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ECONOMIC RESEARCH

P U B L I C AT I O N S

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April 9, 2009
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John C. Williams, executive vice president and director of research
The economy has been suffering from an adverse feedback loop in which
losses by banks and other lenders have led to a tightening of credit
availability, which in turn has crimped spending by households and
businesses. The resulting reduction in demand has dragged down the
housing sector and the broader economy, contributing to greater losses on
loans and even tighter credit.
The housing sector has been at the center of the economic and financial
crisis. After years of healthy increases, house prices have plummeted during
the past three years. Based on the historical relationship between house
prices and rents, house prices appear to be still well above their long-run
trends. Forecasts suggest that house prices will fall about 20 percent over

this year and next year, and will then be close to the “normal” level relative to
rents.
The collapse of house prices and the worsening economy have led to rising
mortgage delinquencies and foreclosures, even for “prime” borrowers.
During the housing boom, mortgage delinquencies were very low, reflecting
the effects of the rapid accumulation of home equity and the relatively
strong economy. Since house prices started falling, delinquency rates for
borrowers with high credit scores have risen sharply. Delinquency rates for
borrowers with low credit scores have skyrocketed, exceeding 40 percent
for adjustable-rate mortgages and 15 percent for fixed-rate mortgages.
The housing boom was financed by an unprecedented increase in debt,
with household debt rising to over 130 percent of disposable income. The
debt service burden—measured as the ratio of payments on debt to income
—also reached an all-time record. But lower interest rates have brought this
ratio down a bit.
Consumers have been hit hard by losses on the values of their homes and
stocks, a weak and uncertain economy, and tight credit. Sharp declines in
housing and stock prices sent household net wealth tumbling by $11 trillion in
2008, bringing down the ratio of wealth to disposable income to levels last
seen during the mid-1990s. The combination of these factors and a desire to
bring debt down to manageable levels portends several years of rising
saving and tepid consumption growth.
Employment continues to plummet, with over 660,000 nonfarm jobs lost in
March. The unemployment rate rose to 8.5 percent from 8.1 percent. Recent
data on initial claims for unemployment insurance point to further large job
losses this month.
A key issue for the outlook is whether this recession will be followed by a
robust “V-shaped” recovery or a more subdued “U-shaped” recovery. A
rapid V-shaped recovery has been the typical pattern in severe recessions
during the postwar period. The sharp declines in new home construction,
automotive purchases, and business inventories point to considerable pent-

up demand that could rebound quickly. Moreover, sizable fiscal and
monetary stimulus—both conventional actions and unconventional
monetary policy actions—should contribute to spending growth.
However, other factors suggest a more gradual recovery. Banking and
financial crises tend to be followed by slow recoveries, in part reflecting the
time needed for the financial sector to heal. Also, the crisis has severely
shaken household and business confidence. This heightened uncertainty
about the future may continue to damp spending and investment for some
time. Finally, this recession has been truly global. Many central banks around
the world have found traditional monetary policy action limited by the zero
lower bound on interest rates. According to forecasts, other major industrial
economies are likely to suffer even deeper and longer-lasting recessions
than the United States. As a result, foreign demand and monetary policy
may provide less of a boost to growth than in past severe recessions.
Some preliminary signs suggest that the economy may be stabilizing and
that the period of rapid economic contraction that started this past fall may
be nearing an end. Housing market indicators have stopped their headlong
plunges and show some tantalizing signs of improvement. The significant
drop in conforming mortgage rates over the past few months should provide
a boost to this sector. Similarly, sales of motor vehicles picked up in March.
And the Institute of Supply Management index of new orders has
rebounded in recent months, although it still points to further declines in the
manufacturing sector. However, it is too soon to tell whether these
improvements will prove to be the beginning of a sustained turnaround or
ephemeral.
After contracting sharply in the fourth quarter of 2008 and the first quarter
of this year, we expect real GDP to decline at a significantly more modest 11/4 percent annual rate in the current quarter. This improvement reflects
positive contributions from consumer and government spending, and less of
a drag from inventory investment. Looking further ahead, we expect the
recession to end in the latter part of this year and to see a gradual Ushaped recovery in 2010. With output growth expected to fall short of its

potential for several more quarters, we expect the unemployment rate to
continue to rise, peaking at 9-1/2 percent. As the expansion gains steam next
year, the unemployment rate should start to edge down. Of course, this
forecast is highly uncertain and there is a significant risk of a larger and
more sustained downturn, accompanied by higher unemployment.
Core and overall measures of price inflation have fallen considerably,
reflecting declines in commodity prices and the emergence of considerable
economic slack. We expect core inflation to continue to edge down,
reaching 1 percent in 2010. Given the weakness of the U.S. and global
economies, the outlook for inflation is highly uncertain. Some Phillips-curve
inflation forecasting models based on the view that inflation expectations
are unanchored predict a high probability of deflation next year. In contrast,
Phillips-curve models based on the well-anchored inflation expectations
seen over the past 16 years indicate little probability of deflation and predict
inflation rising towards 2 percent over the next two years.

The views expressed are those of the author, with input from the forecasting
staff of the Federal Reserve Bank of San Francisco. They are not intended to
represent the views of others within the Bank or within the Federal Reserve
System. FedViews generally appears around the middle of the month. Please
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