1. Real GDP is falling rapidly, but we expect it to
stabilize by about mid-2009. The main reason for
the stabilization is the recently enacted fiscal stimulus,
which should help many households continue to boost
saving without cutting real spending much further.
We think this stimulus will add about 3 percentage
points to the annualized change in real GDP (relative
to a baseline of continued contraction) during the
middle two quarters of 2009. We also expect
residential investment to level out after a long slide
that has cut this industry’s output by more than half.
2. However, the timing of the bottom in real GDP is
highly uncertain, and recovery, when it does begin,
will be anemic. Persistently high levels of claims for
unemployment insurance (both initial filings and
ongoing payments) underscore the strength of the
negative multiplier dynamic, which could short-circuit
any upturn in consumer spending; the other downside
risk is that we may underestimate the degree to which
consumers will cut back spending to achieve saving
objectives. As for recovery, the private-sector forces
that have usually driven strong cyclical rebounds—
vigorous housing recovery, consumer spending on
durable goods, rapid rehiring, and the inventory
cycle—all face significant challenges in the current
environment. Without them, the economy will have
difficulty sustaining growth, especially since we think
the fiscal stimulus now in place will fade out during
2010.
3. As a result, the unemployment rate should reach
10% by year-end 2010. We expect the same type of
“jobless recovery” pattern as occurred in the past two
business cycles, when companies held off hiring fulltime
workers until increases in demand were well
established. This behavior undercuts recovery, greatly
lengthening the lag between troughs in real GDP and
peaks in unemployment.
4. Deflation is a much bigger threat than inflation,
at least for the next few years. Although sharply
expansionary fiscal and monetary policies have caused
many market participants to worry about inflation,
these concerns miss the point that the policies have
been undertaken to combat a large and growing gap
between actual and potential output. Under any
reasonable economic scenario, the output gap will
peak at an extremely large level—8% to 10% of GDP
or more—and thus require years of above-trend
growth to eliminate. Given this prospect, we expect
year-to-year inflation in the core index of consumer
prices—now about 1½%—to cross through zero by
late 2010 if not before.
5. Monetary tightening is highly unlikely before the
end of 2010. Given our inflation outlook, we think
most members of the Federal Open Market Committee
will look for three conditions before raising the federal
funds rate from its current 0-25 basis point range: (a)
job market stability, defined as confidence that the
unemployment rate has peaked or will do so shortly,
(b) housing market stability, defined as a reduction in
unoccupied units large enough to reduce the pace of
decline in home prices, and (c) financial market
stability, defined as “you know it when you see it.”
6. The yield curve remains steep. Although we do
not think inflation worries will prove justified, they
will undoubtedly persist in financial markets and even
be reinforced whenever commodity prices jump in
response to global recovery or expectations of it. This
plus an extraordinarily heavy volume of Treasury
issuance is apt to keep the yield curve steep even as
Fed officials keep short-term rates extremely low.
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