財經觀察 1634 --- US: 9 key Questions for 2009

US -- 9 key Questions for 2009

As 2008 turns into 2009, the uncertainty in the financial markets is unprecedented. Our US Econ Team's forecast remains that massive fiscal and monetary stimulus will end the technical recession in the second half of 2009, setting the stage for a very sluggish recovery that keeps the unemployment rate on an upward trajectory and the federal funds rate near 0% through the end of 2010. But we confess to enormous

uncertainty about this outlook.

Here the team lists out 9 key questions for 2009. The answers to these questions will largely determine whether the crisis abates or deepens over the next year.

1. How much more downside for home prices?
2. How much more upside for credit loss estimates?
3. How far will bank leverage decline?
4. Who will provide the new capital?
5. How much does the personal saving rate need to rise?
6. Will the boost from foreign trade continue?
7. How much stimulus from fiscal and monetary policy?
8. Will the United States be able to fund this unprecedented policy response?
9. Can we avoid deflation?

1. How much more downside for home prices?
The key trigger for both the financial crisis and the recession was the bursting of the US home price bubble starting in early/mid-2006. The unfolding price declines in the world’s largest asset market successively triggered a sharp increase in subprime (and ultimately other) mortgage delinquencies in late 2006, turbulence in the asset-backed commercial paper market and large-scale writedowns among financial institutions in mid-2007, an economic recession starting in late 2007, and distress and insolvency among major financial institutions including Bear Stearns, Lehman Brothers, and AIG in 2008. Hence, stabilization in home prices would mark a major turning point in the crisis. Unfortunately, such a stabilization does not look imminent. Our current expectation is a further 15% drop in home prices as measured by the Case-Shiller national index over the next year. Moreover, the massive amount of excess supply as measured by either the homeowner vacancy rate or the inventory of existing homes for sale, illustrated in the top exhibit on the front page, suggests that the risks to our forecast are tilted to the downside.

2. How much more upside for credit loss estimates?
Just over a year ago, our suggestion that $400 billion in residential mortgage losses could prompt a $2 trillion credit contraction was attacked as hopelessly pessimistic, if not outright inflammatory. Now, some

estimates of the credit losses themselves (!) are approaching $2 trillion, at least when other types of debt such as commercial real estate, consumer, and corporate lending are included. Our latest estimates,

incorporating the estimates of the GS Banks team in equity research for non-mortgage debt, suggest roughly $1.6 trillion of total loan losses. Again, however, the risks are on the side of a worse outcome. The extent of the losses is critical to the broader economy, because—with banks unwilling to increase leverage—incremental losses will result in further lending contraction unless they are plugged with new capital.

3. How far will bank leverage decline?
The lending cutbacks that have been prompted by capital losses will be compounded by banks’ desire to reduce leverage. In an environment where banks face great uncertainty both about the economy and about

their own potential losses, the natural response is to hunker down and reduce the risk of their portfolios. In an attempt to reduce the economic damage, regulators are playing against type by prodding banks

to lend freely. We have assumed a 10% reduction in leverage ratios in our own work. However, if the response is in line with past crises, it could well be larger. For example, banks and thrifts taken together seem to have cut their leverage by more than 20% in the early 1990s.

4. Who will provide the new capital?
Given the size of the potential losses and the damage incurred by private investors in this sector, the investor of last resort—the US government—is likely to have to do more to recapitalize the financial sector.

While the second $350 billion tranche of the TARP funds has not yet been disbursed, a tiny portion of this has already been precommitted to the automakers, and a more significant chunk is likely to be allocated to homeowner assistance (which might in fact benefit financials through a reduction in total loan losses). It’s entirely possible that an additional recapitalization program will be required later in 2009 or 2010. Distressed investors also may begin to step up for institutions that have already imploded (e.g. IndyMac) or are available at firesale prices.

5. How much does the personal saving rate need to rise?
We have worried about the low personal saving rate for a number of years. Until recently, the main question was when the retrenchment would start. Now, the main question is how bad it will be and whether the saving rate will overshoot its long-term equilibrium, which we estimate in the 6%-10% range. As shown in the bottom chart on the front page, our baseline forecast incorporates an increase to the upper half of the equilibrium range. Indeed, the increase might be even more dramatic if households decide that they need to make up for the period of unusually low saving and weak market returns.

6. Will the boost from foreign trade continue?
Over the past two years, net foreign trade has contributed an average of +1.2 percentage points to real GDP growth, as domestic demand has been far weaker in the United States than in most other developed or emerging economies and the dollar has weakened substantially on balance as well. Our baseline expectation is that this boost continues in 2009, albeit with a reduced growth contribution of only ½ percentage point. From an analytical perspective, one could argue that this forecast is on the conservative side given our GS forecasts for real domestic demand (-2% for the US vs. +1½% in the rest of the world) and the dollar (further modest depreciation on a trade-weighted basis). However, from a data watching perspective, the recent numbers have been much worse for US exports than for US imports, and the fourth quarter of 2008 will likely show a negative trade contribution. This could be noise, but it could also mean that non-US demand is even weaker than generally believed.

7. How much stimulus from fiscal and monetary policy?
The most positive development of the past month has been the decisive swing toward policy stimulus. On the monetary side, the Fed is dramatically stepping up the growth rate of its balance sheet, via direct lending facilities as well as purchases of agency securities and agency-backed MBS. Based on the Japanese experience, where the central bank balance sheet grew to over 30% of GDP, it would not be surprising to see an expansion in the Fed’s balance sheet from the current $2.3 trillion to as much as $4-$5 trillion before the crisis is over. Moreover, on the fiscal side, the incoming Obama administration seems to be pushing for a stimulus of around $850 billion spread over 2009 and 2010. This is highly welcome in our view, and it is much more than we were expecting just a few weeks ago. Thus, the increasing momentum for more aggressive policy stimulus poses a significant upside risk to our view, which neutralizes much of the downside risk from the performance of the financial system and the economy.

8. Will the United States be able to fund this unprecedented policy response?
The deterioration in the economy, the sharp swing toward fiscal stimulus, and the capital injections into the financial system have triggered a veritable explosion in the supply of Treasury securities. Given

a federal budget deficit of around $1 trillion and the cost of the Troubled Asset Relief Program, net issuance of Treasury debt is likely to total around $1¾ trillion in fiscal 2009. This financing requirement of

almost 12% of GDP would exceed the previous postwar record of 6% of GDP in 1983 by a factor of 2. However, we are optimistic that the markets will absorb this surge in government borrowing because it

is matched by an even greater drop in private borrowing. Indeed, the sharp swing in the private sector financial balance from deficit to surplus should be sufficient to reduce the overall US dependence on

foreign capital inflows. At least in a net sense, this means that incremental private sector saving will finance more than 100% of the incremental public sector dissaving.

9. Can we avoid deflation?
Although we expect policymakers to succeed in stabilizing economic activity at some point in 2009, the risk of deflation in subsequent years is nevertheless high. In fact, the year-on-year change in the headline CPI is all but certain to fall below the zero line over the next couple of months, and it should stay there for most of 2009. And while the year-onyear changes in the core indexes should remain positive in 2009, there is a strong likelihood of deflation at a later date unless the enormous “output gap” that is currently emerging is unwound via a much stronger recovery in 2010-2011 than we expect. This does not necessarily mean the type of “corrosive” deflation in which deepening declines in inflation expectations push real interest rates higher and higher and economic activity lower and lower. But it does suggest that the risks are strongly tilted in the direction of unwanted deflation rather than unwanted inflation.

Jan Hatzius, Andrew Tilton