February 20, 2009

U.S. Economic Contraction Intensifies

Recently released data indicate that the economic contraction has intensified at a pace associated with severe recessions. Two consecutive quarters of negative real growth, striking job losses and deep declines in both manufacturing and services output defined year-end 2008. While the economic outlook remains bleak for the first half of 2009, a few indicators suggest that the pace of contraction may slow in coming months.

GDP Shrinks Notably in Fourth Quarter 2008
Real gross domestic product (GDP) fell at a 3.8 percent annualized rate in fourth quarter 2008, less steep than market expectations. Accounting for the notable drop in GDP, consumer spending, business investment and residential investment all declined substantially in the fourth quarter (Chart 1). In particular, spending on durable consumer goods plunged 22 percent at an annualized rate, the sharpest decline since 1987. Spending on nondurable goods fell an annualized 7 percent for the second straight quarter, its worst performance since 1967. Real personal consumption expenditures dropped 0.5 percent in December as low consumer confidence spurred consumers to increase the savings rate by 0.8 percentage point to 3.6 percent.

New orders for manufactured durable goods fell 3 percent in December, the fifth consecutive month of decline. Notable drops in core capital goods orders suggest substantial weakening in equipment and software investment in the coming months. Industrial production continued its downward trend in January, falling 1.8 percent following December’s 2.4 percent retreat. On a positive note, retail sales increased 1.1 percent in January following six straight months of declines. The small uptick in the Institute for Supply Management’s indexes of manufacturing and service-sector growth, which hit historic lows in December, ended a streak of steep declines that began in August 2008. While both indexes reflect significant pullbacks in output, January’s uptick may signal a possible stabilization in the rate of economic contraction. The Index of Leading Economic Indicators, which tracks more normal cyclical movements, points to a moderate decline in overall GDP growth in the first half of 2009 (Chart 2).

Labor Market in Distress
Labor market conditions worsened significantly in January. Nonfarm payroll employment fell by 598,000—more than 19,000 jobs per day and the largest one-month drop since 1974. Job losses in November and December were also revised upward to 597,000 and 577,000, respectively. These last three employment reports revealed a net loss of nearly 1.8 million jobs, the largest three-month loss in the post–World War II period. With all major sectors posting substantial declines, payroll employment has fallen by nearly 3.6 million since the start of the recession in December 2007 (Chart 3).

The unemployment rate in January rose 0.4 percentage point to 7.6 percent. The increase experienced by males ages 25–54 was twice that for females of the same age group, putting prime-age males 1.3 percentage points higher on the unemployment scale than their female counterparts. Given the recent spike in initial claims for unemployment to around 630,000—a level last seen in October 1982—further job losses and increases in unemployment are likely in February. While the employment outlook is rather ominous, average hourly earnings are up 3.9 percent from a year ago, and productivity increased at an annualized rate of 3.2 percent in the fourth quarter, suggesting firms are retaining their most productive workers.

Some Financial Market Improvement
One major signal that firms are facing difficulties in obtaining financing is that the benchmark yield spread between Baa- and Aaa-rated corporate bonds jumped in December to levels not seen since 1933. This spread has only narrowed from 350 at its December peak to around 280 basis points in recent days, a level near the peak during the 1981–82 recession. On a brighter note, investment-grade corporate bond issuance increased notably in January, signaling a reopening of the corporate bond market to highly rated firms.

Interest rate spreads in the interbank and commercial paper markets have edged down further following large improvements in late December and early January. Likewise, mortgage rates have come down from their October highs, though they have crept up some in recent weeks (Chart 4). According to senior loan officers surveyed by the Federal Reserve Board in January, the rate of decline in their willingness to make consumer loans has slowed substantially from three months earlier. Credit standards at banks reportedly also tightened at a slower rate through the fourth quarter.

Housing Market Yet to Bottom
Construction indicators declined further in December, with overall construction spending falling 1.4 percent. Housing permits and starts plummeted 11.1 percent and 14.5 percent in December, respectively, having dropped 50.8 percent and 44 percent over 2008. In January, permits fell another 4.8 percent and starts plunged 16.8 percent to only 466,000 units, a new post–World War II low. Both permits and starts are now nearing 80 percent declines from their peaks of three years ago. New-home sales slid another 14.7 percent in December, far worse than expected. However, December existing-home sales surprised the market with a 6.5 percent gain, although the median existing-home sales price increase was 9.7 percent lower than a year ago. Falling home prices have yet to show signs of nearing bottom (Chart 5).

Growing Slack, Rapid Disinflation
Amid growing slack, there has been rapid disinflation in recent months. As of December, prices for nearly half of all goods and services have declined. Consumer prices fell in December and January, largely owing to plunging energy prices. Even less-volatile, year-over-year figures show producer prices falling and consumer price inflation in negative territory—a pattern not seen since August 1955 (Chart 6). Headline PCE inflation was up by only 0.6 percent from a year ago. Year-over-year core CPI and PCE inflation rates have also slowed to about a 1.7 percent pace.

Although the recession has deepened in recent months, efforts to repair the financial system, coupled with fiscal and monetary stimulus, should spur an eventual economic recovery.

—Jessica J. Renier

About the Author Renier is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.