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Economic prospects for 1991.


The current recession will be mild and relatively short, unless of course, the Gulf crisis erupts. By the second half of 1991, homebuilding and economic growth should be rebounding.

Writing about economic prospects is much more fun when the outlook is bright and cheery. But after seven good years and one rather lean one, the economy's prolonged growth since late 1982 has come to an end: 1991 will mark the first recession year since 1982 and the ninth recession of the postwar period.

Forecasting in the midst of an economic downturn is always a chancy business because the dynamics of a decline are hard to predict. This year, the usual difficulties are exacerbated by a series of events and problems that might convert a mild decline into a severe and prolonged one. The Middle East crisis has weakened consumer and business confidence and eroded real income through its impact on oil prices. Many financial institutions are weaker than at any time since the 1930s, and real estate markets in some areas are being battered in ways that have shaken local residents.

The economy of the United States, nonetheless, still has solid footings, and we believe the current recession will be relatively mild in both depth and duration. By the second half of 1991, economic activity and single-family housing construction are expected to turn up again, albeit with less than the usual vigor that is characteristic of earlier postwar recovery periods.

The case for a mild recession

The case for a mild recession rests on three pillars. The first is that absent a shooting war (and maybe even with one, although that is much less certain), oil prices will come down from the average level prevailing since August 2, 1990, to a range of $20 to $25 a barrel. The loss to world oil supplies of Iraqi and Kuwaiti production since August has largely been offset by the increased output of Saudi Arabia and other countries, so that world demand and supply for crude oil are in reasonably good balance. (Today's oil prices still reflect market fears of a disruption of supplies should a shooting war erupt.) Such a drop in crude oil prices--particularly if accompanied by an end to the Middle East crisis--would have a tonic effect on the economy. Consumer spending power would improve; inflation would abate, and consumer and business confidence would turn up again. The crisis in the Persian Gulf is not the only reason for the current recession, but it is a major contributor. Removing that growth impediment would be of major benefit to our overall economic health.

The second pillar on which the case for a mild recession rests is the state of inventories. On average during previous postwar recessions, roughly half of the decline in real GNP was accounted for by a sizable drop in inventory investment. Investment in business stocks will decline in this recession, too, but by modest proportions, because inventories have remained lean relative to sales. Growth in final sales began to slow noticeably early in 1989, as it often does late in an economic expansion. For a time, inventory-sales ratios rose a bit, but that prompted strong action by both manufacturing and trade firms to trim excess stocks. By March 1990, the ratio of inventories to sales for all manufacturing and trade firms had dropped a little below its level 15 months earlier. This remarkable restraint by businesses--aided by sophisticated inventory control systems--will diminish substantially the degree of downward pressure on the economy coming from the need to reduce inventories further as the recession proceeds.

Growing exports provide the third reason for expecting the U.S. economy to pull out of recession before too much damage occurs. Since the summer of 1986, U.S. net exports of goods and services have risen roughly $100 billion in constant dollar terms--about 2 percent of real GNP. The rate of increase was particularly rapid in 1987 and 1988, when the benefits of the dollar's fall in value in exchange markets from early 1985 to early 1988 were most strongly felt. Since then, the rise in net exports has been more subdued, but it is clearly not over. Growth abroad--in Asia as well as in Western Europe--is much stronger than in the U.S. Moreover, the dollar's international value has declined substantially further since mid-1989, thus greatly enhancing our competitive position in world markets. Indeed, measured in foreign currencies, prices of U.S. merchandise exports today are at about the same level as in late 1980. Prospects for a further increase in U.S. net exports during 1991 seem quite good, and that will help keep the economy from going into a free fall.

Based on these considerations, the MBA economics department forecast anticipates an upturn in the U.S. economy in the second half of this year--but a modest recovery. If inventory investment does not decline much, there is little room for the usual early recovery rebound. That factor alone would keep the recovery of moderate dimensions. Dampening the recovery still more will be the problems of financial fragility and weakness in real estate markets mentioned earlier. Some observers believe that these problems will keep the economy in a prolonged recession. Maybe, but we don't think so.

The credit crunch

The economy entered the current recession confronting a problem never before encountered in earlier postwar downturns: a financial system with lots of weak spots. The issue is not whether the fragility of financial markets will shape the contours of economic performance in 1991; that we know for sure. The question is whether financial fragility will doom the U.S. economy to a deep and prolonged recession.

A recession always magnifies the difficulties faced by lenders, because more loans go sour as business sales and profits decline. Some banks, already in a weakened condition, will not survive the recession, and some insurance companies may also fail. Lending standards all across the nation, and particularly in the Northeast, have already been tightened significantly, and will tighten still further as the recession proceeds. Will access to credit by private borrowers be so severely choked off as to prevent the economy's recovery altogether?

Confident answers to that question are impossible, but insights into how the financial system might respond can be gleaned from financial data available to date. Restraints on lending standards to private borrowers have been intensifying since mid-1989, spreading from residential builders and commercial property developers to businesses more generally, and widening from the Northeast to affect virtually every geographic region of the country. Nonetheless, at this writing, credit to the private sector continues to flow, albeit more slowly. Despite severe restrictions on bank lending to finance new multifamily and commercial construction, total real estate loans at commercial banks are still moving up. Despite a decline in commercial and industrial loans at all commercial banks since August 1990, total business short-term borrowing has risen further, as many businesses have met their short-term credit needs by issuing commercial paper in larger quantities.

These results reflect the fact that participants in financial markets over the past two decades have learned to cope with problems by innovating. A combination of earlier regulatory restraints and fierce competition have strongly encouraged innovative behavior by borrowers and lenders alike, and the lessons learned will stand them in good stead during 1991. Moreover, the aggregate supply of funds available for investment this year will increase--bank deposits will rise, pension fund assets will grow, and insurance company reserves for investment will increase. A larger-than-normal portion of the new funds will be invested in Treasury securities, as lenders seek greater safety. But with yield spreads between private securities and Treasury issues widening, lending to the private sector will remain attractive to strong financial institutions (of which there are many) who will search out and lend to businesses with a good bottom line and strong management, and individuals with the wherewithal to buy a home or a new car.

Make no mistake about this: lenders have stopped shoving money down the throats of borrowers, as they did throughout much of the 1980s. This will affect the ability of the U.S. economy to return to a strong economic growth rate once the recession is over. But we do not believe that credit shortages will become so severe as to prolong or deepen the recession unduly.

Real estate markets

Weakness in real estate markets also is thought to pose a threat to make the recession long and deep. Once again, it's possible, but we don't think it will happen.

There are two disaster areas within the general field of real estate: multifamily residential properties and commercial real estate--office buildings, shopping centers, hotels and motels. In both areas, activity (and vacancy rates) rose dramatically in the first half of the 1980s in response to federal tax laws that encouraged investment in buildings whose economic prospects were doubtful. When tax reform came along in 1986, multifamily housing starts began to fall, and are now only one-third of their early 1986 level. The reaction of commercial construction to tax reform was delayed, however, as money continued to pour into the industry--particularly from failing savings and loan associations desperate for front-end fees. Both of these sectors of the real estate industry are now being hammered by severe constraints on the availability of credit.

Construction in both of these areas will decline further in 1991, exercising a drag on GNP growth throughout the year. This would be a major problem for the overall economy if activity in these two areas were a sizable part of the total economy; in fact, together they comprise less than 1 1/2 percent of real GNP.

Other areas of nonresidential construction are doing reasonably well. Industrial construction in constant dollars rose 9 percent over the past year; construction carried on by state and local governments rose a similar amount. Construction of private non-residential buildings other than industrial and commercial structures--such as hospitals and religious and educational buildings--rose 3 percent over the year. In all of these areas, which comprise around 2 1/2 percent of real GNP, activity is expected to continue rising in 1991.

Single-family residential construction, by far the largest single element of the overall construction industry, is a separate case. Mortgage bankers are all well aware that single-family home sales and housing starts have been declining for more than four years. The rate of descent, however, does not begin to compare with the abrupt drop that occurred in the crunches of 1979-80, or 1981-82 (see Chart 1). Unfavorable demographic factors, persistently high real mortgage interest rates and rising unemployment during the current recession will continue to drag down housing activity in the months ahead, but the chance that housing starts will plunge as they did a decade ago is remote. Indeed, we believe that single-family housing starts will bottom out this spring, with the trough not far below current levels, and that activity will improve moderately in the second half when the overall economy shows signs of recovery.

The MBA housing forecast for 1991, shown in Table 1, can hardly be regarded as wildly optimistic. On average, we expect housing starts to be about 10 percent lower this year than last; both existing and new single-family home sales will be down. Mortgage loan originations on one- to four-family residences will probably be below $350 billion, the lowest level since 1985. Mortgage bankers are expected to capture a bit more than one-fourth of the market--a lower share than in 1990, but about the same as in 1989.

With the slower rate of growth of the underlying demographic demand for shelter, a substantially better year for the single-family housing market, and for residential mortgage lenders, would seem to rest heavily on the prospects for a substantial decline in mortgage interest rates, especially rates on fixed-rate mortgages. Continued high long-term interest rates abroad will probably prevent a major decline in U.S. long-term interest rates, unless and until the inflation rate in the U.S. begins to show signs of fundamental improvement. Rising unemployment this year--to a range of 6 3/4 to 7 percent by the second half--will increase the chances of a significant breakthrough on the inflation front. But it may well be 1992 before the Federal Reserve's efforts to curb inflation begin to bear ample fruit.

TABLE 1 MBA Housing Forecast

1990 1991

Housing Starts: (000)
 Total 1,210 1,080
 1-4 Family 950 880
 Multifamily 260 200

Home Sales: (000)
 New Single-Family 540 520
 Existing 3,250 3,200

Mortgage Loan Originations, 1-4 Family, Billions
 Total $335 $345
 Mortgage Bankers 100 90
 Share 28% 26%

[Chart 1 Omitted]

Lyle E. Gramley is chief economist for the Mortgage Bankers Association of America in Washington, D.C.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Gramley, Lyle E.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jan 1, 1991
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