US: Financial Crisis Tipping US into Recession

• The deterioration in financial conditions in recent weeks has been faster and more severe than we had envisioned. Our downside risk scenario for the US economy is now materialising and we have revised our macroeconomic and monetary policy outlook as a result. We now expect the US economy to enter into recession in the coming quarters and do not expect growth to reach trend before 2010.
• With both consumer and business credit drying up, domestic demand will face serious headwinds in the coming quarters. We expect a significant contraction in both private consumption and business investment. While the drop in commodity prices will cushion the blow to households it is not enough to offset a recession as falling equity prices put further downward pressure on consumption growth.
• The Federal Reserve has restarted its easing cycle, and we expect a further 25bp cut at the meetings in October and December, taking the fed funds rate to 1% by year-end. Further policy measures aimed at unfreezing the money and credit markets are also in the pipeline.

Downside risks unfolding

Recession

Incoming data and the escalation of the financial crisis imply that our downside risk scenario for the US economy is now materialising. As a result, we have changed our macroeconomic and monetary policy outlooks.

Our revised forecast involves a recession in the coming quarters and a slower recovery later in 2009. We do not expect the economy to reach above-trend growth before 2010.

As the global growth outlook has been deteriorating, commodity prices have adjusted significantly. Combined with a rapidly building slack in the US economy, inflation concerns have now taken a backseat at the Federal Market Open Committee. Consequently, we expect the Federal Reserve to cut interest rates to a low of 1% by year end.

A weaker starting point

Before turning to the impact of the developments in the financial and commodity markets, it would be fair to mention that incoming data have revealed the macro economy - even before the recent escalation in the crisis - to be in a much worse state than just a few weeks ago.

Incoming data suggest that both households and businesses are now scaling back their pace of spending. Q3 real personal spending is currently tracking a decline of 2.5% q/q AR, while business spending is heading for a decline of 2.0% q/q AR.

Financial markets frozen

Events in the financial markets over the past 3-4 weeks have been dramatic. Money and credit markets have frozen. Hence, access to funding is now severely limited for banks, households and businesses.

As consequence of the freeze in money markets, the monetary transmission mechanism has broken down. The 3M Libor spread over the fed funds rate has reached unprecedented highs. 3M Libor fixings are now quoting 4.82%, even though the fed funds rate has been lowered to 1.50%. With the lending rate of many loans attached to the Libor, this is a significant problem.

Recent developments will affect the economy in the same way as if the fed funds rate had been hiked by around 200bp. If Libor rates do not correct lower in the coming months, a rule of thumb (e.g. from the FRB/US model) suggests that this could take out almost one percentage point of GDP growth over the coming 4 quarters.

With both consumer and business credit drying up, domestic demand will be facing significant headwinds in the coming quarters.

As well as tighter credit, the stock market has lost significant value and is now trading at 2002-levels. If equity markets do not recover soon, this will add another drag of around 1.0pp on the economy (cf. the negative scenario in Research US: Taking stock of the bear market, July 30).

Oil price cushion not sufficient to prevent recession

On the positive side, oil and commodity prices are declining fast as the world economic outlook deteriorates. Although this is going to provide some cushion to the economy, it comes too late, as the internal dynamics of the economy are now turning recessionary.

With commodity prices declining rapidly, headline inflation will recede very fast from here. We expect headline inflation to drop below 2% by mid-2009.

Core inflation is set to remain elevated for a period as second-round effects from a weaker dollar and higher commodity prices are absorbed. However, with a rapidly building slack in the labour market, declining commodity prices and a turnaround in the US dollar, we look for core inflation to edge lower over the course of 2009.

More cuts, credit measures and fiscal stimuli

The combination of a financial market freeze, a recessionary outlook and a significantly improving inflation outlook will allow the fiscal and monetary authorities to devote all their attention to stabilising the markets and supporting the real economy.

The Federal Reserve has restarted its easing cycle by delivering a 50bp cut to 1.50% in coordination with other central banks this week (see Flash Comment - Global: Coordinated central bank action). We expect further 25bp cuts from the Federal Reserve in October and December, taking the fed funds rate to 1.00% by year-end.

On top of further monetary easing, additional measures will almost certainly be implemented to resolve the problems in the money and credit markets. The latest move by the authorities is to target unsecured lending. The Federal Reserve's newly announced (but not yet operating) commercial paper credit facility is an important step in this direction.

However, given the continued freeze in money markets, further - and perhaps internationally coordinated - measures need to be employed. These measures could include a guarantee on inter-bank lending, unlimited deposit insurance and large government infusions of capital in the banking system.

On the fiscal side we would not be surprised to see another round of rebates or further increases in public spending. However, this is hardly feasible until after the presidential election on November 4 and most likely will have to wait until the new president takes office in January.

Danske Bank http://www.danskebank.com/danskeresearch

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