FORECASTING IN UNCERTAIN TIMES
September 25, 2008
The global financial system has suffered a severe and virtually unprecedented blow in recent weeks, leading to the failure, bail-out or acquisition of a number of large and venerable institutions. Events have taken the U.S. economy and indeed the world economy to that proverbial “fork in the road”. Very recent market events highlight the extreme uncertainty among investors as to which path will be taken. Markets around the world crashed following the September 13-14th weekend of financial horror that saw Lehman Brothers file for bankruptcy and Merrill Lynch sold to Bank of America. The massive U.S. government support package for AIG didn’t go far in lifting the gloom. Clearly the market assessment was that economies would go down a path to ruin. But then rumours of still bolder U.S. government action to come led to massive rallies September 18th and 19th. Markets were voting with their money that the path forward would lead to a much brighter place. It is in this environment of extreme uncertainty that we are updating our economic forecast. It is with some comfort that we note that as shocking as recent financial events have been, their general nature has hardly been surprising given the economic and financial imbalances that had developed in the first half of the decade. None of the events in recent weeks have altered the core beliefs that have shaped our economic outlook over the past two years:
- U.S. housing prices would fall until a large number of households conclude housing is a bargain
- Housing price declines would cause stress to household and financial institution balance sheets
- Credit would be tight and remain expensive despite rate cuts of central banks
- U.S. consumption would weaken with a short lag after housing prices started to fall
- The notion that the economies of the rest of the world would completely “de-couple” from the U.S. economy was bogus and the global economy would experience a material slowing
- Slackening world growth along with some supply responses would bring commodity prices down, at least temporarily
- Lower commodity prices and building slack would cap inflation pressures in most countries and prove that the sudden and shrill concerns over inflation were unfounded
The bottom line is that the path forward for economies from this “fork in the road” will look much like the one we have described in previous forecasts. Economies will, however, be slightly weaker. And the fact that economies have never quite been in this place before makes the degree of uncertainty over any point forecast much higher than normal.
History a poor guide to the future
Economists often look to past experience as a guide, but history is of limited use this time around. There have been financial calamities in the past, but nothing that quite mirrors the current financial crisis in scale and scope.
Some draw parallels between the current situation and the Great Depression. However, making this comparison is a stretch. First, the onset of the Great Depression owed to a tightening of monetary policy. The Fed raised rates in 1928 to stem what they deemed excessive speculation fuelling a stock market bubble. In contrast, over the past year the Fed has unquestionably pursued a loosening in financial conditions to inject liquidity into financial markets. Second, the Fed of the early 1930s abdicated its lender-of-last-resort responsibility, allowing widespread failure of banks and undermining confidence in the system. Bernanke’s Fed has lent aggressively and introduced new facilities to better target lending (see Box 1). Third, at the onset of the contraction in the Great Depression, the Fed failed to maintain price stability, inducing deflation. It later reaped what it sowed: policies of low nominal interest rates faced the “zero-bound” problem while deflationary expectations kept real interest rates high. Today, the Fed explicitly has price stability as a cornerstone of its mandate and the inflation outlook rightly factors in any rate decision. Central banks around the world have learned from the mistakes of the Great Depression, which is why we’re seeing more aggressive and coordinated efforts around the world to ensure the global financial system has access to sufficient funds to weather the crisis.
There are some disturbing similarities between today and the Japanese experience of a bursting real estate bubble in 1989 that left carnage in the Japanese financial system for much of the next decade. But again, guidance from this period is very limited. The Bank of Japan (BoJ) committed a similar policy error to that seen during the Great Depression. Due to concerns about re-inflating asset bubbles, the BoJ hiked rates 200 basis points after the stock market peaked and didn’t embark on an easing cycle until 18 months after asset prices were in decline. The central bank tried to play catch-up, pushing rates from 6% down to zero, but this rate adjustment came too late to restore market confidence. Initiatives were also not in place to promote a quick and necessary restructuring of the financial system. It wasn’t until 1998 that the government announced the Obuchi Plan to provide the equivalent of US$500 billion in public funds for loan losses, bank recapitalization and depositor protection.
The U.S. Savings and Loan Crisis (S&L) of the 1980s may be the most similar to the current situation. But, it was much smaller in scale, in part because it did not have the international reach of today’s financial crisis. During the S&L crisis, the government established a Resolution Trust Corporation (RTC) at just over $400 billion. The purpose was to purchase the bad debts of financial institutions and over time sell them back into the market as financial conditions improved. The RTC was able to sell over 95% of the assets they had initially seized with a recovery rate of over 85%. That left the taxpayer ultimately footing a bill of $124 billion, while corporations absorbed $29 billion in losses. The current financial crisis is carrying a bigger price tag. Corporate write-downs and losses have already mounted to over $500 billion, with about half of that being borne by non-American firms.
The U.S. government recently announced an S&L-style fund being dubbed TARP (Troubled Asset Relief Program), which, according to the most recent discussions, will make $700 billion available to purchase residential and commercial mortgage related assets or any other corporate assets deemed necessary to restore financial market operations. When adjusted for inflation, the RTC and TARP funds are similar in size, however, not when one considers the corporate losses that have already occurred in the current cycle in addition to other government initiatives such as placing Freddie Mac and Fannie Mae into conservatorship. The total public and private tally will greatly exceed that of the S&L crisis. While this may seem daunting, at this stage in the cycle, it is more important to head off a more painful deep and extended economic downturn by enacting measures that can quickly restore market confidence and financial market operations in order to prevent a complete freezing up of credit supply.
Go big or Go home
Two key lessons came out of these past experiences that the Fed and other global central bankers have learned well. Firstly, procrastination in easing monetary policy and pumping in liquidity is costly to the real economy. A lengthy period of financial institution failures and dysfunctional credit markets that chokes off credit availability ensures consumers and businesses pay the ultimate price. Secondly, liquidity injections by the central bank and government must be sufficiently larger than the underlying problem. Partial solutions generally just lead to that money being wasted, as market participants find loopholes and oversights. The problem of frozen or dysfunctional credit markets is not cured.
The Federal Reserve has taken aggressive action this time around to avoid the mistakes of the past. Box 1 highlights the liquidity measures put in place since the collapse of the first major U.S. financial institution – Bear Stearns – in mid-March. We believe the Fed is on the right track; however it is important to recognize that TARP and other measures will not act as a magic wand that will make the problems go away instantly.
U.S. will not return to business as usual
The RTC during the S&L crisis remained in existence for six years (until 1995). Although TARP will buy assets for only two years, that doesn’t mean it won’t be around for longer than that. The two years is just the acquisition phase. It may take a long time to dispose of the assets, as was the case in the post S&L phase.
In addition, even with the recent liquidity measures and a restoration in market confidence, it will not be business as usual in credit supply. Once again using the S&L episode as guidance, credit growth continued to slow dramatically two years after the RTC was in place and the economy still tipped into recession. We believe similar events will unfold in the current cycle, the TARP will take considerable time to have its full effect, and the U.S. economy will struggle to gain traction over the next year.
The increasingly bold action of the U.S. government and the central banks around the world has likely capped a lot of the downside risks. But the root problems haven’t gone away. The bad debt is being shifted from private institutions to public balance sheets and it will be easier to handle there. But, capital will still be in short supply for financial institutions and their cost of funds should come down but remain relatively high. Credit will still be tight and somewhat expensive. Further asset devaluation will arise as U.S. housing prices fall further. In order to pay for recent measures, the U.S. Treasury will have to issue a lot more debt in the short-term and that should push up yields.
The general shape of our September 2008 forecast is similar although marginally more pessimistic than that in June. The projection for U.S. real GDP in 2009 has been lowered only marginally by 0.1 percentage points to 1.1%. In 2010, U.S. economic growth finally starts to recover, but only back to 3.2%, as opposed to the traditional 4-5% pops in growth that follow extended periods of economic weakness.
We’re all in this together
Much of the above has focused on the U.S. economy, but the financial turmoil is in fact a global event and the weakness in the U.S. is being transmitted abroad. In recognition of this, global economic growth for next year has been reduced by 0.3 percentage points to 2.9% in 2009, which implies a mild world recession, but the tide turns in 2010 with a recovery to 4.2%. The downgrade in 2009 reflects the fact that several economies are already in or on the brink of recession – U.K., Spain, Ireland, Italy, Japan, U.S., Germany, and France. We have argued for more than a year that speculation of a global ‘decoupling’ from the U.S. recession would be disappointed. This has now occurred and it has led to the commodity price correction for which we were calling.
All of these developments have profound implications for the Canadian economy. Three-quarters of Canadian international trade is with the U.S. And two of Canada’s largest export markets — forestry products and autos — are the most vulnerable to housing and consumption weakness south of the border. Almost a third of Canadian corporate funding comes from the U.S. market so credit tightness there has a direct impact here. The cost to Canadian financial institutions to raise funds has also soared, just not to the full extent as for U.S. banks. Lower commodity prices will reverse much of the extraordinary income gains of recent years, particularly in Western Canada. And if the cross-border effects were not enough, there are some domestic headwinds. Notably, while not crashing American style, Canadian real estate has come off the boil. It is almost inconceivable that painful adjustments in our manufacturing sector have been completed. In all, these factors lead us to a profile for the Canadian economy that resembles the American. Essentially, more sideways movement on output with only a shallow recovery in late 2009. Our forecast for Canadian real GDP growth was edged down to 0.7% (from 1.0%) for 2008, while the 2009 forecast is 1.2%. In 2010, a meaningful economic recovery finally takes hold with 2.7% growth.
We have been on the pessimistic side of the “consensus” of publicly available forecasts for some time. Perhaps a key distinguishing feature was our focus on credit conditions and the probability that they would remain tight. Neither the recent failure of large financial institutions nor the increasingly bold actions of Governments and central banks have caused us to fundamentally change our views. Recent financial events confirm the coming weakness in U.S. domestic demand. The reaction of policy authorities provides assurance that financial markets will not free fall, but it does not give an instantaneous or significant lift to economies being dragged down by the battered balance sheets of financial institutions, households and increasingly, governments. On balance, our September 2008 forecasts are similar in shape but slightly weaker on growth prospects than our previous outlook of June.
Since credit conditions are front and centre in determining our outlook, recent events do widen the range of uncertainty around a point forecast. Confidence and financial stability could be restored sooner than we imagine, leading to an earlier and sharper recovery. However, just as likely in our view is that the financial sector woes and the interaction with the economy will prove more intractable than we have assumed. In other words, the risks to the forecast are balanced. Like us, users of forecasts will have to pay extraordinary attention to economic and policy developments to determine what course will be taken through these unchartered waters. Scenarios must be considered. We will shortly publish thoughts on these. But for now, key elements of our storyline are falling in place and our base case is sticking rather closely to the views we presented in June.
• Over the next 12 months, home prices will have
bottomed, the cost of funds to financial institutions
will have fallen, the worst in institutional
failures will be in the rear view mirror, and the
process of recapitalizing the financial system
will be well underway ...
• ...but don’t expect a return to the status quo.
• Relative to the past decade, the cost of financing
will remain higher and less credit will be
• A convincing and sustainable recovery in consumption
and investment won’t materialize in
the U.S. until 2010.
• The world economy will be in a mild recession
in 2009 before bouncing back in 2010.