The Economic Outlook

The economy has been buffeted recently by several interlinked shocks, and the risk of recession is significantly elevated compared with what it is during normal economic conditions. The pace of economic growth slowed in 2007, and there are strong indications that it will slacken further in 2008. In the Congressional Budget Office’s view, the ongoing problems in the financial and housing markets and the high price of oil will curb spending by households and businesses this year and trim the growth of gross domestic product. In contrast, the relative economic strength of the United States’ major trading partners—in particular, the robustness of emerging economies—when combined with the dollar’s decline will stimulate net exports, thus partially offsetting the sluggishness in domestic demand anticipated this year. Although recent data suggest that a recession in 2008 has become more likely, CBO does not expect the slowdown in economic growth to be large enough to register as a recession.¹ For 2009, CBO forecasts that the economy will rebound, as the negative effects of the turmoil in the housing and financial markets fade.

Specifically, CBO forecasts that GDP will increase in 2008 by 1.7 percent in real terms (after an adjustment for inflation) and rebound in 2009 to 2.8 percent (see Table 2-1). Given the prospect of weak domestic demand this year, CBO expects inflation to be contained over the next two years. Employment growth, which slowed during 2007, is likely to slow further in 2008, and unemployment, in CBO’s estimation, will average 5.1 percent this year. Interest rates on Treasury securities will remain low in 2008 and increase in 2009, CBO forecasts, as the economy works through and emerges from its current difficulties.

		Estimated	Forecast		Projected Annual Average
		2007	2008	2009	2010 to 2013		2014 to 2018


		Year to Year (Percentage change)

Nominal GDP (Billions of dollars)		13,828	14,330	14,997	18,243	^a	22,593	^b
Nominal GDP		4.8	3.6	4.7	5.0		4.4
Real GDP		2.2	1.7	2.8	3.1		2.5
GDP Price Index		2.5	1.9	1.8	1.9		1.9
PCE Price Index^c		2.5	2.6	1.8	1.9		1.9
Core PCE Price Index^d		2.1	1.9	1.9	1.9		1.9
Consumer Price Index^e		2.8	2.9	2.3	2.2		2.2
Core Consumer Price Index^f		2.3	2.2	2.2	2.2		2.2

		Calendar Year Average (Percent)

Unemployment Rate		4.6	5.1	5.4	4.9		4.8
Three-Month Treasury Bill Rate		4.4	3.2	4.2	4.6		4.7
Ten-Year Treasury Note Rate		4.6	4.2	4.9	5.2		5.2
Tax Bases (Billions of dollars)
	Economic profits	1,599	1,620	1,649	1,842	^a	2,320	^b
	Wages and salaries	6,368	6,615	6,913	8,401	^a	10,354	^b
Tax Bases (Percentage of GDP)
	Economic profits	11.6	11.3	11.0	10.3		10.1
	Wages and salaries	46.0	46.2	46.1	46.1		45.9

		Fourth Quarter to Fourth Quarter (Percentage change)

Nominal GDP		4.7	3.7	5.1	5.0		4.4
Real GDP		2.5	1.5	3.3	3.0		2.4
GDP Price Index		2.2	2.1	1.8	1.9		1.9
PCE Price Index^c		3.2	2.1	1.9	1.9		1.9
Core PCE Price Index^d		2.0	1.9	1.9	1.9		1.9
Consumer Price Index^e		3.8	2.5	2.2	2.2		2.2
Core Consumer Price Index^f		2.2	2.2	2.2	2.2		2.2

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

The economic outlook this year is particularly vulnerable to uncertainty about the degree to which the problems in the housing and financial markets will spill over to affect other sectors of the economy. Growth in 2008 could be weaker than CBO expects if the turmoil in the financial markets leads to a more severe economywide curtailment of lending than CBO anticipates. Growth could also be slower if crude oil prices, which jumped sharply late last year, rise even higher and further undercut spending by consumers and businesses.

Alternatively, growth in 2008 could be stronger than CBO is currently forecasting. In particular, financial institutions may be able to absorb mortgage-related losses without triggering significant repercussions in the broader economy. Also, unrelated sectors of the economy (that is, nonhousing and nonfinancial sectors) may continue to support the growth in employment and income necessary to sustain consumer spending.

For the medium-term period (2010 through 2018), CBO projects that real growth will average 2.7 percent and inflation will average 2.2 percent. Those estimates rest on CBO’s assumption that the economy will grow at a pace faster than its potential rate of 2.5 percent during the years after 2009 to close the projected gap between GDP and potential GDP at the end of 2009. (Potential GDP is a level of output that corresponds to a high level of resource—labor and capital—use.) CBO also projects that the unemployment rate will average 4.8 percent and interest rates on 3-month Treasury bills and 10-year Treasury notes will average 4.7 percent and 5.2 percent, respectively, during the latter years of the period.

Compared with its August 2007 estimates, CBO’s current forecast for the near term—that is, the next two years—indicates much slower growth, significantly higher inflation in 2008, lower interest rates, and a smaller share of GDP attributable to firms’ profits. The weakness in the housing sector, the turbulence in the financial markets, and the rise in energy prices now appear to be undercutting the growth of GDP to a greater degree than CBO envisioned last summer. The less expansive outlook for the near term also results in lower interest rates on Treasury securities in 2008 than CBO had expected in August. Inflation as measured by the consumer price index for all urban consumers (CPI-U) during the last few months of 2007 was much higher than anticipated—prices for motor fuel shot up unexpectedly—and that growth has boosted the year-over-year rise in prices that CBO expects in 2008. However, the measure of inflation that excludes food and energy—core inflation—grew only slightly more than CBO anticipated last August, and consequently, the outlook for core inflation is essentially unchanged.

The nation’s financial markets have been buffeted by events stemming from the downturn in the housing sector and the losses associated with subprime mortgage loans—that is, loans extended to borrowers who have low credit ratings and a high risk of default. The ultimate magnitude of the subprime-related losses is highly uncertain, in part because it depends on how the economy evolves over the next few years and how far house prices fall. However, rough estimates by some financial analysts suggest that the losses are in the range of $200 billion to $500 billion.² Moreover, because most subprime loans have been pooled into mortgage-backed securities, rather than held by their originators, and those securities have subsequently been restructured as parts of other complex investment securities, who will actually bear those losses is unclear. The uncertainty among investors about their exposure to subprime-related losses has led many of them to reassess the creditworthiness of a wide variety of financial instruments.

Increased aversion to risk in the nation’s financial markets, which marks a shift from an unusually high level of tolerance for risk taking in recent years, could threaten to slow economic activity above and beyond the direct effects of the subprime losses. The availability of credit has become severely restricted for some borrowers, especially those seeking money for risky mortgages and businesses. In addition, borrowing costs have increased not only for subprime residential mortgages but also for some consumer and business loans. The troubles in the U.S. subprime mortgage market have also affected financial markets in other industrialized countries, threatening to slow economic growth there as well. Consequently, policymakers in the United States and abroad have worked to reduce the turmoil in the markets.

CBO does not expect that turmoil to balloon into a severe, economywide credit crunch. The pullback from risk in the financial markets, though, is likely to contribute to the continued tightness of credit, especially for housing and the riskier ventures among businesses’ investments. If a severe credit crunch did occur, it would drive the economy into recession by significantly curbing financial activity and consumer spending. However, CBO assumes in its forecast that the Federal Reserve will implement policies to prevent such a crunch and that the financial sector is capable of absorbing most of the losses it faces. In fact, despite their current financial stresses, some banks that have suffered large losses from their subprime-related investments have thus far survived those setbacks and are now successfully raising needed capital. Moreover, most prime borrowers—those whose credit ratings are solid—are unlikely to encounter major difficulties in funding their investments.

The recent turbulence in the financial markets originated with subprime mortgage lending, especially on subprime adjustable-rate mortgages, or ARMs.³ The number of subprime mortgages has grown rapidly in recent years: In 2005 and 2006, such loans made up about one-fifth of all originations of home mortgages (in dollar terms); they accounted for about 13 percent of all home mortgages at the end of that latter year.⁴ Although the expansion of subprime mortgage lending allowed more people to buy homes, that outcome was achieved in large part by significantly lowering credit standards and offering terms on such lending that were more favorable than had been seen in the past. For example, lenders sometimes made loans to borrowers who would not be able to make their scheduled future payments after their very low introductory interest rates (known as "teaser rates") expired. The fall in housing prices that has occurred over the past year combined with a tightening of lending standards has greatly diminished borrowers’ ability to sell their homes or refinance their mortgage loans, leaving many of them with repayment problems.

As a result, the number of delinquencies and foreclosures on subprime ARMs began to rise dramatically after 2005. By the third quarter of 2007, almost 19 percent of subprime ARMs were considered delinquent, up from a recent low of 10 percent in the second quarter of 2005 (see Figure 2-1). In addition, the share of subprime ARMs entering foreclosure more than tripled, rising from an average of 1.5 percent in 2004 and 2005 to 4.7 percent in the third quarter of 2007. Although the share of delinquent fixed-rate subprime loans has also grown, it is still smaller and has grown more slowly than the share of delinquent subprime ARMs.

The very high rates of delinquency on recent subprime mortgage loans surprised investors, and lenders have virtually stopped making new subprime loans. Trading of existing subprime mortgage-backed securities (MBSs) has diminished, and their prices have fallen sharply, to as low as 14 cents on the dollar for the riskiest of those securities, because of uncertainty about their value, particularly in view of investors’ loss of confidence in the securities’ credit ratings. The price declines were steepest for subprime MBSs that had been issued more recently, suggesting that lenders have significantly lowered their standards for making loans in the past few years.

Mortgage delinquencies and foreclosures could be a problem for the economy and the financial markets for several years. In the case of subprime ARMs, rates for some loans have already been reset, but those on an additional 1.7 million mortgages will be reset during 2008 and 2009.⁵ Those changes, plus the ones occurring in later years (most before the end of 2010), could eventually add about $40 billion to borrowers’ annual payments.⁶ Although that increase is not large relative to households’ total after-tax income ($10 trillion), many households will be hard-pressed to make the higher payments, and some will default on their mortgages and go into foreclosure. The risk of a sharp increase in foreclosures has led to various actions and proposals to help the market cope with the repayment problems among borrowers with subprime ARMs.⁷

The problems of the subprime mortgage market have undermined the confidence of many investors and caused them to reduce their holdings of mortgage loans and of other asset-backed securities associated with particularly risky lending to businesses and consumers. That contagion effect has been intensified by the lack of transparency about which financial instruments and institutions face losses from defaults on subprime mortgages, forcing investors and financial institutions to reevaluate the risk of their investments in a wide range of financial assets. That reassessment has subsequently lessened investors’ willingness to bear such risk and driven down the value of suspect assets, some of which were once thought to have little possibility of default.

Some of that reassessment can be seen as a correction to the underpricing of risk that had occurred in recent years and that contributed to the current turmoil in the financial markets. For example, because the revaluation of risk led to what the markets term a "flight to quality" (that is, a shift from riskier investments to such instruments as U.S. Treasury securities, which investors consider safe), interest rates on prime mortgage loans have actually declined in recent months. To date, the market for conforming mortgages (mortgages that are no greater than $417,000), which make up the bulk of all mortgage loans, has seen no significant adverse effects from the subprime mortgage troubles (see Box 2-1).⁸ Some people fear, however, that the reassessment will go too far and jeopardize economic growth by indiscriminately reducing funding for profitable investments.

Box 2-1.

Conforming Mortgages and the Role of Fannie Mae and Freddie Mac

The problems in the subprime mortgage market have not affected the availability of conforming mortgages— that is, mortgages that are eligible to be purchased on the secondary mortgage market by Fannie Mae and Freddie Mac. In fact, mortgage rates in the latter market have fallen because investors have bid up the price of the mortgage-backed securities (MBSs) offered by those two government-sponsored enterprises, or GSEs. GSEs are private financial institutions chartered by the federal government to promote the flow of credit for targeted uses—in this case, housing. To do that, they raise funds in the capital markets partly on the strength of an implied federal guarantee against the risk of default (which reduces their borrowing costs and enables them to hold less capital than other borrowers and yet still borrow large sums).

Although losses resulting from the subprime troubles have affected the potential of the GSEs to hold loans, they are unlikely to affect Fannie’s and Freddie’s ability to guarantee MBSs. The two GSEs’ concentration in the prime mortgage market helps insulate them from losses, but as of fall 2007, they still held about $230 billion in subprime and Alt-A mortgages.¹ (In terms of their level of risk, Alt-A mortgages carry a higher rating than do subprime mortgages but a lower rating than prime mortgages.) Because of their subprime-related losses, the GSEs’ capital cushion in the third quarter of 2007 had dropped to just about $3 billion—on top, that is, of the $73 billion in capital that current laws and regulations require to safeguard the $1.6 trillion in assets carried on their balance sheets and the $3.3 trillion in off-balance-sheet guarantees of MBSs for which they are responsible.² That modest cushion of $3 billion left little capacity to absorb further losses.

Consequently, Fannie Mae and Freddie Mac have raised $13 billion in new capital and cut their dividends. However, even if they had chosen not to raise more capital, the GSEs could have continued to guarantee returns on MBSs as long as they reduced their portfolios of mortgages—because the capital they are required to maintain for the mortgages held on their balance sheets is about five times higher than the capital required for their guarantees. Because the implicit federal backing that the GSEs’ guarantees carry is the source of the lower costs for borrowing that they obtain in the conforming mortgage market, any problems that the GSEs encounter will probably not affect that market but could affect their ability to buy more subprime and Alt-A mortgages.

Fannie Mae and Freddie Mac have announced riskbased increases in some of their fees, which will probably be passed on to most borrowers—in the form of higher origination costs—beginning in March 2008. For some borrowers who have low credit scores and small down payments, the additional amounts they will have to pay could be several thousand dollars. For other borrowers who appear more creditworthy and make bigger down payments, the amounts will be much smaller.

Pending legislation would raise the conforming loan limits to assist borrowers in regions of the country (such as the West Coast) where home prices are high. Other proposals would increase the assistance that the GSEs provide to the subprime market. However, unless those initiatives are accompanied by higher capital requirements and regulatory reform, the implicit risk for the GSEs’ operations that is borne by taxpayers will increase.

1. Alt-A mortgage loans, which share many of the same problems as subprime mortgage loans, were often made on the basis of undocumented income. Recently, Alt-A mortgages have included low-down-payment loans, interest-only loans, and loans whose balances rise over time. Those loans are defaulting at sharply rising rates.

2. For more information, see Congressional Budget Office, Measuring the Capital Position of Fannie Mae and Freddie Mac (June 2006).

Jumbo Mortgages. In the mortgage markets, the spillover from subprime defaults has been most pronounced for jumbo mortgages—those in amounts greater than those for conforming loans. The availability of funds in the market for existing jumbo loans (a so-called secondary market that resells such loans in the form of securities) has sharply declined; consequently, rates on new jumbo loans in the (primary) market have risen. Borrowers now pay roughly one percentage point more for jumbo loans than for conforming loans (see Figure 2-2). Relatively few new jumbo loans are now securitized.⁹

Sources: Congressional Budget Office; Federal Reserve Board; Bloomberg; Wall Street Journal.

Corporate Bonds. Spillovers from the troubles in the mortgage markets have also raised the cost of borrowing for businesses that have low credit ratings. In the corporate sector, interest rates on high-yield or speculative-grade bonds—those whose risk of default is judged to be high—jumped last summer when the subprime market’s problems emerged, and the rates remain elevated. By contrast, the average interest rate on investment-grade bonds (those with a low risk of default) was essentially the same last year as in 2006. Nevertheless, the difference between the interest rate on investment-grade bonds and that on 10-year Treasury notes, an indication of the riskiness of those bonds, has risen compared with what it was last year, suggesting that repricing of risk has occurred even in the market for the safest corporate debt.

Commercial Paper. The market for commercial paper, a kind of loan that plays a key role in providing short-term credit to both financial and nonfinancial businesses, has been especially affected by losses in the subprime mortgage market. In particular, those losses have severely curtailed the asset-backed segment of the commercial paper market, which has provided financing for structured investment vehicles (SIVs) and other investment funds (or conduits) sponsored by banks (see Box 2-2). The total amount of outstanding commercial paper has dropped sharply since the summer of 2007, which indicates that businesses’ access to short-term credit has been constricted. That constriction is primarily due to the decline in the amount of asset-backed commercial paper; other commercial paper markets have not been as significantly affected by the subprime losses (see Figure 2-3).

Box 2-2.

Structured Investment Vehicles

Structured investment vehicles (SIVs) are entities that issue short-term commercial paper as well as medium-term notes to finance the purchase of longer-maturity, higher-yielding assets. (Such assets include asset-backed securities, which are made up of bank loans, mortgage-backed securities, and debt obligations backed by credit card receivables, automobile and other loans, and, in some cases, subprime mortgages.) Estimates are that in the summer of 2007, SIVs represented about $400 billion. However, the recent difficulties that those entities have encountered as a result of the subprime-related turmoil in the financial markets have caused a steady decline in that amount, to less than $150 billion as of early December 2007.¹

Because the maturities of their assets are longer than the maturities of their liabilities, SIVs periodically need to roll over, or "re-fund," their debt (that is, pay off their old debt with new debt). That re-funding requires that lenders be willing to take on the risks associated with a SIV’s investment portfolio. However, when markets are disrupted and the value of such a portfolio becomes difficult to establish, refunding also becomes difficult—or impossible. In that case, a SIV may have to sell its most marketable assets to pay off its commercial paper and debt—as many SIVs may have done in recent months.

SIVs are known as off-balance-sheet entities because they are legally separate from the banks (or other institutions) that have created them and typically are not carried on the banks’ balance sheets. Although such banks may have backup agreements with the SIVs to extend credit if requested, they have no legal obligation to cover the SIVs’ losses. They may choose to do so, though, to protect their reputations. As long as the SIV does not appear on the bank’s balance sheet, it has little or no effect on the bank’s capital requirements. Those requirements, promulgated by bank regulators, stipulate (as a ratio) the amount of equity that a bank must hold in relation to the amount of assets on its balance sheet and the riskiness of those assets.

SIVs are often required to start selling their assets if their losses exceed certain threshold percentages of their capital or if they violate provisions that specify the liquidity (broadly, the available funds) they must maintain. Those involuntary sales may then push down the prices of the SIVs’ assets, which could cause losses in the value of similar types of assets held by other SIVs and force those SIVs into such involuntary sales as well. The losses could also trigger defaults on commercial paper already issued by the SIVs and further impede their ability to borrow money.

Recent actions by some large banks to resolve the troubles of their sponsored SIVs have included bringing the SIVs’ assets—and losses—back onto the banks’ balance sheets. Those actions reduce a bank’s capital ratio and absorb some of the bank’s lending capacity—because the assets become either a loan or an investment of the bank, potentially crowding out other loans or investments.

1. Those estimates were drawn from "Remarks by Treasury Secretary Henry M. Paulson Jr. on housing and capital markets before the New York Society of Securities Analysts" (January 7, 2008), available at www.treasury.gov/press/releases/ hp757.htm.

Bank Loans. Some banks have been hit hard by their exposure to subprime mortgage lending, both directly and indirectly through the activities of SIVs, raising concerns that banks might substantially restrict their lending. Banks are an important conduit for channeling credit to businesses and consumers, acting variously as originators of loans, securitizers, providers of backup credit lines to issuers of commercial paper, and investors in bonds. Although no one yet knows the share of subprime-related losses that banks will ultimately have to absorb, the losses announced to date have been significant. Those losses have reduced banks’ capital and forced banks to tighten their credit terms on business and consumer loans. That tightening could curb the growth of the overall economy if many banks cannot easily raise additional capital to fund new lending.

Banks’ capacity to lend to businesses and consumers might already be under stress. Commercial and industrial loans have increased sharply since the turmoil began last summer (see Figure 2-4). That increase probably in large part reflects lending that the banks are committed to make when backup credit lines are activated by failed asset-backed commercial paper programs. At the same time, banks’ investment in securities has increased, as they have brought some of the assets of their sponsored SIVs back onto their balance sheets, displacing other loans they might have made.

The severity of subprime-related losses and their effect on banks’ lending capacity are open questions and likely to remain so throughout 2008, but expectations are that the banking system as a whole will not be imperiled. Thus far, some major financial institutions have been able to raise new capital; also, the tightening of credit standards to date has been less extreme than the tightening that occurred during the banking crisis of the early 1990s. Furthermore, because assets backed by subprime mortgages are widely held, other financial institutions besides banks—including hedge funds, pension funds, and other investment funds—as well as financial institutions in the rest of the world will also absorb some portion of the subprime-related losses.

Since its actions in August, when the turbulence in the financial markets began, the Federal Reserve has taken additional steps to increase the availability of credit and keep the economy growing. In August, it injected temporary reserves into the banking system—which moved the federal funds rate (the interest rate that financial institutions charge each other for overnight loans of their monetary reserves held at the central bank) below its target—and it lowered the discount rate (the interest rate that the Federal Reserve charges on a loan it makes to a bank). With conditions in financial markets still turbulent in the fall of 2007, the central bank cut its target rate, ending the year at 4.25 percent.

Late last year, the Federal Reserve took additional action to lessen the persistent stress on the money markets and announced a new policy instrument called the term auction facility, or TAF. In December, the TAF auctioned $40 billion in short-term financing to depository institutions that are eligible to borrow from the Federal Reserve’s discount window; by the end of January, it will have auctioned another $60 billion (see Box 2-3).

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Box 2-3.

The Federal Reserve’s Term Auction Facility

On December 12, the Federal Reserve introduced a new policy tool, the term auction facility (TAF), to supply funds to financial institutions. The TAF was designed to address the wider-than-normal spread, or difference, that the subprime-related problems in the financial markets induced between the markets’ expectations about the federal funds rate (the rate that financial institutions charge for overnight loans of their monetary reserves) and the dollar LIBOR, or London Interbank Offered Rate (which banks charge each other for short-term loans and which is widely used as a reference rate for financial instruments). Similar discrepancies occurred in LIBOR markets for other currencies.

The TAF has elements of two other mechanisms that have long been part of the Federal Reserve’s monetary policymaking apparatus: open market operations and discount window lending. In its open market operations, which constitute the central bank’s main tool for implementing monetary policy, the Federal Reserve buys and sells U.S. Treasury and federal agency securities through an auction involving representatives of member institutions (known as primary securities dealers). In that way, the Federal Reserve adjusts the supply of monetary reserves in the banking system in order to influence the federal funds rate. (The Federal Reserve’s Open Market Committee establishes a target for that rate.)

In contrast, at the discount window, the Federal Reserve accepts requests for short-term loans by commercial banks and other depository institutions that have short-term liquidity needs or that face severe financial difficulties. For most banks, the discount rate is set as a spread (a certain number of basis points, or hundredths of a percentage point) above the target federal funds rate.¹ The rate that the Federal Reserve charges banks that are in good financial shape is lower than the rate it charges other banks. In times of financial market stress, however, banks have sometimes been reluctant to borrow through the discount window for fear of being stigmatized as weak and thus losing access to private sources of funds (such as other banks).

The TAF, which was designed to overcome that hesitation, is similar to open market operations in that funds are supplied through an auction. However, it differs in that under the TAF, the Federal Reserve announces the amount of funds that will be supplied and the auction determines the interest rate that will be paid by successful bidders, which in effect pushes that set amount of funds into the credit markets. (In contrast, in open market operations, the amount supplied and the interest rate that successful bidders pay are closely connected to the target for the federal funds rate.) Another difference between open market operations and the TAF is that the Federal Reserve will accept a broader range of securities in payment for TAF-supplied funds than it does for funds supplied through open market operations (for which only U.S. Treasury and government agency securities are accepted). Securities eligible under the TAF are the same as those eligible as collateral for the central bank’s discount window lending. However, the open market-type auction of the TAF may eliminate the perceived stigma of using discount window borrowing in times of financial stress and make banks more willing to bid for funds to enhance their liquidity.

The interest rate on TAF-supplied funds in December was between the federal funds rate and the discount window lending rate, but the rate on the funds auctioned on January 14 was below the federal funds target. The two TAF auctions, on December 17 and December 20, each added $20 billion in liquidity to the banking system at respective rates of 4.65 percent and 4.67 percent (compared with a federal funds target rate of 4.25 percent and a discount window rate of 4.75 percent). The auction on January 14 supplied $30 billion at a rate of 3.95 percent. Another auction on January 28 is scheduled to add another $30 billion.

In addition to the implementation of the TAF, the Federal Reserve set up reciprocal currency swap lines with the central banks of the European Community and Switzerland. The swaps, in which the Federal Reserve temporarily exchanges dollars for the respective central banks’ currencies, have facilitated dollardenominated borrowing by those banks’ member institutions.

As a result of the TAF, the swap lines, and other actions, the spread of the dollar LIBOR over the expected federal funds rate has narrowed significantly.

1. Small banks in agricultural or resort communities pay a rate that is an average of selected market rates.

Short-term credit markets have benefited significantly from the Federal Reserve’s actions and its assurances of support for financial institutions. The international interbank market and the domestic commercial paper market—the short-term markets most affected by the subprime problems—have recovered from the summer’s upsets (although in the case of asset-backed commercial paper, spreads, or differences, between borrowing rates and the federal funds rate are still larger than normal, and the number of transactions is smaller than usual.)

CBO expects that the Federal Reserve will further reduce the federal funds rate to prevent credit shortages in 2008 from retarding the growth of the economy and to counter the negative effects arising from a fragile housing market and high oil prices. In CBO’s forecast, the target federal funds rate falls to 3.5 percent by the middle of 2008 and holds at that level for the rest of the year. As the economy recovers, the rate will gradually rise to 4.75 percent in early 2010, CBO anticipates.

CBO’s assumptions about monetary policy and the economy underpin its forecast for interest rates on Treasury bills and notes. CBO estimates that the rate on 3-month Treasury bills will average 3.2 percent in 2008, reflecting the lower federal funds rate and the heightened demand for Treasury securities arising from the subprime-related troubles in the commercial paper market. CBO expects the rate to move higher, to 4.2 percent, in 2009 as the economy recovers and financial market problems ease. For many of the same reasons, CBO forecasts that the rate on 10-year Treasury notes will climb from an average of 4.2 percent in 2008 to 4.9 percent in 2009. That estimate for the 10-year note incorporates the assumption that investors will remain confident that the Federal Reserve is committed to keeping inflation low.

The troubles in the U.S. subprime mortgage market have directly affected financial institutions in other industrialized countries, particularly those that had invested heavily in U.S. securities backed by subprime mortgages or those that were relying on short-term interbank financing for longer-term loans. The international interbank market facilitates domestic and international transactions and provides payment and settlement services to businesses, consumers, and governments. A measure of perceptions of risk among banks in that market is the spread of the three-month dollar interbank rate—known as the dollar LIBOR rate—relative to the expected federal funds rate over that interval.¹⁰ That LIBOR spread jumped during last summer’s turmoil and again in November and early December. Spreads also increased between LIBOR rates for other major currencies and the expected policy rates of the corresponding central banks. A key factor in those hikes was concern about the adequacy of the capital held by banks that have had to absorb subprime-related losses—concern fueled by uncertainty about how much larger those losses might turn out to be.

The European Central Bank, the Bank of Canada, and the Bank of England have each injected substantial amounts of cash into their countries’ financial markets to contain the credit crisis and bolster liquidity. Besides liquidity injections, the Bank of England cut its policy interest rate (similar to the federal funds rate) by 25 basis points on December 6 (a basis point is one-hundredth of a percentage point), acknowledging that the deterioration in financial conditions and the subsequent tightening of credit had increased the risk that economic growth might slow. (So far, other central banks have held off on previously planned hikes in interest rates.) As a result of those and other policy actions, the spread between the three-month dollar LIBOR rate and the expected federal funds rate (like the corresponding spreads in other currencies) has now narrowed but remains high relative to its normal level.

As in the United States, housing prices in many other parts of the world have soared, but the financial disturbances here are unlikely to trigger a collapse in housing markets abroad. Most countries do not have subprime mortgage markets like those in the United States; also, they do not have an oversupply of housing, as this country does, because land is more limited and mortgage financing standards are more conservative. Nevertheless, shortages of credit in some countries may require action by those nations’ central banks.

The pace of economic growth slowed in late 2007, and CBO anticipates additional slackening in 2008. Chief causes of that slowdown are the problems in the housing and financial markets and high oil prices. If those factors continue to worsen, they could further weaken consumers’ and businesses’ confidence about the future, which might constrain economic activity even more than CBO now anticipates. Indeed, some indicators imply that the risk of a recession is high (see Box 2-4). However, the stronger growth of the nation’s major trading partners combined with the dollar’s decline will partially offset weak domestic demand and support growth by increasing U.S. exports.

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Box 2-4.

Recession Signals

Two relatively reliable indicators of a recession, one based on the unemployment rate and the other on a relationship between long- and short-term interest rates, imply that a recession in 2008 is likely. The first such indicator is the change in the three-month moving average of the unemployment rate. Whenever the change in the average from the previous year has been 0.4 percentage points or more, the economy has been in a recession (see the first figure). For all recessions since 1975, the 0.4 percentage-point signal came within one to three months of the onset of the recession.

Changes in the Unemployment Rate

(Percentage points)

Sources: Congressional Budget Office; Department of Labor, Bureau of Labor Statistics.

Note: Changes are from the previous year in the three-month moving average of the civilian unemployment rate. Data are plotted through December 2007.

In the current business cycle, the 0.4 percentagepoint threshold was reached when the Bureau of Labor Statistics released the December 2007 unemployment data on January 4. Yet the signal is partially undercut by the lack of support from some other labor-market data. For example, in past recessions, the number of layoffs usually increased around the time that the recession began. The most prominent measure of layoffs, the four-week moving average of initial claims for unemployment benefits, has begun to edge upward, but the increase to date is small and does not seem to indicate a recession. Moreover, surveys of employers thus far do not suggest that they plan large future reductions in hiring. Still, such labor-market indicators could deteriorate suddenly, once it became clear that demand was substantially weakening.¹

Another relatively reliable signal of a recession is a negative yield spread, which occurs whenever a shortterm interest rate (such as the rate for one-year Treasury bills) is above a long-term interest rate (such as the rate on 10-year Treasury notes). All but one occurrence of a negative yield spread since 1955 have foreshadowed an upcoming recession (see the second figure). From mid-2006 to mid-2007, the yield spread was continuously negative.

Yield Spread

(Percentage points)

Sources: Congressional Budget Office; Federal Reserve Board.

Note: The spread is calculated as the difference between the rates on the 10-year Treasury note and the 1-year Treasury bill. Data are monthly and are plotted through December 2007.

Again, though, that signal may be misleading this time, for two reasons. First, the yield-spread signal incorporates the assumption that high short-term rates and low long-term rates have the same impact on the probability of a downturn. If high short-term rates are more important, then the degree of monetary restraint normally implied by a negative yield spread may not be present this time.

Second, the long period of relatively mild inflation since 1985 may have caused investors to be more confident than in the past about the ability and commitment of the Federal Reserve to control inflation. If concerns about a possible sustained increase in inflation have ebbed over the years, the long-term interest rate would tend to be closer to the short-term rate even if no recession was in the offing—that is, long-term rates would not have to reflect as large an ’inflation risk premium’ as they have in the past. Less volatility in economic activity can have a similar effect. Therefore, a slight inversion of the yield curve may be less of a recession signal now than in the past.

1. Some economists have argued that patterns of hiring and firing over the course of the business cycle have changed in recent years. See Robert Shimer, Reassessing the Ins and Outs of Unemployment, NBER Working Paper No. 13421 (Cambridge, Mass.: National Bureau of Economic Research, September 2007); and Robert Hall, ’How Much Do We Understand About the Modern Recession?’ (paper prepared for the Brookings Panel on Economic Activity, September 2007).

Although the troubles in the oil, financial, and housing markets pose a serious risk to the nation’s economic health, the economy may navigate those obstacles more successfully than CBO now expects. Despite some adverse shocks, the economy has been naturally resilient during the past 25 years (although part of that resiliency can be attributed to well-functioning financial markets, and their ability to continue to function well is one of the risks of the current situation). Moreover, employers in the nonhousing portion of the business sector have not accumulated excess workers, capital, or inventories in recent years, implying that firms will not need to cut back as much as they would have in the past in response to ebbing demand. In addition, although globalization has increased the risk that the United States’ economic troubles might spill over to other nations, it has also allowed the impact of the decline in U.S. consumer spending to be shared globally, reducing its adverse effects on U.S. producers and workers.

The housing sector will continue to be a drag on the growth of output in the first half of 2008, CBO forecasts, but it will probably have little direct effect on growth in the second half. The slowdown in residential investment has reduced the annual rate of growth of real GDP by about a percentage point in the past year and a half. However, as lower housing prices make home ownership more affordable and lower rates of construction help reduce the inventory of unsold homes, the numbers of housing "starts" (new housing units beginning construction) and of sales of new and existing homes will stop falling late in 2008 and then start growing in 2009.

Housing Construction and Sales. During 2007, the numbers of housing starts and home sales continued to fall. The number of starts dropped by more than 38 percent for the year ending in December 2007, after sinking by 18 percent for the year ending in December 2006. Sales of new single-family homes for the year ending in November 2007 fell by 34 percent and are down by 53 percent from their peak in 2005. The ratio of unsold homes to monthly home sales has risen to the level observed in most recessions in the past: In November, it stood at 9.3 months, slightly higher than its level during the recession of 1990 and 1991, for example. Sales of existing single-family homes have also continued to drop: They fell by 20 percent in the year ending in November 2007 and are down by about 30 percent from their peak in 2005.

CBO expects an upturn in the number of housing starts in 2009, in part because currently they are considerably below the underlying demand for new units (see Figure 2-5). Underlying demand—that is, the need for new housing units—is based on growth in the number of households and estimates of the replacements required to cover the net removal of old units from the stock of usable housing. The number of starts is currently well below the estimate of underlying demand because of the unusually large excess inventory of vacant units. As those vacant units are sold, starts are expected to gradually return to the level of underlying demand.

Sources: Congressional Budget Office; Department of Commerce, Bureau of the Census.

Notes: Housing starts include both single- and multifamily homes. The underlying demand for new housing is based on the growth in the number of households and the depreciation of the housing stock.

Prices and Affordability. House prices have fallen sharply since their peak in the middle of 2006. A number of indexes are available to track prices; each is flawed, but together they give a sense of trends. One measure—the Standard & Poor’s (S&P)/Case-Shiller national price index for single-family homes, originally developed by financial economists Karl Case and Robert Shiller—was down by 5 percent in the third quarter of 2007 from its peak in the second quarter of 2006. (Those are the latest data available for that index.) In real terms, that amounts to an 8 percent drop over the period (see Figure 2-6). Rapid declines in home prices continued in the fourth quarter of 2007: By October, a narrower S&P/Case-Shiller index for just 20 cities (but available monthly) had fallen by 6.5 percent from its peak. Those trends are generally confirmed by a third price index, published by Radar Logic, Incorporated, a real estate and data analysis firm. (Another widely used index, the purchase-only index published by the Office of Federal Housing Enterprise Oversight, or OFHEO, did not begin to decline until the third quarter of 2007. The difference between its movement and that of the other indexes may reflect the fact that the OFHEO index does not include homes with jumbo or subprime mortgages and thus excludes parts of the market that have seen the greatest difficulties in recent months.)¹¹

Sources: Congressional Budget Office; Office of Federal Housing Enterprise Oversight; Standard & Poor’s; Fiserv; MacroMarkets, LLC; Department of Commerce, Bureau of Economic Analysis.

Notes: Both indexes have been adjusted for inflation by dividing them by the chained price index for personal consumption expenditures.

The outlook for home prices is highly uncertain, but they are likely to continue to fall during 2008. Expectations of such a decline are widespread. Futures markets, for example, anticipate large additional drops in house prices ranging from 5 percent to 10 percent for the coming year and 13 percent to 20 percent over the next three years. (Such expectations may not be a reliable guide, though, particularly for longer periods, because futures contracts of this kind do not trade frequently or in large numbers and therefore may not represent a broad consensus of investors.)

Private forecasters and investment firms also expect significant declines in nominal house prices. Macroeconomic Advisers, for its December 2007 forecast, assumed a 6.3 percent fall in prices between the middle of 2007 and the end of 2009. Goldman Sachs projects a total decline of 20 percent to 25 percent before an upturn occurs.

Such price declines will help make buying a home more affordable. According to the affordability index compiled by the National Association of Realtors, affordability increased between 2006 and 2007 but remained considerably below its recent high in 2003.¹² The declines in house prices now occurring will contribute to greater affordability, and eventually the number of house sales is likely to increase as buyers start to expect that prices will no longer fall and that their housing investment will yield a positive return in the future.

The growth of real consumer spending slowed last year, and CBO forecasts that its pace will decline further in 2008. The growth of real disposable personal income, a major determinant of consumer spending, is expected to slacken, given the less vigorous economic activity forecast for this year, and households’ net wealth, another important determinant, is likely to decline in response to the continuing fall in house prices. Stricter lending standards and terms for borrowing may also slow the growth of consumer spending overall, and the high cost of energy—particularly gasoline—could further dampen spending for nonenergy goods and services.

The Effect of Declines in Housing Wealth. Housing wealth supported consumer spending through 2006, but falling home prices are likely to undercut spending over the next few years. Between 2003 and mid-2006, the rapid growth of housing prices increased homeowners’ housing wealth, and many owners made use of that wealth by securing home-equity loans or taking cash out when refinancing their mortgages. The amount of housing equity withdrawn (net of mortgage fees, points, and taxes) totaled an estimated $663 billion in 2005 and $696 billion in 2006, down slightly from a peak of $739 billion in 2004. In 2007, lower prices for houses and stricter lending standards contributed to a slide in the amount of withdrawn equity—those withdrawals were about $550 billion (measured on an annual basis) in the first three quarters of the year. Probably only a small fraction of that amount was used for consumer spending; homeowners used the majority of it for such purposes as home improvements and debt repayment.

CBO expects that by the first quarter of 2009, house prices nationwide will have fallen by about 10 percent from their peak. The decline in housing wealth will lower the growth of real consumer spending in 2008 and 2009 by about 1 percentage point and half a percentage point, respectively.¹³

The Growth of Employment and Household Income. Employment growth declined throughout 2007, and CBO anticipates that its pace will slow further in the near future. Current data show that during 2007, the economy added 111,000 jobs per month—a rate substantially below the 189,000 jobs added monthly during 2006 and the 212,000 jobs per month that were added during 2005.¹⁴ With the slowing of employment growth, the unemployment rate has crept up from an average of 4.5 percent during the first half of 2007 to an average of 4.8 percent during the fourth quarter (with a jump from 4.7 percent to 5.0 percent in December).

Thus far, much of the decline in the growth of employment has been attributed to housing-related industries, such as residential construction and mortgage lending. Since early 2006, employment in residential construction has fallen by about 300,000 jobs (8 percent); about half of that decline occurred during the second half of 2007. However, further large job losses in that sector are quite possible because residential investment has declined much more rapidly than employment over the past two years.¹⁵

Despite the increase in unemployment, layoffs may not rise as much as they did in previous slowdowns. In the past few years, firms apparently did not hire excess workers. Much of the slowing in job growth appears to have taken place because of a drop in hiring rather than a rise in layoffs. Rates of both job creation and job destruction have been lower in the past several years than they were in the 1990s, suggesting that employers will need to shed fewer workers when demand weakens than they did during past episodes of ebbing economic activity. That factor, in turn, could prevent the economy’s initial weakening from turning into a self-reinforcing downward spiral in the growth of spending, output, and employment.

CBO expects that the rate of growth of hourly wages will decline in the near term. Wages have grown rapidly over the past few years, helping to sustain a rise in consumer spending in the face of a reduction in housing wealth. But hourly wage growth has already started to inch downward, possibly reflecting the slowdown in job creation. For its forecast, CBO assumed that the slow growth in hourly wages would continue throughout this year. Expectations are that the tepid rise in wages, when combined with a fall in the growth of the number of hours worked, will reduce the growth of household income and consumer spending in the near term.

The High Price of Energy. The price index for consumer spending on energy goods and services rose during 2007, and the increased prices that such a rise reflects are likely to curtail consumer spending on nonenergy goods and services. Consumers’ expenditures for energy were about $50 billion higher in the second half of 2007 than in the second half of 2006. Although the increase in oil prices does not seem to have affected spending for goods and services thus far, the persistently high level of energy prices is expected to weaken consumer spending this year.

Consumer Expectations. Consumers’ attitudes about their future economic circumstances have deteriorated in the past year. Two commonly used indexes of such attitudes are maintained by the University of Michigan and the Conference Board. Both show that consumer expectations are at their lowest point since the aftermath of the 2005 hurricanes, suggesting that consumer spending is likely to be weak in the near term (see Figure 2-7).

Note: Data are monthly, smoothed using a three-month moving average, and plotted through December 2007.

Slower Growth in Investment by Businesses. Stalling domestic demand and the tightening of credit conditions for businesses are likely to reduce the growth rates of firms’ spending on investment this year. However, the growth of investment, in CBO’s forecast, will improve in 2009, as consumer spending rebounds.

The patterns of growth of the two major categories of business fixed investment have diverged in recent years. The nonresidential-structure component provided solid support for the growth of GDP in 2006 and 2007, but spending for producers’ durable equipment and software has been much less robust (see Figure 2-8). The differences in the growth of the two categories can be explained by their cyclical dynamics. In response to the faster growth of demand in 2003 and 2004, businesses boosted the rate of growth of the capital stock by increasing investment. But firms can shift their investment, particularly investment in structures, only slowly because of the time it takes to make such changes and the cost of those adjustments. Investment in equipment and software did not fully catch up to the higher level of demand until early 2006, and nonresidential construction is only now catching up. Just as the growth of investment in equipment and software slowed in 2006 and 2007, the growth o