October 2009

As the longest, deepest recession since WWII wound down during the third quarter, a recovery crept in. But unlike some nascent recoveries that soon chugged ahead, this one has plodded along. In fact, uncertainty about the recovery’s sturdiness has some experts predicting the economy may trudge through the first half of 2010 and keep Federal Reserve credit policy on hold.

Calling recession’s end
The simple measure often cited as signaling the start (or end) of a recession is two consecutive quarters of decline (or growth) in real gross domestic product (GDP). Alternately, the National Bureau of Economic Research, the private group tasked with officially calling the start and end of recessions, may need up to 18 months of data before making a pronouncement in retrospect.

In the interim, other key gauges used to indicate the economy’s status include the Institute for Supply Management’s (ISM) manufacturing index. When this purchasing manager’s index rises above 50, it denotes economic expansion; readings below 50 indicate contraction.

By that yardstick, the recession bottomed out at mid-summer. “The behavior of the ISM manufacturing index suggests that the recession ended in July,” said Paul Kasriel, Northern Trust’s chief economist. The ISM manufacturing composite index popped back above the 50 level in August for the first time since January 2008.

Despite the ISM’s rise, however, the economy’s climb out of the recession has been neither speedy nor robust. “It isn’t that any one sector is soaring,” Kasriel added. “Rather, it’s that a number of sectors either have stopped descending or are descending at a much slower rate.”

Lethargic growth
In particular, although declining first-time weekly jobless claims indicate the worst has passed, Kasriel expects that the unemployment rate (which typically lags turns in the economy) may rise further into mid-2010, possibly peaking at more than 10½%.

At the same time, overextended households and financial institutions are working to repair their balance sheets. He noted that disposable personal income and consumer spending have begun to stabilize, partly because of government unemployment insurance and tax cuts. And chastised consumers are seen as likelier now to invest in traditional instruments such as Treasuries, fixed-income and equity securities, rather than spend on luxuries such as “McMansions,” big cars and plasma televisions.

One area that Kasriel says may prove nettlesome, however, is commercial real estate. He says lenders may stay gun-shy about creating credit over concerns that a new wave of commercial mortgage defaults could render some institutions undercapitalized again. Continued high loan delinquency and charge-off rates also could keep commercial lenders on edge.

“Until financial institutions are confident of their longer-run capital adequacy, they will be unable and/or reluctant to create new credit, which will restrain the pace of the economic recovery,” Kasriel added.

Well into the recovery, however, the ballooning federal budget deficit could hinder the economy as the deficit swells to nearly 4% of GDP. If federal spending threatens to crowd out business investment, it could possibly lower future potential economic growth.

“Will those headwinds prevail and push the economy back into recession? That’s not likely,” Kasriel said, noting that 50 years of data suggest the Fed’s actions are the linchpins that can cause recessions.

Inflation also is unlikely to flare up anytime soon, he added, because so much of the Fed credit creation has wound up sitting idle in safe deposit boxes and on banks’ books.

“The sharp increase in Fed credit is not currently inflationary but has the potential to be if the Fed does not neutralize this credit at the appropriate time,” Kasriel said. “But the earliest the Fed is likely to begin neutralizing this credit is mid-2010, and then only tentatively.”