Confluence of structural and cyclical change clouds outlook for 2008 and beyond.

Nevertheless, the slowing U.S. economy has caused the Federal Reserve System to expand the money supply and reduce interest rates in an attempt to stimulate the domestic economy. Similarly, expansionary fiscal policies (in spite of the federal budget deficit) are intended to provide another form of stimulus. Time will tell if the dual stimulus efforts will provide a sufficient level of stimulus and yet not create excessive inflationary pressure. Ample evidence exists that the timing and effectiveness of federal actions are questionable at best. This time may be an exception, but evidence exists that the unintended consequences of both the monetary and fiscal policy initiatives will be negative. The actions and inactions of the Fed, bank regulators, and financial institutions in general were the primary cause of the housing explosion, the subprime market meltdown, and the subsequent credit crunch. But it is not clear that the Fed's actions can reverse the damage and that further interest rate reductions will offset the negative impact of declining home sales, starts, and prices. In fact, it is clear that interest rates are causing inflationary pressures to increase at the same time that the housing and credit markets remain in disarray. Similarly, it is not clear that providing more money to those most likely to spend it and those most deeply in debt will solve the problem of declining asset wealth, the illiquidity of homes, or the generation of new jobs. With the increasingly global leakages from our domestic economy, the size and the timing of any impact from increased spending are in doubt.

So what does this mean? Higher prices, slower growth, fewer jobs, less pay, and declining assets cannot be positive for the U.S. economy either this year or next year. The length of prior recessions shown in Table 2 clearly indicates that even modest recessions have a longer-term impact on the typical measures of economic activity. For example, following the July 1990 to March 1991 recession (eight months), unemployment rates that were 5.5 percent at the beginning of the recession continued to rise until June 1992 (fifteen months later) and peaked at 7.8 percent. Unemployment rates did not return to 5.5 percent until forty-four months later in December 1994. Similar time lags existed for the March 2001 to November 2001 recession when unemployment rates were 4.3 percent at the start of the recession, peaked nineteen months later at 6.3 percent, and returned to 4.4 percent after fifty-nine months.

Shorter time lags existed for other important variables including nonfarm employment, industrial production, and average monthly single-family home sales. Employment fell 1.24 million during the 1990 recession and 1.6 million during the 2001 recession. In the 1990 recession, employment levels continued to fall for only two months, but it took twenty-two months for the recovery to offset the job losses from the recession. In the noted post-2001 jobless recovery, employment continued to fall for twenty-one months and did not return to the starting recession level until thirty-eight months later.

Changes in the timing of declines in industrial production more closely correspond to the business cycle. The trough of industrial production occurred at the same time or one month after the end of the recession in both periods. But the return to pre-recession levels did not occur until thirteen months later in the 1990 recession and fifteen months later in the 2001 recession.

Changes in average monthly single-family new-home sales followed a similar pattern with declines of 18.7 percent and 3.7 percent during the respective recessions. The eight-month average sales after the 1990 recession were still seventy thousand units less than the average for the period prior to the recession. The dramatic interest rate reduction and the explosion in the housing market following the 2001 recession marked the beginning of the housing expansion. The average sales totals for the eight months following the recession were sixty-one thousand higher than the recession levels and were twenty-eight thousand higher than during the time period prior to the recession. The powerful incentives available for the housing sector were not offset by the slow job growth that took place during the period. Other factors such as corporate earnings and profits also lag the recovery period. In the February 17, 2008, New York Times article, "When Will Earnings Recover?," Paul J. Elm wrote the following:

In fact, over the last 60 years, corporate earnings have

typically started to recover three months after the official

end of a recession.

And it often takes much longer than that before

profits accelerate sharply. The most recent recession,

for example, ended in the fourth quarter of 2001.

Yet it wasn't until the fourth quarter of the next year

that S.& P. 500 profits started growing by double digits,

according to S.& P.

It took even longer for profits to recover after

the recession in the early 1990s. That contraction

began in the summer of 1990 and ended in March

1991, according to the National Bureau of Economic

Research. But it wasn't until the fourth quarter of 1992

that earnings rebounded by double digits. (5)

To the extent that lower interest rates stimulate the housing and capital goods markets and improve credit conditions, the impact on economic growth should be positive. Similarly, the impact of the fiscal stimulus package may be in doubt, but it should be positive and should increase economic activity. Without doubt, the nation is entering 2008 with enormous economic difficulties that will not go away quickly. In a recent assessment of economic conditions, Ben Bernanke, Federal Reserve Chairman, suggested that additional interest rate cuts might be necessary to avoid a recession and deal with a sluggish but not yet recessionary economy and a deteriorating housing market. (6)

Most analysts expect it to be 2010 or 2011 before the housing market shows signs of recovery. The magnitude of the declines in housing values is unknown. The duration and severity of the current slowdown will determine the ultimate outcome. Recessionary periods are rarely alike, but a rule of thumb might suggest that this one will exceed the average in both duration and severity. The confluence of cyclical and structural forces combined with the nature and magnitude of the causes and the increasingly uncertain impact of policies make the following questions difficult to answer. The past is only as useful as a tool for understanding the economic outlook for 2008-2009 as we can make it fit with the conditions which are in play.

We at the Sparks Bureau of Business and Economic Research believe that 2008 and 2009 will both be subpar years in spite of continued monetary and fiscal stimuli. The overhang from the housing and credit markets will continue to be the principal drag that slows the economy, increases unemployment, limits wage growth, and constrains consumer confidence. In the absence of a positive outlook, neither businesses nor consumers are likely to respond to investment or consumption incentives. With a tendency to be conservative, businesses and consumers will need to see more positive evidence that good times are just around the corner before they begin to spend again. With globalization, business opportunities are more subject to broader market conditions. Consumers are more likely to respond to improved credit conditions, more job opportunities, and both earned and unearned income increases than they are to news of strong international economic conditions. Time will tell if consumer, government, and business spending will grow enough to prevent a prolonged recession and generate a rapid recovery. At the moment, increasing producer and consumer prices being driven by record oil, commodity, and import prices are a serious concern and will clearly impede the recovery process. To the extent that inflationary pressures grow in importance, stimulus efforts that are inflationary will be in jeopardy as the focus of the Fed and other government entities changes. All this is justification for the belief that the slowdown will be prolonged by the nature of the problems and the difficulty of implementing effective solutions in a stagnant and inflated economy.

Questions and Answers

Q1. There seems to be more questions than answers for 2008. What are the main economic concerns for 2008?

At the top of the list of concerns will be the ongoing correction in the housing market and its ripple effects. Approximately 2.0 million mortgage resets are scheduled through the first half of 2009, and foreclosures are expected to continue at a historical pace. Housing prices are anticipated to drift lower, and the large housing inventory stock will likely restrain new starts and keep existing home sales lackluster. The housing crisis cut approximately 1.0 percent from economic growth in 2007. The fallout has been widespread, deeply affecting U.S. and international banking sectors, bond insurers, and even student loans. Rating agencies are expected to reevaluate some $500 billion in mortgage loans.

Another major concern will be the ancillary credit squeeze resulting from the subprime meltdown. Despite lower interest rates, tighter lending standards have made it much harder for both individuals and businesses to get the money they need. Already, there are growing fears that the next sectors to suffer delinquencies and defaults will be credit cards and auto loans, as bank are adding funds to their reserve accounts.