Latest View from Moody's Chief Economist

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Monetary policy. The Federal Reserve remains aggressive in using all of its considerable resources to support the financial system and economy. The effective federal funds rate remains near zero and policymakers continue to state that it will remain there for an "extended period."

The Fed has also engaged in aggressive forms of credit easing in which it essentially prints money to buy financial securities. It has purchased commercial paper, the debt and mortgage securities guaranteed by Fannie Mae and Freddie Mac, and Treasury securities. The Fed had approximately $1 trillion of mostly Treasury securities on its balance sheet before it began its buying; now it has close to $2 trillion worth of a wide range of securities on its balance sheet. This is expected to rise further, peaking near $3 trillion by spring 2010.

The Fed's unprecedented actions have stabilized the financial system. Interbank lending has returned to normal, and the commercial paper market is functioning well. Residential mortgage rates have also fallen, and yield spreads on various asset-backed securities and corporate bonds have narrowed.

Despite these successes, the financial system remains troubled and the Fed is thus expected to maintain its zero funds rate through this time next year. Private residential and commercial mortgage-backed bond issuance is moribund, and most depository institutions are reluctant to extend credit except to their very best household and corporate borrowers. Policymakers will also be uneasy about raising interest rates as long as the unemployment rate is rising and core inflation is decelerating. Both conditions are likely to continue through at least next spring.

The Fed is expected to slowly begin normalizing interest rates by late 2010 once the financial crisis has completely subsided; the unemployment rate is headed lower, and deflation risks have dissipated. Policymakers will be fearful of keeping rates too low for too long, a mistake the central bank seemingly made coming out of the tech-stock bust. The funds rate is expected to end 2009 at effectively zero and end 2010 at closer to 75 basis points.

Fiscal policy. The federal government's fiscal problems remain enormous. The budget deficit has ballooned to near $1.6 trillion in the just ended 2009 fiscal year, up from $475 billion in fiscal 2008. Budget deficits are expected to moderate beginning this fiscal year but remain extraordinarily high, at close to $1 trillion through fiscal 2012.

This poor budget outlook reflects the expected more than $2 trillion ultimate price tag to taxpayers of the financial crisis and Great Recession, equal to 14% of GDP. For historical context, the savings and loan crisis in the early 1990s directly cost taxpayers some $350 billion in today's dollars, $275 billion in direct costs, and $75 billion due to the associated recession, equal to almost 6% of GDP at that time.

The budget outlook remains extraordinarily poor even after the costs of the financial crisis abate, as expenditures on Medicare, Medicaid and Social Security are set to balloon. President Obama's first budget proposal does not significantly address the nation's long-term fiscal problems. The Congressional Budget Office projects that the nation's federal debt-to-GDP ratio will rise to over 80% a decade from now under the president's plan; this is double the approximately 40% ratio that prevailed before the current financial crisis. Policymakers are soon expected to pass healthcare reform legislation, but this is not expected to significantly change the budget outlook. The long-term budget outlook will thus remain untenable, which will ultimately force various substantial cuts to entitlement programs and tax increases.

U.S. dollar. The U.S. dollar has sagged a bit since the beginning of the year as the flight-to-quality bid for U.S. assets has faded with improving financial conditions and the moderating global recession. Despite the recent decline, the dollar is still almost 10% stronger on a broad, trade-weighted basis compared with its low in the summer of 2009.

The dollar is expected to trend generally lower over the next several years as it is currently an estimated 10% overvalued against the British pound and a more significant 25% against the Chinese yuan. Once the financial crisis completely subsides, the Chinese are expected to resume revaluation of their currency, eventually resulting in a freely floating yuan by the middle of the next decade. Any decline will be modest on a broad trade-weighted basis, as the dollar is appropriately valued against most of the world's major currencies, including the euro at $1.40, the Canadian dollar at near $0.90, and the Japanese currency at ¥90 per dollar.

Concern that the U.S. dollar is at risk of losing its reserve currency status is overdone. The dollar accounts for nearly two-thirds of global reserves; this is unlikely to change much anytime soon since the U.S. remains far and away the global economy's largest and most stable economy and the predominant player in global trade. There are also no good alternatives: Europe's current economic problems rule out the euro, and the IMF's SDRs are nothing more than a unit of account.

Energy prices. Oil prices, as measured by a barrel of West Texas Intermediate crude, are trading near $70. Over the past year, prices have ranged from well below $50 at the start of 2009 to a record of almost $150 in summer 2008. Retail gasoline prices have risen to over $2.5 per gallon, compared with an all-time high of close to $4. Natural gas prices remain low, particularly compared with oil prices, at around $3 per million BTU.

Global economic conditions and their impact on demand are driving energy prices. The recent firming in prices reflects growing expectations that the worst of the global downturn is over as the Chinese economy reaccelerates and the U.S. recession has ended. However, until the global expansion begins in earnest, oil prices are not expected to rise much above current levels for very long. Oil prices are expected to average over $60 per barrel for all of 2009 and $75 in 2010. Early in the next decade, a barrel of West Texas intermediate is expected to range between $75 and $100, consistent with trend global demand and supply fundamentals.

Natural gas prices will have trouble keeping up with oil prices over the next several years as a very substantial glut of gas has developed. Demand has weakened sharply with the recession, and supply has increased substantially in response to the previously very high prices. Natural gas prices are expected to average less than $4 per million BTU in 2009, around $4 in 2010, and closer to $8 in the longer term.

Mark Zandi

October 2009

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