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The data in Table 1 shows that real GDP expanded
from $11.3 trillion to $11.6 trillion over the past twelve months or by 2.6
percent. The output of the
nation’s factories increased by approximately 2.0 percent in the third
quarter 2006 to the third quarter 2007 comparison.
Meanwhile short-term interest rates declined from 4.77 percent to
3.82 percent over the same period.
Moreover, inflation as measured by the Consumer Price Index rose by
2.8 percent. The inflation rate
while moderate is in the upper range of what the Federal Reserve feels is
acceptable.
The year over comparison figures in Table 1 indicate that the economy has
performed reasonably well over the past twelve months.
Along the same line the most recent data suggests that the nation’s
Gross Domestic Product rose by an unexpectedly healthy 3.9 percent during
the July-September 2007 time frame.
Further, 166,000 jobs were created in the nation during October 2007.
However, as I mentioned in a previous report the sub prime housing market
was a wild card in terms of any forecast about economic performance.
It appears the collapse of the sub prime housing market is now
putting a considerable amount of downward pressure on the economy.
The
Federal Reserve has become so concerned by the situation that it has already
cut the key federal funds rate twice.
The cuts have lowered this key short-term borrowing rate by 75 basis
points. Thus, the central bank
of the United States
has temporarily switched its focus from fighting inflation to trying to
prevent the economy from slipping into a recession.
In other words, the Federal Reserve is now attempting to provide a
sufficient amount of liquidity to offset the negative economic effects of
the sub prime housing market collapse.
The
Federal Reserve and a number of prominent economists are concerned that the
sub prime housing market woes might spread to the broader economy.
How this might happen is very complex.
In brief, the impact of this financial situation cuts across many
segments of the economy. The
impact on home owners is not just limited to those who are experiencing
foreclosure. In
California, Florida,
Texas, the
northeastern corridor and large urban areas, home prices are falling.
This means there is less of an opportunity to extract wealth from
real estate. To a large extent
the consumption surge that fueled the economy during the post dot-com era
bubble and the post 9/11 attack was predicated on consumer spending financed
by real estate appreciation.
Household consumption of goods and services accounts for approximately
two-thirds of all economic activity, so anything that impacts consumption
will have a large influence on economic performance.
The
problem, however, goes beyond the home owner.
Major financial institutions like Merrill Lynch, Bear Sterns,
Countrywide Financial, and Citi Bank are facing serious financial difficulty
because of the sub prime housing market collapse.
In brief the investment in nonperforming real estate backed financial
instruments have had a large negative effect on the balance sheets of these
and other financial institutions.
In and of itself this is bad for the economy, but it goes further
than this. A more serious
problem is that this could make getting credit more difficult for
corporations. In other words an
impairment of our nation’s credit market would hamper corporate spending and
have a large impact on profits, income and job creation.
This of course would not bode well for the stock market which has
been another major source of wealth creation in the United States.
To the extent that people feel less wealthy, whether it be from
falling housing prices or a decline in their stock portfolio, it will have a
negative influence on household spending.
Lastly no one knows, not even the Federal Reserve, the extent of the fallout
from the sub prime housing collapse.
Case in point, some analysts forecast the loss to financial
institutions to be in the $400 billion range while others say the loss may
amount to only $40 billion.
Clearly there is a great deal of uncertainty surrounding the situation.
However, the Federal Reserve and economists in general are in
agreement that the probability of a recession next year has risen.
Some like Alan Greenspan put the probability in the 35-40 percent
range. Only time will tell how
this situation plays out. The
best guess is that it will be about mid-2008 before this question can be
answered.
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