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Moody's Economic Outlook
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Transcript of Moody's Economic Outlook
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7/27/2019 Moody's Economic Outlook
1/10
Monetary policy. The Federal Reserve
is using all of its considerable resources
to stabilize the financial system and the
economy. The effective federal funds rate
remains near zero, and policymakers haveindicated that the funds rate will stay atzero for an "extended period." The Fed isalso aggressively buying financial securities
ranging from commercial paper to Treasurysecurities, guaranteeing troubled assets ofkey financial institutions, and extendingcredit to investors to facilitate their pur-chases of financial securities.
The Fed's unprecedented actions ap-pear to be working, with varying degreesof success. Efforts to revive the commer-
cial paper market have been particularlyeffective as the private CP market is func-
tioning well and Fed ownership of CP hasbeen winding down since peaking late lastyear. The recent rise in long-term Treasury
yields and fixed mortgage rates shows thelimits of the Fed's actions, however, asinvestors have seemingly become morefearful of future inflation and heavy gov-
ernment borrowing. Inflation is, after all,a monetary phenomenon, and the Fed is
printing trillions of dollars.Although inflation may very well get
uncomfortably high at some point earlyin the next decade, it is unlikely to bethe problem feared and is certainly nota reason for the Fed to hold back in itsresponse to the current crisis. Moneygrowth ignites inflation only if it first leads
to more and less costly credit, which thenfuels an economy so strong that labormarkets get tight and utilization ratesbump up against capacity constraints.Policymakers have time to respond beforeall of this transpires, as it could be yearsbefore credit flows freely again and the
economy finds its way back to full employ-
ment. Also, most of the liquidity the Fedhas provided so far to the financial system
is very short term.The Fed is expected to begin normal-
izing interest rates by summer 2010. Atthat time, the financial crisis will have sub-sided and house prices and the broader
economy will be stabilizing. The fundsrate is expected to end 2009 at effectivelyzero and 2010 at closer to 1%.
Fiscal policy . The federal govern-ment's fiscal situation is rapidly deteriorat-ing. The budget deficit, which was $475
billion in fiscal 2008, is expected to bal-loon to a whopping near $2 trillion in fis-cal 2009 and total a cumulative $6 trillionover the next four fiscal years. This reflectsthe expected nearly $2.6 trillion price tag
to taxpayers of the financial crisis.Of the $2.6 trillion in costs, $ 1.8
trillion represents the direct cost of thegovernment response to the financialcrisis. This includes nearly $800 billion
for the economic stimulus package spentfrom fiscal 2009 to 2012, and $1 trillionfor what the government is committing to
support various institutions and marketsless what the government will recoup infuture asset sales. The commitments have
quickly mounted and include such thingsas $700 billion for the Troubled Asset
Relief Program, $400 billion for recapi-talizing Fannie Mae and Freddie Mac,and over $2 trillion in Federal Reserveloans to various financial institutions.For context, the savings and loan crisisin the early 1990s directly cost taxpayers
some $275 billion in today's dollars. Theweaker economy, the resulting loss oftax revenues, and increased spending tosupport those losing their jobs and otherincome support programs will cost theTreasury another $800 billion.
The budget outlook will remainextraordinarily daunting even after thefinancial crisis abates as the costs ofMedicaid, Medicare and Social Security
balloon. President Obama's first budgetproposal does not significantly addressthe nation's long-term fiscal problems.The Congressional Budget Office projects
that the nation's federal debt-to-GDP ratiowill rise to over 80% a decade from nowunder the president's plan, about doublethe approximately 40% ratio that prevailed
before the current financial crisis. Thisbudget outlook is untenable, however,and policymakers will need to undertake
various substantial changes to entitlementprograms and taxes.
U.S. dollar . The U.S. dollar has sagged
a bit in recent weeks as the flight-to-quality
bid for U.S. assets has faded with the better
financial conditions and the moderatingglobal recession. Despite the recent decline,
the dollar is still up over 10% on a broad
trade-weighted basis from its low about
one year ago, rising most against the British
pound and Canadian dollar.
The dollar is roughly appropriatelyvalued against most of the world's majorcurrencies, including the euro, Canadiandollar and Japanese yen. The dollar is
somewhat overvalued against the British
pound and significantly overvalued, bysome 25%, against the Chinese yuan.Once the financial crisis subsides, theChinese are expected to resume revalua-tion of their currency, eventually resultingin a freely floating yuan by the middle ofthe next decade.
Energy prices . The price of a barrel ofWest Texas intermediate crude oil is trading
near $70. Over the past year, prices have
ranged from well below $50 per barrel at
the start of 2009 to a record of almost $150per barrel in summer 2008. Retail gasoline
prices are near $2.50 per gallon, comparedwith an all-time high of close to $4. Natural
gas prices have also fallen sharply, to wellbelow $4 per million BTU.
Global economic conditions and thesubsequent impact on energy demand aredriving energy prices. The recent firmingin prices reflects growing expectations thatthe worst of the global downturn is overas the Chinese economy reaccelerates andthe severity of the U.S. recession abates.Oil prices are not expected to rise above$ 75 for very long, at least not until theglobal recession is over late this year. How-
ever, prices are expected to move steadilyhigher in 2010 as global growth resumes
and energy demand picks up in earnest.For all of 2009, oil prices are expected toaverage near $55 per barrel, and to aver-age $75 per barrel in 2010. Early in thenext decade, oil prices are expected torange between $75 and $100 per barrel,
consistent with global demand and supplyfundamentals and abstracting from thevagaries of the global business cycle.
Natural gas prices will have trouble
keeping up with oil prices over the next
several years as a very substantial gluthas developed. Demand has weakenedsharply with the recession, and supplyhas increased substantially in response to
previously very high prices. Natural gasprices are expected to average $4.5 per
million BTU in 2009, $7 per million BTUin 2010, and closer to $9 per million BTU
in the longer term.Martz Zanuli
June 2009
Moody's Economy com www.economy .com help @economy.com Precis MACRO June 2
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Fiscal stimulus . The policy response outof Washington will help end the recession
late this year but could provide a boost morequickly than expected. The government's
one-time payment to Social Security recipients
occurred in May. This, combined with taxrefunds and other fiscal stimulus, will add
an estimated $22 billion, or $264 billion atan annualized rate, to household cash flowin May. The massive infrastructure spendingcould also kick in more quickly than expected,
providing a big boost to the labor market andbusiness investment.
' Fed policy. The Federal Reserve is fully
engaged, and additional unconventional actionscould stabilize financial markets, stimulate
growth, and improve confidence more quickly
than expected. The Fed is involved in almost all
financial activities to promote the resumptionof normal credit flows, and its actions may buy
additional time for the economy to recover.
Reduced stress in financial markets has led to a
decline in demand for many of the Fed's creditfacilities. This implies that banks are finding it
easier to access other sources of credit, which
lends some upside risk to the outlook.j. Bond market . A selloff of Treasury bonds
is driving interest rates higher, threatening
to unwind the improvement in financial
conditions. Treasury yields have surged because
of a renewed appetite for risk in an effort to find
higher yields and concern that large budget
deficits and expansionary monetary policy
could lead to higher inflation. Treasury prices
could fall further, pushing borrowing costs
up, and higher mortgage rates could extend
the downturn in housing. The 30-year fixed
mortgage rate is expected to fall below 5%
in the third quarter but unease in the bondmarket suggests that rates could move higher
than expected.
j Labor market . The forecast is for a peak-
to-trough decline in payroll employment of
almost 8 million and for the unemployment
rate to peak near 10%, but job losses could
be even larger than expected. Forward-
looking labor market indicators are bad, with
initial claims for unemployment insurance
benefits still above 600,000. The strength
of the recovery will determine how quickly
the unemployment rate declines. In fact, the
unemployment rate is not expected to return
to its equilibrium rate of around 5% until
2013, and a weaker than expected recovery
could delay this even further, creating drags on
incomes and consumer spending.
j Wages. Although the pace of job lossesmoderated in May, the substantial deteriorationin the labor market is weighing on wages
more quickly than expected. The rapid rise
in the unemployment rate is expected to
unleash powerful disinflationary pressuresover the coming quarters as a downshift in
compensation causes core inflation to slow.
Given a 0.7/o drop in aggregate hours worked
in May, the payroll report's proxy for labor
income is falling at a more than 6% annualized
pace, a massive headwind for consumer
spending. Businesses will need to cut far fewer
jobs if labor income is to stabilize, a necessary
condition for sustained economic growth asfiscal stimulus fades.
., Energy prices . Oil prices could increase
more quickly than expected, putting upward
pressure on headline inflation and reducinghousehold purchasing power. The price of abarrel of West Texas intermediate crude has
more than doubled since the end of 2008 and
is expected to remain near $60 through the restof 2009. However, further increases in energy
prices would raise costs for gasoline and home
heating oil, pulling down consumer spendingon other items and weighing on sentiment.,, Detroit 3. Disorderly bankruptcies atChrysler and/or GM would lead to larger than
expected job losses and declines in industrialproduction and vehicle sales. Chrysler appears
to have avoided liquidation; a deal worked
out with the Obama administration, Fiat, theUAW and creditors will allow the company
to continue operations. In liquidation,Chrysler's factories and other operations
would have closed and the company's assetssold off to pay creditors. The bankruptcies of
Chrysler and GM could slow the recovery in
manufacturing and add another hurdle for thelabor market to overcome.
.+. Lending standards . Lending standards
remain extremely tight despite a massive
infusion of capital from the government, which
could slow the recovery in housing. Banks'
unwillingness to lend except to borrowers with
pristine credit is weighing on the recovery.
With consumers' access to credit impaired,
a significant rebound in home and auto sales
is unlikely over the next few quarters. The
economy will remain very vulnerable until
credit flows more freely between banks and
creditworthy borrowers. The forecast assumes
a loosening in lending standards, but there
is a possibility that this will not materialize,
extending the housing downturn and recession.
j Inflation expectations . With the
recession showing signs of abating, inflationexpectations could increase more quicklythan anticipated, complicating matters for
the Fed. Market-based measures of inflation
expectations have climbed steadily over thepast few months, and concern is growing that
the Fed's massive expansion of its balance sheet
and enormous budget deficits will fuel future
inflation. The increase in inflation expectations
may be overdone because the sizeable output
gap is expected to keep inflation low. Further
increases in inflation expectations could forcethe Fed to tighten monetary policy with the
expansion still uncertain.j Foreclosures . Rising foreclosures threatento overwhelm the Obama administration's
mortgage mitigation efforts and could delay
the expansion. Without further governmentaction, mortgage loan defaults-the first stepin the foreclosure process-will reach 4 millionthis year, or nearly one in 12 first mortgages.
The increase in foreclosures would add moreinventory to an already-bloated housing market,
driving prices even lower. From peak to trough,
Moody's Economycom expects prices to fall
almost 40%, based on the Case-Shiller HomePrice Index, but surging foreclosures could
magnify the decline. If house prices overshoot,
falling below equilibrium levels, lenders would
be forced to write down even more mortgages,
and household wealth would decline further.4. Investment . Businesses' access to credit
remains impaired, which threatens to deepen
the contraction in nonresidential fixedinvestment. The baseline forecasts calls for
nonresidential fixed investment to decline
into 2010, but deeper business pessimism
could extend the contraction. Businesses are
already slashing capital expenditure plans and
liquidating inventories in an effort to better
align them with final demand.
j Fiscal conditions . Washington's eroding
fiscal situation threatens long-term economic
growth, and there is great risk that the budget
deficit could be much larger than expected. Thestimulus package passed earlier this year was
necessary but will result in budget deficits of
close to $2 trillion for the next two years. With
costs for Medicare, Medicaid and Social Security
set to increase substantially in coming years as
the baby boomers retire, policymakers will have
to make very difficult decisions about long run
taxes and spending.
Ryan Sweet
June 2009
Moody's Economy. c o m www.economy.com [email protected] Precis MACRO Ju ne 20 5
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New-Home Inven tor ies Are Back to Normal
60 0
55 0
50 0
45 0
40 0
35 0
30 0
25 0
00 01 0 09
The recession continues on, but the basis for an economic re-
covery is coming into place. Monetary and fiscal policies remainextraordinarily stimulatory, and progress is being made in correct-ing the excesses that are at the heart of the downturn. Householdsand businesses are rapidly deleveraging, as is the financial system.Retailers and manufacturers have been cutting inventories for thebetter part of the past two years. The sharp decline in house priceshas restored housing affordability, and homebuilders have success-fully reduced their inventories of unsold homes to where they were
prior to the housing bubble.
Not a V-Shaped Recovery
Net % of senior loan officers at large comm ercialbanks willing to make a consumer loan
The severe recession is expected to end this year, with real GDP
falling 3%, the largest annual decline since the Great Depression. Therecovery expected in 2010 will be disappointingly weak, with realGDP advancing just over 1%. This stands in contrast to the muchstronger recovery expected by the Obama administration's Officeof Management and Budget and the Congressional Budget Office.History argues for a stronger recovery, but this is unlikely, given thatthe troubled housing and vehicle industries will not be able to drivegrowth as they have in times past. Weak credit growth due to the re-
structuring of the financial system will also impair recovery.
Mortgage Refinancing Wave Is in Jeopardy
6. 830-year fixed mortgage rpte, % (L)Source: Freddie Mac
6.4 t
4.8 r
Mortgage refinancing applications, index, March 16, 1990=100 (R)Source: Mortgage Bankers Association
8,000
7,000
6,000
5,000
4,000
3,000
2,000
} 1,0004'08 F M A M J J A S O N D J'09 F M A M J
Even more policy action is likely necessary to ensure that the re-
cession ends this year. Most notable is the need for more concertedaction to stem surging foreclosures and shore up the still-weakeninghousing market. The Obama administration's foreclosure mitigationplan has yet to have a meaningful impact, and a bolder plan maybe required. The Federal Reserve may also need to increase its com-mitment to purchasing Fannie Mae and Freddie Mac debt and themortgages they insure and Treasury bonds. The recent rise in long-term rates is already short-circuiting the mortgage refinancing wave
and threatens to undermine any housing recovery.
Credi t Will Not F low Freely An y Time Soon
67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
-8 0
Key to the timing of the end of the recession and the characterof the subsequent recovery will be how quickly credit begins to flowmore normally again. The worst of the credit crunch is over, as the
banking system has stabilized, credit spreads have narrowed, andsome bond issuance has resumed. However, underwriting standardsremain very tight across all types of lending, particularly for con-sumer and residential and commercial mortgage loans. When com-bined with weak credit demand, debt outstanding is falling sharply.A strong, self-sustaining economic expansion will not take hold
until credit is expanding again.
Moody's Economycom www.economy.com help@ economy.com Precis MACRO June 2009 7
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Prospects are improving that the reces-sion will be over by year's end. Real GDP
which fell nearly 6% annualized in the first
quarter, is on track to decline 3% in the sec-
ond quarter and to see marginal gains in thesecond half of the year. Behind this upbeat
outlook is evidence that the long-running
downdraft in housing construction is windingdown, consumer spending has stabilized, andgovernment spending is picking up. All of this
will be just enough to offset continued weakbusiness investment and exports.
Evidence indicating that housing startsare near bottom includes the recent firmingn new-home sales and lower new-home in-
ventories. A floor has formed under sales, ashomebuilders are lowering prices more ag-
gressively and mortgage credit is becoming abit more ample. Tax credits in various statesand a nationwide tax credit for first-timebuyers included as part of the fiscal stimulusare also helping.
Consumers are no longer panicked,n part because they are saving again. The
personal saving rate, which was essentiallyzero one year ago, is now closer to 6% afteraccounting for various measurement issues.The saving rate will move higher, but onlylowly, as lower-income households with
very low saving rates are in no position toave much more in this tough economy.
While this does not mean that consumer
pending will ramp up any time soon givenhe difficult job market, it does suggest thathe spending declines are over.
The infrastructure outlays included aspart of the fiscal stimulus will also begin toncrease in earnest later this year. These dol-
ars should more than offset the budget cutshat many state and local governments are
being forced to make, at least for a while.Rate threat . The recent increase in
ong-term interest rates poses a new threat
o optimism that the recession will be over
oon. Yields on the 10-year Treasury haveumped 1 percentage point since mid-Aprilo just below 4%, pushing the rate on a con-orming 30-year fixed mortgage up to nearly
5.5%. If sustained for much longer, these
higher rates would curtail the budding mort-gage refinancing wave and undermine anyevival in home sales.
Heightened worries about future infla-ion and record government borrowing are
driving rates up. Both concerns are over-
done, or at least premature. Given the excesscapacity throughout the economy, defla-tion-not accelerating inflation-remainsthe predominant risk through this time next
year. Not only is the unemployment rate ap-proaching double digits, but office and retailspace vacancy rates are rising, the capacity
utilization rate in manufacturing is at a re-cord low, rig counts in the Gulf of Mexico
are off sharply, and the numbers of moth-balled airplanes and cargo ships rise. Mostbusinesses have little or no pricing power.
Concerns that the massive liquidity theFederal Reserve is currently pumping intothe financial system will eventually ignite
runaway inflation are misplaced. Most ofthe Fed's credit facilities are short-term and
designed to wind down as private creditmarkets revive. The commercial paper pro-gram policymakers established last year isa case in point. The Fed owned upward of$350 billion in commercial paper during theheight of the financial panic late last year,
but now owns only one-third of that, as theprivate commercial paper market is againoperating well and rates are below what theFed is charging.
The nation does have very serious fis-cal problems, but it seems premature forinvestors to be focused on that now. Thegovernment's unprecedented borrowing is
occurring when private credit demands areextraordinarily low and personal saving hassurged. As a result, global investors have notbeen called upon to increase their Treasurypurchases. That may be the case if govern-ment borrowing does not abate when thebroader economy improves and credit de-mands meaningfully increase, but this mo-ment of truth is still some way off.
Unless long-term rates soon give back
some of their increases, the Federal Reserve
will be under pressure to significantly increase
its current commitment to purchase $300
billion in longer-term Treasury securities. Up-ping the ante to, say, $600 billion or even $1
trillion may not get yields back down, but it isworth the effort, given the threat that higher
rates pose to the struggling economy. ,
V U or ...? Despite the threats, the endof the recession is close enough in view that
it is reasonable to consider the character of
the subsequent economic recovery. History
would suggest a strong recovery is in the off-
ing, as the one and only regularity of business
cycles is that strong recoveries (V-shaped) fol-
low severe downturns and shallow recoveries
(U-shaped) follow shallow downturns.
Unfortunately, history is not expected
to be a prologue, as this is likely to be aU-shaped recovery. V-shaped cycles have
always been powered by the interest rate-sensitive housing and vehicle industries.
While homebuilding and vehicle sales willincrease from their current record lows incoming months, the gains will be limiteduntil most of the excess existing housing in-ventory is sold off and the ample amount ofspent-up vehicle demand is worked off. Theproblems in the banking system and credit
markets will also take time to resolve, sug-gesting that the credit crunch will lift only
slowly. Given these headwinds, economicgrowth will not be in full swing until early inthe next decade.
While less likely, it is too early to ruleout an L-shaped business cycle, in which the
severe recession is followed by an extended
period of halting growth, or even a W-shaped
cycle, in which the economy slides back
into recession after a brief recovery. A more
prolonged financial crisis than anticipated
could result in an L-shaped cycle, much like
the one that plagued Japan in the 1990s afterits banking debacle. A W-shaped cycle could
occur if policymakers do not soon credibly
address the nation's daunting long-term fis-
cal challenges, leading global investors to flee
U.S. assets, sending the dollar crashing and
inflation and interest rates soaring.
Outlook . In the baseline, most likely,
U-shaped economic outlook, real GDP isprojected to decline 3% this year, increase bya disappointing 1.2% in 2010, and grow by4.4% in 2011. Employment is expected tofall by 8 million jobs peak to trough, and theunemployment rate will peak near 10% in
early 2010 . The economy does not return to
full employment until late 2013.
The risks to this baseline outlook havebecome more balanced in recent months but
remain somewhat skewed to the downside.
Given that the baseline outlook represents
about 50% of the distribution of possible
economic outcomes , there is a 30% prob-
ability that the outlook is measurably worse
than the baseline (L- or W- shaped) and a
20% probability that it is better (V-shaped).
Mark Zandi
June 2009
M
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Recent Performance . The good news is
that with each passing month, evidence thatthe housing market is at or near bottom is
strengthening. The bad news is that there is nosign that housing will turn around soon. Top-
line indicators of housing such as home sales
and housing starts have been bouncing alonga bottom since the end of last year The Aprildata were no different, with sales of existing
homes rising slightly, new-home sales flat, and
housing starts-omitting the volatile multi-
family sector-up slightly.On the policy side, a new HUD rule will
mildly boost home sales; it allows first-time
homebuyers to use their $8,000 tax credit toreduce their mortgage balance in excess of
the required 3.5% down payment on an FHAloan. Homebuilders were hoping that the taxcredit could be applied directly to the 3.5%down payment.
Despite the hopeful signs, one key indica-
tor of the health of the housing market-houseprices-continues to descend, at least by themost reliable indicator, the Case-Shiller Home
Price Index. Foreclosures are depressing house
prices, and the foreclosure rate is up again, as
Fannie Mae, Freddie Mac, and several large
mortgage lenders ended their foreclosure mora-
toriums in the spring.
Diverging prices . The three most oftencited measures of house prices are diverging.
The Federal Housing Finance Administration'spurchase-only index and the Realtors' medianexisting single-family sale price have both been
about flat since the end of last year, while the
S&P/Case-Shiller 20-city index continues to
decline. The rate of decline in the S&P/CS
index is not worsening, but it remains sub-
stantial at about 2% per month, a pace it hasmaintained since last September. Since peaking
in early 2006, the index has declined by 31%,
compared with 11% for the FHFA index and
24% for the median price. Although the S&P/CS 20-city index is based on a small sample of
metro areas, its growth rate has closely matched
that of the more geographically inclusive Case-
Shiller national index since that measure's
peak in 2006. Thus, trends in the 20-city index
should be comparable to the U.S. FHFA index
and the median price.
There are several reasons behind the wid-
ening gap between the S&P/CS index and the
other two house price measures. The NAR me-dian house price reflects only realtor sales, and
currently, many foreclosure sales are accom-
plished without the aid of a real estate agent.
RealtyTrac, for example, reports that 70% of
real estate-owned properties in its database
are not currently listed with a realtor. Nonreal-
tor sales are included in the S&P/CS index.
Foreclosure sales typically are for lower prices
than for normal home sales, thus omission offoreclosure sales would bias up the median
price. Foreclosed homes often go for a lowprice because their holders, such as mortgagelenders, are eager to get these houses off their
books and are therefore more likely to dis-
count the sale price. Additionally, foreclosed
homes are often ill-maintained or damaged,
reducing their selling prices. Another reasonfor the gap between the S&P/CS index and
the median price is a shift in the mix of homes
sold. As mortgage credit problems infect the
alt-A and prime mortgage markets, more own-
ers of larger, more expensive homes are selling,thus skewing up the median price.
While the FHFA index does not have themix problem and includes foreclosure sales, it
only includes foreclosed homes purchased witha government-sponsored enterprise owned or
securitized mortgage. A number of foreclosed
houses, particularly less expensive ones, are
likely being purchased with cash. Furth er; the
growing share of the GSEs in the mortgage mar-
ket is probably muddling appreciation in theFHFA price index. Many homes now being pur-
chased using conforming mortgages were previ-
ously bought at the height of the market withsubprime, nonconforming mortgages. Because
the FHFA index only includes homes bought
with a conforming mortgage, it likely underesti-
mated the runup in the price of homes during
the first half of the decade and is now underes-timating the more recent price decline.
Foreclosures . Foreclosures also have a
neighborhood effect on house prices that is
evident in all of the price measures, as fore-
closed properties drive down prices of nearby
homes that are not distressed. Foreclosures addto the inventory of available homes, in turn
depressing prices. Additionally, the'stigma of
being next door to a foreclosed property will
make a home less desirable. A recent study bythe FHFA of California indicates that even when
omitting foreclosed properties, the FHFA index
has declined by a still-substantial 36% from thepeak of the market to the first quarter of 2009,
compared with a 41% decline when including
foreclosed properties.
The continued rise in foreclosures points
to further declines in house prices, despite the
firming in the FHFA and median prices. If the
housing market is to stabilize this year it is
essential that loan modifications proceed at afaster pace to limit foreclosures. Falling home
prices result in more households owing more
on their mortgage than the home is worth; be-
ing "underwater" increases the risk of falling
into foreclosure and makes it more difficult tomodify the mortgage.
Outlook The housing market will remainexceptionally weak this year although the
free fall has ended. Home sales are firming,
although much of the improvement is due to
sales of distressed properties. By year's end,
sales will likely inch up to a pace comparable
to that of the late 1990s. Low mortgage rates,
stabilizing consumer confidence, and low house
prices will help place a floor under demandfor housing. Residential construction is also
finding a bottom, but given the large overhangof distressed homes and the tough financing
environment, it is expected to crawl at a pacenear its current record low until 2011. Houseprices will be one of the last indicators of hous-
ing to recover. Prices will fall until the beginning
of next year, with a peak-to-trough decline of
38% for the Case-Shiller Home Price Index.
Although the Obama administration's Hom-eowner Affordability and Stability Plan will help
limit foreclosures, rising negative equity and
increasing job losses will make it impossible to
halt the tidal wave this year, placing downward
pressure on house prices.Risks . Although the outlook is firming
around a bottom for housing, risks remain on
the downside. Moreover, the longer it takes to
ramp up the mortgage modification portion
of the HASP the worse the downside risks forhousing and for the broader economy become.
A key to the current outlook is that policy mea-
sures significantly reduce foreclosures. While
the HASP will not prevent foreclosures from
increasing this yeah under the baseline scenario,
it will help modify some 1.5 million to 2 mil-
lion loans. The slow start to the modifications,
however threatens this assumption, as the con-
tinued descent in house prices will erode home
equity and render fewer borrowers eligible for
these programs. Other risks include the pos-
sibility that the job market recovers more slowly
than expected, that consumer confidence may
be too fragile to encourage potential homebuy-
ers to step back into the market, and that lend-
ers remain reticent to underwrite mortgages to
all but the best credit risks.
Celia Chen
June 2009
36 Mody s Econom com www .economy .com help @ economy com Precis MACRO June 2009
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Foreclosures Rise A gain
10% of mortgages outstandingSource: Mortgage Bankers Association
9+
8+
7t
6t
5+
INDUSTRY VIEW
98 99 00 01 02 03 04 05 06 07 08 09
1.4
1.2
1 . 0
0. 8
0.6
0.4
0.2
0.0
Foreclosures continue to plague the housing market. Accordingto the Mortgage Bankers Association, foreclosures started as a shareof total mortgages outstanding increased again in the first quarterof 2009 to a new high of 1.34%; this follows a slight decline at theend of last year. Behind the most recent increase in the foreclosure
rate is the end of the moratoriums that Fannie Mae, Freddie Macand several large mortgage banks implemented. Foreclosures will
climb higher in the coming quarters, even though loan modifica-tions are stepping up under the Obama administration's Homeown-
er Affordability and Stability Plan.
Foreclosures A re Suppor t ing Sales
12 0
10 0
80
60
40
2 0
0
s Normal I] Short sales Foreclosure sales
Share of existing-home sales by type o f sale, %Source: National Association of Realtors
0 '0 8 N D J'09 F M
Sales of distressed homes are growing steadily as a share of total
existing-home sales. According to the National Association of Real-tors, just over 50% of homes sold in March were either short sales,
in which the sale price is below the amount outstanding on themortgage, or foreclosure sales. This share likely understates the true
depth of the problem, however, since the statistics represent onlysales that are listed through a real estate agent, and large numbers
of distressed homes are being sold without the use of an agent.Distressed sales are elevating inventories and pushing down houseprices and will continue to do so until early next year.
4 W r
Job Losses , High Obligations Drive Foreclosures
Unemployment/loss of income
Illness/death in family
Excessive obligation
Marital difficulties
Other
Property problerrVcasualty loss
Inability to sell or rent property
Employment transfer/military service
Extreme hardship
I
I I IMain reason for delinquencyamong prime borrowers, %Source: Freddie Mac
010203040 50
Two of the main forces driving homeowners into mortgage de-
linquency are related to economic conditions. About 43% of thosesurveyed by Freddie Mac cite a job or income loss as the main causeof delinquency. Job losses are expected to continue through the endof this year, pushing delinquencies up even further. Excessive ob-ligation-that is, being highly indebted-is another leading causeof delinquency. The share of delinquent borrowers citing excessive
obligations has risen measurably since 2001-2005, as the lendingbinge earlier in the decade is now weighing on consumers.
Excess Inven tor ies Regional ly Con cen t rated
Difference between 2008 vacancy rate and average rate, percentage pointsSources: Census Bureau,
Moody's Economy.com
U >1.8 u 0.4to0.8
0.8 to 1.80
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7/27/2019 Moody's Economic Outlook
7/10
Recent Performance . With no meeting
of the Federal Open Market Committee inMay, purchases of government securities,management of the Fed balance shee t, and
rhetoric in response to movements in thebond market defined the performance of thecentral bank during the month. The FOMCis keeping the federal funds rate betweenzero and 0.25%, while the bank's balancesheet remains in the $2.07 trillion to $2.16
trillion range.Fed attempts to manage the yield curve
suffered a modest setback in the intermeet-
ing period. Concerns over inflation and theexploding federal deficit were the primaryreasons behind the sharp steepening in theyield curve. The spread between yields on10-year and two-year Treasuries increased to
279 basis points, after averaging 214 basispoints since the March 18 quantitative eas-ing announcement. Yields on the 10-year
moved from 3.2% in early May to 3.9%by early June. Mortgage rates also trendedhigher, with the 30-year fixed rate rising from4.8% to 5.3%. If sustained, rising rates willrestrain refinancing activity in the housingsector and discourage the rebuilding of in-
ventories by firms which will short circuit anyprospective economic recovery.
Although some high-frequency eco-nomic indicators suggest that the economy
has bottomed out, it is premature to declarethat a recovery has begun. The labor market
remains weak, and the unemployment ratewill move up well after the start of the ex-
pansion. This will constrain any inclinationby the Fed to embark on an early ra te hikecampaign. Moody's Economy.com expects
that the Fed will begin tightening rates in
the middle of 2010.Policy actions . The Federal Reserve's
balance sheet contracted by 4% in May andstands below the peak of $2.3 trillion record-ed in December. Holdings of government
securities breached the $1 trillion mark theweek ending May 8, and stood at $1.1 trillion
as of May 29.Demand for emergency liquidity via the
Primary Dealer Credit Facility, discount win-dow and currency swaps with foreign cen-
tral banks all declined sharply over the pastmonth. The Fed's purchases of governmentsecurities are on pace to exhaust the $300billion committed by the central bank to tar-get longer-dated maturities well in advance
of its self-imposed autumn deadline. Thus
far, the Fed has purchased $145 billion inTreasuries in total, with roughly one-thirdof those targeting the critical seven-year to
10-year area.During the April 28-29 FOMC meeting,
there was discussion of expanding the out-right purchases of securities above the $1.75trillion that was authorized at the March18 meeting. However, considering spreadson agency paper have been compressedto remarkably low levels, any prospectiveincrease in purchasing will almost certainly
have to be targeted toward the purchase of
government securities.The Federal Reserve Board announced
that starting in July, certain high-quality com-mercial mortgage-backed securities issuedbefore January 1, 2009 will become eligible
collateral under the Term Asset-Backed Secu-rities Loan Facility. Participation in the TALF
has increased marginally, but the $27.5 bil-lion in outstanding loans remains well short
of the Fed goal of allocating $1 trillion incredit in 2009. Private sector actors are hesi-tant to participate in the TALF due to con-cerns that profits may be subject to ex-postlawmaking by Congress. The TALF is critical
to restarting the trillion dollar asset-backedsecurities market and increasing the overallflow of credit while the private financial sys-
tem recapitalizes itself.
Listening to the Fed . The Federal Re-serve was clearly caught off guard by the
steepening yield curve during the intermeet-ing period. Central bank attempts to reframe
the shifting yield curve as a function of posi-tive developments in the economy met withmixed success. The fixed-income communitysought to test the resolve of monetary au-thorities by pushing up the spread between10-year and two-year yields to intraday re-
cord levels in the hours preceding the Fed's
outright purchase of Treasury coupons.Indeed, these concerns were foreshadowed
by Dallas Fed President Fisher who earlier in
May stated that the looming challenge for the
Fed is to reassure financial markets that the
monetary authority is not going to become the"handmaiden" to fiscal profligacy. The Fed
has attempted to communicate to marketsin recent weeks that it intends to supportthe functioning of private financial markets
without monetizing the federal deficit. Fed
Chairman Bernanke pointed out the need tocontrol federal spending, and Kansas City Fed
President Hoenig suggested that higher yields
are a signal that the Fed should begin to bringmonetary policy into better balance due to
market concerns over inflation.
Outlook . The Federal Reserve has com-
mitted to keeping the federal funds rate at the
zero bound for an extended period. Ahead ofthe June 23-24 FOMC meeting, Fed speak-ers will be sure to address Treasury yields in
general and rising mortgage rates in particular.
The Fed has explicitly targeted the 30-year
fixed rate to mend the housing market. Thecentral bank will be reluctant to give up hard-
earned terrain to a trigger-happy bond market.
The FOMC may choose to use the upcomingmonetary policy statement to outline an in-crease in i ts commitment to purchase govern-ment securities and suggest a willingness to
hold these securities to maturity.
The central bank will support financialmarkets through at least the end of 2010.The Fed will seek to slowly withdraw fromfinancial markets by selling some assetsoutright or on a temporary basis throughreverse-repurchase transactions. They mayalso choose to draw down holdings slowlywhile raising the federal funds rate, usingthe rate paid on excess reserves held at theFederal Reserve to establish an effective
floor on the policy rate.Core measures of inflation remain within
the implied target of the monetary author-
ity. Headline inflation will fall in the nearterm due to the impact of past declines incommodity and energy prices. Some disinfla-tion is moving through the system, but theeffective integration of monetary and fiscalpolicy should work to reduce the risk of anextended bout of deflation.
Risks . Risks to the monetary outlook are
twofold. First, market or political pressure toprematurely withdraw from financial marketscould short-circuit a potential recovery. Sec-ond, over the longer term, the integration ofmonetary and fiscal policy will create the con-ditions for higher inflation, should the centralbank not withdraw from financial markets atthe proper time. Once recovery is identified
as sustainable, inflation risks may increasedue to potential interference from the ad-ministration or lack of political support forthe central bank from Congress. The FederalReserve will need to carefully navigate these
potent cross currents as it seeks to mend fi-nancial markets and support the economy.
Joseph BrtisuelasJtuie 2009
3 8 Moy s Economy.com www .economy .com help @ economy .com Precis MACRO June 20
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8/10
Yield Curve Steepens Over Inflation Fears
2 . 8
2 . 6
2 . 4
2.2
2 . 0
1.8
1.6
1 . 4
Yield spread, 10-year Treasury over 2-year T reasury, ppt.
J '09 F M A M J
Anxiety over the U.S. fiscal position and the Federal Reserve's quan-
titative easing program has led to a sharp steepening in the yield curve.
The difference between 10-year and two-year Treasury yields widened to
275 basis points in early June but has since narrowed to about 250 basis
points, well above the 214-point average since the March 18 FOMC
statement. The 10-year yield has traded in a range between 3.5% and
3.75% over the past few weeks, well above the 3% implied target range
assumed by the fixed income community. The 30-year fixed mortgage
rate, which is sensitive to movements in the 10-year yield, briefly moved
to 5.3% but has subsequently fallen back to below 5%.
Strong Money Demand Requi res Increase in Money Supply
15
1 0
5
0
- 5
- 1 0 HHHHHHHHHHH
65 69 73 77 81 85 89 93 97 01 05 09
The broad money supply, both nominal and adjusted for inflation
using the CPI, is expanding at a swift pace. Although there has beensome perceptible improvement in the economy, the pace at whichmoney circulates through the economy, or the velocity of money,continues to fall. Without the increase in the money supply, real eco-
nomic activity would be far weaker than it is now. Due to job lossesand a rising unemployment rate, the monetary supply will continue
to expand in the near term. The challenge for the Fed will be to an-
ticipate when the demand for money begins to ease and to start re-straining growth in M2 to prevent an outsized increase in inflation.
Securities Purchases Intensify on Fed Balance Sheet
2,500 ^
2,000 t
1,500 }-
1,000
5 0 0 +
0
Federal Reserve assets, $ bil Otherss Swap liness PDCFs
Term auction facilityo Discount windowO Repurchase agreementsO TSLFs Securities lent to dealersO Securities held outright
J08 F MAMJJAS ON D J09 F MAM
The purchase of government securities dominates the expansion of
the Federal Reserve's balance sheet. Securities held outright increased to
$1.107 trillion for the week ending May 29. The Primary Dealer CreditFacility saw zero demand for the third consecutive week, and the Federal
Reserve, in conjunction with its foreign counterparts, reduced currencyswaps to $181 billion, down from $682 billion in December 2008. At
the April 23-24 FOMC meeting, participants discussed increasing the
$300 billion committed to purchase long-dated U.S. Treasuries. Giventhe ongoing turmoil in the bond market, the FOMC may choose to in-
crease its commitment to purchase longer-dated government securities.
Rising Unem ploym ent Rate Suggests Fed on Hold fo r a Whi le
- 3
00 01 02 03 04 05 06 07 08 09
Fixed-income players will test the Fed's resolve. In past recessions,
the central bank has been reluctant to withdraw liquidity from the econ-
omy until it is certain that the unemployment rate has crested. Moody's
Economy.com does not expect the Federal Reserve to raise policy rates
until the second half of 2010. The Fed balance sheet has fallen by 4% as
demand for emergency liquidity has faded and the banking system re-
mains capital constrained. With the economy still contracting, the central
bank is likely to further increase the size of its balance sheet and reducethe real federal funds rate, making monetary policy much more accom-
modative, before entertaining any serious discussion of higher rates.
Mood ys E conom y. com wwwecon my. com he p@econ my. com Pec s MACRO Jun 20 09 39
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9/10
Recent Performance . The federal budget
deficit continues to widen in response to thefinancial crisis and recession and is running
far ahead of last year's record pace. The deficitthrough the first eight months of fiscal 2009
was more than three times larger than at thesame point in fiscal 2008. Revenues were
down 18%, while outlays were up 19%. The
on-budget deficit, excluding Social Security
and the Postal Service, was up more than200% on a year-ago basis in the first eight
months of fiscal 2009.The federal government recently an-
nounced a change in its accounting for capital
injections into banks and automakers as partof the Troubled Asset Relief Program. The
government is now measuring these purchaseson a net present value basis, offsetting the cost
with future expected returns. Previously, the
government was simply counting the entire
capital injection as an outlay, with no adjust-ment for expected returns. The impact is toreduce measured spending on the TARP and
lower the budget deficit.
Deficit concerns . Concern about the fed-
eral government's long-run budget picture hasintensified recently, with negative ramifications
for the economy. With the economy showing
signs of stabilization, investors are now look-
ing at what happens after the recovery begins.The combination of large budget deficits, very
expansionary fiscal policy, and a return toeconomic growth has raised concerns aboutinflation. There is also worry that the federal
government will deliberately use a policy of
high inflation to monetize the debt that it isnow taking on. As a result, forward-looking
measures of inflation, based on differences in
yields between nominal and inflation-indexed
Treasury securities, have moved much higher
over the past couple of months.
With inflation fears rising, investors are de-
manding higher yields on longer-term Treasuries
to compensate for the perceived risk. The yield
on the 10-year Treasury has gone up from 2.2%in January to almost 4% in early June. Although
spreads over Treasuries have been declining, the
net impact has been to push various long-term
interest rates higher, especially 30-year fixed
mortgage rates. Higher mortgage rates could
end the nascent stabilization in the housing
market, and higher rates more generally would
threaten the economic recovery.
Some of these fears are likely overdone. The
economy remains very weak, with a great deal
of slack in labor and product markets, making it
difficult for workers to earn wage increases and
for firms to raise prices. Still, with higher rates
threatening the expansion, the Obama adminis-
tration is talking up longer-run efforts to reduce
the budget deficit once the current crisis passes.
Healthcare . President Obama is moving
ahead with efforts to expand health insurance
coverage. He has called for Congress to pass abill sometime this year and has included someof the hundreds of billions of dollars needed
to expand coverage in his proposed budget for
fiscal 2010.
Many of the most basic details still need to
be resolved. Perhaps the top issue is whetherthe federal government will require individu-
als to purchase health insurance. During thepresidential campaign, Obama opposed sucha mandate, but he is now considering it. Low-
income Americans would presumably receive
some sort of federal government subsidy to
purchase health insurance.Another key unresolved issue is who
would offer health insurance. Most politi-
cians favor keeping the current system ofemployer-provided coverage in place. In
addition, President Obama is pushing for agovernment-sponsored health insurance plan.He maintains that such a plan would guaran-tee more competition in the health insurancemarketplace, helping keep premiums low. Op-
ponents argue that a government plan would
end up taking over the market and eventuallylead to a government-controlled healthcaresystem. Private insurers are strongly opposed
to a government-run program. As a fallback
position, congressional leaders and the admin-istration are looking at nonprofit cooperatives
that would provide health insurance.Also still unresolved is how to pay for
expanded health insurance coverage. TheObama administration has called for rolling
back the personal income tax cuts enactedunder President Bush for wealthy householdsand using the money to pay for health insur-
ance. This would cover some, but not all, of
the cost. It also means that the money wouldnot be available for deficit reduction.
The administration argues that healthinsurance changes are key to reducing long-
run spending on healthcare. Budget directorPeter Orszag has made the point that federal
spending on Medicare and Medicaid is ex-
pected to see enormous growth as the babyboomers age, putting tremendous pressure onthe federal budget. He argues that substantive
healthcare changes would lead to greater ef-
ficiencies and result in lower federal spendingon these programs, even with expanded cover-
age, reducing long-run budget deficits. How-
ever, the Congressional Budget Office has been
unwilling to adopt this view and thus is likelyto score healthcare proposals as adding to thebudget deficit, making it more difficult to get
them through Congress.Outlook . With the combination of the re-
cession, stimulus, TARP and additional aid for
the financial system, the federal government
will run enormous budget deficits of close to$2 trillion over the next few fiscal years. Thiscompares with a deficit of $459 billion in fis-
cal 2008, the largest ever in nominal dollars.
These deficits will be about 12% of GDP the
largest as a share of the economy in the post-
World War II era.
The deficit will shrink for a few years as
economic growth picks up and the direct im-pact of the financial crisis fades from the bud-get. However, over the longer run, given cur-
rent trends and higher interest payments as aresult of the debt that the federal governmentis taking on to battle the downturn, thereis a structural imbalance between taxes andspending. Greater federal spending on retire-
ment programs as the baby boomers age, par-ticularly for healthcare, will lead to consistent
budget deficits of close to 4% of GDP absent a
dramatic reorientation in fiscal policy.
Risks . There are signs of stabilization inthe economy, but if the financial crisis heats
up again and the recession is longer and moresevere than expected, the budget deficit wouldwiden further because of a large decline in
revenues and stronger growth in spending onsocial programs. Congress would also be more
likely to implement even more fiscal stimulus
or another financial relief plan, further boost-
ing the near-term deficit.President Obama is more likely to raise
taxes than President Bush, at least for high-
income earners. This would reduce the deficit,
although any tax increases would not comeuntil the recession is over. However, he could
also push for more spending, especially as partof efforts to expand health insurance coverage.
There is talk that the president and Con-gress could reach a "grand bargain," designed
to reduce long-term spending on retirementprograms in exchange for higher taxes. Such a
deal could dramatically lower long-term bud-
get deficits.
Augustine Faucher
June 2009
40 Moody s Econo my com wwwecon omy com he p@econ omy com Pec s MACRO June 20 09
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Social Security Deficits Will Start Soon1ocial Security program, % of taxable pay
17
16
15
1 4
1 3
12
11
10
9
roll
Costs
r
Income
i IIII---I70 80 90 F 20F 30F 40F 5
The Trustees of the Social Security and Medicare programs-the
secretaries of the Treasury, Labor and HHS and the Social Security com-missioner-recently released their annual reports on the programs'financial status. Right now, the Social Security program is running asurplus, with revenues-including interest on money the Social Secu-rity Trust Fund loans to the Treasury Department to finance the rest of
the budget deficit-exceeding outlays. However, the program will startto run deficits in the middle of the next decade, as the baby boomers
retire and smaller cohorts replace them in the labor force. By 2037,
Social Security will be unable to pay all of its promised benefits.
. ..And Is the Real Long-Run Prob lem
1 2
1 1
Med icare Is Already R unning Def ici t s .. .
44 0
40 0
360 -I
320 ^
28 0
240 -i
20 0
1601
1 20
Hospital Insurance Trust Fund, $ bilCosts
Total income f!' Income excluding interest
I I i I I I I i I I E I Ii !I I i
00 02 04 06 08 10F 12F 14F 16F 18F
The problems for Medicare are more immediate. The Hospital
Insurance Trust Fund, which covers inpatient Medicare expenses,ran a deficit in 2008. Income to the HI program, including payrolltax revenues and interest on the trust fund, exceeded outlays lastyear, and deficits will continue. The HI Trust Fund is projected to beexhausted in 2017, when it will be unable to pay full benefits; thisis two years earlier than in last year 's report. The SupplementaryMedical Insurance component of Medicare, which covers outpatientphysician bills and prescription drug coverage, is funded from gen-eral revenues and premiums and has no long-term trust fund.
Real Defense Spen ding S t i ll Growing
5
Federal defense spending, 12 mo. M A,% change year ago
10F 20F 30 60 F 70F 80F
Although the political debate over entitlement programs gener-
ally focuses on Social Security, Medicare faces more severe long-term problems. Medicare faces the same demographic crunch asSocial Security from the retirement of the baby boomers, but newtechnologies and healthcare inflation will also result in very stronggrowth in per-beneficiary costs. Total Medicare spending, includingboth HI and SMI, is projected to exceed Social Security spending inabout 20 years and to increase rapidly as a share of GDP through-
out the trustees' 7 5-year projection period. Social Security spendingis expected to see a slight decline as a share of GDP once all of the
baby boomers retire.
- 5 i -- ++-I -- I -H -f
00 , 01 02 03 04 05 06 07 08 09
Defense spending growth slowed in 2004 after the initial inva-
sion of Iraq, although it continued to increase strongly. Growth re-accelerated in 2007 as the U.S. undertook the "surge" in Iraq. Withrelative calm now in that country, nominal defense spending growthis slowing once again. Taking into account very low inflation, how-ever, defense spending is increasing in real terms, up about 7% overthe past year. Real defense spending growth is likely to accelerateeven further in the near term as the U.S. focuses more attention onAfghanistan and brings some troops home from Iraq; the costs ofredeployment will add to spending in the short run.
Moody s Econom ycom wwwecono my. com he p@econo y. com Pec s MACRO June 20 09 41