US to face worst recession in 26 years

The US economy appears to be plunging into what many experts believe will be its worst recession since 1982.

Senior officials at the Treasury and Federal Reserve are confident that the rescue plan for US banks will succeed in preventing a financial system meltdown and ensure there will not be a repeat of the Great Depression. But they know that a sharp economic downturn is already baked in the cake. They do not,however, know how deep or protracted it will be.

The focus of concern is shifting from the markets – although these remain dangerously stressed – to the wider economy, where the consumer finally appears to be cracking.

The Fed and Treasury were expecting the economy to weaken but not as rapidly as it has, with collapsing consumer confidence, falling home starts, slumping retail sales and falling industrial production.

“The actual deterioration in the data in the last few weeks has been much more severe than anyone was expecting,” said Frederic Mishkin, a professor at Columbia university and former Fed governor.

Consumers, who account for 72 per cent of the US economy, are pulling back amid a brutal tightening of credit conditions on everything from car loans to credit cards and home equity lines. Meanwhile, foreign demand is also weakening.

Alan Blinder, a professor at Princeton and former Fed vice-chairman, said: “It looks to me like the economy has fallen off a cliff.”

He said it was all but certain the US would face a recession worse than in 2001 or 1990-1991.

“The game is now about making sure this recession is less deep and less long than the 1982 recession.”

Many experts expect unemployment will soar from its current level of 6.1 per cent and worry it could go above 8 per cent.

The Fed now thinks that unemployment will rise above 7 per cent and is likely to peak at about 7.5 per cent – a level last seen in 1992.

“We may be talking about one of the most severe recessions in the post-war period,” said Larry Meyer, chairman of Macroeconomic Advisers and a former Fed governor.

This is in spite of the extraordinary measures taken to stabilise the banking system, which senior officials believe will gain traction in the weeks ahead.

Policymakers believe that as the markets become more comfortable with the new arrangements the credit freeze will gradually thaw. If it does not, they are grimly determined to return with still more force.

“We are moving in the right direction. The Europeans are moving as well, which is very important,” said Mr Mishkin. “But we won’t know whether it is enough until we see how the market responds. A lot of damage has been done already.”

The battle over the $700bn bail-out was very costly, he said. “People are really terrified and this has the potential to have a big impact on spending.”

The US entered the crisis with a very low savings rate – unlike, for instance, Japan in the 1990s – making it vulnerable to a sudden consumer retrenchment.

Many economists think the savings rate – which was 0.2 per cent this year before being temporarily lifted by a tax rebate – will rise to between 3 per cent and 4.5 per cent. The fall in the price of oil will accommodate part of this.

But if it happens over a few quarters – as seems increasingly likely, given the shock to wealth and extreme denial of credit – it would produce a deep, if not necessarily long-lasting, recession.

Rising unemployment threatens to deepen the housing slump, further depress mortgage debt and increase delinquencies on car loans, credit cards and other consumer loans.

Meanwhile economic weakness is likely to multiply corporate defaults, including private equity deals. This second wave of losses for banks might prolong the credit crisis.

Some worry this could end in deflation. Senior Fed officials admit they cannot completely rule it out. However, Fed simulations with even severe recessions do not result in falling core prices, due to the high initial level of inflation, firm expectations and a weak relationship between unemployment and prices.

Standard models suggest that the US central bank should cut rates further from 1.5 per cent to 1 per cent and possibly lower, and do so quickly.

Policymakers will probably end up doing this. But senior Fed officials are unenthusiastic, worrying that further rate cuts will not have much impact and this could weaken confidence further.

At best, they now see rate cuts as a secondary issue, compared with bank recapitalisation, asset purchases, borrowing guarantees and Fed commercial paper purchases.

Some believe even these actions might not be enough. Democrats in Congress are calling for a second fiscal stimulus to hold down unemployment.