending for equipment, inventories and payrolls have been a major source of growth in the economy in recent quarters. Without the contribution from equipment spending, second-quarter GDP growth would have been zero. A key composite of equipment orders plunged 8 percent in July, and jobless claims for Aug. 20, while down from the previous week’s surge, remain high. Both trends suggest that companies are pulling back.
If the economy is to make it through this soft patch without any additional help from Fed policy, a lot will have to go right. In its weakened state, the U.S. is especially vulnerable to some new shock, which would further weaken demand, compounding the problems in the labor markets and state and local finances, while increasing the risk of deflation. Barring that, Bernanke & Co. are betting that the recovery already has enough support to carry through on its own. It’s a high-stakes gamble.