Winds of Change - Economic Recovery Will Find the Landscape Changed

Steve Rick, CUNA’s senior economist for CU360
August 20, 2009 | COMMENTS

Like a skydiver jumping out of an airplane, the U.S. economy's rate of descent started out modestly—averaging 158,000 job losses per month during the first three quarters of 2008. But as momentum built, eventually the rate of decline reached its nadir in the first quarter of 2009. By then, monthly job losses were averaging 691,000.

Now, however, it appears a parachute has been deployed and the rate of descent in job losses is slowing. Payroll employment declined “only” 345,000 in May 2009, according to the Bureau of Labor Statistics. Some may say all we need now is a strong updraft to reverse our economic freefall. But what might provide the impetus for these winds of change?

Liquidity and Stimulus

At least four sources of an economic wind are available to the current American economy:

1. The largest injection of bank liquidity by the Federal Reserve in its 96-year history, along with new lending initiatives, will stimulate additional private-sector borrowing and spending later this year, giving a lift to the struggling economy.

The Federal Reserve's balance sheet, as measured by the monetary base, more than doubled from $823 billion in April 2008 to $1.7 trillion in April 2009. This is a measure of the massive “quantitative easing” that the Federal Reserve is undertaking to stabilize the financial markets. In early June, depository institutions were sitting on $838 billion of excess reserves, up from $2 billion a year earlier.

2. The largest fiscal stimulus in American history (The $787 billion American Recovery and Reinvestment Act) will begin financing “shovel ready” investment projects over the next few quarters. The Act also includes federal tax relief; expansion of unemployment benefits and other social welfare provisions; and domestic spending in education, health care, and energy infrastructure.

3. The recent inventory correction, which led to a 12% year-over-year drop in industrial production, will have run its course with factories increasing their pace of production.

4. An economic contraction is an aberration for any economy. The U.S. economy typically grows 3.5% per year, due to 1% labor force growth and 2.5% productivity growth. Economists consider this the “natural” or “organic” rate of economic growth. Since the U.S. population has not stopped growing, nor have individuals stopped thinking up new ways to increase efficiency, the economy still has this natural tendency to expand.

Savings

The nature of the upcoming economic recovery will be weaker than normal. There has been a significant economic slowdown not just in the U.S. but around the world. Many of our major trading partners such as Europe and Japan will not see a recovery well into 2010. This will curtail U.S. exports, dampen economic growth, and contain inflationary pressure.

Changing consumer behavior will also be a major factor altering the nature of the upcoming economic recovery. Household wealth declined 18% in 2008—roughly $11 trillion. This has now produced a strong incentive for Americans to increase their saving rate from near zero in 2005 through 2007 to 5.7% today—the highest rate since February 1995.

No longer can households rely on rising stock and home prices to fund their retirement accounts. They must boost retirement funds the old fashioned way, by consuming less than their income. Personal income rose 0.7% in the January to April 2009, while consumption spending was down 1.5%, according to the Bureau of Economic Analysis. The sharp increase in the U.S savings rate in conjunction with the continuing worldwide savings glut will maintain deflationary pressures for the next few years.

For inflation to really take hold an upward wage-price spiral must be put into motion. But with the unemployment rate headed for double-digit territory, the likelihood of this happening is quite remote. A slack labor market will force workers to underbid each other for jobs. This will keep a lid on wage inflation, if not create outright wage deflation.

Recovery and Unemployment

You might be asking yourself how an economic recovery can coincide with a rising unemployment rate. Four factors explain this counterintuitive result:

1. When firms begin to see a pickup in demand for their good or service, they do not hire new workers right away. First they look to increase the output of their current workforce. We historically see a pickup in labor productivity in the first year of every economic expansion—and always before hiring increases.
2. Many firms turn first to part-time workers. If the rise in demand begins to overwhelm a firm's workforce, it will often offer part-time staff the option of working full time. Even though this action benefits the workers' financial position, it does not reduce the statistical unemployment rate that already counted part-time workers as having a job.
3. Previously discouraged workers return to actively searching for work upon hearing the recession is over. As they spend time searching for work, the government will now count them as unemployed.
4. Population growth, and therefore labor force growth, will be faster than the growth in output when adjusted for productivity growth.

New Normal

With the economy falling for more than a year and a half, it now appears the decline is coming to an end and we may even begin to see signs of rising back up relatively soon. But financial institutions will find it difficult to generate earnings in the future. Changing consumer behavior—debt reduction and savings boosting—and a sluggish recovery will present both challenges and opportunities for credit unions. That's why you should not minimize the scale of the winds of changes sweeping over the financial services industry. And if you haven't already, you should be planning now for the “normal” business landscape.