Is the U.S. in a Recession? Gallup's chief economist tackles this and other pressing questions — and tells how business can protect itself if there's a serious downturn

Gallup Management Journal, Feb 14, 2008

Byline: A GMJ Q&A with Dennis Jacobe, Ph.D., Gallup's chief economist

Synopsis: This question has been nagging at executives, investors, and the media. Here, Gallup's chief economist sheds some much-needed light on the subject. He also tells how companies can protect themselves if there's a serious downturn and what managers -- many of whom have never lived through a real economic slump -- should know.

In a rare unscheduled meeting on January 22, the Federal Open Market Committee (FOMC) cut the federal funds rate from 4.25% to 3.5%, the largest rate cut in 24 years. The following week, at its regular meeting on January 30, the FOMC cut the federal funds rate a further one-half of one percent.

At the same time, House leaders and the White House announced agreement on a new emergency fiscal stimulus plan. Still, the financial markets remained unsettled while fears of recession grew with release of reports of slow GDP growth in the fourth quarter of 2007 and the first actual loss in jobs in January 2008.

This, says Dennis Jacobe, Gallup's chief economist, reveals the new limits of the Fed's power to affect the U.S. economy, given the globalization of the financial system. He asserts that the Fed's greatest power right now is essentially the psychological impact it can assert on financial markets worldwide. At the same time, when the Fed takes drastic "emergency" action, it can cause dramatic psychological reactions both domestically and worldwide, leaving the economy highly vulnerable to the law of unintended consequences.

And that's what's happening now. Yes, we're facing a recession, says Dr. Jacobe. And yes, it's probably time to stock the bunkers. But he's not sure that this will be "The Big One" -- something approaching the scale of the recessions of the mid-1970s and the early 1980s. Much lower interest rates could help stabilize the financial markets, and a fiscal stimulus package might soften a major economic downturn. But they might not.

In this interview, Dr. Jacobe explains what's going on with the Fed, how businesses can protect themselves if this turns out to be a major recession, and what managers -- many of whom have never lived through a real economic slump -- should know.

GMJ: Why did the Fed cut the federal funds rate instead of making it easier to get a cheap mortgage loan? Wouldn't helping the flailing housing market have done more for the economy?

Dr. Jacobe: There are a couple of different things going on. The emergency cut in the Fed's funds rate, followed by another cut a week later, has two effects. One effect is to change the psychology of the market. There's been a lot of criticism of [Fed Chairman Ben] Bernanke and the Fed for not being ahead of what's going on in the markets. There was significant instability in the world marketplace in January, so the Fed tried to settle things down with a dramatic, emergency, intermeeting move on January 22, followed by another cut shortly thereafter. Now the Fed has the markets believing it will do whatever is necessary to maintain financial stability and moderate a slowdown of the U.S. economy.

A second effect is that the sharp reduction in interest rates helps banking institutions and other big investment banks; it reduces their cost of funding and creates a more normal and steeper yield curve, where longer term interest rates are higher than shorter term interest rates. So the rate cut can help financial services firms as they work their way through their recent problems, thereby encouraging financial stability. A reduction in interest rates helps the housing and mortgage markets to some degree. So will a change in the Fannie Mae, Freddie Mac, and FHA loan ceilings, allowing more home buyers access to federally backed loans.

Still, none of this really helps with the loan underwriting process. Unfortunately, the tightening of loan underwriting standards is something that needs to happen, and moderating its impact on consumers is not something the Fed can easily address.

GMJ: Will financial institutions pass the benefits they get from lower interest rates on to their consumer borrowers?

Jacobe: Yes. Highly qualified borrowers will find that they will get lower interest rates when they borrow. Small business and other borrowers who borrow at the prime rate probably are helped to some degree. On the other hand, older Americans who live on the interest generated by their investments will find that the interest rate banks will pay to them will be even lower than it has been.

The reality is that banks and financial services firms have been squeezed. They have faced what is called an "inverted yield curve," meaning that short-term interest rates have been higher than long-term rates. This hurts banking institutions because they tend to make money by borrowing short-term at lower rates and lending longer term at higher rates.

In addition, financial services firms such as UBS and Citigroup have posted huge losses on their investments in things like subprime mortgages and some of the more exotic investment vehicles associated with them. As a result, banking institutions need to increase earning power to rebuild their reserves, because they need reserves if they are going to increase their ability to lend. So in that context, the Fed's moves were positive, and they were probably necessary, but they are not necessarily sufficient to stabilize the U.S. economy and calm jittery investors worldwide.