Fed funds hit zero

Federal Reserve Bank chairman Ben Bernanke has signalled that unconventional policy options, including aggressive quantitative easing and yield curve manipulation, is about to intensify. The Fed Funds rate was slashed from one per cent to a range of between 0.00 per cent to 0.25 per cent on December 16.

Based on our forecast of an 8.8 per cent unemployment rate by 2010 (up from eight per cent previously), we think the Fed will not have to raise rates until 2011, at the earliest. This, with the Fed making aggressive purchases of Treasuries and mortgage-backed securities at the long end, is likely to drive 10-year Treasury note yields to two per cent, eventually taking the 30-year mortgage rate to about four per cent.

Economic growth is expected to decline in the first quarter of 2009 before recovering back into positive territory from the second quarter, as the Obama fiscal package begins to hit the economy. No one knows exactly how big the stimulus will be, but it will be large, most likely $600 billion and some have talked about as much as a $1 trillion package.

Given that yearly government spending is almost $3 trillion, a $600 billion fiscal package equally distributed over two years with little or no multiplier effect (which would be consistent with an on-going broken financial system) implies the level of GDP in 2009 and 2010 will be two per cent higher than what would otherwise be the case.

This should allow GDP to get back into positive territory by Q2 of 2009 if the package is enacted soon after January 20, when Barack Obama takes office, which is what we assume. If the package gets stuck in Congress, then we might need to wait until Q3 for a return to positive growth.

Once we assume some price increases for the government price deflator, and the likelihood that state and local general government budgets are cut (even as state and local infrastructure investment booms on the back of likely federal transfers), the overall impact on real growth will be less. Also depending on timing, government spending could make the shape of GDP growth through 2009 a rollercoaster ride.

If the government surprises to the upside with a $1trillion package distributed equally over two years (starting to be talked about a little but may be on the high side of what is likely), that implies both 2009 and 2010 GDP would be about 3.5 per cent higher than what would otherwise be the case.

On the Fed policy front, significant quantitative easing has been in play since the AIG and Lehman Brothers collapse in mid-September, and the Fed chairman has made it clear that he is willing to expand the Fed's balance sheet to whatever amount is required to get the economy back on track (so far it has risen from about $900 billion in early September to about $2.2 trillion now). What is less clear is whether it will have any sustainable impact in repairing both the financial system and the economy.

However, if extreme, unconventional quantitative easing from the Fed and the large fiscal stimulus work, then growth will take an alternative path. Under this scenario, it is assumed that the authorities have success in starting to heal the financial system through 2009 and that financial conditions will head towards normalisation by end-2010. Under these circumstances, the normal relationships between policy and the real economy begin to work again.

The most likely case remains that the consumer recession will remain with us for a while, and even as it returns to positive growth later in 2009, the rate of growth will be constrained so that it will remain subdued for all of 2009, and rise slightly to two per cent through 2010. With falling net wealth, the saving ratio will likely go up from zero per cent recently to 5.5 per cent by the end of 2010.

Non-farm payrolls are anticipated to decline an average of about -250,000 per month through the first half of 2009, before the losses lessen to -170,000 in the third quarter, dropping further to about -50,000 per month in the final quarter of 2009. Very modest job gains may then appear through 2010. With the labour force growing at about 120,000 per month, this, of course, implies the unemployment rate will continue to rise, reaching eight per cent by mid-2009, 8.4 per cent by end-2009, and rising a little further to 8.8 per cent in 2010.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.