United States

OECD Economic Outlook, Dec, 2008

The US economy is facing extremely difficult conditions. The financial crisis has intensified at a time when growth had already been weakened by the prolonged housing downturn. A credit crunch is likely to result in a pronounced contraction in activity over the near term and a further deterioration of the labour market. Once financial conditions normalise, GDP growth should resume but at a slower pace than in past recoveries, in part because of negative wealth effects. In response to lower commodity prices and the opening of a large output gap, inflation should recede significantly to around 1 1/2 per cent in 2010.

An additional fiscal stimulus package might become desirable in the near term if financial conditions do not quickly improve. Once the crisis has passed, the focus should shift to restoring fiscal sustainability by reducing the budget deficit and tackling the challenge of rising entitlement spending. The unfolding events since mid-2007 have highlighted the need for a major overhaul of financial regulation and supervision, a process which should be started soon also to boost investor confidence and thus help to revive the economy.

Economic weakness has become more pervasive ...

The US economy was confronting substantial challenges even before the recent deepening of the financial crisis. Over the course of 2008, the housing market has remained a major drag on GDP growth. While home sales seem to have stabilised, foreclosures have continued to rise and construction activity and home prices have declined further. There is also mounting evidence that the rest of the economy weakened substantially during the second half of the year. Most noticeably, the pace of decline in payroll employment has stepped up since August, especially in manufacturing. The unemployment rate has climbed to well above its estimated structural rate. The declines in employment, together with earlier increases in food and energy prices, have diminished the purchasing power of households. These factors, in combination with the phasing out of the stimulus coming from the rebate cheques, have depressed real consumer spending in the second half of 2008.

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... hitting all sectors of activity

In the business sector, declining sales prospects and a heightened sense of uncertainty have begun to weigh on outlays. Industrial production--a good coincident indicator of equipment and software investment--has declined since the second quarter, and incoming data on factory orders and shipments foreshadow further weakness. Even investment in non-residential structures, which held up well until the third quarter of 2008, seems to have turned down. While exports have been the main engine of growth in recent quarters, the slowdown in global activity and the recent appreciation of the dollar prefigure some softening here as well. Following moderate growth in the first half of 2008, there is likely to be a broad-based contraction of output in coming quarters. The only positive note is the recent drop in energy prices, which has reduced inflationary pressures and will attenuate the decline in real incomes.

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The financial system is under extraordinary stress ...

The financial crisis, not only in the United States but also in much of the rest of the world, has intensified. Falling home prices and the consequent deterioration of mortgages have led to substantial losses across the financial sector. Financial institutions' efforts to repair their balance sheets have constrained their lending. Furthermore, mounting uncertainty about the values of excessively complex and opaque mortgage-linked securities has progressively led investors to become more reluctant to bear credit risk. This has generated further declines in financial asset prices and a drying-up of liquidity. As a result, many securitisation markets, such as that for private-label mortgage-backed securities, have stopped working. In September, credit and money markets came to a near halt, with interest rates in these markets skyrocketing.

... which is spilling over to the real economy

The aggravation of the financial crisis is likely to affect economic activity through several channels, most notably by restricting the availability of credit. Banks are reducing credit card limits, and denial rates on automobile loan applications are reportedly rising. Even households with good credit histories face difficulties obtaining mortgages or home equity lines of credit. Businesses, too, are impaired by diminished access to credit. For instance, tighter bank lending standards--as evidenced by October's Senior Loan Officer Opinion Survey--and disruptions in the commercial paper market have made it harder for firms to obtain the working capital they need to meet routine expenses such as payrolls and inventories.

Household wealth is declining

The strains in financial markets have also led to a sharp drop in equity prices, which have fallen to a five-year low. Capital losses on corporate equities, combined with further losses in real estate due to continued falls in home prices, have put a considerable dent in household net worth, which will restrain consumer spending as households boost savings to rebuild their wealth.