1. When President-elect Obama takes office on January 20, 2009, he will face an economy that continues to sink. We now expect an unemployment rate of 81Ž2% by 2009 Q4, for a total increase of 4 percentage points since 2007 Q1. Assuming a modest further rise in 2010, this would imply the biggest cumulative increase of the postwar period.
2. We now also think that the Fed will cuts its funds rate target further from 1% to 50bp at the December 16 FOMC meeting. We're not sure about this, and in any case it isn't a very big deal -- it would just bring the target closer to the actual funds rate, which has averaged just 26bp since the October 29 FOMC meeting. This is likely to be the last step for conventional monetary policy. A funds rate of literally 0% would probably cause more problems -- e.g., money funds going out of business and forcing banks to take more assets onto their balance sheets -- than it would solve. So it's clear that we are reaching the end of the rate cut road.
3. The next step will be on the fiscal side. We estimate that given the current level of asset prices, the private sector of the US economy might cut its spending (relative to its income) by 6% of GDP or more over the next 1-2 years. Some of this demand hit will be absorbed by a smaller trade deficit, but most of it is likely to translate into a sharp reduction in output. If the private sector is retrenching, the obvious response is for the public sector to step into the breach via a large fiscal stimulus program. The minimum in our view is $300 billion, but $500 billion would be a better number. Such a bold program will further boost the near-term budget deficit. But in the longer term this cost is likely to be considerably smaller than that of allowing the recession to deepen further and tax receipts to slide as a result.
4. Can monetary policy contribute further to stabilization policy once interest rates are near 0%? The answer is an emphatic yes, via three potential channels:
a) Using the Fed balance sheet to substitute for private-sector lending. This is already happening, as the Fed balance has more than doubled since early September.
b) Trying to affect longer-term Treasury yields, either by pre- committing to low rates for a "considerable period" or by buying longer-term Treasuries. This could occur in conjunction with fiscal policy, i.e. buying some of the bonds that are issued by the Treasury in order to finance the stimulus package.
c) Trying to affect the prices of risk assets by buying corporate bonds or equities. Legally, the Fed isn't allowed to buy assets with a meaningful chance of a loss, so this would have to come in cooperation with Treasury and Congress. So in practice, the Treasury might buy risk assets and issue debt that is then purchased by the Fed -- i.e. the process would resemble b), except that the money is spent on assets rather than goods and services.
In practice, we don't think anything beyond a) and perhaps a soft version of b) via some kind of "considerable period" language is imminent, and I'm pretty confident that the upcoming stimulus package will be financed via old-fashioned borrowing from the public. But if the downturn deepens further and/or there are any signs that large-scale borrowing is putting upward pressure on Treasury yields, the "monetization" of additional fiscal stimulus via Fed purchases of longer-term Treasuries would become more conceivable. And if a yet bigger boost is required, these proceeds from the Treasury's bond sales to the Fed could be purchase risk assets. In any case, the important point is to heed the advice given by Ben Bernanke in his famous speech on deflation in 2003 -- do not underestimate the Fed's essentially limitless ability to ratchet up the policy response to a deflationary downturn, especially when cooperation with the Treasury is assured as it likely would be under President Obama.
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Jan Hatzius Chief US Economist Goldman, Sachs & Co.