Credit Crunch: Sizing Up Potential Damage

The mortgage industry and consumption activity are among the culprits dampening the U.S. economy

by Michael Englund

The credit crunch is moving like a hurricane through the U.S. economy, and the markets will brace for the first insights on the damage to growth from the associated interest rate jolt.

For Action Economics' gross domestic product estimates, we will treat the crunch as a one-off event—similar to a storm—that will unwind as fixed-income yields drop back. Of course, if the fixed-income market correction proves late in materializing, we will push back our assumed correction and downgrade growth accordingly.

Mortgage Meltdown

The biggest impact of the seizing up of credit markets over the past two weeks should be seen in the eye of the storm, the U.S. mortgage industry itself. New home sales posted a hefty 18% pullback in 2006, and we expect a similar decline in 2007, leaving a big hit to sales in August and September as mortgage market disruptions are likely to scuttle many real estate commitments. A similar hit is expected to affect existing home sales, which fell 8% in 2006 and should post a similar 2007 drop.

We expect housing starts to receive a jolt that should take these figures to a 23% rate of decline in 2007 and a September trough that we peg for now at a 1.25 million annual rate. Note that disruptions in the jumbo mortgage market may have had a big impact on some areas, but housing starts are concentrated in the South and Midwest where jumbo loans are uncommon, and this will also prove important to some degree for the real estate sales figures.

With these real estate market assumptions, we will continue to expect a 10% to 15% rate of decline in 2007 in most residential construction indicators, such as the monthly construction spending reports and the residential construction figures in the GDP accounts.

For the quarterly residential construction figures, we will assume 16% rates of decline in both the third and fourth quarters that are similar to the 16.3% rate of decrease in the first quarter and the 14% rate of decline we expect with the next round of second-quarter GDP revisions. At this point, we expect a fairly persistent downdraft in residential construction activity through 2007, as builders continued to take down production levels to unwind their inventory of unsold homes.

Consumer Tie-In

Though the bulk of the effect of the credit market crunch on GDP should be seen via housing, we might also see a pullback in big-ticket purchases by consumers in August, and maybe September, that should hold down auto sales, retail sales, and consumption growth.

For now, we will assume a repeat in August of the weak July vehicle sales rate and restrained retail sales gains of 0.3% in both August and September. Thankfully, falling gasoline prices should still allow 2.5% real growth in consumption in the third quarter, following a likely upwardly revised 1.5% rate of growth in the second, and we would expect a bounce in fourth-quarter real (adjusted for inflation) growth to about 3.5%. Note that weekly sales data have shown little disruption thus far in August, though reports indicate that vehicle sales are proving weak on the month.

The impact of the credit crunch on business inventories should be to boost levels, as sales should be more disrupted in August and September than output. This inventory bounce should follow a hefty upward revision in the second-quarter inventory accumulation rate, which partly reverses the inventory downdraft of the 2006 fourth quarter and 2007 first quarter.

Crunching Confidence

We may also see the impact of the credit crunch on business confidence over the coming months. We note, however, that the commercial paper market for nonfinancial corporations recovered quickly last week from the early August jolt, and commercial and industrial loans from U.S. banks have accelerated sharply in August. In addition, capital spending plans in the August Empire State and Philly Fed surveys were solid, as were most of the other survey components and other factory sentiment reports for the month, suggesting little disruptions in business confidence at least thus far.

Business fixed investment should experience a small boost in the second quarter from upward commercial construction revisions, and we still expect respectable 5% to 6% growth in the third and fourth quarters. The solid durable goods report for July suggests a healthy trajectory for equipment spending and factory activity overall as we entered the third quarter.

In total, we will assume that GDP growth slows in the third and fourth quarters to around 2.8%, following the hefty upward revision we expect in second-quarter GDP growth to 4.3% from the 3.4% "advance" estimate last month.

Our downgrades to GDP growth in late 2007 reflect the modest impact we would assume if the credit crunch continues to unwind through the last week of August and first week of September. Of course, if the credit crunch changes course this week, with further deterioration rather than improvement, we will further adjust our GDP forecasts downward.

If the credit crunch unwinds as we assume, the Federal Reserve will experience notably reduced pressure for an outright easing in policy as we approach the Sept. 18 Federal Open Market Committee meeting, despite harsh market rhetoric to the contrary.

Englund is principal director and chief economist for Action Economics.