Next Year’s Green Shoots
Tom Acitelli Dec. 21, 2009, 9:15 p.m.
The Federal Reserve’s Open Market Committee released its customary monetary policy statement following its December meeting last Wednesday. While maintaining its accommodative target for the federal funds rate, the committee cited evidence of sustained improvements in economic activity, strengthening of financial markets and an easing of job losses in explaining the sunset timetable of its myriad liquidity interventions. Purchases of agency mortgage-backed securities and agency debt will conclude in the first quarter, as will the various lending and credit facilities. The term asset-backed securities loan facility’s support for new CMBS will run through next June.
The committee is hedging its bets, of course, leaving open the option of timetable adjustments should conditions deteriorate unexpectedly. The decision to leave the cost of Fed borrowing near zero is a further concession to the committee’s view that growth will fall short of inflation-inducing levels.
Just as monetary and fiscal policies remain extraordinarily supportive, the improvements in economic conditions in the second half of the year have actually exceeded policy makers’ expectations. The Fed currently projects that the economy will contract in a range between 0.4 percent and 0.1 percent in 2009. At the upper end of this central tendency, growth in the second half would almost fully offset the contraction in the first half of 2009.
Six months ago, the Fed was markedly more conservative in its expectations for the year, projecting a 2009 contraction between 1.5 percent and 1 percent. The committee’s central tendency outlook for unemployment has remained stable, anticipating a 2009 unemployment rate in a narrow range around 10 percent. Looking forward, the committee’s projections for 2010 GDP growth have been revised up, to a growth rate of between 2.5 and 3.5 percent. The outlook for the unemployment situation has been tempered, however; the unemployment rate is expected to remain above 9.5 through the next year before falling below 9 percent in 2011.
Federal, State, and Local Government
The Fed’s central tendency projections for economic growth are based on expectations for how different sectors will contribute to activity over the next year. In the latter half of this year, federal government spending and consumers have been the principal drivers of growth. In the latter case, most of the gains have resulted from stabilization in residential activity and from a surge in automobile sales relating to the Car Allowance Rebate System program (more commonly, the “CARS” or “Cash for Clunkers” program). With this in mind, it behooves us to ask what 2010 may hold if housing falters under the weight of higher foreclosures and absent an incentive for durable goods expenditures equal to CARS.
The federal government, unique in its ability to borrow at will, has the most direct control over its own spending and investment activities but can only influence other areas indirectly. In the third quarter, total government activity contributed 0.63 percentage points to the headline 2.8 percent growth rate in real G.D.P. growth. Breaking down that contribution, increases in defense spending accounted for the bulk of the increase in government activity. Non-defense activities were less significant. Net declines in state and local governments were drags on the economy.
Notwithstanding constraints on the federal purse and a commitment to unwind some aspects of its direct intervention, Washington’s political machinery is also acutely aware of the relevance of job growth for next November’s midterm elections. Whatever the motivations, the current bias suggests that federal payrolls (apart from the Postal Service) will continue to grow in 2010. The relative distention of federal employment over the past year has benefited the District of Columbia disproportionately. In other parts of the country, increases in federal and federally funded jobs has been offset by declining state and local government payrolls.
In spite of federal assistance, many states are grappling with the most serious drop-offs in revenues since the Great Depression. Given sharply lower income-, sales- and property-tax receipts, state and local governments are expected to drive deeper in cutting jobs and services. The deleterious impact of states’ attempts to rebalance their receipts and outlays is readily observable in California, both in Sacramento and in every other city where public services ranging from schools to fire departments are important contributors to employment.
Like the labor market, state revenues generally lag behind aggregate output. As a result, a number of states will face greater fiscal challenges in the next year than in the last. Budget cuts have already encroached on payrolls in 29 states; elementary and secondary education, in 29 states; higher education, in 33 states; social service, in 27 states; and, mass transit, in 21 states. In each of these categories, program cuts for the next fiscal year are planned by an even larger number of states.
Apart from spending cuts, many states and localities have been forced to enact tax and service-fee increases. The combination of deteriorating service and higher costs is a dangerous one, however. The experience of Philadelphia during and after the fiscal crisis of the early 1990s is instructive in this regard. Wharton’s Robert Inman, among the preeminent scholars of public finance, pointed out in the aftermath: “The city emerged from the crisis with city residents and shoppers paying an additional 1 percent sales tax, city workers facing a two-year wage freeze and a reduction in employee benefits, and residents living with reduced public services. The long-run effects on city employment and property value are sure to be damaging.”
For commercial property investors, Inman’s analysis is of real import. Some cities and states will handle their fiscal crises in ways that are supportive of long-term economic growth and business investment. Others will not. The multifamily and commercial real estate outlook cannot be separated from an evaluation of these public choices.
The Private Economy
Our long-term prosperity depends upon the private economy weaning itself from the government and reasserting its dominant role. So far, it has only done so with government support, which has sought to influence housing tenure choice through the first-time home-buyer tax credit while accelerating durable goods purchases in the auto sector.
Following 14 consecutive quarters of declines, residential investment turned positive in the third quarter, rising by 19.5 percent and contributing 0.45 percentage points to third-quarter GDP growth. The increase corresponds with a rise in new residential construction activity reported by the census, both in terms of construction starts and value put-in-place. Investment in nonresidential structures, including commercial real estate, fell by 15.1 percent over the same period. This is the fifth consecutive quarter of declining nonresidential activity, reflecting a 0.55 percentage point drag on headline growth.
Declining commercial construction activity will remain a drag on the economy through the next year. The housing outlook is less clear. While investment has picked up and signs of stabilization are present in a growing number of indicators, rising foreclosures and the uncertain future of Fannie Mae and Freddie Mac qualify optimism on the housing front.
Weakness in the housing market will necessarily constrain consumer behavior. In turn, there can be no resumption of robust growth absent consumers’ contribution. Even now, consumers represent more than 71 percent of GDP To the economy’s benefit, consumers loosened their purse strings over the summer, driving the strongest growth in consumption since the first quarter of 2007. According to the preliminary estimate, personal consumption expenditures (PCE) grew by 2.9 percent in the third quarter, more than reversing the second quarter’s 0.9 percent decline.
The benefits of higher spending have not accrued to retailers. Increases in spending on nondurable goods and services were muted. Rather, the total increase in PCE was dominated by a 20.1 percent rise in durable-goods spending, corresponding with the sharp rise in automobile production and purchasing. The increase in auto production, heavily dependent upon the CARS program, contributed 1.45 percentage points to headline GDP growth. Put another way, GDP growth in the third quarter was approximately 1.3 percent (instead of 2.8 percent) when controlling for the total contribution of the auto industry and auto purchases. The summer’s increase in auto activity is not expected to persist, however, requiring that we look elsewhere for growth.
Part of the solution will come from the moderation of job losses. As the labor market has stabilized-and in spite of the troubling outlook for those seeking employment-an improvement in consumer sentiment has prompted a broader increase in spending. In October, personal income increased by 0.2 percent; and disposable personal income, by 0.4 percent. Consumption outpaced both measures of income, increasing by 0.7 percent, on a decline in the savings rate from 4.6 percent to 4.4 percent. Here again, however, the trend will need to be monitored carefully. Digging into the numbers, it is apparent that salaries and wages have stagnated. Improvements in consumers’ budgets over the past year have accrued from a small decline in tax obligations that is unlikely to repeat itself in 2010.
A Brighter Year Ahead for the Economy
What will drive economic growth next year? Modest contributions will come from consumers, housing, businesses and the federal government. Drags from state and local government, nonresidential spending and the export imbalance are likely to persist. Overall, the baseline expectation of measured growth holds, albeit with risks of a fallback if unexpected shocks upset the fragile recovery.
The potential for a rise in inflationary pressures is one of the major risks, which I will visit in January. For the time being, consumer sentiment is rising, pushing savings rates lower and spending rates higher. But a weak labor market will continue to weigh on consumers’ aggregate incomes. Consumers’ contributions will remain middling until wages and salaries improve, limiting the prospects for stronger growth. As for the government’s net contribution, any federal spending increases will be offset by constrained local and state government activity. Federal policy support of the residential sector will prove necessary to sustaining that sector’s recent gains, requiring a close monitoring of the administration’s proposals for the GSEs and the impact of those proposals for the apartment sector.
All that said, and in spite of an abundance of qualifiers, the year ahead looks brighter for the economy than the year gone by.
Sam Chandan, Ph.D., is president and chief economist of Real Estate Econometrics and an adjunct professor of real estate at Wharton.