Looking For a Bottom

Given the length and depth of the current recession, it is natural for analysts to start looking for a bottom. In such an environment, bad news will be ignored while the seemingly good news is overblown. For example, the most recent initial unemployment claims report indicates that labor markets continue to deteriorate; we have yet to see a turning point consistent with improved conditions. Likewise, the durable goods report was heralded as a positive sign, but the jump in this volatile series needs to be taken in context of the severe drop the previous month. The chart of nonair/nondefense new orders is not particularly encouraging:

That said, things will eventually get less worse, if only because some sectors, such as new residential housing, will hit a bottom. And that bottom is not likely to be zero, and, I suspect, that bottom will be late this year or, at worst, early next year. That should not, however, be confused with an optimistic outlook, as the durability and strength of the eventual recovery is in doubt. I am confident that the economy will not spiral downward endlessly; I am more worried that the we will be left at a suboptimal equilibrium chiefly characterized by low growth and persistently high unemployment.

San Francisco President Janet Yellen outlined the “optimistic” case in a speech Wednesday:

However, I am well aware that my views are strikingly more optimistic than those I hear from the vast majority of my business contacts. They tend to see conditions as dire and getting worse. In fact, many of them can’t believe I would even suggest what they see as such a patently rosy scenario! So why is it that so many of us who prepare forecasts seem to be more optimistic than many others? I think there are several reasons. First, as forecasters, we distinguish between growth rates and levels….Second, it takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today’s very low levels—not a robust performance at all—a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point…

The key point, often lost to the general public, is that data patterns can quickly reverse when the economy hits bottom. Still, job growth can remain largely nonexistent, similar to the 2001-2003 period. Next:

Third, policies are in place that could jump-start the economy, including the fiscal stimulus package, the Administration’s housing program, and a growing list of Federal Reserve and Treasury credit programs that aim to improve financial market function and the flow of credit.

A significant amount of stimulus will be flowing into the economy, and while it is not enough to fill the output and credit gaps, it is not negligible. Finally:

Finally, at some point, negative feedback loops can turn positive. For example, if federal government and Federal Reserve policies were to jump-start the economy, credit losses of financial institutions could diminish and lenders might increase the supply of credit available to finance spending. More credit, and better consumer and business confidence, could further boost the economy and employment, which would feed back positively on credit conditions. In other words, the negative feedback loop that is currently in play could be replaced by self-reinforcing positive dynamics.

I am less optimistic that negative feedback loops will soon turn positive. Again, while the amount of stimulus flowing into the economy is significant, credit worthiness looks to be deteriorating at a faster rate. As noted early, the employment picture is not yet turning rosier (Yellen expects unemployment to rise into 2010), households are already choking on debt, and, as reported in the Wall Street Journal, commercial real estate loan delinquencies are rising. I suspect that Richmond Fed President Jeffrey Lacker is close to the mark when he said today:

One popular notion is that the credit market disruptions we have seen over the last year or so impede the financial sector’s ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending. But causation can flow in the opposite direction as well. When overall economic activity seems poised to contract, the outlook for household income and business revenues deteriorates as well, and borrowers become less creditworthy, all else constant. Moreover, consumer and business demand for lending declines when they cut back on discretionary outlays. My reading of current conditions is that the economy is holding back credit markets much more than credit markets are holding back the economy.

The lack of creditworthy borrowers, especially considering more reasonable underwriting standards, strikes me as a significant impediment to the Fed’s plans for restarting securitization markets via TALF. (Lacker also looks for positive signs, notably the recent retail sales data, and appears more optimistic, but like Yellen highlights downside risks). That said, the willingness of monetary and fiscal authorities to pump massive amounts of money into the financial sector has staved off a collapse – and thus created another sort of bottom.

Still, despite the prospects for bottoming, the key in my mind remains the subsequent path of activity. On that Yellen says:

…for some time to come, disinflation, and even deflation, will represent greater risks than inflation. With economic activity weakening, economic slack is likely to be substantial for several more years. We need to be sure that we avoid the kind of deflation that Japan experienced during its lost decade. While I don’t think such an outcome is likely, it should be on our list of concerns.

Likewise, I am not optimistic on the longer term. The US economy is suffering the aftereffects of a credit bubble, and this will have lingering effects on the growth path. This is especially the case given the depth and breath of the global downturn; indeed, few others are pursuing stimulus as aggressively as the US, promising to prolong US weakness with continued pressure on exports.

In short, analysts should be looking for the bottom, and it would not be a surprise to get a strong bounce in the data soon after hitting the bottom. But I think sustaining that bounce will be difficult. Expectations of a rapid return to sustainable, high growth path are likely to be met with disappointment. Hitting the bottom is inevitable. It is the subsequent pace of growth that should be the focus of concern.

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