November 14, 2008

Most measures of the economy contracted in recent months as financial turmoil escalated to alarming levels. While recent weeks have shown small signs of improvement in the credit market, further slowing of real growth appears likely.

GDP Contracts in Third Quarter 2008
Real gross domestic product (GDP) declined in third quarter 2008 at a 0.25 percent annualized rate, primarily due to a sizable 2.3 percentage-point decrease in personal consumption expenditures. Residential and nonresidential fixed investment also contributed to contracting GDP, while inventory investment, net exports and government spending made positive contributions (Chart 1). Although positive, net exports—the one strong leg on which the economy was standing—contributed much less than in the second quarter, driven down in part by weakening foreign economies and a stronger dollar.

Absent strong export demand, durable goods orders increased just 0.9 percent in September, making up for less than one fifth of the 5.5 percent drop seen in August. Excluding transportation, new orders for all manufactured goods fell 3.7 percent in September, following a 3.6 percent decline in August. According to the Institute for Supply Management, both the manufacturing and services sectors are contracting at levels that have occurred only during recessions (Chart 2). Adding the lowest reading of consumer confidence on record and continued weakness in the housing market, most indicators suggest further slowing of real growth over the coming quarters.

Labor Market Shows Considerable Deterioration
Labor markets weakened significantly in September and October with recessionary-level, nonfarm job losses of 284,000 and 240,000, respectively. Private nonfarm payroll employment shed 263,000 jobs in October—the largest one-month drop since November 2001—with broad-based declines occurring across firm sizes and industries. According to the Challenger Report, layoff announcements hit the highest level in nearly five years in October, with 72 percent of industries now in downsizing mode. To date, the labor market has lost close to 1.2 million jobs since peaking in December 2007. About half of this decline has occurred in the last three months as businesses responded to shrinking demand and tighter credit with deeper cost-cutting.

The unemployment rate increased 0.4 percentage points to 6.5 percent in October, reflecting higher unemployment across all ages. Teens, in particular, experienced a 1.5 percentage point increase in unemployment. Unemployment rates of these levels are consistent with or higher than those of most previous recessions (Chart 3).

Tentative Signs of Possible Credit Thaw
Tentative signs that the frozen credit market may be thawing have emerged in recent weeks, albeit very slowly. Investment-grade bond spreads have sluggishly come down off of record highs experienced at the end of October, while high-yield bond spreads have remained stubbornly high. In response to the opening of the Federal Reserve's Commercial Paper Funding Facility, issuance of longer-term commercial paper has begun climbing, and spreads over Treasury bills, while volatile, have retreated from October highs. While mutual mistrust still exists in the interbank market, the ballooned TED spread [1] that followed the collapse of Lehman Brothers has slowly narrowed since October 10 following recapitalization initiatives and dramatic, global policy moves (Chart 4). The credit market remains extremely fragile. According to senior loan officers surveyed by the Federal Reserve Board in October, credit standards at banks tightened further through the third quarter and officers are less willing to lend.

Housing to Continue Drag on Growth
Both existing and new home sales increased in September as mortgage rates came down, improving conditions for homebuyers. Single-family existing-home sales increased 6.2 percent, the largest one-month increase since January 2002, while the median sales price fell another 5.6 percent. Since then, however, mortgage rates have risen, appearing unresponsive to lower money market rates. Taking into account further notable declines in housing permits and starts, residential investment will likely continue to be a drag on growth over the coming quarters, but it is unclear for how long. Single-family building permits are now 69.6 percent below the peak in September 2005.

Inflationary Pressures Dissipating
In response to the downgraded economic outlook, commodity prices—oil in particular—have tumbled (Chart 5). Import price inflation, even when petroleum is excluded, has slowed and price pressures across the board have all but disappeared. Core PCE inflation has decelerated to a 2.1 percent annualized rate in September from its June high of 3.5 percent. Trimmed Mean PCE and core CPI inflation have also decreased by 2.1 and 2.3 annualized percentage points since their summer highs, respectively. While headline PCE and CPI inflation are still elevated from the summer months, they slowed noticeably in August and September. Overall PCE and CPI inflation are currently up 4.2 and 4.9 percent from a year ago. Recently the International Monetary Fund (IMF) forecast of global GDP growth was revised down to 2.2 percent for 2009. A forecast of negative GDP growth for advanced economies as a group has not been seen since World War II, but is consistent with the IMF's most recent forecast. Falling energy prices and a bleaker economic outlook suggest further declines in inflationary pressures over the coming quarters.

—Jessica J. Renier

About the Author Renier is a research analyst in the Research Department at the Federal Reserve Bank of Dallas. Note The TED spread is the three-month London Interbank Offered Rate less the three-month Treasury bill yield.