Reasons for optimism

The U.S. economy's performance has improved steadily since the end of major hostilities with Iraq. Demand and production have surged in recent months with topline year-over-year real GDP currently expanding at well over 3%.

Fueling the stronger growth are highly stimulatory monetary and fiscal policies. Lower interest rates have supported robust vehicle sales, housing activity, and extraordinarily aggressive mortgage borrowing. Automakers have been able to offer 0% financing deals only because their own borrowing costs are so low. Also, fixed mortgage rates of close to 6% have driven home sales, single-family homebuilding, and mortgage origination activity to record highs.

Massive tax cuts and accelerating federal government spending also have been key wellsprings of growth. Tax withholding schedules were reduced, and many families with children were mailed a rebate check this past summer. Government also is writing increasingly larger checks for everything from defense and homeland security to Medicare and infrastructure spending. Real federal outlays are rising at a rate only experienced during the height of the Vietnam War, Korean War, and World War II.

Working off the excesses of the late 1990s has benefited the economy as well. Rapid rates of depreciation and previously weak investment are reducing unused information technology capacity. Corporate balance sheets also have been largely repaired due to weak corporate borrowing and low interest rates. Businesses are currently financing their investment out of cash flow, with little need for external sources of funds.

Most fundamentally, the economy is being supported by extraordinarily robust productivity gains, the benefits of which are accruing to businesses largely in the form of rising profits. Corporate profits have returned to their late 1990s' record peak. Better profitability is inducing businesses to consider expanding their activities. Advertising has improved, business travel has firmed, and investment in computer hardware and software is on the rise.

Job cuts seem to be lessening, too. Lower unemployment insurance claims, increased hours worked in manufacturing, and rising temp jobs suggest that the very recent modest rise in payroll jobs will gain momentum in coming months. All the preconditions for this to occur--better profits and balance sheets and stronger demand and production--are in place.

On the other hand. A return to more substantial and consistent job growth in coming months is necessary to ensure that the recovery evolves into a sustained economic rebound. Without these jobs, the economy will fade again by this time next year. Consumers will need the jobs and resulting wages and salaries to fill the void left by waning tax cuts and less potent mortgage borrowing.

There are reasons to be concerned that businesses may fail to step up and resume hiring as anticipated. Senior managers have been put through much in the past several years, from terrorism, to wars, to corporate scandals. They may lack the confidence necessary to aggressively expand their activities. This caution is evident in the continued paring of inventories and investment outside of the replacement demand-driven increase in computer hardware and software purchases.

Also weighing on the job market is the growing prevalence of global outsourcing of U.S. production and jobs. Offshoring describes the outsourcing of previously U.S.-based production and jobs to overseas enterprises, whether affiliates of U.S.-based firms or other third-party firms. The goods and services produced overseas are then imported back to the U.S. Offshoring is not new to manufacturing, but it is new to a wide range of other information and service businesses.

Another concern is that policymakers have few response options if the economy does weaken again. The large and rapidly growing federal budget deficit, which is now expected to approach $500 billion in the coming fiscal year, as well as the very low federal funds rate target of 1%, make it difficult for policymakers to provide additional economic stimulus.

Restrained growth. Even if job growth soon resumes in earnest and a sustained rebound ensues as anticipated, growth for 2004 and 2005 will be restrained.

Unemployment will fall, but only slowly. The economy's prospects are limited by an expected measurable falloff in vehicle and housing activity. Both markets have seen substantial forward buying, the implications of which will become apparent once interest rates begin to rise. Long-term interest rates are expected to rise beginning early next year with the resumption of job growth. The Federal Reserve will be slow to resume tightening of monetary policy, waiting, perhaps, until after next November's presidential election.

The economy also will continue to contend with widening trade and current account deficits. Despite the recently weaker dollar, the U.S. economy is sure to import increasingly more than it exports as it leads the global economic rebound. The European and Latin American economies remain just barely out of recession. Besides, the U.S. dollar remains strong or is strengthening against many key currencies, including the Chinese yuan and Mexican peso. State government budget woes will remain a problem as well, as state policymakers are cutting programs and raising taxes. Thus, while the most likely near-term economic outlook is a sanguine one, the risks remain decidedly on the downside.

Implications. This economic outlook has a number of key implications for bank lenders. Most broadly, there will be a shift in lending activity away from consumer lending--particularly mortgage lending--to business lending. Mortgage origination volume, which will easily pass an astounding $3 trillion this year, will likely be more than halved next year. Refinancing activity is most vulnerable, as a third of mortgage debt outstanding can be profitably refinanced at a 6% fixed rate, while virtually nothing can be refinanced profitably at a 7% rate.

Already weakening mortgage credit quality is expected to erode further. House prices, which are currently expanding at a high single-digit pace, are expected to slow to a low single-digit pace by this time next year. In high-flying housing markets throughout California, the Northeast corridor, and Florida, pricing will be even weaker, with outright price declines in certain communities. Mortgage delinquencies and foreclosures will thus continue to move higher despite a better economy and job market.

A beneficiary of the weaker housing and mortgage markets will be credit card lenders. Credit card receivables have been barely growing, in part due to booming mortgage borrowing, as homeowners substitute cheaper mortgage debt for higher-cost credit card debt. Loan quality is expected to improve as the industry's tighter underwriting standards in recent years soon reap benefits.

Commercial and industrial lending also is expected to stabilize by year's end and move measurably higher by mid-2004. Outstanding C&I loans have been falling steadily for nearly three years. Businesses have worked hard to reduce their inventories and thus the need for the C&I loans needed to finance them. Recent improvement in corporate cash flow also has reduced the pressure for bank funding. However, businesses are ready to more aggressively expand their inventories and other operations, which will not be fully covered by their cash flow. Indeed, better C&I lending will be a strong signal that businesses are becoming more aggressive and that the current widespread optimism regarding the economy's prospects are well founded.

Mark Zandi, Ph.D., is chief economist at Economy.com in West Chester, Pennsylvania.

Mark Zandi presents a semiannual economic forecast and the impact for bankers.

Contact Zandi by e-mail: mzandi@economy.com.

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