Moody's Economic Outlook

7/27/2019 Moody's Economic Outlook

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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

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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


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


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


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


10/10

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

Moody's Economic Outlook

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