Headwinds Fade, Tailwinds Develop
Mark M. Zandi discusses the factors that have weighed on the economic recovery (video, 28:37).
00:10 Let me begin by saying I’m optimistic about the economy’s prospects. Let me give you a few numbers, just to make that concrete, and then I’ll try to defend it. GDP has been growing about two percent-ish since the recovery began; the recovery is almost four years old—hard to believe, but it’s been four years of recovery. Q1 is actually going to be close to four; it was a pretty strong quarter. But that comes after no growth in the fourth
00:37 quarter of last year, so you average it, it’s still about two percent growth. I don’t think things change a whole lot, over the next couple, three quarters it’s going to be at two percent, calendar year 2013 is going to be a couple percentage points. But I do expect much better growth in ‘14, closer to three and a half percent, and even better than that in ‘15, growth of over four percent.
01:03 So that means more jobs. The economy’s been creating a couple million per annum; that’s what we’ve been doing for the last two years. That’s roughly what we’re going to create this year, a couple million jobs, but next year I expect three million and about the same in 2015. And that means unemployment will eventually come down. We’re at 7.6; I don’t know if we’ll make a whole lot of progress this year. If we do, it’s only because labor force will continue to climb. But I do expect a lot of progress in ‘14 and ‘15, and I expect to be back to full employment, which is an
01:32 unemployment rate of 5.5, 6%, by mid-2016. So June 2, 2 p.m. eastern, something like that, we’ll be back to full employment. Let me say two things about the outlook before I move on. First is, I am more optimistic than the consensus. Take a look at the Federal Reserve’s forecast. Very similar for 2013, Q4—for Q4 my forecast is 2.6; that’s right at the mid-point of the Fed forecast. But I am
02:02 stronger for 2014 and 2015; I’m more optimistic. The second thing I’ll say about the forecast is—and you should know this—I’ve been wrong, you know [Laughter]. I’ve been overly optimistic for the last couple of years. I had expected more from our economy; it has been disappointing, particularly in terms of GDP growth. Not every measure, but in terms of GDP growth in particular. And, you know, I've done a lot of soul–searching and trying to ask why.
02:32 I think one of the key reasons is the long shadow of the recession itself. I underestimated the damage the recession did to the collective psyche. I’m a numbers guy; you know, you have models, and I didn’t pay enough attention to sentiment. It’s very important; confidence is key, particularly when you go through such a wrenching period. And I underestimated the gravitational force from what we went through. So I think that’s been a
03:05 significant drag. You know, I think also the nature of the shocks we’ve been grappling with, I think conflating with a lack of confidence. So, you know, the European debt crisis, it’s pretty hard to handicap the risk that that poses. If you're a business person, you have a pretty good grip on what’s going on in your industry, certainly what’s going on in your company, you can attach a probability to the—to the risks that you face. But to attach a
03:31 probability to a crack up of the Euro zone, that’s pretty difficult to do. You can listen to economists like me say it’s one-third probability, but, you know, appropriately so you don’t believe it. And if you can't attach a probability to something, you can't plug it into a spreadsheet, then that means—it doesn’t mean you're going to cut employment, doesn’t mean you're going to pull back on investments to a significant degree; that would be a recession. But it does mean
03:54 you’ll freeze; you won't engage, you won't take the risks that you normally take. And the fiscal issues also, very similar kind of existential threat that’s very difficult to attach probability to. You know, you go back to the summer of 2011, when it felt like we were going to reach the debt ceiling, we felt like we were going to shut the government down a couple of times. That really makes people nervous, and I think, particularly in the context of a lack of confidence.
04:25 I also think, regardless of how you feel about Dodd-Frank and healthcare reform, you know, I’m not commenting on the merits of those particular reforms; there's good and bad in both of them. But I think it’s pretty straightforward to say these are pretty wrenching changes for the financial system and for businesses in general to grapple with. A lot of moving parts. The moving parts are still moving in many regards, and until we get full clarity, it’s hard for businesses to really engage. So these are the kinds of things, I think, conspire to cause the recovery to fall short of my expectations.
05:04 Now, you may be asking, well, why do you think any different now? I have to say, it feels like to me—and I know that’s squishy—but it feels like to me confidence is in a much better place today than a year or two ago. I talk to lots of different business people and lots of parts of our economy, all across the country, and there is a palpable change in sentiment. Actually, here in San Francisco, it’s unbelievable. When you take a look at the city it’s just incredible, what you see.
05:33 I come from Philadelphia; that’s not quite San Francisco. But even there, confidence has improved. Those existential threats, uh they feel a lot less threatening, you know, given what the European Central Bank has done, the commitment that they’ve made, it seems very—or I should say, much less likely that the Euro zone will crack up. It’s going to be a slog for Europe under any kind of scenario, but they’ll keep it together and so that—that threat just feels less threatening.
06:05 And even the fiscal issues. I mean, we've got the debt ceiling we’ve got to get around, that’s coming up. But that’s the last big hurdle, and I think—there the odds are now much lower that these folks are—in Washington—are going to take it right to the brink. And, you know, there'll be some brinkmanship and some vitriol, but I don’t think it’ll be on par with what we’ve experienced. So—and Dodd-Frank, healthcare reform, we’re well on our way to nailing those
06:31 things down. We’re not quite there yet, but I figure a year from now, I think those issues will be resolved to a significant degree. So I think the things that have conspired to make this a very sub-par recovery are becoming less significant. And all the good that’s happened in our economy will begin to shine through.
06:51 Now, to get to my optimism, we do need to get through some pretty significant fiscal headwinds that are dead ahead. If you add up all the drag from all the various policy that’s been implemented over the past couple of years, it’s going to cut about a point and a half from GDP growth in 2013—1.5 percentage points. Just to give you context, the expiration of the payroll tax holiday, that’s probably five, six tenths of a percent. The sequester, it’s about half a percentage point. And all the other tax cuts and spending cuts, that’s another half a percent. So that’s pretty significant. That’s
07:27 the—this is ambitious. I mean, the last time we, as a nation, have gone through this kind of fiscal drag was in—just immediately after World War II, and the draw down after the war. The British have tried something a little bit—a little bit more austerity than this; they had a fiscal drag of one and a half to two percentage points back a couple years ago, and the apex of their drag has been tough on their economy. So this is pretty serious stuff. And the apex of the fiscal drag in our country literally will be in Q2-Q3 of this year.
07:57 So, you know, my sense, it’s going to feel a little bit uncomfortable, that things are going to kind of throttle back—we’ll be lucky if we get two percent-ish annualized growth in the next couple of quarters. Job growth will slow—maybe not to the same degree—but it’s going to feel uncomfortable. And we are going to be vulnerable at that point, if anything else goes wrong—and I’ll come back to that in a few minutes. But I do think we’ll navigate through. And, you know, there's—if we do, I think we’re in pretty good shape. My sense
08:30 is the debt limit will be increased, again with a little bit of angst and brinkmanship and vitriol, but I think the politics are such that the Democrats and the Republicans will come together and will get a reasonable solution to it. And I don’t—I don’t think we’ll get much more additional deficit reduction of consequence—maybe some things on the margin, but I don’t think it’s going to be of significant consequence. But that’s OK; it’s not great. It would be wonderful if we could come to terms on entitlement reform and
09:02 tax reform and have more deficit reduction and get the debt to GDP ratio moving south in a consistent way. But I don’t think that’s going to happen. But again, that’s not—it’s OK. We have accomplished a lot in the last couple of years. You know, it doesn’t—it’s hard to believe, but all this Sturm und Drang, all this angst, has resulted in some significant deficit reduction, and under reasonable economic assumptions, deficits in the future will be
09:32 small enough that the nation’s debt to GDP ratio will stabilize—at a high level, admittedly. It’s not a great place to be. Publicly traded debt to GDP will be about 75%, but, you know, that’s—that’s OK. And it’s OK in the sense that fiscal policy’s going to fade from the front pages, and will allow the private sector to do its thing, and for it to shine through, and we can really hit escape velocity and get moving here.
10:01 How are you feeling? [Laughter] I haven't really given you anything meaty yet. Let me give you a couple of real substantive reasons for optimism; I’ll give you two. I could give you more, but Mary only gave me 30 minutes, so I’ll give you two. And you should actually soak this in, because I will leave a few minutes at the end to take you back down, so take this in. [Laughter]..
10:26 The first reason is, I think we have righted a lot of the wrongs that got us into this mess. You know, at core, the reason for the financial collapse and the great recession is that we made a lot of bad loans. Bad in the sense that under reasonable economic assumptions, these loans would not get repaid, and obviously they did not. Brought the system to its knees, required a bailout, and thus the Great Recession. But the good news is that we have worked through these problem loans in lightning speed.
11:01 You know, we—I think we've gone down roughly the same path every other economy historically has gone down in the wake of a financial crisis. It’s not like we’ve done anything terribly different; it’s just that we've done it very, very rapidly. We have, in fact, completed the deleveraging process. And you can see that—right from the beginning of the crisis, and you take the banking system the whole stress test process was really quite amazing. I was very skeptical, back in early 2009, about the efficacy of that policy
11:31 stuff, but it actually worked out to be quite—quite important. We required our banks to go through very stressful stress tests; they had to raise a boatload of capital. And it’s now, I think, fair to say they have plenty of capital. If you look at the FDIC data, tier one capital ratios, Q4 2012 were nine and a quarter percent. That’s the highest it’s ever been. On average, it’s about seven and a half percentage points. Liquidity—very ample. Obviously, credit
12:03 quality is very good and improving on a daily basis. The banking system is on very solid ground, and the credit spigot should steadily open. And this stands in striking contrast to what’s gone on in the rest of the world. Take the European experience. Europeans still, to this day, have not engaged in a truly serious round of stress testing. The first round of stress tests, obviously, wasn’t very therapeutic. The Irish Banking System went belly up a week after the stress tests-results were announced. The second round was a little bit better, but Dexia, the big Belgian/French bank went belly up a week or two after those stress tests. They seem to have gotten the hang of it, but at the end of the day, they haven't required their banking system to raise enough capital, and of course, the Europeans are much more dependent on the banking
12:53 system to provide capital than here in the United States, where our capital markets are quite deep and are very important. So their economic prospects are very, very different than ours, and it’s largely because they have not de-leveraged like, like we have. Nonfinancial US corporations have done an excellent job of de-leveraging. Take any measure of balance sheet strength that you want, it looks about as good as it’s ever been in the data that I've seen. Interest covered ratios, quick ratios, plenty of cash. Businesses have done a marvelous job reducing their cost
13:28 structures; profit margins are as wide as they’ve ever been. Profitability’s very strong. They're very competitive. You know, labor costs today are about where they were five, six years ago, and in manufacturing, which obviously globally trading, very competitive, labor costs are back to where they were 20 or 25 years ago. And that’s all in dollar terms; if you put that into RNB terms or real terms, or rupee terms, it’s even more compelling. And then you throw in the fact that energy and availability of energy, prices are going to remain low, I think our companies are sitting in very good shape. And household sector, also. Now, here we have to
14:08 make a little bit of a distinction between low income households, lower/middle income households and high income households. Those folks in the bottom part of the distribution of income, they're clearly struggling. That’s where we still have some foreclosure issues, and student loan debt is clearly an issue. But folks in the top part of the distribution, they're doing fabulously well, I’d say the top third, maybe even the top half. If they have any debt at all, it’s a 30-year fixed rate mortgage loan they’ve been refi-ing down, probably have a coupon, now four, four and a half percent, and they’re taking to get down into three and a half to four percent.
14:45 They may have an auto loan, but the only reason they have an auto loan is it’s free money. You know, you get an auto loan for a couple, three percentage points, so why wouldn’t you take an auto loan? You can see it in the credit statistics. So we collect data from Equifax, the credit bureau, on all the credit files in the country, and compile this every month. And just got the March data and here’s just a statistic. If you look at the 30 to 90 day delinquency rate, percent of dollars outstanding, on all household liabilities—
15:08 ex-first mortgage; let’s just exclude first mortgage for a second—that’s credit card, auto, consumer finance, student loans, home equity, closed end seconds, you know, everything. The delinquency rate as of the end of March was 1.9%--1.9%. Just for context, that’s lower than at the low point in the middle of the housing bubble back in 2006; the low point back in 2006 was 2.1%--2.1%. Even first mortgage. We’ve made a lot of progress. The delinquency rate, 30-90 day delinquent, percent of dollar outstanding, end of March, seasonally adjusted, stood at 2.8%. The peak was seven;
15:57 that was in early 2009. And the low point, back in early 2006, it was 2.2%. and 30 day delinquent is already at a record low, so the number of—the percent of first mortgage loans that are one month late is at a record low. Two months late is almost at a record low, and 90 is still elevated, but coming down very rapidly. Yes, we have a lot of loans in the foreclosure process, but on the other side of that, once we work through those loans, the credit environment is unbelievably good. It’s just beautiful. In the United States, cutting across all bank assets; it’s going to look as good as it has ever looked, in terms of credit quality, a year from now.
16:41 How are you feeling now? Better? OK, let me give you one more reason for optimism—and this is where we get the juice. You know, the reason I just gave you, the de-leveraging process, that it’s over more what I consider a fundamental structural reason. Let me give you a cyclical reason, and that’s housing. You know, the housing market is kicking into full swing. Now let me give you a little bit of data just to reinforce the point. The current level of construction—that would be single family, multi-family and manufactured housing, is running around 950,000 units. That’s annualized. Just for context, at the low point back in early 2009, construction was running somewhere around 500 to 550,000 units. And that is as low as it had ever been since World War II. So that was a pretty
17:26 low level of activity. So we’ve made some significant progress—and it is adding to economic activity. In a normal economy—not even, you know, a really good one, just a normalized economy, we should be producing 1.8 million housing units. That would be 1.25 million households that should get formed every year. That’s just looking at population growth, and the ethnic and age distribution of the population. And, of course, we’ve been well below that for much of the last several years. Twenty-somethings can't find work, they’ve
17:56 been doubling up with their parents. So you could argue, there's a fair amount of pent up household formation that will get unleashed at some point in the not too distant future when we start to get some more job growth. But let’s just go with 1.25 million. Three hundred and fifty thousand in obsolescence, so, you know, Hurricane Sandy blew through my neighborhood, wiped out 250,000 homes. Now that’s an extreme example, but we have hurricanes on the east coast; they seem to be coming with increasing regularity and severity. Tornadoes, and just normal
18:25 obsolescence, about 350K. and then those high income households? Those folks, the—many of them are in their 50s, are thinking about—that’s the teeth of the Boomer generation, they're thinking about second vacation homes, and we’re building a couple hundred thousand of those every year. So you add that up—1.25 million formations, 350K in obsolescence, a couple hundred thousand vacation homes, is 1.8 million. We’re going to go from the current level of construction—950K—to 1.8 million over the next
18:54 several of years. And that provides a lot of economic growth and a lot of jobs—just another rule of thumb—every single family start generates somewhere around four and a half to five jobs over a period of a year. So that’s construction jobs, it’s manufacturing jobs, you know, the lumber, fixtures, all the fabricated metals—steel, cement. It’s trucking jobs—you’ve got to move all that stuff around. It’s financial services jobs, it’s the Home Depot, it’s Lowe’s, it’s home improvement. It’s cable hookup, it’s landscaping—it runs deep into the labor market. And actually,
19:34 this is very, very important to small businesses, because smaller establishments, companies, those with less than 50 employees, particularly those with less than 20, are very tied in—disproportionately tied into the construction cycle. And you can feel it; if you look at some of the payroll processing data form ADP that we collect, you can see that the companies that are very, very small are now coming back to life. And job growth among those companies in the last six to 12 months has been stronger than
20:00 at other size companies, which is a complete reversal of what had been going on throughout the—throughout the economic recovery. Now, I could be a little optimistic about how quickly the supply side of the housing market kicks in here. You know, the recession was pretty debilitating to the housing industry; kind of wiped out the infrastructure for building. And it takes time to resurrect that, particularly in key housing markets, like in California, where, you know, the permitting process is very cumbersome. So you know, it may take a little bit longer than expected. I was at a Harvard Joint
20:34 Center for Housing Studies meeting a couple, three weeks ago, and this was a really good meeting, because you get CEOs of builders and building supply and finance companies—companies that finance these guys, banks that finance these guys. And they were obviously very optimistic and euphoric, but the thing that they were most worried about is, can I get enough flatbed trucks; you know, can I get enough forklift operators? For the small builders, can I get construction land development loans? The big guys, no problem; they have access to capital markets, and they have plenty of cash, but the smaller builders need—need the bank credit.
21:10 And, of course, banks are still—particularly smaller banks are still quite reluctant to make those loans in the context of loss that they’ve taken on that type of lending. So could be that I’m overly optimistic about how quickly things ramp up. But if that’s the case, then we’re just going to get even more economic growth as we move into 2015 and 2016. May not happen in 2014, but it will happen; I’ve very convicted of that. One other thing I’ll say about that is, if I’m wrong about the pace at which builders put up homes, I’m probably also wrong about the pace of house price growth. So currently I’m expecting mid-single digit house price
21:46 growth, which is, you know, slightly less than what we got in 2012. But if you listen to the builders, they're licking their chops. If they can't build a home, they're going to raise price, and they, in fact, would much rather raise the price than build a home; much easier way to make money, to raise the price than build a home. And so we could see much stronger house price growth in the next couple of years than anyone’s anticipating. The other thing that would support that is it appears that people—potential sellers are not putting homes on the market because they seem to have some kind of reservation price in mind. They—they have in their
22:20 mind, what is a fair value for their home. Some obviously are underwater and they’re not going to sell until they're above water and can cover their transaction costs in a sale. But others feel like I know what my home should be worth, and I’m not going to list that home until I hit that price or come close to it. If that’s the case, we could see some pretty—if you look at inventory of homes for sale, they're rock bottom; they're very low. And so that could mean we could get some really heady house price growth over the next couple of years. And, of course, you know, that has negatives, but I think at this point there are much bigger positives, and it will be very, very good for economic activity.
22:53 So, the thing that—the reason I think that I am more optimistic than the consensus is not because everyone else doesn’t know this about the housing market. But I think they are underestimating how powerful this is going to be—just like we—many underestimated the drag from the housing collapse, on the flip side, back in the peak of the economic recession.
23:21 This is it; this is the apex. How are you feeling? [Laughter] Let me end with—just because it is appropriate to talk about the risks, ‘cause there are plenty. Let me just stipulate that, you know, Washington remains a risk. The debt limit is a thorny problem, and again, we’re going to be debating that when the economy probably is going to be on the soft side. Remember, the next six-nine months are going to be, I think, a bit uncomfortable. And Washington could make that worse. So we’ll just stipulate that as a risk. Let’s stipulate that Europe is a risk, you know, much less so, but nonetheless, these countries are under severe economic pressure, unemployment in the entire Euro zone is now 12%
24:11 and rising. The full employment/unemployment rate in Europe, in the Euro zone, is probably somewhere around eight and a half percent. You know, you go into Spain, or Italy, or Greece, you know, real—this is real stress. And the political process could come unraveled. I don’t think that’s the base line, but it’s certainly a possibility. So we can't discount that. And there's always, given what happened with the Cypriot banking situation that reminds us that, you know, there is the possibility of a policy error that could make things go in the wrong direction.
24:46 There are other geopolitical risks; I’ll mention two. There is, obviously, North Korea. We all discount that, but again, you can't really handicap it. The other thing—the other geopolitical risk, though, that I worry more about is Iran and the Iranian oil embargo. Despite all the good things that are happening in our energy sector, we still are very energy dependent. Oil prices rise—that’s a big—and gasoline prices—and you guys know this better than I, here in California that’s a big problem. So I worry about that.
25:18 But let me end with one last risk. This is the risk I hear non-stop now, when I travel the country, and that’s the risk posed by rising interest rates. And so if you buy into my scenario, my narrative, obviously it implies higher interest rates. I’ve got Federal Reserve quantitative easing, winding down toward the end of the year, coming to an end in early 2014. I’m a little bit more optimistic than the, sort of the mid-point of the Fed forecast, so I have the Fed raising interest rates beginning in early 2015. I have normalization of rates in the so-called equilibrium, say Federal Funds rate targets about four percent; I get there by the end of 2016 or early 2017. That’s—that’s my outlook. Of course, long term interest rates
26:05 rise faster than that, the bond market anticipates. So this is—I’m just rounding here, but the ten-year bond is south of two, ends the year two and a half, ends next year three and a half, normalizes the sort of equilibrium ten-year yields is about five percent. We get there, you know, some time late 2015, early 2016, and in all likelihood, we overshoot. If we—if that’s kind of the scenario, we’re good. You know, we’re OK. I mean, the rates are rising because the economy’s doing better, we’re generating more jobs, unemployment’s falling, everything’s—it does ding the housing market a little bit, but, you know, it won't undermine it because
26:41 the job market will be fueled by the better—the housing market will be fueled by the better job market. But the risk is that—and the theory is sound and the empirical evidence that we have would suggest that this is the way it should work. And if you look at what happened after the end of QE1, QE2, you know, it’s—there are a lot of moving parts there, and it’s hard to disentangle all the things that are going on. But, you know, it suggestive of the idea that this is the way interest rates should rise, in a slow, orderly way. But the risk is, and the concern is out there in the world, is that
27:16 we got, this theory’s all wrong, and interest rates are going to rise a lot faster than people anticipate, as bond investors are—they—everyone knows, in the bond community, that the terminal interest rate, ten-year bond, is five percent, so they may take it from two to five in a lot—not over a three year period, but over, you know, a three month period. And of course, if that were to happen, that would be—that would be a significant problem for the economy. I--you know, that’s not my base line; I don’t think that’s the likely scenario. But that is the concern among folks out there.
27:48 One last point about that. Even in my base line, there will be financial stress as a result of that kind of rise in interest rates. There always is. There will be some kind of financial event—it probably won't be in the regulated banking system, just because the stress test process is now accounting for this. The adverse scenario in the stress test is exactly this interest rate scenario, so the banking system should be well prepared for it. But the shadow system is, in all likelihood, not, so even in my outlook of slowly rising interest rates, I think we’re in store for some bumps along the way.
28:28 I will end there, and you will be happy to know that I hit my 30 minutes to the second, to the second. Thank you very much.
28:37 END FILE
Dr. Mark M. Zandi discusses the factors that have weighed on the economic recovery, including the housing crash, deleveraging, fiscal drag, and the loss of confidence and heightened uncertainty. Each of these factors will soon become less weighty, suggesting the economic recovery should gain traction as we move to the middle of the decade.
Download the transcript (pdf, 190 kb)
Download the presentation slides (pdf, 491 kb)
This video is also available on our YouTube channel.
Mark M. Zandi is chief economist of Moody’s Analytics, where he directs economic research. Moody’s Analytics, a subsidiary of Moody’s Corp., is a leading provider of economic research, data and analytical tools. Dr. Zandi is a cofounder of Economy.com, which Moody’s purchased in 2005. He conducts regular briefings on the economy for corporate boards, trade associations, and policymakers at all levels. Dr. Zandi is often quoted in national and global publications and interviewed by major news media outlets, and is a frequent guest on CNBC, NPR, CNN, Meet the Press, and various other national networks and news programs. He is the author of Financial Shock: A 360º Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis, described by the New York Times as the “clearest guide” to the financial crisis. His new book, Paying the Price, provides a road map for meeting the nation’s daunting fiscal challenges.
Dr. Zandi earned his B.S., M.A. and Ph. D. from the Wharton School at the University of Pennsylvania. See his page on Moody’s Analytics.