Smith Faculty Opinion Article

Peter Morici By Dr. Peter Morici, Professor of International Business
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January 3, 2008

Recession Watch, the Jobs Report and Fed Policy

The holiday season did not bring a lot of good economic news. Weak retail sales, the flagging fortunes of automakers and declining industrial production have pundits guessing whether the U.S. economy has entered a recession and, if so, how long will it last.

Tomorrow, the Labor Department releases data on December jobs creation. The consensus forecast is for 70,000 jobs. That is hardly a robust number, but it would indicate a slowing economy and not one that is contracting. Unless this number decidedly disappoints forecasters, the economy will not record negative growth in the fourth quarter of 2007.

Inflationary pressures should not constrain Federal Reserve efforts to head off a recession. Rising demand for energy, metals and other materials are pushing up prices, but the Federal Reserve can do little to curb there pressures. Robust growth in China and elsewhere in Asia is pushing up energy and raw material prices, and the Fed could only marginally compensate for these forces by constraining U.S. growth.

Federal Reserve will aggressively cut interest rates to combat the U.S. slowdown, but these efforts will prove insufficient to head off a painful economic slowdown. Fed actions, quite simply, continue to lag developments and fail to indicate an appreciation of the nature of the problems besetting financial markets and the broader economy.

The housing sector is in a recession, because the secondary market for mortgages has broken down. Investors are reluctant to purchase mortgage-backed bonds that are not issued by Fannie Mae or other federally-sponsored underwriters.

With the federally-sponsored banks largely limited to high quality lenders and mortgages up to $417,000, loans for home owners and buyers with less than perfect credit histories and mortgages for more expensive homes are difficult to obtain. Moreover, the expected wave of foreclosures on adjustable rate mortgages and the fear of further falling housing prices have made prospective buyers in all price ranges reluctant to commit.

The commercial paper market still has not adequately recovered, because the ultimate amount of subprime write downs at major U.S. banks is not yet known. Balance sheets are just too weak for normal commercial banking activity. The Federal Reserves Auction Facility implemented in December added liquidity, but it is simply not enough to fundamentally alter conditions in credit markets.

The subprime meltdown reveals endemic structural flaws in the U.S. banking system. The write downs at Citigroup, UBS and others indicate that bankers have been overvaluing mortgage-backed securities. The motivation is clear. The compensation awarded bank executives who create mortgage-backed and other securities is directly related to the estimated values banks assign these complex and opaque instruments.

Mutual funds, U.S.-state run money market funds for municipalities, pension funds, insurance companies, and individual investors that trusted Citigroup and other banks now hold worthless paper. Consequently, the market for mortgage-backed securities has evaporated.

The whole chain that creates financing for mortgages has been corrupted from loan officers to banks that bundle loans into securities, to bond rating agencies like Standard and Poor’s who demand payments from banks instead of charging investors to evaluate mortgage-backed securities.

The Federal Reserve and Treasury need to prod the private banks to reform lending practices and compensation structures, and to encourage to bond rating agencies to return to investor-financed ratings.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.