1. The US economy has evolved along the lines of the recession template we laid out in early January. First, the most important labor market indicators -- nonfarm payrolls, the unemployment rate, and the jobless claims data -- are now all deteriorating at a clearly recessionary pace. Second, the news on consumption has worsened substantially in recent weeks, with a sharp deterioration in auto sales and auto loan delinquencies (now at the highest level in 30+ years) and poor anecdotals about March retail sales. Third, taken together the monthly measures of economic activity that are used to officially "date" business cycles -- payrolls, income, business sales, industrial production, and monthly GDP -- are also looking more consistent with recession, at least if we allow for the normal tendency of economic data to be revised downward at this stage of the cycle.
2. We still think that the pace of decline in real GDP will be relatively modest. This is partly because of structural changes in inventory and payroll management, partly because of the weak dollar and the improvement in foreign trade, and partly because fiscal and monetary policy have already responded aggressively to the downturn. The fiscal boost, in particular, is likely to lift consumer spending in the second half of 2008, and an add-on package is not out of the question if the jobs picture continues to deteriorate (some Democrats are already calling for this). This is why he have held onto our forecast that the Federal Open Market Committee will stop easing monetary policy after one more 25bp cut on April 30. Cuts in subsequent months are unlikely because the committee will want to assess the effects of the tax rebates before moving further. Moreover, Fed officials are hopeful that the financial market improvement over the past few weeks will reduce the pressure on them to ease further.
3. But the economy is likely to look weak until house prices bottom, which we don't expect until the second half of 2009. The reason is simple supply vs. demand. Although home inventories reported by builders and realtors have started to decline, broader measures that include foreclosed homes still seem to be rising. Until the excess supply shrinks substantially, home prices are likely to keep falling; we are looking for further declines totaling 10% in 2008 and another 5% in 2009.
4. As we have argued before, these declines are likely to result in credit losses totaling $500 billion in residential mortgages alone, and over $1 trillion including other credits. Of this total, we estimate that roughly $460 billion (equivalent to about $300 billion on an after-tax basis) will fall on leveraged US financial institutions. So far, they have only announced about $120 billion of this total. They are likely to respond to further losses by continuing to shrink their balance sheets. Using the model developed in our Leveraged Losses paper (with Greenlaw, Kashyap, and Shin), we estimate that these losses imply about a 2-percentage-point hit to real GDP growth, before considering multiplier effects. Even after the formal recession ends, this retrenchment is likely to weigh on the economy, and this is one reason why we expect the unemployment rate to reach 6-1/2% by the end of 2009.
5. As long as the unemployment rate is still rising and house prices are still falling, the Fed will not raise rates. So short-term interest rates will need to stay low for an extended period of time, and renewed cuts in late 2008 or 2009 are much more likely than early interest rate hikes. This is not necessarily an "investable" view at this point -- if the data do get a bit better in the wake of the fiscal stimulus, the markets continue to relax about systemic risk, and the Fed is stingy with near-term rate cuts, a further modest selloff in the Eurodollar curve contracts is quite possible. But Eurodollar curve flatteners could become attractive soon.
Jan Hatzius Chief US Economist Goldman, Sachs & Co.